Lecture 3 Tuesday September 11 THE MARKET HOW

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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 = 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

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