Overview of Comparative
Economics
Chapter II
Market Capitalism
1
Market Capitalism



Form of Ownership → Most of the time land and
produced means of production (capital stock) are
owned by private individuals or private firms
Role of Planning → Market capitalism is usually
planned by the market (with demand and supply)
Material Incentives → In market capitalism material
incentives exist in forms of rewards for
entrepreneurship and capital investment as
economic profits
2
Market Capitalism


Income Redistribution → is usually done
through social safety nets in market
capitalism
Role of politics and ideology → Are market
capitalist countries mostly democratic?

Social democrat parties exist in market capitalist
countries supporting income redistribution,
extensive social safety nets, nationalization and
central planning
3
Why Market Capitalism Popular?


End of communism → most former
communist countries are concentrating on
market capitalist economic systems
Predominantly market capitalist economies
are making efforts to move toward a purer
version of this system
4
Advantages and Disadvantages of Market
Capitalist Economies

Experienced enormous technological
advances and growth as they underwent the
Industrial Revolution in the late 18th century


“ability to revolutionize the means of production”
Experienced large macroeconomic
fluctuations with serious downturns in the 19th
century (unequal distribution of income and
increasing concentrations of industrial
monopoly power)
5
Pure Version of Market Capitalist System


Pure version of market capitalist system does
not exist
Closest to the ideal of pure laissez-faire
market capitalism are:



Hong Kong
Singapore
New Zealand
6
Efficiency

Static efficiency → no one in society can be
made better off without making someone else
worse off


resources are being utilized to their best potential
given the existing technology
Dynamic efficiency → allocation of resources
over time to maximize long-run sustainable
growth


technological dynamism
destabilizing process of “creative destruction”
7
Theoretical Efficiency of Market
Capitalism

Efficiency Theorem

The general ability of markets to allocate goods
and resources efficiently through the law of
supply and demand
 A complete
 competitive
 full-information
 general equilibrium is efficient
8
Theoretical Efficiency of Market
Capitalism

Complete


For any good or service that affects someone’s
utility, there is a market
Competition



There are many buyers and sellers with free entry
and exit
There are well-defined homogenous goods and
services
No individual supplier has any control over the
price in his or her market
9
Theoretical Efficiency of Market
Capitalism

Full information


All agents in the economy know everything about
consumer preferences, production technologies and prices
General equilibrium


Every single market is in equilibrium in the sense that the
quantity supplied equals the quantity demanded of the
good or service
If that does not happen:



Surplus
Shortage
Partial equilibrium with a few markets being in equilibrium
10
Theoretical Efficiency of Market
Capitalism

Efficiency


Pareto optimality → no one in the economy can
be made better off without making someone else
worse off
If someone can be made better off without making
someone else worse off, then the economy is not
producing as much as possible of what people
want
11
Why is a complete, competitive, full-information,
general equilibrium efficient?



Adam Smith’s invocation of invisible hand of the
market working across all sectors to allocate goods
in a way that maximizes the “wealth of the nations”
He founded classic laissez faire economics
He argued that the government should get out of the
economy (minimal government intervention)

It is at the equilibrium price that the maximum amount
will be both produced and sold and thus actually
consumed by public
12
Invisible Hand





In the free marketplace an “invisible hand”
regulates and self-corrects the economy
The market itself will regulate the economy
Efficient producers will prosper and the
inefficient producers will lose
The public will get the best product for the
lowest price
Supply and demand will determine prices
better than any government official can
13
Limits to The Efficiency of Laissez-Faire
Market Capitalism




Monopoly Power
Externalities
Collective Consumption Goods
Imperfect Information
14
Source of Inefficiency:
Monopoly Power
Monopoly power prohibits competition
 Monopolist will maximize profits by setting marginal
cost equal to marginal revenue
Exceptions:
 Natural monopoly



Characterizing an industry with economies of scale
(declining LRAC) even at level of output equal to total
market demand
Technological dynamism

More competitive industries will be more technologically
progressive
15
Source of Inefficiency:
Monopoly Power

Intermediate market forms

Monopolistic competition



Many firms, each having some price setting power as a
result of product differentiation
Excess capacity theorem
Oligopoly


Small number of firms in industry with reaction to any
action taken by others
Perfect collusion


Joint-maximizing cartel (OPEC in oil crisis)
Longest surviving cartel?
16
Source of Inefficiency:
Externalities

These are either costs or benefits that are
born by or accrue to an agent other than the
agent generating them


External costs negative externalities
External benefits positive externalities
17
Source of Inefficiency:
Externalities

External costs are negative externalities,
such as environmental pollution

If the firm that generates pollution damages
another industry but does not reduce that damage
→ the private marginal cost to the firm does not
equal the social marginal cost and too much
pollution is produced, resulting in inefficiency
18
Source of Inefficiency:
Externalities

External benefits are positive externalities,
such as technological invention without patent
protection for inventors


If an inventor has no patent protection, then other firms can
steal her invention and she may make no money even if
her invention generates great social benefits
Private marginal benefit to the inventor does not equal
marginal social benefit of the invention and too little
inventing will occur, resulting in inefficiency
19
Source of Inefficiency:
Collective Consumption Goods

Consumption goods = public goods → such as
national defense


Because of the nature of such goods, it is difficult for
private markets to organize themselves to provide these
goods in optimal quantities
The characteristics of pure public good:


Non-excludability of consumption: It is not possible to
exclude this kind of consumption
Non-depletability of consumption: Everyone consumes it
simultaneously, and no individual’s consumption reduces
any other individual’s consumption

Free-rider problem
20
Source of Inefficiency:
Imperfect Information


Unrealistic to have perfect information
When one party in a transaction knows more
than another, special problems arise causing
asymmetric information



Akerlof “The market for Lemons”
Principal agent problem
Sub-optimizing behavior
21
The Role of Labor Unions



Redistribute income to their members
Deal with safety, job security, benefits, social
functions and lobbying politically for broader
social outcomes
Offset the monopolistic power of big firms
22
Macroeconomic Instability of Market
Capitalism

The General picture



The major market capitalist economies have been less than
perfectly stable over time
There was a general increase in unemployment rates after
the early 1970s in many countries, associated with a
general stagnation of economic growth, that appears to
have been reduced recently
The considerable variation in capital investment can be
explained by factors



Exogenous fluctuations in new technologies that can serve as
the basis for the investment
Fluctuations in government monetary policies affecting interest
rates
Psychological fluctuations due to the “animal spirits” of those
making investments
23
Macroeconomic Instability of Market
Capitalism

QUESTION


Why do these variables lead to fluctuations in the
unemployment rate, since in a perfectly labor
market, wage rates should fall when the demand
for labor falls, thereby preventing the emergence
of any involuntary unemployment?
TWO DIFFERENT ANSWERS


Keynesian School
Classical School
24
Macroeconomic Instability of Market
Capitalism

Keynesian School


Rigidities of various sorts exist in labor markets
and that capital investment can collapse and stay
down for extended periods of time, as in the Great
Depression
The implication is that government intervention
through fiscal or monetary policies is advisable to
stimulate the economy and to stabilize and
smooth out business cycles
25
Macroeconomic Instability of Market
Capitalism

The Classical School




Deriving from 19th century classical political
economists such as David Ricardo
Market capitalist economies are powerfully selfstabilizing
Conscious government intervention merely
generates inflation and intensifies fluctuations
To minimize unemployment, unions should be
broken up and a stable fiscal and monetary
environment should be maintained within a
laissez-faire environment
26
Laissez-faire Economic Policies


Shift toward supporting more laissez-faire
economic policies
There is a tension between asserting the
efficiency of competitive equilibria and
recognizing the limits of the applicability of
that theorem

Chicago School’s (Milton Friedman) argument
draws directly from the efficiency theorem and
follows by asserting the irrelevance or
unimportance of the various exceptions and limits
27
Chicago School






Markets are almost always efficient, so government should keep its
hands off
The most externalities will be resolved by private markets if property
rights are properly defined and enforced “free market”
Many of the goods provided by the public sector are not really
collective consumption goods and could be more efficiently provided
privately
Information costs are inevitable and cannot be avoided
The Chicago School supports the Classical School approach in
macroeconomics
 Friedman is the most prominent advocate of monetarism in the
US
With respect to distribution of income, people should be allowed to
keep what they earn from the free market
 Inequalities are the necessary outcome of providing sufficient
incentives for production, investment and growth
28
Public Choice Theory

“Criticism of government intervention”


The government agencies designated to carry out
the market-correcting activities are self-interested
agencies that became captured by special
interests operating through their legislative
connections
Anne Krueger “rent-seeking”
29
Austrian School


They reject equilibrium analysis and emphasize
dynamic market processes
Entrepreneurs are the most important agents in the
economy


They must be allowed to function freely, without
government restriction, so that they can lead the market to
evolve in conjunction with the evolution of consumer
preferences through process of innovation
Static efficiency is relatively unimportant

It is the dynamic success of market capitalism that is its
most important economic feature
30