2
What Lecture are markets?
Markets are economic coordinating mechanisms in which
1. Consumers express preferences through buying
2. Buying gives consumers exclusive control of the good exclusion
principle
3. If supply differs from demand, its rational for producers to adjust to
the point that supply and demand of any given good converge at a
given pricelaw of supply and demand (if firms fail to respond to
consumers, they will eventually fail. This competition among firms
generates accountability. It also spurs technical change and other
improvements in productivity, which increases social wealth)
4. At equilibrium, after all trades are made, the result isgiven natural
scarcity, current levels of technology, and a given distribution of income
a perfect match between consumer preferences and production
possibilitiesPareto optimality
Adam Smith on invisible hand and human nature
Markets have the effect of making an individual who intends only his own gain to
be led by an invisible hand to promote an end which was no part of his intention.
Nor is it always the worse for the society that it was no part of it. By pursuing his
own interest he frequently promotes that of the society more effectively than
when he really intends to promote it.
Classical Liberalism
A popular belief system favoring
1. Universal civil rights and civil liberties
2. Limited government (government which governs least is the best)
3. Self-regulating markets
4. Natural (not just positive) right to private property and its
accumulation
On the classical liberal view, there are certain
Things the state should do
Provide law and order (security, enforcement, of contracts)
Provide basic public goods (sanitation, transportation, and other physical
infrastructure, general education)
Ensure competition and limit negative externalities or neighborhood
effects
And things it should not
Create anti-poverty programs or social insurances schemes
Subsidize higher education or training for workers
Set limits to the terms of contracts between employers and workers
Regulate markets to prevent their negative social effects
Free market ideal is one in which
1. All participants have perfect information (about their wants,
capacities, chatter of goodsit helps if also about the future, each
other all possibilities, and contingencies)
2. All markets (in goods capital, and labor) are competitive
3. All costs are reflected in prices
4. All preferences are given or exogenous
5. Exchangers have no transaction costs, and all investment is divisible
and fungible, permitting ready trading
6. There is no state interference (taxes, subsidies, etc.) that distorts
the above
7. Everyone is motivated solely by maximizing personal utility, usually
measured by wealth or income, and no other goals or values
Is that plausible? Not really
Very unworldly assumptions about information flow, individual capacity,
power distributions, and much elseJoseph Stiglitz said, The invisible
hand is invisible because it doesnt exist.
In thinking about actually existing markets, its useful to distinguish
between
Market imperfections: ways in which existing markets depart
from the free market ideal
Market failures: ways in which even perfectly functioning
markets are suboptimal
Always ask about alternativesif not markets, what? If not government,
what?
The general argument
Markets are a desirable feature of any complex economy because 1) they
contribute in significant ways to efficiency and 2) the opportunity for markets
exchanges positively affects individual freedom but 3) self-regulating markets
with minimal government intervention do not come even close to performing in
optimally efficient ways and actually limit individual freedom so 4) what we need
are different non-market (ideally, democratic) institutions (including but not limited
to the state) to steer markets toward producing more socially desirable results, or
provide them directly.
The big remaining issues are a) what are the best such institutions and b)
where should they be in steering or substituting for markets
What is capitalism?
Capitalism is an economic system oriented to the production and exchange of
the commodities (including free labor) for profit
Exchange: Production is not for immediate use, but to sell things to their
people
Commodities: The things you produce for exchange
Commodification: Extension of the market into spheres previously not
governed by exchange
Decommodification: Retreat from market provision
Market: The social process through which these exchanges of
commodities take place
Capitalism: While all capitalism requires markets, not market societies
are capitalist. A capitalist market society is one in which
(i) the means of production are owned privately (not by the state
of by communities), which means investment is also privately
controlled and (ii) labor is among the commodities exchanged,
and most adults participate in and depend on the functioning of
that labor market
Two big pro-market arguments
Moral Argument: capitalist markets promote freedom: negative freedom
Pragmatic Argument: capitalist markets promote efficiency
Markets and Freedom
Negative Freedom: Freedom fromno one can physically force you to do
things
Positive Freedom: Freedom tothe actual capacity to do things, to realize
your goals
The market is a pretty good institution for realizing negative freedom. The free
market generates great inequalities in positive freedom, increasing it for some
people while reducing it for others.
Four of kinds efficiency
Allocative Efficiency: assigning things as precisely as possible to those who
want and can afford them; the distribution of things is Pareto optimal (Pareto)
Technical Efficiency: doing most with least (Tesla)
Dynamic Efficiency: optimal innovation, risk taking and growth (Schumpeter)
Macro-economic Efficiency: smooth running of the systemlow inflation, low
unemploymentmaking fullest of possible use of productive inputs (Keynes)
Market efficiency: allocative efficiency
Optimality: the best possible outcome of a process
Pareto Optimality: a distribution of things in which at least one person
could be made better off without anyone being made worse off
Pareto sub-optimality: a distribution of things in which at least one
person could be made better off without anyone being made worse off
Basic claim about markets: free markets generate Pareto optimal
distributions of things exchanged on the market
Sources of Market Inefficiency
1) Faulty Consumer Information: markets only allocate products efficiently if
people have perfect information about what they buy, but this is often very difficult
for consumers, especially because firms have incentives to distort information
2) Concentrated Economic Power: Allocative efficiency depends on perfect
competition, but actual markets are dominated by large corporations and great
unevenness in market bargaining power. Instances of monopoly, monopsony,
and oligopoly abound.
3) Externalities: An externality is a cost or benefit of economic activity not
reflected in market prices. Markets efficiency depends on prices reflecting the
true costs of producing things, but firms often systematically displace costs and
risks on others by not including these social costs in the price.
Types of externalities include positive and negative
a) Production externalities: producers directly affecting other producers
b) Consumption externalities: consumers directly affecting other
consumers
c) Hybrid externalities: producers directly affecting consumers and vice
versa
4) Endogenous Preferences: Pareto optimality refers to the market allocation of
goods and values according to rank ordered consumer preferences. But
sometimes those preferences come from market action itself. This happens in
two ways: preference manipulation and preference structuring
5) Short Time Horizons: Competition among profit-maximizing firms leads firms
to have relatively short time-horizons. This imposes costs on future generations
for our present production and consumption. You might think of this as an
intergenerational negative externality. Global warming is a good example.
6) Under-provision of Public Goods: A public good is a good characterized by
jointness in supply and the non-applicability of the exclusion principle; its
production provides benefit even to those not contributing to the cost of
producing it. Profit maximizing firms in competitive markets will fail to produce
adequate public goods, even those public goods which are necessary for
maintaining healthy markets.
Free Rider Problem (FRP)
Problem in the production of public goods
Contribution to their provision ensures costs, but doesnt guarantee
gain
Non-contribution doesnt preclude gain, but ensures no cost
If youre economically rational, never makes sense to contribute
If everyone comes to this same conclusion, no public good
Prisoners Dilemma (PD)
Economic rationality
Strategic action
Maximum criterion
Other examples of PD:
Negative Externalities vs. FRP/PD:
Negative externalities: I benefit from imposing costs on you
FRP/PD: Everyone is harmed, including me, but I am especially
harmed by altruistic behavior when its not reciprocated
Solutions to the FRP
Government provision of public goods and/or requirement of
contribution to them: Instead of relying on the marker, the
government acts to ensure that the good is available and the
costs of producing it are shared; it restricts free-riding
Conditional altruism: People may not be purely selfish and can
want to cooperate, thus their preference ordering is not like the
prisoners dilemma
7) Incompleteness: All sorts of important markets, principally in labor and
capital, are by nature incomplete
8) The Free Market and Social Values: Markets act to weaken certain kinds of
values and traits and reinforce others. Three particularly important instances of
this are markets inclination to erode community, commercialize morally salient
aspects of life, and to encourage skills of exit as opposed to voice.
Bottom Line?
Markets are really useful tools of social coordination, and almost universally
advance negative freedom (story on positive freedom is mixed), but theyre not
the only ones, and have some prominent drawbacks. Relying on them alone, or
trying to, is really stupid.
FRP, working through ER, means that, ceteris paribus, youll have fewer public
goods. And that means youll have more inequality, which affects political power.
But ER also mans that poorer people will be dominated in even formally fair
politics through rational ignorance, Assume you limit your costs of information
acquisition to those exceeded by gains. In most cases, that recommends that
youll limit information acquisition to that which can be acquired at zero cost,
which is free. But who might give you that? So, workings of the very thing that
seems to separate economic from political power, the market, actually
undermines the separation.
QED: Classical liberalism fails as a coherent belief system