Chapter 2 (1.1): How the market works?

1. Chapter 2 (1.1): How the market works? • What is the market? • Voluntary exchanges • Invisible hand • Self-correcting through price mechanism • Assumptions to understand how the market works? • Individuals: unit of analysis • Individuals are self-interested • Individuals are rational

2. Chapter 2 (1.2): How the market works? • What is Laissez-faire doctrine? The government should let the market rule the economy. Why? • Allocative efficiency, innovation, liberty • But we need perfect competition

3. Perfect competition • All small and there are many • No barriers • Consumer rational and maximize • Technology constant or decreasing returns on scale • Buyers and sellers full knowledge • Sellers’ items are identical • Prices flexible • Transaction cost = 0

4. Market failure • Public goods • Externalities • Monopoly • Information asymmetry • Agent misdirection • Agents act on behalf of principals. client – attorney, shareholder - manager, citizen – bureaucrat. • Social goals • Inequality • Economic instability

5. Public Goods • Tangible and intangible items that people use together. They have value that spills onto people without their assent or awareness. • Different from publicly-provided goods. • The market will not provide them in sufficient volume • Attributes: excludability and subtractability • Few pure public or pure private goods exist. • Problem: free riding. • Stopping free riding – high transaction cost

6. Externalities • They are external to market exchanges, and thus do not figure in producers’ and consumers’ internal accounting. • Link with public goods. Public goods are items with large positive externalities.

7. Monopoly and imperfect competition • In some markets buyers or sellers have the power to dictate exchange terms. • Monopolies may be simply the winners in wars of competition or the result of unfair competitive tactics. • They may be unavoidable. Then people frequently prefer them to be publicly owned or at least monitored by public service commissions.

8. Information asymmetry • Limited or lopsided information • Transaction cost: Information is neither free nor easy to get. • People has mobilized to get the government to pick up the tab. • Adverse selection: Since producers are likely to have more information than buyers they may abuse their position of power.

9. Agency problems • Principal agent: Client – attorney; shareholder – manager; citizen –bureaucrat. • Moral hazard: Agents are tempted to put their self-interest ahead of the interest of the principal. • Transaction cost of monitoring very high. • Government offsets but introducing legislation that punish to those agents who do wrong by their principals. Example: Insider trading legislation.

10. Social goals • We do not want “obnoxious” markets to function: e.g. drugs, prostitution, gambling. • We want the market to produce some goods (“merit goods”) which it does not or only limitedly: food, housing, health, education. • Welfare state: • FDR’s New Deal (1933): Food aid, subsidized public housing, subsequently unemployment insurance, social security, aid to children • Lyndon Johnson’s Great Society (1963-69): Food Stamps, Medicare, Medicaid. • 1970s – 2nd thoughts

11. Inequality and unfairness • People born in poverty have fewer chances of getting ahead • Governments can take the rough edges off the income distribution.

12. Economic instability • The market is prone to boom and bust • Bust periods are supposed to clear out inefficient firms but citizens may not want to bear the pain without any type of safety net. • Keynesian economics: Bust periods are made worse when the government cannot spend money (become a buyer, an actor in the market)