Econ Puzzle Redux

Earlier today, we posted the following econ puzzle (which was found at Cafe Hayek):

An American tourist goes to a remote island for a vacation. The natives live by a barter system-they have no money.  When the tourist tries to pay for his lodging with a check, the owner laughs at first, but then decides that the design on the check is quite attractive and agrees to accept the check in return for lodging. This happens again when the tourist pays for food and some native artwork. The checks are never cashed. They begin to circulate on the island as money, replacing the barter system that had existed before.

If the checks are never cashed, who pays for the vacation of the tourist? Or is it free?

If you want some more time to think about it take it now.  Here's our thoughts on the subject, though not quite willing to offer a definitive answer.  The first thought is that the tourist pays for the vacation.  After all, having to distribute the checks, no matter how cheap to him, does entail some cost.  Still, this answer seems a bit unsatisfying.  We know he basically got a free vacation no matter how you slice it.

But assuming that he pays for all goods and services each with a single check something else is happening.  He's paying the same amount to the hotelier (which would probably be a major cost) as he is to the coconut juice salesman, which should cost very little.  Yet if he leaves, and each check is worth the same amount (because the value is in the paper itself, not in whatever price was denominated) the coconut juice salesman has seen a major boost to his fortunes -- at least compared to the hotelier.  While one offered a service significantly more valuable than the other, they both end up with the same wealth.  So my hunch is that it's the high value vendors (hoteliers, fancy restaurants, transportation vendors) who pay for the man's vacation by helping to transfer so much wealth to the low value vendors. 

Does this make sense; is this clear?  What do you think.

Comments

[dfxoreilly]

How does the tourist know that the checks will never be cashed? Unless he wants to run the risk of being overdrawn at some point, the money is technically spent.

[krammer]

That was a dumb comment written above. The money is not techically spent, it is theoretically spent. The man paid for his vacation because he gave something of value for the service of the hotel. The value of something is beheld by a perception. Nothing has value if it is not perceived as having value. Gold, Money, Google stock...All based on faith.

[brazos]

many things have value,
food has a value outside of perception.

[Fred]

Isn't it still barter? If they value the checks as art then they are art. The value of that art has been added to the economy.

He should of course put a stop payment order on the checks with his bank just in case the art falls into the wrong hands.

Years ago I got a TV repaired for the equivalent of about eighteen cents. I had been to Mexico on business and returned with some left over Peso coins. They were left sitting on top of the TV. The TV repairman wanted them for his kids and I gave them all to him. He generously responded by not charging for the repair work. I think both of us found value in that exchange beyond the face value of the coins.

[The Stalwart]

The checks aren't barter because they're a universal medium of exchange, not a consumable item produced by someone with the skills to produce it.

And I agree. First thing upon getting back to civilization: a stop order. At least if he started operating under the assumption that the checks wouldn't be cashed.

[Patrick]

The tourist paid, and he paid by discovering a resource not previously known to be of value.

If he had found a gold nugget on the beach, and used that to pay for his trip, you wouldn't say he had a "free" vacation, he paid using his newly discovered wealth.

[lisa]

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[Shamil]

The tourist is creating inflation for his "cheque-currency" - the more he distributes them, the lesser their value. In the long term, if he continues on the island, the currency will loose sufficient value for him to find some other good. If he does not, and goes home and tells friends about his experience, and those friends start coming to the island for a 'free' vacation, the currency becomes further undervalued resulting ultimately in loss of value. Thus, in the long term, there is no such thing as a free lunch/vacation

[Shamil]

The tourist is creating inflation for his "cheque-currency" - the more he distributes them, the lesser their value. In the long term, if he continues on the island, the currency will loose sufficient value for him to find some other good. If he does not, and goes home and tells friends about his experience, and those friends start coming to the island for a 'free' vacation, the currency becomes further undervalued resulting ultimately in loss of value. Thus, in the long term, there is no such thing as a free lunch/vacation

[Shamil]

The tourist is creating inflation for his "cheque-currency" - the more he distributes them, the lesser their value. In the long term, if he continues on the island, the currency will loose sufficient value for him to find some other good. If he does not, and goes home and tells friends about his experience, and those friends start coming to the island for a 'free' vacation, the currency becomes further undervalued resulting ultimately in loss of value. Thus, in the long term, there is no such thing as a free lunch/vacation

[karun]

You made an assumption that the checks are treated as equal value. This is unlikely, because on hearing that one check was paid for lodging and another for coconut juice, the natives would start discerning the difference in the number (or at least its pattern) on the check and modify their behavior to value the checks more accurately.

Assuming the tourist intended to honor all checks, he has essentially borrowed money from each vendor with a promise to pay it back when they present the check to his bank (they could always just transfer it to anyone else for trade). Since he has now got into the business of issuing debt (promissory notes), he is now effectively a bank.

If the tourist prudently puts aside the total amount he issued checks for on the trip and never uses it, he would be indulging in 100% reserve banking, a particularly useless form of banking. However, he is free to use fractional reserve banking and maintain only a portion of the total debt issuance as liquid cash. He will however have to compete with ther such banks that issue their own currencies, providing the incentive for him not to get too lax on reserves.

How's that for a Hayekian analysis...?

Cheers.

[will]

The tourist is borrowing for free from the islanders. He has a nominal liability outstanding, and if it is never cashed then that liability effectively costs zero (NPV of any nominal quantity at time infinity is zero now).

As for who pays: if the islanders begin using the checks as currency then it is added to the money supply, and should create some inflation.

[butters]

I think this is one of those bizarre contrived puzzles that's not good for anything. These are two disassociated universes, for all purposes. The guy brings colored paper from one to another and trades it for services. Who pays? - the guy, of course. What does it cost to him - the cost is check printing fee. Don't make it harder than it really is: how often does it happen that something of no or little value to you is valuable to someone else? - watch antique roadshow, for god's sake.

[donny]

The tourist paid for the vacation with the service he provided of bringing the cheques to the island. It doesn't matter that this took little effort on his part; what matters is what effort it might have taken an islander to obtain the cheques by any other means. The cheques are not fiat currency; the tourist may have tried to declare a value, but this was not accepted by the islanders, who put their own value on the cheques.

[Stockblogs Editor]

What's interesting to me is how the checks will be valued after the vacationer leaves - in other words, will the juice vendor be able to trade his one check for a night at the hotel he couldn't otherwise afford, thus making him much more wealthy than before?

Over time, it can be assumed, the number of checks will diminish (being thin, easily destroyed paper), thus increasing their value by scarcity. But that's Econ 101, as is the fact that the marginal value of the checks to the tourist is very low (he has thousands), while the marginal value of the checks to the islanders is very high (assuming a closed system where there are no other sources of checks). But that's also the nature of free trade.

Look at the colonial fur trade in North America. Native peoples traded furs (which were worth a FORTUNE in Europe) for glass beads (which were hugely valued by native peoples).

Or, for a more interesting discussion of strange island trade, look at the history of the rai stone currency of Yap

[paul]

a related post;
It all depends on who you’re!
http://truckandbarter.com/mt/archives/2006/07/it_all_depends.html

[alex]

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[Reinhard]

I agree that the islanders pay initially and the hoteliers disproportionally so, and the vacationer got a free vacation. I also agree with the guy stating that the new-found currency is somewhat akin to finding gold. Since it serves as an efficient medium of exchange, much future time will be saved versus barter. So the overall economy of the island becomes more efficient and can even make up for the initial loss. The islanders who either didn't provide any initial service or those who bartered the most (merchants) gain now disproportionally. Evidently, the free market moved them to this optimum, provided that they stay honest, keep using the checks, not make excessive amounts of new ones, etc. It is kind of like digging for gold, the work of digging was a small price to pay for an efficient exchange system. Fiat currencies evolved since you don't need to waste time in digging. Unfortunately, history has shown that fiat currencies end up being misused by their creators, harming the economy. So the "wasted" work of digging seems again to be the smaller evil.

[jackdawson]

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