HOW IT IS SUPPOSED TO WORK Lecture 3 Tuesday, January 24 THE MARKET: HOW IT IS SUPPOSED TO WORK Open Office Hours: Tuesdays & Fridays, 1:00-2:00 8112D Social Science

ABOUT CAPITALISM & MARKETS  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. 

ABOUT CAPITALISM & MARKETS  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. 

ABOUT CAPITALISM & MARKETS  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. 

ABOUT CAPITALISM & MARKETS  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? Capitalism is only one way among many of organizing economies Definition. Capitalism is not just a free market economy. It is a market economy with two other critical elements: (i) Economic enterprises are owned privately, not by the state or by communities or by the workers. (ii) The labor that is used to produce goods and services in those enterprises is obtained through voluntary market exchange: the labor market. U.S. economy is 3. The U.S. economy is NOT pure capitalism; it contains many noncapitalist economic activities and organizations.

II. WHAT IS CAPITALISM? Capitalism is only one way among many of organizing economies Definition. Capitalism is not just a free market economy. It is a market economy with two other critical elements: (i) Economic enterprises are owned privately, not by the state or by communities or by the workers. (ii) The labor that is used to produce goods and services in those enterprises is obtained through voluntary market exchange: the labor market. U.S. economy is 3. The U.S. economy is NOT pure capitalism; it contains many noncapitalist economic activities and organizations.

II. WHAT IS CAPITALISM? Capitalism is only one way among many of organizing economies Definition. Capitalism is not just a free market economy. It is a market economy with two other critical elements: (i) Economic enterprises are owned privately, not by the state or by communities or by the workers. (ii) The labor that is used to produce goods and services in those enterprises is obtained through voluntary market exchange: the labor market. U.S. economy is 3. The U.S. economy is NOT pure capitalism; it contains many noncapitalist economic activities and organizations.

II. WHAT IS CAPITALISM? Capitalism is only one way among many of organizing economies Definition. Capitalism is not just a free market economy. It is a market economy with two other critical elements: (i) Economic enterprises are owned privately, not by the state or by communities or by the workers. (ii) The labor that is used to produce goods and services in those enterprises is obtained through voluntary market exchange: the labor market. U.S. economy is 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? Babies Sexual services Body parts National parks

III. TWO PRIMARY ARGUMENTS IN DEFENSE OF CAPITALIST MARKETS 1. MORAL ARGUMENT: capitalist markets promote freedom 2. PRAGMATIC ARGUMENT: capitalist markets promote efficiency & prosperity.

III. TWO PRIMARY ARGUMENTS IN DEFENSE OF CAPITALIST MARKETS 1. MORAL ARGUMENT: capitalist markets promote freedom 2. PRAGMATIC ARGUMENT: capitalist markets promote efficiency & prosperity.

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: Planning and command Markets and voluntary exchange DEFINE PRAGMATIC: A “Pragmatic” defense means that something works better than alternatives; it is the best way to solve a practical problem. GIVE EXAMPLE: BUILDING A HOUSE

How do markets solve the problem? Adam Smith’s “invisible hand”: 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.”

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

Key mechanisms that do the solving: Supply & demand + prices Coordination through information and incentives generated by prices. Implication: Consumer Sovereignty and allocative efficiency

Key mechanisms that do the solving: Supply & demand + prices Coordination through information and incentives generated by prices. Implication: Consumer Sovereignty and allocative efficiency

Key mechanisms that do the solving: Supply & demand + prices Coordination through information and incentives generated by prices. Implication: Consumer Sovereignty and allocative efficiency Example of how buying a chocolate bar  information to the store owner  information to the choc factory owner  information to the cocoa importer  information to the peasant in Nigeria Implication = when you buy a candy bar you are communicating with a peasant in Columbia!

The Technical idea of allocative efficiency: Pareto Optimality 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 Example: Example of randomly distributing oranges and apples ion a classroom

Two Kinds of Efficiency in Markets Allocative Efficiency: the distribution of things is “Pareto optimal” Dynamic Efficiency: optimal innovation and growth through incentives for risk taking

IV. The Market & Limited Government

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 The Problem: To defend the free market you need not only an argument for why free markets are GOOD, but also an argument for why government interference is BAD. Since it seems natural to people that governments can help us solve problems, what is needed is an argument against Government interference with markets.

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 (1) state incompetence: unintended negative effects of government intervention are pervasive  this mucks up efficiency of free market. Why should unintended consequences of state action be any less than private action? State malevolence: Frankenstein effect: building up the state to do good things  create an apparatus in which (a) bureaucrats pursue their own interests and enrich themselves at the expense of the people, and (b) powerful private actors can capture for their own particularistic purposes. This is heart of Trumps attack on “The Washington Establishment”