Lecture 5
Cracks in the Wall
My description of neo-classical economics might cause one to think that the mechanism is perfect. It's a model in which every product and service is produced to the point that the cost of producing the next unit exactly equals the dollar measure of the amount of enjoyment people are getting from that product. This is, indeed, an optimal solution. If you produce less than this amount, the amount of enjoyment people get from the product will be greater than the cost of producing it. You should produce more. If you produce more than the equilibrium amount, the cost of the incremental unit will exceed the enjoyment that people get from it, so it should not be produced. Only the equilibrium point (of an intersection of a demand and supply curve) yields a solution such that the incremental cost equals the incremental enjoyment (utility).
Not everyone agrees, however, that the neo-classical vision is either optimal or correct. Some economists, such as the American Institutionalist School, felt that neo-classical analysis was static and unrealistic. These economists, John Commons, Wesley Claire Mitchell and Thorstein Veblen among them, developed alternative views of the economic system. Veblen felt that the economy was, in effect, victimized by businessmen. Their goal, he felt, was to strategically withhold production, driving up prices and profits. Humans, Veblen thought, were driven by a series of basic motivations; among these motivations were "craftsmanship" and "predation". Craftsmanship was the basic human drive to create good and useful products‹usually dominant (in modern times) in production focused individuals such as engineers. Predation was the motivation of the Feudal nobles, and involves power, conflict and control. In modern economic society, businessmen are motivated primarily by "predation". They tend to restrict efficiency and output rather than promote it. A proper economic society, Veblen felt, would be organized under the control of those motivated by "craftsmanship". Veblen was best known as a social critic through his most famous book, "The Theory of the Leisure Class", in which he lambasted the rich and powerful. While important in intellectual history, the institutionalists faded from mainstream economic consciousness.
More significant is the market's inability to deal with certain conditions and goods. These situations where the market cannot properly operate are called "market failures". The first of the market failures is:
PUBLIC GOODS:
Public goods are products or services whose distribution cannot be controlled. A lighthouse, for example, provides a service that is fully rendered when the navigators sees the light. There is no way to make the navigator pay for the service, and his utilizing doesn't diminish the service, so it's still there for others to enjoy‹free of charge. Because you can't restrict the use of the service, and thus can't charge for it, it is impossible for a normal business to provide the product. National defense is another such service. Broadcasting would have been had station owners not figu
red out the people would pay to advertise on their stations. In fact, many countries, Britain for example, chose to treat broadcasting as though it were a public good. The British taxed people who used broadcasting (had radio and TV licenses) and used the proceeds to fund the broadcasting service. By freeing broadcasting from the whims of public taste and fancy, the BBC was able to pursue it's vision of quality broadcasting, generating, in process, some of the finest programming available.
There is another class of goods which receives attention from government in the form of subsidies and taxes. These are goods for which we may have a preference, like education, or and aversion (tobacco is an example). These goods are not "public" goods like those discussed above, but are, rather, goods for which the market does not make the decisions we'd like to see. In the case of education, we feel that people operating in the unfettered market will choose less education than it ideal. In order to get them to purchase more, we subsidize education so that, at the cheaper price, more education will be "purchased". The consumption of tobacco, on the other hand, would be greater than ideal under free market choices. As a result, we tax tobacco products to induce people to reduce their use of the product.
Another important example of market failure is found in the realm of external economics and diseconomies. When there is a cost or benefit flowing from the production or use of product that is not captured in the price of that product, we are facing what we call externalities. These are costs (or benefits) affecting people other than those producing or using the product for which no one is paid (or charged). For example, beekerpers are only paid for the honey their bees produce, but are typically not rewarded for the pollenation the bees do, to the great benefit of orchardists, for example. To the extent that bee keeepers are not rewarded for this external benefit, they will keep less than the optimal amount of bees. Often, orchards keep their own bees thus gaining the benefit of the pollenation and the honey--thus "internalizing" that "externality".
More ominously, the cost of dumping, say, paper mill effluent into rivers is not apparent to the mill owners (or wasn't over much of US industrial history). Costs such as this affect the environment adversely, but are not automatically picked up in the price of the good in question. Similar external dis-economies occur when any waste is disposed of in the air or water: automobile exhause, toxic chemical dumping, sulphur and other compounds in the air all lead to serious economic and environmental consequences but are never charged to the customers that use the products which cause these emmissions. The problem, here, is a lack of ownership in the air and water. No individual owns the air or water. It is commonly held. When something is commonly heald, there is no clear way to regulate or limit the use of that product. In Medieval Europe, many Manors would have common lands. These were for the use of everyone. What happened, typically, was that these lands would be over grazed and stripped of firewood. Gradually, it would become clear that the commons was "wasting", when that realization emerged, the logical thing to do would be to manage the use of the commons to that it could provide a sustainable flow of services (grazing and firewood) to all. In fact, since there was no one who could limit the use, people would increase their use in order to get some of the grazing or firewood before it was all gone. Far from slowing the destruction of the commons, the behavior of commons users would hasten it's demise. The destruction of commons lands flows from the lack of any ownership in the land, and is referred to as the tragedy of the commons.
In modern times, the lack of ownership in the air and water meant that there was no obvious way to regulate the dumping of waste there. In fairness, it wasn't untill the industrialization of the US was well along that it became clear that Ýhese costs existed and were serious. While industrial output and population was small, the free dumping of wastes into the air and water probably was not terribly damaging. As the economy grew larger, however, these cost have become significant and serious. In order to assure that these costs are taken into account they need to be determined and applied to prices so that people can have the correct information about the real costs of the products and services they use.
In order to include these costs, they must be identified and somehow measured. This is far easier to say than to do. Some of these costs involve causing illness and premature death among people. What is the value of a human life? Is it the value of the output one produces in the course of a liifetime? We do use this measure, but are we happy with it. What is the value of a species? How do we quantify this? What is the value of untrammeled wilderness? Do we have any agreement among ourselves as the what "nature" means, much less what it is "worth"? Obviously, these are political questions. We need, via the political process, to determine what the definition of costs shall be, and how the should be measured. Economists cannot answer these questions for us, nor can scientists. We must decide as a nation according to our best judgement. Having done this, we can use economics as a tool to help us "internalize" these costs effectively.
For example, it makes less sense to simply order polluters to desist, or to cut pollution by some equal percentage, accross the board. While it may sound "fair", it really is a poor use of our anti-pollution resources. Obviously, some sources of pollution are cheap and easy to remove, others are middling so, and others, still, are very, very costly to mitigate. Logically, we should concentrate on those areas where lots of pollution reduction can be achieved at little resource cost, and allow the most costly to mitigate sources of pollution to continue pending some sort of improved technology. The way to do this is to determine how much pollution you're going to allow, and sell the rights to do that polluting to the highest bidder. The polluter willing to pay the most for the right to continue dumping will be the polluter for which mitigation is the most costly. Folks who can clean up cheaply, will pass on the bidding, and buy cleanup technolgy. In this way, we get the biggest "bang" for our antipollution expenditures.
There is, further, a sense in which the market model generated by microeconomics is incapable of dealing with very large parts of our modern economy. Microeconomics, for example, is based upon the assumption of
perfect competition.
Perfect competition presumes the following conditions:
1. All firms are small, too small to affect the price of what they produce. They are "price takers", in the sense that they take the price determined by the market--wheat farmers would be a modern example.
2. There is not advertising. All products are "generic". There are no brands--it's like every produt is the same as the generic "BEER" beer, that came in white cans with black lettering. The idea is that no firm can develop "market power" through the consumer's belief that a certain brand is "better". If I think that Heinz catsup is better than the others, I'll pay them more for it and be a bit "loyal" to that brand. We don't want "mini-monopolists" in pure microtheory.
3. Perfect knowlege and foresight. We assume that all producers, workers and consumers fully understand the options open to them everywhere in the world, and know with certainty what will happen in every market. We want a perfectly working microeconomic world, and don't want people to do things through ignorance.
4. Ease of entry and exit from any industry. We want resources to flow toward greater opportunities as quickly as possible.
5. Quick and easy movement of resources between all productive applications in the economy. We want resources to move quickly and freely toward their best options.
These simplifying assumptions allow us to see where the "pure" market economy will go according to it's own internal logic. We don't want to deal with monopolsts, market power, sticky resources and ignorance in seeing where things will go left to themselves. They can considered by themselves, one by one, later. All of this works quite well for perfectly competitive firms, and for monopolists, oddly enough. It is more difficult to deal with Oligopoly, a system where there are a few larger firms. These few larger firms differ from small firms because (unlike perfectly competitive firms or monopolists) they face effective retaleration from large competitors. The competitive firm cannot raise his prices, because he simply takes prices. Monopolists choose an output level that gives them the optimal price. Oligopolists don't have the same control over prices as monpolists, and face the responses of othere firms in the industry. Because of this, it is difficult to predict what output and prices will result from oligopolist decisions. Some economists have tried game theory, market share enhancement, personal empire building and simply getting by as the motivation of oligopolistic, corporate officers. None of these theories successfully predicts what oligopolies will do any better than microeconomic theory does. On the basis that simple theories are better than complex ones, particulaly where the simpler theory predicts as well or better, most economists argue that oligopolists act like profit maximizers, or they go out of business in the longer run.