Economics 1: Principles of economics

Looking at the basics

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Free markets

Markets: The market is a conceptual place where demand and supply meet

"Partial equilibrium" - the single good/industry market is shown in the market cross.

Law of Supply; The number of goods supplied increases with price - at a higher price more suppliers are likely to enter the market and suppliers may expand their production at a higher price.

Law of Demand: The number of goods consumers demand will fall with an increase in price - some buyers may be unwilling/unable to buy at a higher price.

Competition: with free entry and exit of participants, if the price consumers are willing to pay is above the price at which suppliers are willing to supply the quantity supplied will increase and vice versa. Equilibrium is reached at point OQE and price PE. The last unit sold costs OPE to produce and sells at the same price.

The area between the two curves is the net social benefit obtainable in this market or industry - it is the difference between the total balue to consumers and the cost of production to suppliers. The net social benefit is highest at 0QE. Distortions can occur if there are too few suppliers. The excess profit they make is called a 'rent'.

The economic case for the free market is that the prices can adjust without interference from third parties.

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Normative arguments for the free market

Modern market theory claims the pointat which net social benefit is the highes is 'optimal' in a normaitve sense.

Wilfredo Pareto (c1920): at the point of equilibrium no-one can be made better off without someone else being made worse off. Exchanges between individuals lead to the optimal allocation for all parties. No other state is unanimously preferred - unanimity of opinion makes it efficient. 

This is called 'allocative efficiency', the central concept of efficiency in modern market theory. It is the only one that makes reference to free market theorists' idea of normative standards for economic interactions

'Market Imperialism' - the idea that everything in society should pay its own way.

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General equilibrium

General equilibrium: This principle states that the case of partial equilibrium can be extended to an infinite number of markets.

There exists an optimal allocation of resources across an infinite number of markets and industries, attainable through the price mechanism, that leaves an infinite number of individuals satisfies and equates demand and supply in each of these markets at the same time.

Assumptions behind 'general equilibrium':

Each agent starts off with a set of assets, over which property rights are defined and which can be protected costlessly.

All agents are rational - they have complete and consistent preference ordering over all possible choices. This is mathematically sufficient to define a utility function for the consumer and a profit function for the producer, each of which can be maximised through buying and selling assets.

Markets for all relevant commodities exist. This assumes mthat there are markets at anvery point in time and every location.

If all these are satisfied, there exists a set of simultaneously determined prices that clears all markets. It has the nrmative characteristic of being Pareto-optimal. 

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Free market definitions

Charles Lindblom:

A free market is one in which each economic actor is able, free from coercion and in a competitive environment, to conduct such transactions as will give him or her the maximum benefit (profit/utility). Economic actors are free to enter and exit markets as they wish. The interactions between buyers and sellers in the market system coordinate and organise individuals' activities without the need for government planning: factors such as the price of goods and the manner in which they are distributed are decided through market interactions alone.

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Roots of modern free market theory

Adam Smith: The 'Invisible Hand' - idea of spontaneous coordination in the economic sphere creating the best outcome for society as a whole.By maximising their own utility, individuals create the best outcome for society. By pursuing their own interest, they promote the interest of society more effectively than when they set out to do so.

Individualism: Free market theory has transformed broad philosophical individualism to methodological individualism. The former is a basic idea of the enlightenment (Locke - the state is the servant of the individuals who create it), and the latter states that all social outcomes can be explained in terms of decentralised and subjective individual choices. This is a radical step, from Adam Smith's 'invisible hand' to saying economic relations are fully described by individuals' choices at any time and place, under given resource constraints, based on their self-interest.

Utilitarianism: Jeremy Bentham, James Mill and John Stuart Mill. Society must be designed to maximise individuals' happiness. Pareto optimality is the interpretation of utilitarianism most compatible with the libertarian free market argument.

Rationality: Free market theory assumes individuals are selfish and rational. See Smith - the 'invisible hand' in the Wealth of Nations and Theory of Moral Sentiments (although this depends on numerous conditions). Individuals are capable of making rational choices in order to maximise their utility (Francis Edgeworth - idea of humans as 'pleasure-seeking mechanisms' allowed him to apply a mathematical framework to show that where perfect competition exists, each human will achieve the highest amount of pleasure possible).

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Free market theorists

Friedrich Hayek:

The institutions created by the inadvertent actions of individuals are better than those that result from central planning.

Markets protect the individual from coercion by the state - they allow activity to be adjusted without intervention, dispensing with centrally generated social controls and preserving individual choice. The market is the most efficient mechanism for processing the wide swathe of information necessary to coordinate the actions of individual economic agents. It preserves the sanctity of the individual Locke described.

Milton Friedman

Both Hayek and Friedman say competition is the most effective guardian of individual freedom by protecting individuals from coercion by each other. Buyers are protected from coercion by sellers because they are able to go to a different seller and vice versa.

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Free market policy prescriptions

Hayek, Friedman, Gissurarson etc propose a minimal role for the state because it could lead to coercion, loss of economic freedom and economic failure.

Hayek: The Road to Serfdom - an argument against Keynes-inspired 'moderate planning'. Socialism seeks to supplant competition with a directed economy, putting the consumer at the mercy of monopolies. In the book, he said the UK is moving blindly toward centralisation through moving healthcare and other previously privately-operated sectors into the public sphere.

Friedman: Removing economic power from the hands of the state acts as a counterweight to political power. Government should only create and enforce rules necessary for free market function, and adapt them where necessary. It should protect the vulnerable and provide services that can't be repaid in profit such as the army. Government intervention curtails the right to free speech.

Practical applications: World Bank and International Monetary Fund's espousal of the Washington Consensus. The consensus created the conditions under which developing countries may obtain loans, called structural adjustment policies. These promote liberalisation, privatisation and the reduction of trade barriers.

One example is the promotion of austerity measures in Argentina as a condition for the growing loans the IMF handed to the country from 1998. The IMF required government spending cuts in order to bring down inflation and reduce prices.

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Free market policy prescriptions

The 1970s economic crisis led eventually to the demise of Keynes's 'moderate planning' and the resurgence of free market-inspired economic policy on the back of perceived government failures resulting from over-reliance on the state.

Free market theorists say the state should not try to correct market failures as government failures are generally worse (Chang, 2002).

Free markets provide a predictable means to create the freest, most efficient society possible.

Friedman: I know of no example in time or place of an economy that has been marked by a large measure of political freedom that has not also used something comparable to a free market to organise the bulk of economic activity.

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Critiques of free market theory

Sraffa's Paradox: Piero Sraffa's critique of the partial equilibrium model is that the supply curve assumes that as production expands, production costs increase. The idea of the upward sloping supply curve goes as follows: competition means that it makes no sense for producers to expand production indefinitely so there is an optimal firm size. This is also ensured by the fact that producers will only produce so lng as the price they can obtain on the market is higher than the cost of producing one additional unit (marginal cost).

As long as marginal costs increase as production expands and eventually hit the point where the last unit produced costs as much to produce as the given market price, there will be an optimal firm size. But the assumption that marginal production costs go up as production expands depends on the 'law of diminishing marginal returns', which  says that as producers expand production, they employ more resources - inputs/factors of production such as land, labour and capital. Beyond some point, each additional unit of at least one factor of production will yield less and less output so producing more of a unit using this factor of production will cost more than before. Assumption 3 - some factors of production are variable while others are fixed (cannot be expanded in the short period) - however, this doesn't mean much any more now that we are not dependent on the land to produce units of production.

Sraffa - the upward-sloping supply curve is an unconvincing application of early 19th Century agricultural economics to modern industrial economics. It is not generally possible to find a case where the above conditions apply. This will have an affect on distribution, demand and ultimately, our industry. If changes in industries have effects on others, then there will be a different demand curve for every point on the supply curve.

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Critiques of free market theory

Charles Lindblom: The assertion that free markets are a necessary condition for freedom ignores constraints markets place on individuals and assumes non-market economies offer no choices. But in Soviet Russia and Communist China, planners gave subjects the ability to choose their profession - it is easier to allow volunteers to choose than draft a workforce. Ignorance, inequality of income both allow coercion within free markets, i.e. ignorance re the Bhopal accident; Nestle formula milk.

John Maynard Keynes: Free markets suffer from a 'fallacy of composition' - where that which is true for an individual may not automatically apply to society as a whole. One fallacy of composition is the 'paradox of thrift' - saving on an individual level is beneficial but if it occurs across the economy it may cause a recession my reducing demand.  This concept has been applied to the debt deflation theory - the 'paradox of debt' (Paul Krugman) - consumers' debt is increasing as they save more. 

Saving creates inefficiencies that would not be recognised under the free market concept (savings do not automatically create more investment) - equilibrium can exist even where there is mass unemployment.

Ha-Joon Chang: The concept of how far it is acceptable for the state to interfere is a political framework, not a set of universal principles. Neo-liberal economists who criticise minimum wages and high labour standards as unwarranted incursions also support immigration restrictions.

Schotter: Individualism is also alien to many cultures,i.e. in Japan where management analysts say Japanese companies are superior because they promote consensual managing.

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Critiques of free market theory

The assumption that agents rationally choose how to maximise their utility has come under attack.

The assumption forms the basis for the predictability of market outcomes and the conditions for the market's ability to maximise societal benefit.

The Carnegie-Mellon School, led by Herbert Simon developed the concept of bounded rationality - how agents 'satisfice' by setting reachable rather than maximal goals. Individuals use 'heuretics' - educated guesses - to calculate how to behave rather than maximixing.

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