Introduction: Visualizing Exchange
Popular discussions in economics contrast mutually beneficial exchange
to zero-sum games. In mutually beneficial exchange we both win. The traditional
example involves a farmer and a tool maker. The tool maker gets food from
the farmer. The farmer gets tools from the tool maker. Both are better
off. In zero-sum exchange one person's gain comes as a result of another
person's loss. The standard example is gambling. In gambling no wealth
is created; wealth is merely transferred from one person to another.
Now, if we create a graph to show how exchange impacts me and impacts
them it quickly becomes visually obvious that perfect mutually beneficial
exchange or pure zero-sum exchange is highly unlikely. An entire plane
of partially equitable and partially inequitable exchange is possible.
Estimating the Mutually Beneficial Exchange and Zero-sum components
||Let's review the graph. The black diagonal in the first
quadrant represents perfect mutually beneficial exchange. The line
represents both parties gaining equally. The purple in the second
quadrant represents zero-sum exchange where I lose and others gain.
The green line in the fourth quadrant represents zero-sum exchange
where I gain and others lose. The red line in the third quadrant represents
negative sum exchange where both parties lose. We should also note
that the x-axis represents gain or loss for me that has no impact
on others and the y-axis represents gain or loss for others that has
no impact on me.
I can sell you a used car. We agree to a price
of $1000. But I know and don't tell you that the transmission is
bad and it's about to seize. Thus the car is only worth about $400.
The positive sum part of our exchange is $400, the real value of
the car. The remaining $600 is the zero-sum part of our exchange,
where my gain comes totally from your loss.
I have a yard sale. I offer an old relic I had in the attic for
$20. You recognize that the relic has collectors value, so you buy
it for $20 then immediately resell it to a collector for $300. Your
knowledge was of value to me, but your failure to share your knowledge
allowed you to make a zero-sum gain. (You added no value to the
item being resold.) The mutually beneficial part of this exchange
was $20. But most of the $300 was zero-sum gain for you, where you
profited from withholding information from me, just as the seller
of the junk car profited by withholding information about the car
from the buyer.
We should quickly recognize that there is no reason to expect the
actual measure of exchange to be limited to any of the diagonals
or the axes. Intuitively, we know this already. We know that sometimes
we get paid less than we should for the work we did or risks we
took. We all have stories or know stories where others have profited
more from our work than they contributed or supported. We know that
when we get a bargain we paid the seller less than he could have
received for his goods. If we could measure the gain or loss that
each party got in these exchanges we know that we would not have
perfect mutually beneficial exchange - the point would not be on
the perfect exchange diagonal.
We should note that deviations from perfect exchange usually result
from imperfect information or coercion. Somebody involved in the
transaction doesn't know what the real cost or value of his actions
are. Many economic theories are based on the assumption that people
make well informed decisions where perfect information can or does
exist. The theories assume either sufficient laws or sufficient
ethics to prevent coercion in the transactions.
No real human exchange is purely mutually beneficial exchange nor pure
zero-sum game. Thus, we can evaluate all exchange as being composed of
both a mutually beneficial part and a zero-sum part. We can break the
value of each exchange into its parts; we can estimate what portion of
the exchange is mutually beneficial and what portion is zero-sum. The
zero-sum gain part of any transaction will be the difference between the
gains of the two parties. The mutually beneficial part is the twice the
lesser gain. In a perfect free market with perfect information and no
coercion both parties would receive a profit equal to the average of the
Parts to this discussion
- Introduction: visualizing exchange
- Evaluating the components of exchange
- Recognizing Externalities
- Estimating the Ponzi portion of profits
- Implications and conclusions
Related pages at this site
Externalities: Unintended Consequences to Third Parties
We must remember that our choices affect others. Our actions and exchanges
will affect people who were not privy to our agreement. In economics the
impact on uninvolved third parties is termed externalities. To develop
an analytical means to review how profits are made from impacts on third
parties we need to work with three dimensions - two parties involved in
the exchange, plus the uninvolved third parties who are affected.
We can borrow the three dimensional graphing system used for soil
science to guide us visually here. We will first plot what percent
of the costs each party contributed to the exchange. We then plot
the profit that each party made from the exchange. The zero-sum
part of the exchange is the vector from the cost point to the profit
point. The direction the vector points shows who received the profit
and who suffered the loss of the zero-sum part of the exchange.
For our example, we represent a mining company. The owners &
executives provide 5% of the total cost of running the mine through
buying the equipment, mineral rights, and managing the operation.
The workers contribute 75% percent of the operating costs through
their labor and personal risks. The community absorbs 20% of the
operational costs by accepting the cost of the impact on their water
supply, breathing the particulates, and dealing with subsidence
and other property damages. The workers receive 70% of the revenues
and the owners and managers receive 30% of the revenues. We see
this on our graph with the red dot C representing the distribution
of costs, and the blue dot P representing the distribution of revenues
or profits. The green vector shows that one group, the executives,
took a larger share of the profits than they contributed in costs
Here again, we diagram an imperfect market where part of the profit
is derived from mutually beneficial exchange and part from zero-sum
Estimating Ponzi Element of the exchange
Two essential features make up a Ponzi Scheme. 1. A zero-sum exchange
occurs. 2. The number of people paying in is larger than the number of
people taking out. There are many ways to decorate these features to make
the scheme appear different and exciting, but these two elements together
make a Ponzi scheme regardless of the decorations. As we have reviewed
above, all real human exchanges have a zero-sum portion. All that is needed
to complete a Ponzi scheme is a means of having a large number pay while
a small number profit.
We can informally evaluate where Ponzi schemes occur by comparing who
pays in, and how many pay in, to who profits, how many profit, and how
much they profit. Formally, analytically, we can use the vector in the
three dimensional graph. If the vector points from a large number paying
in to a small number profiting, we have a Ponzi scheme embedded within
a beneficial exchange. Formally, we could estimate the size of Ponzi portion
of the exchange by comparing the size of the group paying in to the size
of the group benefiting and measuring the portion of the profit that is
derived through zero-sum gains (green vector in our graph.)
Environmental Ponzi Scheme: A gas company gets
permission to "frack" an area to extract the gas. After ten
years have passed five company executives have each pocketed over $2
million. But the fracking has contaminated the ground water. 1000 local
residents have to buy and maintain water filters at a cost of about
$100 per year for the next 30 years. Five people at the top of this
scheme have taken a total of $10 million but only by making 1000 people
pay in a total of $3 million. In short, at least 30% of their profit
was the result of an environmental Ponzi scheme.
Transfer of Risk Ponzi Scheme: Executives at an investment firm
create a plan to sell debt to high risk borrowers. The ten executives
each pocket $5 million derived from interest and fees charged to 500,000
borrowers. When the economy weakens 100,000 borrowers lose their investments
to foreclosures and a government bailout rescues the bank by giving
the bank $10 billion derived from 300 million taxpayers. In this example,
all of the profit made by the bankers was derived transferring the risk
of the decisions to borrowers and taxpayers.
Leveraged Position Ponzi Scheme: Executives at one company believe
that a smaller company is undervalued. They buy controlling shares of
that company, merge the smaller company, eliminate a product line, close
a facility, and lay off workers. A few months later stock values decline.
The executives each take a $1 million bonus for their actions. In this
example, the executives added no value to the smaller company. Their
profit was totally derived from losses suffered by the former company's
workers and investors, as well as their customers. Nothing mutually
beneficial occurred during this exchange.
Each of our examples is derived from well documented scenarios that have
been in the news over the last 30 years.
Implications & Conclusions
Imperfect information within an economic system combined with coercion
(leveraging) can and will lead to zero-sum gains being part of nearly
all human transactions. Mutually beneficial exchange is a free market
ideal that, like democracy, is never perfectly realized.
It is important to remember how the uncompensated costs of externalities
contribute to the profits of large organizations. In large organizational
transactions the zero-sum gains can develop a Ponzi scheme characteristic.
The Ponzi nature of situations becomes so evident with these graphing
tools one is led to suspect that a formal analysis will show that large
corporate profits and executive salaries are frequently derived through
the Ponzi nature of externalities and leveraging.
This has implications for tax fairness. It is justified to tax unearned
income at a higher rate than earned income. Portions of incomes, particularly
incomes that are significantly larger than the other involved parties
(e.g.: executive salaries) are effectively unearned as they are derived
from zero-sum gains.