Why do we trade?
Resources are in the wrong place!
People have better uses of resources than they are currently being used!
Why are resources in the wrong place?
We have the same stuff but different preferences
Why are resources in the wrong place?
We have different stuff and different preferences
With high transaction costs, resources cannot be traded
Resources cannot be switched to higher-valued uses
If others value goods higher than their current owners, resources are inefficiently allocated!
Markets are institutions that facilitate voluntary exchange between strangers and reduce transaction costs
There's a lot of institutions in the “bundle” we call “markets”:
All of those things are assumed/ignored when we “draw” markets as neat graphs on the blackboard
Other courses: how do various political & social institutions enable markets to flourish? (some of my courses):
Regular sense of the word:
Achieving a specified goal with as few resources as possible
Examples:
We will ruminate more in coming lessons
Society, government, law, etc. has no single, universally agreed-upon goal
“Society” is not a choosing agent — people have their own separate interests, constraints, etc.
Problem 1: Resources have multiple rival uses
Problem 2: Different people have different subjective valuations for uses of resources
It is inefficient (immoral?) to use a resource in a way that prevents someone else who values it more from using it!
Solution: Prices in a functioning market accurately measure opportunity cost of using resources in a particular way
The price of a resource is the amount someone else is willing to pay to acquire it from its current use/owner
Property rights provide a pattern of ownership
Prices give us information about how to use scarce resources
Profits incentivize production that creates value and Losses discipline waste
Economic efficiency: degree to which as many people as possible get as much as possible of what they want
Preferences are subjective
Higher incomes + freedom of choice = greater preference satisfaction
Harder to directly evaluate outcomes, better to look at basic processes/mechanisms (especially exchange)
Economic surplus = Consumer surplus + Producer surplus
Maximized in competitive equilibrium
Resources flow away from those who value them the lowest (min WTA) to those that value them the highest (max WTP)
The social value of resources is maximized by allocating them to their highest valued uses!
Suppose we start from some initial allocation of resources
Pareto Improvement: we make a change where at least one party is better off, and no party is worse off
Suppose we start from some initial allocation of resources
Pareto Improvement: we make a change where at least one party is better off, and no party is worse off
Pareto optimal/efficient: no possible further Pareto improvements
†I’m simplifying...for full details, see class 1.8 appendix about applying consumer theory!
Voluntary exchange is a Pareto improvement
In equilibrium, markets are Pareto efficient: there are no more possible improvements
Note Pareto efficiency contains a normative claim about equity:
Pareto efficiency is conceptual gold standard: allow all welfare-improving exchanges so long as nobody gets harmed
In practice: Pareto efficiency is a first best solution
Kaldor-Hicks Improvement: an action improves efficiency its generates more social gains than losses
Kaldor-Hicks efficiency: no potential Kaldor-Hicks improvements exist `
Keeps intuitive appeal of Pareto but more practical
Consider policies where winners' maximum WTP > losers' minimum WTA
Policies should maximize social value of resources
Example: “eminent domain”
The “takings clause” of the 5th Amendment to the U.S. Constitution:
“No person shall...be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.”
What is a “public use”? What is “just compensation”?
Kelo v. City of New London, 545 U.S. 469 (2005
Markets are great when:
Market failure: if these conditions are not met
† Or public goods, or asymmetric information. But I treat these as special cases of more common externalities.
Collective action problem: situation where an individual's interest and a group's interest may conflict
Benefits (or costs) of outcome flow to all members of the group
Decisions & costs need to be incurred by individuals
Individual preferences need to aggregate into a single decision/outcome
Groups may share a common interest
But composed of individuals with their own preferences
Additionally, transaction costs/ bargaining to get a group to agree on decision
Public Good: a good that is non-rival and non-excludable
Rivalry: one use of a resource removes it from other uses
Excludability: ability or right to prevent others from using it (ownership)
Individual bears a private cost to contribute, but only gets a small fraction of the (dispersed) benefit of a good
If individuals can gain access to the good (nonexcludable) without paying, may lead to...
Free riding: individuals consume the good without paying for it
No incentive for people to contribute and pay for the good
If enough people obtain the benefits without incurring the costs...
Not profitable for private market actors to supply it
Adam Smith
1723-1790
“The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expence to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain. The performance of this duty requires, too, very different degrees of expence in the different periods of society,” (Book VI, Ch. 9).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Safner, 2021, “‘Public Good’ or ‘Good for the Public?’ Political Entrepreneurship and the Public Funding of Scientific Research,” Journal of Private Enterprise 36(1): 17-44
Groups often need “selective incentives” to reward contribution and to punish free riding in groups
Positive and negative incentives
Olson, Mancur, 1962, The Logic of Collective Action
Groups provide immaterial, “social/spiritual goods”, to individuals
Good members must contribute to the group and not drain its resources
Groups often do some combination of the following to overcome the free rider problem:† Sacrifice and Stigma
Iannaconne, Lawrence, 1992, “Sacrifice and Stigma: Reducing Free-riding in Cults, Communes, and Other Collectives,” Journal of Political Economy 100(2): 271-291
Demand: marginal social benefit (MSB)
Supply: marginal social cost (MSC)
Equilibrium: MSB=MSC
Price system mitigates costs and benefits of people's actions
People using scarce resources must account for consequences:
Externality: an action that incurs a cost or a benefit not compensated via prices
Often interpreted as an action that affects (benefits or harms) a third party not privy to the action
The real problem is that it is external to the price system!
People base decisions off of their preferences and opportunity costs of resources for society (captured in prices)
Prices properly negotiate the opportunity costs and provide information to people
But without price, decisions do not internalize those effects!
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Overproduction due to external cost
A deadweight loss from overproduction
A.C. Pigou
1877-1959
Policy solutions to externalities should focus on the missing price
“Pigouvian” tax or subsidy
Set a specific tax t=MSC−MPC
Eliminates the DWL
Internalizes the externality into the price system
Producers (and consumers) now consider the true cost to society
"Sitting is banned in the following places: "in St. Mark’s Square and in Piazzetta dei Leoncini, beneath the arcades and on the steps of the Procuratie Nuove, the Napoleonic Wing, the Sansovino Library, beneath the arcades of the Ducal Palace, in the impressive entranceway to St. Mark’s Square otherwise known as Piazzetta San Marco and its jetty." ($200)
"I. A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary. By correcting a well-known market failure, a carbon tax will send a powerful price signal that harnesses the invisible hand of the marketplace to steer economic actors towards a low-carbon future."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
"II. A carbon tax should increase every year until emissions reductions goals are met and be revenue neutral to avoid debates over the size of government. A consistently rising carbon price will encourage technological innovation and large-scale infrastructure development. It will also accelerate the diffusion of carbon-efficient goods and services."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
"III. A sufficiently robust and gradually rising carbon tax will replace the need for various carbon regulations that are less efficient. Substituting a price signal for cumbersome regulations will promote economic growth and provide the regulatory certainty companies need for long-term investment in clean-energy alternatives."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
How do we know what the right tax is? Will it be borne by the right parties?
Will it be administered correctly?
Are there opportunities for corruption?
Tragedy of the commons: multiple people have unrestricted access to the same rivalrous resource
Rivalry: one use of a resource removes it from other uses
Hardin, Garett, 1968, "The Tragedy of the Commons," Science 162(3859):1243-1248
Cannot exclude others
No responsibility over outcome
Incentive to overexploit and deplete resource (before others do)
A negative externality on others
“Property is a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” (Cooter and Ulen, p.73)
possess, use, develop, improve, transform, consume, deplete, destroy, sell, donate, bequeath, transfer, mortgage, lease, loan, or exclude others
Coooter, Robert and Douglas Ulen, 2012, Law and Economics, 6th ed.
Example: There is a car which you value at $3,000, and I value at $4,000.
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Suppose instead, you own the car
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Suppose instead, you own the car
It does not matter who is initially assigned a property right, our bargaining will reach the efficient result!
If transaction costs are low, with well-defined and tradeable property rights, parties can bargain voluntarily to reach the efficient outcome.
Coase, Ronald H, 1960, “The Problem of Social Cost,” Journal of Law and Economics 3: 1-44
We don't need to resort to law for mutually-agreeable transactions (like the car)
What's more interesting are incompatible uses of our own property that give rise to conflict
Here, we do need the law to define the rights...but that's not the end of the story
My neighbor likes tall trees
You want to have a party
I own a small plant located on a river
Most externalities in U.S. mediated through common law
Courts assess how much harm was caused
Individuals causing harm to others must pay:
Externalities persist if property rights are not clear or are not enforced
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can transform public goods into “club goods” by making them excludable
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can transform public goods into “club goods” by making them excludable
“Common resources” can be managed with the right set of rules or property rights (otherwise the tragedy of the commons results)
Elinor Ostrom
1933—2012
Economics Nobel 2009
A wide variety of solutions are possible for managing common resources efficiently
So long as they set up good rules that solve the free rider problem, remove the incentive to overuse resource, negative externality on others
Safner, Ryan, 2016, “Institutional Entrepreneurship, Wikipedia, and the Opportunity of the Commons,” Journal of Institutional Economics 12(4): 743-771
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Why do we trade?
Resources are in the wrong place!
People have better uses of resources than they are currently being used!
Why are resources in the wrong place?
We have the same stuff but different preferences
Why are resources in the wrong place?
We have different stuff and different preferences
With high transaction costs, resources cannot be traded
Resources cannot be switched to higher-valued uses
If others value goods higher than their current owners, resources are inefficiently allocated!
Markets are institutions that facilitate voluntary exchange between strangers and reduce transaction costs
There's a lot of institutions in the “bundle” we call “markets”:
All of those things are assumed/ignored when we “draw” markets as neat graphs on the blackboard
Other courses: how do various political & social institutions enable markets to flourish? (some of my courses):
Regular sense of the word:
Achieving a specified goal with as few resources as possible
Examples:
We will ruminate more in coming lessons
Society, government, law, etc. has no single, universally agreed-upon goal
“Society” is not a choosing agent — people have their own separate interests, constraints, etc.
Problem 1: Resources have multiple rival uses
Problem 2: Different people have different subjective valuations for uses of resources
It is inefficient (immoral?) to use a resource in a way that prevents someone else who values it more from using it!
Solution: Prices in a functioning market accurately measure opportunity cost of using resources in a particular way
The price of a resource is the amount someone else is willing to pay to acquire it from its current use/owner
Property rights provide a pattern of ownership
Prices give us information about how to use scarce resources
Profits incentivize production that creates value and Losses discipline waste
Economic efficiency: degree to which as many people as possible get as much as possible of what they want
Preferences are subjective
Higher incomes + freedom of choice = greater preference satisfaction
Harder to directly evaluate outcomes, better to look at basic processes/mechanisms (especially exchange)
Economic surplus = Consumer surplus + Producer surplus
Maximized in competitive equilibrium
Resources flow away from those who value them the lowest (min WTA) to those that value them the highest (max WTP)
The social value of resources is maximized by allocating them to their highest valued uses!
Suppose we start from some initial allocation of resources
Pareto Improvement: we make a change where at least one party is better off, and no party is worse off
Suppose we start from some initial allocation of resources
Pareto Improvement: we make a change where at least one party is better off, and no party is worse off
Pareto optimal/efficient: no possible further Pareto improvements
†I’m simplifying...for full details, see class 1.8 appendix about applying consumer theory!
Voluntary exchange is a Pareto improvement
In equilibrium, markets are Pareto efficient: there are no more possible improvements
Note Pareto efficiency contains a normative claim about equity:
Pareto efficiency is conceptual gold standard: allow all welfare-improving exchanges so long as nobody gets harmed
In practice: Pareto efficiency is a first best solution
Kaldor-Hicks Improvement: an action improves efficiency its generates more social gains than losses
Kaldor-Hicks efficiency: no potential Kaldor-Hicks improvements exist `
Keeps intuitive appeal of Pareto but more practical
Consider policies where winners' maximum WTP > losers' minimum WTA
Policies should maximize social value of resources
Example: “eminent domain”
The “takings clause” of the 5th Amendment to the U.S. Constitution:
“No person shall...be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.”
What is a “public use”? What is “just compensation”?
Kelo v. City of New London, 545 U.S. 469 (2005
Markets are great when:
Market failure: if these conditions are not met
† Or public goods, or asymmetric information. But I treat these as special cases of more common externalities.
Collective action problem: situation where an individual's interest and a group's interest may conflict
Benefits (or costs) of outcome flow to all members of the group
Decisions & costs need to be incurred by individuals
Individual preferences need to aggregate into a single decision/outcome
Groups may share a common interest
But composed of individuals with their own preferences
Additionally, transaction costs/ bargaining to get a group to agree on decision
Public Good: a good that is non-rival and non-excludable
Rivalry: one use of a resource removes it from other uses
Excludability: ability or right to prevent others from using it (ownership)
Individual bears a private cost to contribute, but only gets a small fraction of the (dispersed) benefit of a good
If individuals can gain access to the good (nonexcludable) without paying, may lead to...
Free riding: individuals consume the good without paying for it
No incentive for people to contribute and pay for the good
If enough people obtain the benefits without incurring the costs...
Not profitable for private market actors to supply it
Adam Smith
1723-1790
“The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expence to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain. The performance of this duty requires, too, very different degrees of expence in the different periods of society,” (Book VI, Ch. 9).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Safner, 2021, “‘Public Good’ or ‘Good for the Public?’ Political Entrepreneurship and the Public Funding of Scientific Research,” Journal of Private Enterprise 36(1): 17-44
Groups often need “selective incentives” to reward contribution and to punish free riding in groups
Positive and negative incentives
Olson, Mancur, 1962, The Logic of Collective Action
Groups provide immaterial, “social/spiritual goods”, to individuals
Good members must contribute to the group and not drain its resources
Groups often do some combination of the following to overcome the free rider problem:† Sacrifice and Stigma
Iannaconne, Lawrence, 1992, “Sacrifice and Stigma: Reducing Free-riding in Cults, Communes, and Other Collectives,” Journal of Political Economy 100(2): 271-291
Demand: marginal social benefit (MSB)
Supply: marginal social cost (MSC)
Equilibrium: MSB=MSC
Price system mitigates costs and benefits of people's actions
People using scarce resources must account for consequences:
Externality: an action that incurs a cost or a benefit not compensated via prices
Often interpreted as an action that affects (benefits or harms) a third party not privy to the action
The real problem is that it is external to the price system!
People base decisions off of their preferences and opportunity costs of resources for society (captured in prices)
Prices properly negotiate the opportunity costs and provide information to people
But without price, decisions do not internalize those effects!
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Marginal Private Cost to producer is less than Marginal Social Cost to society
Market Equilibrium (B) too much q at too low p compared to Social Optimum (A)
Overproduction due to external cost
A deadweight loss from overproduction
A.C. Pigou
1877-1959
Policy solutions to externalities should focus on the missing price
“Pigouvian” tax or subsidy
Set a specific tax t=MSC−MPC
Eliminates the DWL
Internalizes the externality into the price system
Producers (and consumers) now consider the true cost to society
"Sitting is banned in the following places: "in St. Mark’s Square and in Piazzetta dei Leoncini, beneath the arcades and on the steps of the Procuratie Nuove, the Napoleonic Wing, the Sansovino Library, beneath the arcades of the Ducal Palace, in the impressive entranceway to St. Mark’s Square otherwise known as Piazzetta San Marco and its jetty." ($200)
"I. A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary. By correcting a well-known market failure, a carbon tax will send a powerful price signal that harnesses the invisible hand of the marketplace to steer economic actors towards a low-carbon future."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
"II. A carbon tax should increase every year until emissions reductions goals are met and be revenue neutral to avoid debates over the size of government. A consistently rising carbon price will encourage technological innovation and large-scale infrastructure development. It will also accelerate the diffusion of carbon-efficient goods and services."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
"III. A sufficiently robust and gradually rising carbon tax will replace the need for various carbon regulations that are less efficient. Substituting a price signal for cumbersome regulations will promote economic growth and provide the regulatory certainty companies need for long-term investment in clean-energy alternatives."
Signed by 27 Economics Nobel Laureates, 4 former Federal Reserve chairs, among many other famous economists
How do we know what the right tax is? Will it be borne by the right parties?
Will it be administered correctly?
Are there opportunities for corruption?
Tragedy of the commons: multiple people have unrestricted access to the same rivalrous resource
Rivalry: one use of a resource removes it from other uses
Hardin, Garett, 1968, "The Tragedy of the Commons," Science 162(3859):1243-1248
Cannot exclude others
No responsibility over outcome
Incentive to overexploit and deplete resource (before others do)
A negative externality on others
“Property is a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” (Cooter and Ulen, p.73)
possess, use, develop, improve, transform, consume, deplete, destroy, sell, donate, bequeath, transfer, mortgage, lease, loan, or exclude others
Coooter, Robert and Douglas Ulen, 2012, Law and Economics, 6th ed.
Example: There is a car which you value at $3,000, and I value at $4,000.
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Suppose instead, you own the car
Example: There is a car which you value at $3,000, and I value at $4,000.
It is efficient for me to end up with the car.
Suppose I start out with the car
Suppose instead, you own the car
It does not matter who is initially assigned a property right, our bargaining will reach the efficient result!
If transaction costs are low, with well-defined and tradeable property rights, parties can bargain voluntarily to reach the efficient outcome.
Coase, Ronald H, 1960, “The Problem of Social Cost,” Journal of Law and Economics 3: 1-44
We don't need to resort to law for mutually-agreeable transactions (like the car)
What's more interesting are incompatible uses of our own property that give rise to conflict
Here, we do need the law to define the rights...but that's not the end of the story
My neighbor likes tall trees
You want to have a party
I own a small plant located on a river
Most externalities in U.S. mediated through common law
Courts assess how much harm was caused
Individuals causing harm to others must pay:
Externalities persist if property rights are not clear or are not enforced
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can transform public goods into “club goods” by making them excludable
Can classify into 4 types of goods based on rivalry & excludability
Economics mostly focuses on “private goods”
Largest issues with “public goods”
Can transform public goods into “club goods” by making them excludable
“Common resources” can be managed with the right set of rules or property rights (otherwise the tragedy of the commons results)
Elinor Ostrom
1933—2012
Economics Nobel 2009
A wide variety of solutions are possible for managing common resources efficiently
So long as they set up good rules that solve the free rider problem, remove the incentive to overuse resource, negative externality on others
Safner, Ryan, 2016, “Institutional Entrepreneurship, Wikipedia, and the Opportunity of the Commons,” Journal of Institutional Economics 12(4): 743-771