Microeconomics
Markets and Prices
(Chapter 3)
Why people trade
What markets do
Why have firms?
Why people trade
By virtue of exchange, one man's
prosperity is beneficial to all others.
Frederic Bastiat
It pays to be different
• People trade for 2 reasons
– Different abilities
– Different preferences
• Different abilities yield comparative advantages
• Comparative advantage is the ability to perform a
task at lower cost
• Where you have comparative advantage you are
more efficient
• Comparative advantage yields gains from trade
Lessons from the Iowa Car Crop
Source: Chapter 21, The Armchair Economist, Economics and Everyday Life,
Steven E. Landsburg, The Free Press, New York, 1995, p. 197-199.
A thing of beauty is a joy forever, and nothing is more beautiful than a succinct
and flawless argument. A few lines of reasoning can change the way we see the
world.
I found one of the most beautiful arguments I know while I was browsing
through a textbook written by my friend David Friedman. While the argument
may not be original, David's version is so clear, so concise, so incontrovertible,
and so delightfully surprising, that I have been unable to resist sharing it with
students, relatives, and cocktail party acquaintances at every opportunity. The
argument concerns international trade, but its appeal is less in its subject
matter than in its irresistible force.
David's observation is that there are two technologies for producing
automobiles in America. One is to manufacture them in Detroit, and the other
is to grow them in Iowa. Everybody knows about the first technology; let me tell
you about the second. First, you plant seeds, which are the raw material from
which automobiles are constructed. You wait a few months until wheat
appears. Then you harvest the wheat, load it onto ships, and sail the ships
eastward into the Pacific Ocean. After a few months, the ships reappear with
Toyotas on them.
International trade is nothing but a form of technology. The fact that there is a
place called Japan, with people and factories, is quite irrelevant to Americans'
well-being. To analyze trade policies, we might as well assume that Japan is a
giant machine with mysterious inner workings that convert wheat into cars.
Any policy designed to favor the first American technology over the second is
designed to favor American auto producers in Detroit over American auto
producers in Iowa. A tax or ban on "imported" automobiles is a tax or ban on
Iowa-grown automobiles. If you protect Detroit carmakers from competition,
then you must damage Iowa farmers, because Iowa farmers are the
competition.
The task of producing a given fleet of cars can be allocated between Detroit and
Iowa in a variety of ways. A competitive price system selects the allocation that
minimizes total production cost.* It would be unnecessarily expensive to
manufacture all cars in Detroit, unnecessarily expensive to grow all cars in Iowa, and
unnecessarily expensive to use the two production processes in anything other than
the natural ratio that emerges as a result of competition.
That means that protection for Detroit does more than just transfer income from
farmers to autoworkers. It also raises the total cost of providing Americans with a
given number of automobiles. The efficiency loss comes with no offsetting gain; it
impoverishes the nation as a whole.
There is much talk about improving the efficiency of American car manufacturing.
When you have two ways to make a car, the road to efficiency is to use both in
optimal proportions. The last thing you should want to do is to artificially hobble
one of your production technologies. It is sheer superstition to think that an Iowagrown Camry is any less "American" than a Detroit-built Taurus. Policies rooted in
superstition do not frequently bear efficient fruit.
In 1817, David Ricardo – the first economist to think with the precision, though not
the language, of pure mathematics--laid the foundation for all future thought about
international trade. In the intervening 150 years, his theory has been much
elaborated but its foundations remain as firmly established as anything in
economics. Trade theory predicts first that if you protect American producers in one
industry from foreign competition, then you must damage American producers in
other industries. It predicts second that if you protect American producers in one
industry from foreign competition, there must be a net loss in economic efficiency.
Ordinarily, textbooks establish these propositions through graphs, equations and
intricate reasoning. The little story I learned from David Friedman makes the same
propositions blindingly obvious with a single compelling metaphor. That is
economics at its best.
*This assertion is true, but not obvious. Individual producers care about their individual
profits, not about economywide costs. It is something of a miracle that individual selfish
decisions must lead to a collectively efficient outcome.
What markets do
The natural effort of every individual to better his
own condition is so powerful that it is alone, and
without any assistance, not only capable of carrying
on the society to wealth and prosperity, but of
surmounting a hundred impertinent obstructions
with which the folly of human laws too often
encumbers its operations.
Adam Smith
Information
and incentive problems
• Fundamental problem: produce output
customers want at least cost
– Information often held by many individuals and is
specific/local (expensive to transfer)
– Decision makers often don’t face the right
incentives
• Principal challenge: provide decision makers
the relevant information and motivate them
to use it correctly
General vs specific knowledge
• Distinctions
–
–
–
–
Perishability
Complexity
Idiosyncratic
Subjective
• What has been
the effect of
technology on the
cost of knowledge
transfer?
Cost of transferring
knowledge
General Knowledge
- low cost to communicate
- more likely to centralize
Specific Knowledge
- high cost to communicate
- more likely to decentralize
Market solutions
• How do markets solve information and incentive
problems?
– Private property rights (Greece’s Property Rights Problem: 2:402:45)
– Prices
• Markets
– Allocate resources and property rights to their highest value use
– Make good use of specific knowledge
– Reward and punish resource owners
• Market coordination decentralized
• How would a central planner solve the fundamental
problem?
The market as a metaphor
• What did we say markets are good at?
• Could your organization’s structure mimic a
market?
• Could transfer prices help?
• Still, most coordination of organizational
activity is done administratively – Why?
Why firms then?
Whether a transaction would be organized within a firm or
whether it would be carried out on the market depended on a
comparison of the costs of organizing such a transaction within
the firm with the costs of a market transaction that would
accomplish the same result. All this is very simple and
obvious. But it took me a year to realize it – and many
economists seem unaware of it (or its significance) to this day …
As it was a new approach (I think) to this subject, I was quite
pleased with myself. One thing I can say is that I made it all up
myself. As I said in my Nobel Prize lecture, I was then twentyone and the sun never ceased to shine.
Ronald Coase
Transactions costs
• A firm is an institution that hires and organizes
inputs to produce some output or outputs
• Why do they exist? Why isn’t everyone an
individual contractor?
• Because of transactions costs (Coase)
– What are transactions costs? (See first 1:40)
– Finding “contractors”
– Negotiating and enforcing contracts
Firm boundaries
• Why don’t we just have one big firm?
• There are also internal contracting costs
– Motivating workers who aren’t owners
– Monitoring performance
– Transferring information
• What is the optimal boundary? (What did
Coase say)
Make or buy?
What do you think about these statements?
• Make the input if it gives you a competitive
advantage
• Buy the input to avoid the costs of production
• Make the input to keep profits from its sale
• Make the input because you can make it at cost,
where you would pay market prices to buy it
Conclusions
• Exploit comparative advantage, become more
efficient and reap gains from trade
• International trade is just a form of technology
• Solve the fundamental problem by providing the
right information and the incentives to use it
• Appeal to markets for decentralized solution to
coordinating economic activity
• Transactions costs give rise to firms and establish
their boundaries