1. Chapter 2 (1.1): How the market works? What is the market? –Voluntary exchanges –Invisible hand –Self-correcting through price mechanism Assumptions to understand how the market works? –Individuals: unit of analysis –Individuals are self-interested –Individuals are rational

2. Chapter 2 (1.2): How the market works? What is Laissez-faire doctrine? The government should let the market rule the economy. Why? –Allocative efficiency, innovation, liberty But we need perfect competition

3. Perfect competition All small and there are many No barriers Consumer rational and maximize Technology constant or decreasing returns on scale Buyers and sellers full knowledge Sellers’ items are identical Prices flexible Transaction cost = 0

4. Market failure Public goods Externalities Monopoly Information asymmetry Agent misdirection –Agents act on behalf of principals. client – attorney, shareholder - manager, citizen – bureaucrat. Social goals Inequality Economic instability

5. Public Goods Tangible and intangible items that people use together. They have value that spills onto people without their assent or awareness. Different from publicly-provided goods. The market will not provide them in sufficient volume Attributes: excludability and subtractability Few pure public or pure private goods exist. Problem: free riding. –Stopping free riding – high transaction cost

6. Externalities They are external to market exchanges, and thus do not figure in producers’ and consumers’ internal accounting. Link with public goods. Public goods are items with large positive externalities.

7. Monopoly and imperfect competition In some markets buyers or sellers have the power to dictate exchange terms. Monopolies may be simply the winners in wars of competition or the result of unfair competitive tactics. They may be unavoidable. Then people frequently prefer them to be publicly owned or at least monitored by public service commissions.

8. Information asymmetry Limited or lopsided information Transaction cost: Information is neither free nor easy to get. –People has mobilized to get the government to pick up the tab. Adverse selection: Since producers are likely to have more information than buyers they may abuse their position of power.

9. Agency problems Principal agent: Client – attorney; shareholder – manager; citizen –bureaucrat. Moral hazard: Agents are tempted to put their self-interest ahead of the interest of the principal. Transaction cost of monitoring very high. Government offsets but introducing legislation that punish to those agents who do wrong by their principals. Example: Insider trading legislation.

10. Social goals We do not want “obnoxious” markets to function: e.g. drugs, prostitution, gambling. We want the market to produce some goods (“merit goods”) which it does not or only limitedly: food, housing, health, education. Welfare state: –FDR’s New Deal (1933): Food aid, subsidized public housing, subsequently unemployment insurance, social security, aid to children –Lyndon Johnson’s Great Society (1963-69): Food Stamps, Medicare, Medicaid. –1970s – 2 nd thoughts

11. Inequality and unfairness People born in poverty have fewer chances of getting ahead Governments can take the rough edges off the income distribution.

12. Economic instability The market is prone to boom and bust Bust periods are supposed to clear out inefficient firms but citizens may not want to bear the pain without any type of safety net. Keynesian economics: Bust periods are made worse when the government cannot spend money (become a buyer, an actor in the market)