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Wednesday, May 30, 2012

Middlemen and Markets

One of the persistent features of politics and social life is the way that many insights of economics conflict with strongly held and widespread beliefs among both the general public and the business class. This contrast between the economic way of thinking and what we may call the “gut instincts” of many people makes economics seem counterintuitive much of the time. In many cases the principles of economics also conflict with moral intuitions or commonly held sentiments, and so the analysis is felt to be not only absurd but also immoral.

One example of this phenomenon is the widespread hostility to middlemen: people who speculate in commodities by buying them at a low price in order to sell them at a higher price. The popular intuition is that such people are simply parasites. That is, they do not create wealth or value because in the final analysis they do not actually create anything real such as a physical product or a direct service. A popular example of this is the intense hostility many people feel toward “scalpers” (or “touts,” as they are called in my own country), who buy tickets for events and concerts at face value and then resell them for more. The point of course is that the people who buy tickets from scalpers do so willingly; thus by definition it must have been worth their while to do so. Yet often these very customers complain the most bitterly. Hostility to scalpers means that in many jurisdictions it is a criminal offense to buy tickets and resell them to willing purchasers.

Thinking more carefully about this, however, reveals exactly what it is that the middleman offers and also makes clearer the underlying (albeit mistaken) intuition that gives rise to the hostility. In fact the middleman does add value to both parties he transacts with, making both better off. Moreover the activity of the middleman—the connecting of willing buyers and sellers who do not know each other and would find it impossible or excessively costly to get to know each other—is essential to a functioning economy. Interfering with this by legislation or simple brute force has significant adverse effects. In cases such as tickets we may regard these as trivial, but in other ones the results can be deadly.

Work and Value

The mistaken intuition is the idea that value comes from work or effort and the act of trading something does not add or create value. This is simply wrong. Work in itself does not create value. It is perfectly possible to work all day to make something, but if nobody wants it enough to exchange something for it, it has no value. Value as a social phenomenon is created not by production but by exchange. The value of something for a person is defined by what other things he is prepared to give up in exchange for it. When a good is transferred from one person to another the receiver (like his trading partner) has more value than when he started.

What then happens with tickets to events? There is a fixed supply of a good (seats) and a potentially high demand. The difficulty is how to find out who is willing to pay most for the seats and ensure that they get them. One way would be to have an auction where people (or more likely their agents) bid for the tickets. The other way is to have middlemen—scalpers—who buy the tickets (often from the original promoters or venues) and then offer them for resale to people who are prepared to pay more for them. This benefits both sides. The ticket originators avoid the risk they would run if they set the price themselves, overestimated demand, and made a loss. They also avoid the cost of running an auction. The ultimate buyers do not have to do what they would otherwise do and spend a lot of (valuable) time either standing in line or seeking out willing sellers. Provided they are prepared and able to pay enough, they can be sure of getting the seats. In the process they evaluate just how much they are prepared to give up in other goods to get the ticket.

What middlemen do in other words is to align supply and demand by connecting suppliers and demanders. In doing this they make both parties better off and channel resources to where they are most in demand. Of course most people would rather get goods for less than the price asked, but in the real world that option is often unavailable. Either they will have to pay but in a different way (say, by standing in line for hours) or they will not get what they want.

High Stakes

In some cases this last point is trivial but in others it is vital. Take for example trade in grain carried out by speculative middlemen who buy where it is relatively cheap so as to sell where it is relatively dear. Historically people engaged in this highly speculative and risky trade attracted intense moral opprobrium. In fact, however, they were literal life savers. France is the best example. Under the ancien régime an array of legal controls was intended to stop this kind of trade between different parts of the kingdom. There were many reasons for this, but the ultimate driver was the widely held belief that it was morally wrong for people to profit from hunger and dearth. As a result, grain did not move from areas of relative abundance to areas of shortage when famine struck.

In 1774 the chief minister and early classical-liberal economist Turgot swept away the controls on the grain trade, explicitly stating the economic reasoning for the edict. The harvest of 1774–75 was marked by widespread failures. What followed in the spring of 1775 was both a triumph and disaster for Turgot. On the one hand, the economics worked: The price of bread rose but widespread famine was avoided. However, there was also an intense popular backlash against the price rise, which found expression in a wave of riots, the so-called guerre de farines. This contributed to Turgot’s fall from power in 1776, when the King failed to support him in the face of opposition from vested interests to his reform program, the Six Edicts. Later on during the Terror, the Convention imposed price controls on foodstuffs with the infamous Law of the Maximum. This was so disastrous that the policy was abandoned for good. Thereafter the French State went to a policy of increasingly free trade in grain (while still trying to manipulate the trade by “market interventions”), and by the early nineteenth century, famine and serious dearth had ceased to be problems.

The evidence of history is clear: Allowing middlemen to trade and speculate will maximize human well-being and in some cases save lives that would otherwise be lost. The job of economic educators is to show this and to undermine the persistent and misguided notion that middleman activities are exploitative and parasitic.

  • Stephen Davies is a program officer at the Institute for Humane Studies and the education director at the Institute for Economics Affairs in London.