Lecture 3
Tuesday, September 11
THE MARKET:
HOW IT IS SUPPOSED TO WORK
I. THE OVERALL ARGUMENT
ABOUT CAPITALISM & MARKETS
Markets are a desirable feature of complex economies for two basic
reasons:
1) Markets can contribute in significant ways to efficiency and
prosperity, and
2) Market exchanges can contribute to individual freedom.
However:
3) The unregulated free market with minimal government
intervention ends up deeply limiting individual freedom,
restricting prosperity and undermining efficiency.
Conclusion:
4) What we need are democratically accountable market institutions.
II. WHAT IS CAPITALISM?
1. Capitalism is only one way among many of organizing economies
2. Definition: Capitalism is not just a free market society; it is a market
society with two other critical elements:
(i) The means of production are owned privately, not by the state or
by communities or by the workers.
(ii) The labor that is used in production is obtained through
voluntary market exchange: the labor market.
3. The U.S. economy is NOT pure capitalism; it contains many
noncapitalist economic activities and organizations.
Question: Are there goods and services which you think
should not be produced and distributed by free markets?
III. TWO PRIMARY ARGUMENTS
IN DEFENSE OF CAPITALIST MARKETS
1. MORAL ARGUMENT:
capitalist markets promote freedom
2. PRAGMATIC ARGUMENT:
capitalist markets promote efficiency & prosperity.
The moral argument:
Markets promote individual freedom
since in a free market all transactions are
the result of voluntary agreements – no
one is forced to do anything.
Freedom here = negative freedom
The pragmatic argument:
The central problem needing a solution =
cooperation & coordination in a complex world
Two basic solutions:
1. Planning and command
2. Markets and voluntary exchange
How do markets solve the problem?
Adam Smith’s “invisible hand” (Wealth of Nations, 1776):
An individual who “intends only his own gain” is
“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.”
Key mechanisms that do the solving:
Supply & demand + prices
Coordination through information and
incentives generated by prices.
Implication:
Consumer Sovereignty and allocative efficiency
The Technical idea of allocative efficiency:
Pareto Optimality
Optimality = the best possible outcome of a process
Pareto Optimality = a distribution of things such that no one
can be made better off without someone becoming worse off.
Pareto suboptimality = a situation in which by redistributing
things at least one person could be made better off without
anyone becoming worse off.
Basic claim about markets: free markets generate Pareto
optimality of distributions of things exchanged on the
market
Two Kinds of Efficiency in Markets
1. Allocative Efficiency: the distribution of things
is “Pareto optimal”
2. Dynamic Efficiency: optimal innovation and
growth through incentives for risk taking
IV. The Market & Limited Government
Two core arguments against state
interference with the market:
1.
Moral argument:
state coercion inherently reduces freedom, therefore
limited government rather than an affirmative state
2.
Pragmatic argument:
state incompetence & state malevolence