Why Money?

Author(s): Armen A. Alchian

Source: Journal of Money, Credit and Banking, Vol. 9, No. 1, Part 2 (Feb., 1977), pp. 133-140
Published by: Ohio State University Press
Stable URL: http://www.jstor.org/stable/1992014 .
Accessed: 06/07/2014 15:11

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp

.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.

Ohio State University Press is collaborating with JSTOR to digitize, preserve and extend access to Journal of
Money, Credit and Banking.

http://www.jstor.org

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
 ARMEN A. ALCHIAN*

Why Money?
Ignoranceof availabilityof goods and of their termsof
trade aild attributeswill provokeefforts to reducethat ignorancein orderto
achieVE more trade.Severalinstitutionshaveevolvedto reducecosts of reducing
that igHorance: money;specialistmiddlemenwhoareexpertsin assessingattributes
of goods, who carry inventories,and whose reliabilityof assuranceis high;
specializedrnarketplaces; andevenunemployment. Thispaperconcentrates on the
way in whichthat ignoranceleadsto the use of moneyandhow moneyrequires
concurrentexchangewith specialist,expert,highlyreputablemiddlemen.It willbe
seen that the use of moneydoes not reston a bookkeeping,debt-recording func-
tion. The recordingfunction 0uld be done by any good without specialized
marketsif goods were perfectlyandcostlesslyidentifiablein all relevant,present
and future attributes,itibltdiflgfuture terms of trade.We mean by money a
commodityusedin all, or a dominantnumberof, exchanges.
Imaginesociety to be cdmprisedof peoplewith differentgoods but without
costlesstyperfectknowledgeof characteristics or attributesof each good. Any
exchangeproposedbetweentwo partieswith two goodswillbe hindered(be more
costly)the less fully inforied arethe two partiesaboutthe truecharacteristics of
the profferedgoods.We assuMethat interpersonal differencesexist in degreesof
knowledge about different g6;ods-eitherby fortuitous circumstanceor by

*The best way I can indicaterespect for my long associationwith KarlBrunnerand admira-
tion for his work is to report as a secretary-reporter
the gist of some ancientjoint discussions
when we were willing to admit we had a lot to learn. These notes are here rewrittenas an
article" to facilitateexposition. My hope is tiat he will find the reportfaithful,while others
may find it interestingand instructive.Brunnetcannot be absolvedfrom blame for errorsnor
credit for merit. The interestedreaderwill fifid it instructiveto read the more generallater
fotmalizationin Brunnerand Meltzer,"The Uses of Money:Money in the Theory of an Ex-
changeEconomy,"A merican Economic Review, 61 (December1971), 784-805 .

Armen A. A Ichian is professor of economics, University of California,Los

Angeles.

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
134 : MONEY,CREDIT,AND BANKING

deliberatedevelopmentof suchknowledge.Goodsdifferin the costsof determining

or conveyingto otherstheir true qualitiesand attributes.Peopledifferin their
reputabilityas sourcesof reliableinformationabout goods, and their rankingis
differentamonggoods.Peoplediffernot only in theircosts of assayinggoodsbut
in searchingout potentialprofferersof the goods. These differencesmay be
fortuitousor maybe developedin responseto economicmotives,a pointto which
we shallreturn.Withtheseconditionsit canbe shownthat
a. People will specializein certaingoods in providinginformationand avail-
abilityto searchingbuyers.
b. Specialistpurveyors(or buyers)of goods will be reputable(low variance)
sourcesof estimatesof the qualityof whatis beingpurchased fromor soldto
thatspecialist.
c. Peoplewho havedevelopedlowercosts of identifyingcharacteristics of goods
will be specialistsin selling,buying,inventorying,-and givinginformation
aboutthe good.
d. Tradebetweena specialistanda novicewill involvelowertransactions costs
thantradebetweentwo nonexperts.
e. If somegood weresufficientlyandmostcheaplyidentifiable so thateveryone
werelike an expertin it, the cost of exchanging thatgoodfor anyothergood
wouldbe less thanif a morecostly to identifygood wereoffered,andit will
becomea money.
Considera worldof four goods:diamonds,wheat,oil, andthe one calledjustC.
Not all areimmediatelyidentifiablein all theirtruecharacteristics at insignificant
costs, and somearemoreexpensiveto identifythanothers.The communitycon-
sists mostly of novices,or nonspecialists,in thesegoods.Imagine(andthis begsa
questioninitially)thatfourpeopleareexperts,one in eachof the fourgoods.
Beforetwo novicescompletean exchangeof diamondsfor oil, eachwill incur
costs of identifyingthe other'sproductattributes,includinglegal entitlements,
quantity,and all aspectsdefiningthe rightsand the qualityandquantityof the
goodbeingtransferred. Thenet valuetransferaftersubtracting those costs willbe
lessthanif theylearnthe truecharacteristics of thesegoodsat zerocost.
Table 1 shows the proportionsof value remaining after "transactions" costs
betweenall pairsof traderswith variousgoods.For example,if a diamondnovice
were to trade some of his diamonds(no matter why!) for anothernovice's
diamonds,only 4 percentof the (perfectknowledge)valuewouldbe remaining, as
statedin row one. Why?Eachpartyknowsthe qualityonly of his owndiamonds.
Eachwould assessthe qualityof the other'sdiamonds.Assumethe costs of the
assayamountto 80 percentof the diamondstested-a sort of destructivetest in
whichfour out of five good diamondsweredestroyedfor eachone determined to
be good. Insteadof a destructive test, one canthinkof the costsof determining the
qualityas beingequalto 80 percentof the valueof the diamond.If offeredone
hundreddiamondson a one-for-onebasis (priorto tested quality)then net of
examinationcosts he is receivingtwenty provendiamondsfor his hundred.The

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
 ARMEN A. ALCHIAN : 135

TABLE 1
Net Value After Exchanges
Single Party Novices Experts
after
Inspection D O W C D O W C
Value 0.20 0.40 0.60 0.95 0.85 0.90 0.95 0.99
Novices
D 0.20 0.04 0.08 0.12 0.19 0.85 0.18 0.19 0.20
O 0.40 0.08 0.16 0.24 0.38 0.34 0.90 0.38 0.40
W 0.60 0.12 0.24 0.36 0.57 0.51 0.54 0.95 0.59
C 0.95 0.19 0.38 0.57 0.90 0.81 0.86 0.90 0.99
Experts
D 0.85 0.85 0.34 0.51 0.81 1.00 1.00 1.00 1.00
O 0.90 0.18 0.90 0.54 0.86 1.00 1.00 1.00 1.00
W 0.95 0.19 0.38 0.95 0.90 1.00 1.00 1.00 1.00
C 0.99 0.20 0.40 0.59 0.99 1.00 1.00 1.00 1.00

secondparty,also a novice,will incurthe samecostsin examiningthe firstparty's

stones.He will net only twenty of the hundreddiamondshe wouldreceive.So,
knowinghis own proffereddiamondsaregood,the firstpartywouldbe willingto
offer only twenty of his diamondsfor the hundreduntestedones of the other
party.The second,who would receivetwenty untesteddiamonds,wouldend up
with four tested, provendiamondsafterhe incurshis tests. So the secondparty
wouldhavegivenone hundredof his diamondsto getbackfourtestedones-a loss
fromexchangeof 96 percentof the valueof whathe gaveup. An exchangeis not
likely.
If a pairof noviceswereto makean agreeableexchangeof a diamondfor some
oil, their costs of ascertainingthe qualitiesof the two productsto be purchased
would,accordingto Table1, amountto 92 percentof the valueof the goods.Only
eightcentson the dollarwouldbe remaining. Unlessat leastone of the partieshad
a veryhighmarginal personalvaluefor one of thosegoods,no tradewouldoccur.A
verylargepart of that net potentialgainwouldbe dissipatedin the transactions
costs.
If a diamondnovicewereto tradehis diamondfor wheatfroma wheatnovice,
12 percentof the valueof the two goodswouldremain.
By definitionof C, a novicetradingdiamondswith a novicein C wouldloseless
thanhe wouldby tradingdiamondsfor any othergood, as can be seen fromthe
firstrow,left side. The firstrowis pertinentto a novicein diamondswhoproposes
to sell a diamond.The righthalf of the row is the resultof tradesmadeby our
diamondnovicewith expertsin diamonds,oil, wheat,or C. Anexpertis definedas
one who has a lower cost functionfor identifyingattributesof a good. (We
temporarily begthe questionof whysomearemoreexpertthanothers.)
It willcost a novicelessto tradewithan expertthanto tradewithanothernovice,
if the novicewho buys the productfromthe expertwillrelyon the expert'sword.
The expert'sword will have value if he developsa reputationfor honestyand
reliabilityin his assessment.Theexpertwillthensellhis knowledgeat a pricelower

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
136 : MONEY, CREDIT, AND BANKING

thanthe cost for a buyerto get suchinformation in otherways.It is not necessary

that the expertbe the sellerof the good in whichhe hasexpertise.He couldbe an
independentassayer,but fortreasonsto be discussedlater,expertswfli-ll tend to be
dealersin the commodityin which they are experts-anddealerswill tend to be
expertsin the goodsin whichthey deal.
The right-handhalf of row one indicatesthat a diamondnovice tradinghis
diamondfor somefroma jeweler(diamondexpertspecialist)-nomatterwhy such
a tradewouldbe made-will experiencea lowerloss of valuethanif he sold the
diamondto anexpertin anyothergood.Tradeof a diamondfor a diamondwill get
bettertermsbecausethe ex?ertis anexpertin bothwhathe is gettingandwhathe
is giving(herejust one kindof good),whereasa diamondnovicebutyingoil from
an oil expertwillsaveon oil identificationcosts,butnot on diamondidentification.
Hence the costs of transactionsbetweena novice and an expert in the same
commodityarelessthanthosebetweena noviceandanexpertin a dif@rentgood.
The matrixis completed,with someredundancy, by fillingin the rowa
cel},sin the
bottomhalf, representing salesby expertsin diamonds,wheat,oil, anciC to;novices
(in the left-handhalf of those rows).Exchangesbetweenpairsof eX?¢rts,one in
each commodity,arerepresented in the lowerright-hand half. Weassumeexperts
are perfectlyknowledgeable in the commoditiesin whichthey specializeandare
100 percenthonest.Thisassumption maybe too strong,but we makeit.
Lessloss occurswith tradebetweentwo noviceswhenone exchangesdiamonds
for C thanwhenhe tradesdiamondsfor wheat.It maybe tempting,but erroneous,
to concludethat tradesshouldoccurof diamondsfor C andthen of C florwheat.
Thatis not correct.
To test that, try to find how a novice in one good couldtradefor anothergood
with a noviceandgainby goingthroughan intermediary good. It cannotbe done
in the upperleft-handportionof the table becausethe costs of reco,^izingthe
intermediate good arean addedcost,whilethe costsof identifyingthe two "basic"
goodsarenot reduced.
Usingthe specialistexpertinvolvesan extraexchange,a cost of identficationof
anothergood-the one offeredto him,in whichhe is not anexpert.An expertis an
expertin one good only, not in allpairs of goods.Hencethe problemof zdentifica-
tion costs persists.Now,if thereis somegoodin whichidentificationcost! areboth
(a) low and (b) low for everyone, that will permitpurchaseof prdducliVeptifica-
tion informationcheaplyfromthe specializedintermediary expert.If hjs CQstS of
identifyingthat offered(money)goodarelessthanthe reductionsin costsby using
the specialistforinformationaboutthe basicgoods,the totalcostsof identification
canbe reduced.
The cost of identifyingthat intermediary good is less thanthe reducedcostsby
use of a specialistwho providesinformationabout the basicgood at a low cost.
Thatdoubleevent,(1) a low identification cost to everyoneaboutthe intermediate
commodityand (2) specialist-experts who providequalityassuranceandinforma-
tion more cheaplythan novicescan providefor themselves,explainsthe use of a
low identificationcost commodity-m,oin,ey-as a generalintermediary mediumof

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
 4.
2.
3.
1. Diamond
Diamonds
novice
to
to C
wheat,
oil(cash)
to to
wheat
novice
wheat,
towith
wheat,
to
all
wheat
novice
through(Dn
all expert (Dn
Wn).
through We).
A(Dn
novices
novices (Dn
°nnet
tWn)
diamond
The Cn Wn).
novice
result
yields
ex-
The
is

ARMEN A. ALCHIAN : 137

exchange.It permitspurchaseof informationfromlowercost sources,a cost reduc-

tion that exceedsthe addedcost of usingan intermediary good for indirectex-
change.Indeed,it is a generalprevalenceof doublecoincidenceof information
ratherthanwantsby bothpartiesthatwouldavoidthe useof money.
Thematrixillustratesthe abovepropositions.
Forexample,considersomealterna-
tiveroutesof exchangefor a novicewithdiamondswhowantssomewheat.

changesdiamondsfor wheatwith a wheatnovice.The net valueobtainedby the

diamondnovice,accordingto the matrixof information-transaction
costs,is 0.12.

0.0196 (=1 X 0.08 X 0.24). This is less than 0.12 becauseof an extra pair of
identification
costsof oil.

resultis a net valueof 0.108 (=1 X 0.19 X 0.57). Identificationcosts for cashare
less thanfor oil. Thoughbetterthanthroughany othermediaryit is not as cheap
aseitherdirector indirectbarter(routes1 and2).

0.19. Contrasting this with the priorroute showsthe gainfromusingthe wheat

expert.The differenceis the savingto the diamondnovicein identifyingthe wheat,
becausethe wheatexpertoffershim "wheatassurance" at a lowercost. Andthe
wheatexpert'sword,his reputablereliability,is a sourceof income.A dishonest
expertwouldlose a sourceof incomeif he destroyedhis credibility.So an estab-
lished wheat merchant,or specialist,will be an expertin wheat and has more
incentiveto makehonest statementsabout the qualityof his wheatthandoes a
transientnovice.
5. Interposingthe intermediarygood C into route4 willworsenmattersbecause
the costs of identifyingan intermediarygood areaddedto the process,withno re-
ductionsin any othercosts. For example,goingfroma diamondnovicethrougha
C novice-or even a C expert-ratherthan througha diamondexpertfirstwon't
help. Somebuyerof the novice'sdiamondsstill has to valuethem.Evaluationby
anyoneotherthana diamondexpert(who becomesa specialistmiddleman) won't
reducecosts. An introductionof C as anothergood only addsanotheridentifica-
tion cost.Thenet valueof a routefromdiamondnovicethroughC througha wheat
expertis 0.1715, comparedto 0.19 for a directbartervia route4 withoutinter-
mediategoods.
6. A gain would ariseif the lower cost servicesof a diamondexpertcouldbe
usedin the exchangeprocess.Whatdoes permitfurtherloweringof costs through
an intermediary good is the use of two experts-in wheatandin diamonds.The
diamondnovicesellsto a diamondexpert(whoassessesqualitiesmorecheaplythan
any otherbuyercould),andthenournovicetakesthe proceedsof C andpurchases
wheatfroma wheatexpert,relyingon theexperts'reputations andknowledgeas a
cheapersubstitutefor the diamondand wheatassessmentcosts by novices.The
extracostsof usingC areoffsetby the expert'slowerdiamond-assessment costs.
In our matrixwe can computethe net value(0.767) of the intermediate-good,

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
138 : MONEY,CREDIT, AND BANKING

two-middleman route whereina diamondnovicegoes to a diamondspecialistand

then to a wheatspecialistusingthe goodC as the mediumbetweenspecialists.The
valueis 0.767, as the productof 0.85 X 0.9025, the valuesrespectivelyof (a) the
diamondspecialistwho paysC and(b) the entryin the cell for the C novice(the
formerdiamondnovicewho now offersC to the wheatspecialist)sellingC to the
wheat specialist.lThis increasein valueto 0.767 is the resultof abilityto get
qualityassuranceat a lowercost fromthe diamondandwheatexpertswithoutim-
posingon themthe highercosts of identifyinggoodsotherthanC, in whichmost
peoplearenearlyexperts.
The featureemphasized here(withoutexcludingothers)is the use of the pairof
expertsin diamondsandwheatto reduceinformation costs.Withonly one expert,
no intermediary good helped(see routes2-5). The intermediary good C wouldbe
of no use in this context if two (or more)expertswerenot usedas economical
sourcesof qualityassurance.It is both (1) the presenceof more thanone expert
and(2) the generallylow identification-costgood,C, thatenablesindirectexchange
to reducecost of ascertaining goodwiththe
quality.By usingC as the intermediary
lowestgeneral identificationcosts,the novicecanobtaininformation morecheaply
fromseveralexperts.
Whatpropertiesof the matrixof informationcosts are critical?First,experts
permitlower costs, as indicatedby the largernumbersin the cells in the upper
right-handor lowerleft-handquadrants.Secondly,the row andcolumnof C for
novicesis largeruniformlythanany otherrow or column,andthe corresponding
rowsandcolumnsfor expertsarealso dominant.It is the dominanceof therow of
C both for the noviceandfor the expertsin othergoodsthatseemscritical.Since
everyonecan assessthe qualitiesof C, it can be used as a low-costmeansof
purchasing information aboutothergoodsfromexpertswithoutimposingoffsetting
highcostson the expertsto identifythe goodC.
An alternative viewof the reasonfor useof a commonmediumof exchangeis in
its presumedrole of avoidingthe necessityof a doublecoincidenceof wants.But
any commodityused as an intermediary would do that. If goodswereperfectly
identifiableat zero costs,rightsto goodscouldbe transferred andanycommodity
wouldserveas measureof debt.Thiswouldthen leavesomegoodsas presumably
less volatilein valueso that the exchangevalueof unitsof those goodswouldbe
preferred.But this confusesthe storeof valuewith the mediumof exchange.The
two neednot be the samegood.
Anotherpresumedrationaleis the cost of searchoverthe populationfor potential
demandersof a good. If everyoneusesa good,it is morelikelythat it couldbe a
mediumof exchange.But againeveryoneuses breador milk.Universality of use
aids but is neithera sufficientnor a necessaryprecondition.Generality is a
here

lWhere does the diamond specialist get C to pay the diamond novice who offers diamonds?
From a C specialist. The diamond specialist will have an inventory of C on hand because that
will economize on information costs when the novice purchases wheat from the wheat
specialist. Of all the intermediary goods tobe used by a novice between successive specialists
the best is C, a generally easily recognizable good. Try interposing others and the poorer results
will be demonstrated with the data of the matrix.

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
 ARMEN A. ALCHIAN : 139

result of people using a good as a mediumof exchange,not a cause of its

becominga medium.For example,chocolatecandyand nylonsbecamea near
moneyduringpricecontrolsin post-warGermanyin the absenceof other"money."
Theitemswerecheaplyidentifiableby manypeople-notnecessarily consumedby
everybody.
Costsof identifyingqualitiesof a good arewhatcount.If costs for somegood
are low and generallylow acrossmembersof society, the good will becomea
mediumthroughwhich informationcosts can be reducedand exchangemade
moreeconomical.But it will riseonly with the riseof chainsof expertsin various
goods and commodities,who know the goods cheaply,whose reputationfor
reliableevaluationis high,andwho,becauseof thatknowledgeandthe low cost of
assuringbuyers, become specialistmiddlemenin the good both as inventory
carriersand buyingand sellingagents.Otherexplanationsof the occurrenceand
use of money are silent or vacuouson the existenceof specialistsand their
reliabilityandactivities.
This analysisexplainsthe use of money,whichgoodbecomesmoney,why it is
not necessarilyalso the storeof value,the existenceof two or moreexpertsin the
sequenceof exchangeswith money,the reputabilityof expertsas an integralpart
of theircapitalvalues,andthe reasonexpertsarealsodealers.
Thismodelis also consistentwith the explanationof unemployment as a search
and selectionprocessfor best work opportunitiesduringdemandshifts among
potentiallyperformedactivities.Commodities or servicesthataremoredifficultto
assessin qualitieswill experiencegreaterlossesor changesin valuesconsequentto
demandshifts.Thathighercost tendsto act like specificityof a goodto particular
tasks.Thehighercosts of assessingtheirattributesis like a tax on transfer.Hence
the largergains(or avoidanceof loss) frommoreexpensivesearchin the eventof a
demandshift (with a largechangeor high varianceof next best knownoppor-
tunities)inducesgreateror longersearch.It is not simplya taskof searchingout
best opportunities,but also a searchfor potentialdemanders to assessproductive
qualities.Thosecosts of becominginformedaboutwhata goodor serviceor rented
goodwill do raisetransfercostsandalsorewardlongeror greatersearching activity
by potentialbuyersor employers.Commodities or serviceswithqualitiesthathave
high costs for otherpeopleto ascertainwill tend to be held longerin inventories
awaitingsaleandwill suffergreatercosts of exchange-asevidencedby largerbid-
ask spreads,wholesale-retail spreads,or "unemployment"lengths. Since the
commodityusedas moneywillhavelow costin theserespects,we concludemoney
willhavethe lowest"unemployment" rate.
It is not the absenceof a doublecoincidenceof wants,norof the costsof search-
ing out the marketof potentialbuyersandsellersof variousgoods,nor of record
keeping,but the costlinessof informationaboutthe attributesof goodsavailable
for exchangethatinducesthe useof moneyin anexchangeeconomy-ifsomegood
haslow recognitioncostsfor a largesegmentof the population,whileothergoods
do not. A resultis the use not only of moneybut of knowledgeable experts,with
highreputability, who dealin the goodsin whichthey arespecialists.

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions
140 : MONEY,CREDIT, AND BANKING

Becausemost of the formaleconomicmodelsof competition,exchange,and

equilibriumhaveignoredignoranceand lack of costlessfull andperfectinforma-
tion, manyinstitutionsof our economicsystem,institutionsthatareproductive in
creatingknowledgemorecheaplythanotherwise,havebeenerroneously treatedas
parasiticappendages.The explanationof the use of money,expertisewithdealing
in a goodas a middleman specialistwitha trademarkor brandname,reputabilityor
goodwill,alongwith advertisingof one'swares(andevenunemployment) is often
misunderstood. All these can be derivedfrom the sameinformation-cost factors
thatgiveriseto useof anintermediary mediumof exchange.

This content downloaded from 82.2.64.135 on Sun, 6 Jul 2014 15:11:41 PM

All use subject to JSTOR Terms and Conditions