Arbitrage, gains from trade and social diversity: a uni¯ed perspective on resource allocation." Working Paper

We trade because we are different. Gains from trade and the scope for mutually advantageous reallocation depend naturally on the diversity of the traders ' preferences and endowments. The market owes its existence to the diversity of those who make up the economy. An excess of diversity could however stretch the ability of economic institutions to operate efficiently: this has recently been a concern in regions experiencing extensive and rapid migration, such as US and the ex-USSR. Are there natural limits on the degree of social diversity with which our institutions can cope? This paper will argue that there are. I shall argue that not only is a certain amount of diversity essential for the functioning of markets, but, at the other extreme, that too much diversity of a society's preferences and endowments may hinder its ability to allocate resources efficiently. This will be examined rigorously in the context of two classical forms of resource allocation: by markets, and by social choice or voting, arguably those most frequently used in modern economies. Until quite recently, diversity has been an elusive concept. However, a precis