An 'Ideal' World
What can we say about the functioning of the market system now that we have looked at our analysis of the individual decision makers? Are there reasons to expect the system will operate efficiently - producing just the correct amounts of goods and services, supplying the right amount of labor, and allocating the correct amount between the present and the future?
A useful place to start our discussion would be with a brief review of the conservative, free-market view of the economy - a perspective that lost the ideological and political high ground during the Great Depression of the 1930s. Conservative theory can be traced at least as far back as Adam Smith whose classic, The Wealth of Nations was published in 1775. As so often happens, timing is everything. The United States, emerged as a nation at precisely the same time and it was the perfect place to 'test' Smith's view of the superiority of the market system - and the test seemed to work. From independence in 1775 to the Great Depression of the 1930s, the market system, aided by a near limitless frontier containing abundant supplies of the key resources powering the industrial revolution, provided spectacular economic growth. [A snapshot of the country in 1790 and 1920 provides some sense of the magnitude of the changes].
A Conservative revival in economic policy was ushered in by Ronald Reagan in the US and Margaret Thatcher in England in the late 1970s and early 1980s. The fall of 'the wall' a decade later was viewed by many as 'proof' of the market system's superiority. While we may not have seen the end of history, the ideological battle between supporters of the command system (communism) and supporters of the market system (capitalism) was viewed as all but over. The extraordinary success of the Asian economies, meanwhile, was attributed to minimal government intervention and openness to international trade - although this model for economic growth lost a bit of its luster in the Asian Crises of 1997-98 and upon closer inspection these countries are not quite as open and free of government intervention as first thought.
At the center of the conservative view is the competitive equilibrium model - the pieces of which we have already looked at in the sections on individual and business choices. We have firms maximizing profits and individuals maximizing their satisfactions and both are guided in their actions by prices. Now we will simply put the pieces together in a general equilibrium model which has the advantage of allowing us to see the interrelationships between the markets - precisely what we saw earlier with the circular flow diagram. For example, let's look at the impact of increased immigration on the economy. In a partial equilibrium analysis we would simply look at the labor market where we would demonstrate the immediate impact of the increased labor supply would be a reduction in the price of labor. In a general equilibrium model, however, we would trace through the impact on the other markets. The reduction in wages will prompt firms to shift their input mix in the production process toward labor and away from capital. The decreased demand for capital will drive down interest rates which will increase savings which will... You get the point.
To make life easy for those interested in understanding the basic structure of the competitive equilibrium model, we will begin with the following simplifying assumptions for each of the three main markets:
How are we to evaluate the workings of the competitive model? What would make us support the market system as the 'best' solution to society's basic economic question - What, How, and for Whom?
Conservatives emphasize the concept of efficiency - the effectiveness of the economy should be evaluated in terms of its efficiency. To understand their view, we need to introduce the concept of Pareto efficiency, named after the Italian economist and sociologist Vilfredo Pareto (1848-1923). An allocation of resources is said to be Pareto efficient if there can be no reallocation of resources which improves the well being of everyone. When we look at the economy, there are three conditions for efficiency specified by Stiglitz in his introductory text.
To see how the 'ideal' market system could produce Pareto efficient results, we can look at each efficiency components.
Exchange Efficiency - We saw in our analysis of individual choice that the consumer would allocate income in such a way that MUx/ MU y = Px/ P y. People choose the level of consumption so the product's price equals the marginal benefit received from consuming the product. Each person will continue to buy as long as the benefits outweigh the costs (MUy > P y). If all consumers follow the same approach, we find the marginal benefit from consuming a product is the same for all consumers and there can be no trade making both better off.
MUx/ MU y = Px/ P y
Production Efficiency - Firms that are maximizing profit will respond to input prices in a way that they always choose the least cost mix of inputs and operate at the lowest point on the average cost curve. The condition for optimal input use is MRPK/ MRP L = PK/ P L. This can be rewritten to give us the condition MRPK/ PK = MRP L/ P L - the last dollar spent on capital (K) will create the same revenue as the last dollar spent on labor (L). If we produce everything at minimum cost, then we could not get more of any product without less of another - we would be operating on the production possibility curve.
MRPK/ MRP L = PK/ P L
Product - mix Efficiency - Firms face the same prices as individuals which means they face the same tradeoffs - a fact reflected in their similar conditions for optimal behavior.
Individuals: MUx/MUy = Px/Py
Firms: MCx/MCy = Px/Py
Firms choose output levels such that they can trade off outputs at the same rate that individuals want to exchange them at existing prices.
The bottom line - in an ideal competitive environment all decision makers have agreed to all of the trades they want and there is no trade all will find beneficial. But what about the real world? What about the world of imperfect competition and imperfect information? As we will see in the next unit, the introduction of imperfections in competition and information changes everything? Where we once believed the market system would produce the 'best' results, now we have reason to believe the market system may not be optimal, it may not be the most efficient system for promoting social welfare, there are some imperfections that suggest the need to consider corrective government intervention. This is the subject matter of the remainder of this course.
Our analysis will begin with an extension of our earlier work on the choices made by individuals. This will be followed by a discussion of the output and pricing decisions of firms. Here we will relax the assumption of perfect competition and examine briefly three models of imperfect competition in the output market - monopoly (one seller), oligopoly (a few sellers) and monopolistic competition (a large number of sellers selling slightly different products). We will also look at the government's response to imperfect competition through regulation and antitrust laws. This unit will be followed by one focused on a number of additional potential imperfections in the system including imperfect information, externalities, and public goods. We will finish with a discussion of the labor market.