Microeconomics Markets and Prices (Chapter 3)

1. MicroeconomicsMarkets and Prices (Chapter 3) Why people trade What markets do Why have firms?

2. Why people trade By virtue of exchange, one man's prosperity is beneficial to all others. Frederic Bastiat

3. It pays to be different • People trade for 2 reasons • Different abilities • Different preferences • Different abilities yield comparative advantages • Comparative advantage is the ability to perform a task at lower cost • Where you have comparative advantage you are more efficient • Comparative advantage yields gains from trade

4. Lessons from the Iowa Car Crop Source: Chapter 21, The Armchair Economist, Economics and Everyday Life, Steven E. Landsburg, The Free Press, New York, 1995, p. 197-199. A thing of beauty is a joy forever, and nothing is more beautiful than a succinct and flawless argument. A few lines of reasoning can change the way we see the world. I found one of the most beautiful arguments I know while I was browsing through a textbook written by my friend David Friedman. While the argument may not be original, David's version is so clear, so concise, so incontrovertible, and so delightfully surprising, that I have been unable to resist sharing it with students, relatives, and cocktail party acquaintances at every opportunity. The argument concerns international trade, but its appeal is less in its subject matter than in its irresistible force. David's observation is that there are two technologies for producing automobiles in America. One is to manufacture them in Detroit, and the other is to grow them in Iowa. Everybody knows about the first technology; let me tell you about the second. First, you plant seeds, which are the raw material from which automobiles are constructed. You wait a few months until wheat appears. Then you harvest the wheat, load it onto ships, and sail the ships eastward into the Pacific Ocean. After a few months, the ships reappear with Toyotas on them. International trade is nothing but a form of technology. The fact that there is a place called Japan, with people and factories, is quite irrelevant to Americans' well-being. To analyze trade policies, we might as well assume that Japan is a giant machine with mysterious inner workings that convert wheat into cars. Any policy designed to favor the first American technology over the second is designed to favor American auto producers in Detroit over American auto producers in Iowa. A tax or ban on "imported" automobiles is a tax or ban on Iowa-grown automobiles. If you protect Detroit carmakers from competition, then you must damage Iowa farmers, because Iowa farmers are the competition. The task of producing a given fleet of cars can be allocated between Detroit and Iowa in a variety of ways. A competitive price system selects the allocation that minimizes total production cost.* It would be unnecessarily expensive to manufacture all cars in Detroit, unnecessarily expensive to grow all cars in Iowa, and unnecessarily expensive to use the two production processes in anything other than the natural ratio that emerges as a result of competition. That means that protection for Detroit does more than just transfer income from farmers to autoworkers. It also raises the total cost of providing Americans with a given number of automobiles. The efficiency loss comes with no offsetting gain; it impoverishes the nation as a whole. There is much talk about improving the efficiency of American car manufacturing. When you have two ways to make a car, the road to efficiency is to use both in optimal proportions. The last thing you should want to do is to artificially hobble one of your production technologies. It is sheer superstition to think that an Iowa-grown Camry is any less "American" than a Detroit-built Taurus. Policies rooted in superstition do not frequently bear efficient fruit. In 1817, David Ricardo – the first economist to think with the precision, though not the language, of pure mathematics--laid the foundation for all future thought about international trade. In the intervening 150 years, his theory has been much elaborated but its foundations remain as firmly established as anything in economics. Trade theory predicts first that if you protect American producers in one industry from foreign competition, then you must damage American producers in other industries. It predicts second that if you protect American producers in one industry from foreign competition, there must be a net loss in economic efficiency. Ordinarily, textbooks establish these propositions through graphs, equations and intricate reasoning. The little story I learned from David Friedman makes the same propositions blindingly obvious with a single compelling metaphor. That is economics at its best. *This assertion is true, but not obvious. Individual producers care about their individual profits, not about economywide costs. It is something of a miracle that individual selfish decisions must lead to a collectively efficient outcome.

5. What markets do The natural effort of every individual to better his own condition is so powerful that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often encumbers its operations. Adam Smith

6. Information and incentive problems • Fundamental problem: produce output customers want at least cost • Information often held by many individuals and is specific/local (expensive to transfer) • Decision makers often don’t face the right incentives • Principal challenge: provide decision makers the relevant information and motivate them to use it correctly

7. Cost of transferring knowledge General Knowledge - low cost to communicate - more likely to centralize Specific Knowledge - high cost to communicate - more likely to decentralize General vsspecific knowledge • Distinctions • Perishability • Complexity • Idiosyncratic • Subjective • What has been the effect of technology on the cost of knowledge transfer?

8. Market solutions • How do markets solve information and incentive problems? • Private property rights (Greece’s Property Rights Problem: 2:40-2:45) • Prices • Markets • Allocate resources and property rights to their highest value use • Make good use of specific knowledge • Reward and punish resource owners • Market coordination decentralized • How would a central planner solve the fundamental problem?

9. The market as a metaphor • What did we say markets are good at? • Could your organization’s structure mimic a market? • Could transfer prices help? • Still, most coordination of organizational activity is done administratively – Why?

10. Why firms then? Whether a transaction would be organized within a firm or whether it would be carried out on the market depended on a comparison of the costs of organizing such a transaction within the firm with the costs of a market transaction that would accomplish the same result.  All this is very simple and obvious.  But it took me a year to realize it – and many economists seem unaware of it (or its significance) to this day … As it was a new approach (I think) to this subject, I was quite pleased with myself.  One thing I can say is that I made it all up myself.  As I said in my Nobel Prize lecture, I was then twenty-one and the sun never ceased to shine. Ronald Coase

11. Transactions costs • A firm is an institution that hires and organizes inputs to produce some output or outputs • Why do they exist? Why isn’t everyone an individual contractor? • Because of transactions costs (Coase) • What are transactions costs? (See first 1:40) • Finding “contractors” • Negotiating and enforcing contracts

12. Firm boundaries • Why don’t we just have one big firm? • There are also internal contracting costs • Motivating workers who aren’t owners • Monitoring performance • Transferring information • What is the optimal boundary? (What did Coasesay)

13. Make or buy? What do you think about these statements? • Make the input if it gives you a competitive advantage • Buy the input to avoid the costs of production • Make the input to keep profits from its sale • Make the input because you can make it at cost, where you would pay market prices to buy it

14. Conclusions • Exploit comparative advantage, become more efficient and reap gains from trade • International trade is just a form of technology • Solve the fundamental problem by providing the right information and the incentives to use it • Appeal to markets for decentralized solution to coordinating economic activity • Transactions costs give rise to firms and establish their boundaries