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The Market: How it Actually Works

This lecture discusses the functioning of markets, focusing on the four virtues of markets: freedom, coordination, efficiency, and innovation. It also examines the comparison between the free market and government regulation, addressing the moral and pragmatic issues. The lecture examines the impact of markets on freedom and discusses pragmatic problems such as inefficiency and market failures.

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The Market: How it Actually Works

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  1. Lectures 4 & 5 January 26 & 31, 2017 The Market: How it Actually Works

  2. Summary from last lecture: • I. Four Virtues of Markets • Freedom: Markets are an expression of the value of individual freedom: exchanges are voluntary • Coordination of complex systems: Markets accomplish this remarkable result through supply, demand and the price mechanism. • Efficiency: Unfettered markets result in allocative efficiency (“Pareto Optimality”) • Innovation and Growth: Markets create strong incentives for risk-taking and innovation • II. The Free Market versus Government • Moral issue: State regulation is an affront to freedom • Pragmatic issue: State incompetence and malevolence

  3. Three Themes for discussion of • how markets really work: • How well does the free market perform around its core moral value: freedom? • Pragmatic problems: inefficiency and market “failures.” • The impact of free markets on nonmarket social interactions and social values

  4. I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

  5. I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

  6. I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

  7. I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

  8. II. PRAGMATIC ISSUES: INEFFICIENCY & MARKET FAILURES 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.

  9. The Case of the Ford Pinto (late 1960s) The problem: because of faulty placement of gas tanks, tendency for cars to explode in some rear-end collisions Cost of change: roughly $11/car Ford’s calculation: more profitable not to make the change. Ford’s strategy: obstruct accountability and regulation Results: the legislation to require higher safety standards was delayed from 1961 to 1966 and effective implementation of regulations delayed until 1977. Hundreds of lives lost as a result.

  10. Sources of Market Inefficiency #2 Concentrated Economic Power Allocative efficiency depends on perfect competition, but American capitalism is dominated by giant corporations, and giant corporations exert real power over firms and individuals in markets.

  11. Sources of Market Inefficiency #3 Negative Externalities Market efficiency depends on prices reflecting the true costs of producing things, but firms often systematically displace costs and risks on others in many ways. Definition: a negative side-effect of an activity that affects other people.

  12. What are some other examples of Negative Externalities?

  13. Other implications of • Negative Externalities • Violates value of fairness: it is unfair that I can impose risks and costs on you for my own benefit. • Violates freedom: I coercively impose costs on your with voluntary consent.

  14. Sources of Market Inefficiency #4 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. (Intergenerational negative externalities).

  15. Sources of Market Inefficiency #5 Under-provision of Public Goods Profit-maximizing firms in competitive markets will fail to produce adequate public goods, even those public goods which are necessary for maintaining healthy markets. Definition of Public Goods: a public good is a good which, if it is produced, provides a benefit to people even if they do not pay for it.

  16. What are some other examples of public goods and quasi-public goods?

  17. THE PRISONERS DILEMMA Self-interested preference ordering for X: B>A>D>C

  18. THE TRADGEDY OF THE COMMONS Your self-interested preference ordering : B>A>D>C

  19. Free-riding & Public Goods problem: Firms Providing Training for Workers Training costs = $10,000 Extra Gross Profits with trained workers = $30,000 Net extra profits if you provide training and keep workers = $20,000 Net extra profits if you provide training and workers leave = -$10,000

  20. Contrast: Negative Externalities vs Free-rider Problem Negative externalities: I benefit from imposing costs on you. Free-riding problem for public goods: Everyone is harmed – including me – because of free-riding, but I am even worse off if I individually refuse to free-ride. This is a “Pareto suboptimal” situation.

  21. Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government produces the public good and regulates free-riding. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

  22. Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government blocks free-riders through regulations and government provision of public goods paid by taxation. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

  23. Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government blocks free-riders through regulations and government provision of public goods paid by taxation. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

  24. CONDITIONAL ALTRUISM and THE TRADGEDY OF THE COMMONS Your self-interested preference ordering: B>A>D>C Conditional Altruist (cooperative) preferences: A>D/B>C

  25. III. The Free Market & Social Values • Key idea: institutions shape values • Effects of under-regulated markets on salient values: • Erosion of community • Commercialization of morally salient aspects of life • Skills of “exit” and “voice”

  26. III. The Free Market & Social Values • Key idea: institutions shape values • Effects of under-regulated markets on salient values: • Erosion of community • Commercialization of morally salient aspects of life • Skills of “exit” and “voice”

  27. III. The Free Market & Social Values • Key idea: institutions shape values • Effects of under-regulated markets on salient values: • Erosion of community • Commercialization of morally salient aspects of life • Skills of “exit” and “voice”

  28. III. The Free Market & Social Values • Key idea: institutions shape values • Effects of under-regulated markets on salient values: • Erosion of community • Commercialization of morally salient aspects of life • Skills of “exit” and “voice”

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