Overview of Comparative Economics

1
Overview of Comparative Economics

• Chapter II
• Market Capitalism

2
Market Capitalism

• Form of Ownership ? Most of the time land and
  produced means of production (capital stock) are
  owned by private individuals or private firms
• Role of Planning ? Market capitalism is usually
  planned by the market (with demand and supply)
• Material Incentives ? In market capitalism
  material incentives exist in forms of rewards for
  entrepreneurship and capital investment as
  economic profits

3
Market Capitalism

• Income Redistribution ? is usually done through
  social safety nets in market capitalism
• Role of politics and ideology ? Are market
  capitalist countries mostly democratic?
• Social democrat parties exist in market
  capitalist countries supporting income
  redistribution, extensive social safety nets,
  nationalization and central planning

4
Why market capitalism popular?

• End of communism ? most former communist
  countries are concentrating on market capitalist
  economic systems
• Predominantly market capitalist economies are
  making efforts to move toward a purer version of
  this system

5
Advantages and Disadvantages of Market Capitalist
Economies

• Experienced enormous technological advances and
  growth as they underwent the Industrial
  Revolution in the late 18th century
• ability to revolutionize the means of
  production
• Experienced large macroeconomic fluctuations with
  serious downturns in the 19th century (unequal
  distribution of income and increasing
  concentrations of industrial monopoly power)

6
Pure version of market capitalist system

• Pure version of market capitalist system does not
  exist
• Closest to the ideal of pure laissez-faire market
  capitalism are
• Hong Kong
• Singapore
• New Zealand

7
Efficiency

• Static efficiency ? no one in society can be made
  better off without making someone else worse off
• resources are being utilized to their best
  potential given the existing technology
• Dynamic efficiency ? allocation of resources over
  time to maximize long-run sustainable growth
• technological dynamism
• destabilizing process of creative destruction

8
Theoretical Efficiency of Market Capitalism

• Efficiency Theorem
• The general ability of markets to allocate goods
  and resources efficiently through the law of
  supply and demand
• A complete
• competitive
• full-information
• general equilibrium is efficient

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Theoretical Efficiency of Market Capitalism

• Complete
• For any good or service that affects someones
  utility, there is a market
• Competition
• There are many buyers and sellers with free entry
  and exit
• There are well-defined homogenous goods and
  services
• No individual supplier has any control over the
  price in his or her market

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Theoretical Efficiency of Market Capitalism

• Full information
• All agents in the economy know everything about
  consumer preferences, production technologies and
  prices
• General equilibrium
• Every single market is in equilibrium in the
  sense that the quantity supplied equals the
  quantity demanded of the good or service
• If that does not happen
• Surplus
• Shortage
• Partial equilibrium with a few markets being in
  equilibrium

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Theoretical Efficiency of Market Capitalism

• Efficiency
• Pareto optimality ? no one in the economy can be
  made better off without making someone else worse
  off
• If someone can be made better off without making
  someone else worse off, then the economy is not
  producing as much as possible of what people want

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Why is a complete, competitive, full-information,
general equilibrium efficient?

• Adam Smiths invocation of invisible hand of the
  market working across all sectors to allocate
  goods in a way that maximizes the wealth of the
  nations
• He founded classic laissez faire economics
• He argued that the government should get out of
  the economy (minimal government intervention)
• It is at the equilibrium price that the maximum
  amount will be both produced and sold and thus
  actually consumed by public

13
Invisible Hand

• In the free marketplace an invisible hand
  regulates and self-corrects the economy
• The market itself will regulate the economy
• Efficient producers will prosper and the
  inefficient producers will lose
• The public will get the best product for the
  lowest price
• Supply and demand will determine prices better
  than any government official can

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Limits to the Efficiency of Laissez-Faire Market
Capitalism

• Monopoly Power
• Externalities
• Collective Consumption Goods
• Imperfect Information

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Source of InefficiencyMonopoly Power

• Monopoly power prohibits competition
• Monopolist will maximize profits by setting
  marginal cost equal to marginal revenue
• Exceptions
• Natural monopoly
• Characterizing an industry with economies of
  scale (declining LRAC) even at level of output
  equal to total market demand
• Technological dynamism
• More competitive industries will be more
  technologically progressive

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Source of InefficiencyMonopoly Power

• Intermediate market forms
• Monopolistic competition
• Many firms, each having some price setting power
  as a result of product differentiation
• Excess capacity theorem
• Oligopoly
• Small number of firms in industry with reaction
  to any action taken by others
• Perfect collusion
• Joint-maximizing cartel (OPEC in oil crisis)
• Longest surviving cartel?

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Source of InefficiencyExternalities

• These are either costs or benefits that are born
  by or accrue to an agent other than the agent
  generating them
• External costs negative externalities
• External benefits positive externalities

18
Source of InefficiencyExternalities

• External costs are negative externalities, such
  as environmental pollution
• If the firm that generates pollution damages
  another industry but does not reduce that damage
  ? the private marginal cost to the firm does not
  equal the social marginal cost and too much
  pollution is produced, resulting in inefficiency

19
Source of InefficiencyExternalities

• External benefits are positive externalities,
  such as technological invention without patent
  protection for inventors
• If an inventor has no patent protection, then
  other firms can steal her invention and she may
  make no money even if her invention generates
  great social benefits
• Private marginal benefit to the inventor does not
  equal marginal social benefit of the invention
  and too little inventing will occur, resulting in
  inefficiency

20
Source of InefficiencyCollective Consumption
Goods

• Consumption goodspublic goods ? such as national
  defense
• Because of the nature of such goods, it is
  difficult for private markets to organize
  themselves to provide these goods in optimal
  quantities
• The characteristics of pure public good
• Nonexcludability of consumption It is not
  possible to exclude this kind of consumption
• Nondepletability of consumption Everyone
  consumes it simultaneously, and no individuals
  consumption reduces any other individuals
  consumption
• Free-rider problem

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Source of InefficiencyImperfect Information

• Unrealistic to have perfect information
• When one party in a transaction knows more than
  another, special problems arise causing
  asymmetric information
• Akerlof The market for Lemons
• Principal agent problem
• Sub-optimizing behavior

22
The Role of Labor Unions

• Redistribute income to their members
• Deal with safety, job security, benefits, social
  functions and lobbying politically for broader
  social outcomes
• Offset the monopolistic power of big firms

23
Macroeconomic Instability of Market Capitalism

• The General picture
• The major market capitalist economies have been
  less than perfectly stable over time
• There was a general increase in unemployment
  rates after the early1970s in many countries,
  associated with a general stagnation of economic
  growth, that appears to have been reduced
  recently
• The considerable variation in capital investment
  can be explained by factors
• Exogenous fluctuations in new technologies that
  can serve as the basis for the investment
• Fluctuations in government monetary policies
  affecting interest rates
• Psychological fluctuations due to the animal
  spirits of those making investments

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Macroeconomic Instability of Market Capitalism

• QUESTION
• Why do these variables lead to fluctuations in
  the unemployment rate, since in a perfectly labor
  market, wage rates should fall when the demand
  for labor falls, thereby preventing the emergence
  of any involuntary unemployment?
• TWO DIFFERENT ANSWERS
• Keynesian School
• Classical School

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Macroeconomic Instability of Market Capitalism

• Keynesian School
• Rigidities of various sorts exist in labor
  markets and that capital investment can collapse
  and stay down for extended periods of time, as in
  the Great Depression
• The implication is that government intervention
  through fiscal or monetary policies is advisable
  to stimulate the economy and to stabilize and
  smooth out business cycles

26
Macroeconomic Instability of Market Capitalism

• The Classical School
• Deriving from 19th century classical political
  economists such as David Ricardo
• Market capitalist economies are powerfully
  self-stabilizing
• Conscious government intervention merely
  generates inflation and intensifies fluctuations
• To minimize unemployment, unions should be broken
  up and a stable fiscal and monetary environment
  should be maintained within a laissez-faire
  environment

27
Laissez-faire Economic Policies

• Shift toward supporting more laissez-faire
  economic policies
• There is a tension between asserting the
  efficiency of competitive equilibria and
  recognizing the limits of the applicability of
  that theorem
• Chicago Schools (Milton Friedman) argument draws
  directly from the efficiency theorem and follows
  by asserting the irrelevance or unimportance of
  the various exceptions and limits

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Chicago School

• Markets are almost always efficient, so
  government should keep its hands off
• The most externalities will be resolved by
  private markets if property rights are properly
  defined and enforced free market
• Many of the goods provided by the public sector
  are not really collective consumption goods and
  could be more efficiently provided privately
• Information costs are inevitable and cannot be
  avoided
• The Chicago School supports the Classical School
  approach in macroeconomics
• Friedman is the most prominent advocate of
  monetarism in the US
• With respect to distribution of income, people
  should be allowed to keep what they earn from the
  free market
• Inequalities are the necessary outcome of
  providing sufficient incentives for production,
  investment and growth

29
Public Choice Theory

• Criticism of government intervention
• The government agencies designated to carry out
  the market-correcting activities are
  self-interested agencies that became captured by
  special interests operating through their
  legislative connections
• Anne Krueger rent-seeking

30
Austrian School

• They reject equilibrium analysis and emphasize
  dynamic market processes
• Entrepreneurs are the most important agents in
  the economy
• They must be allowed to function freely, without
  government restriction, so that they can lead the
  market to evolve in conjunction with the
  evolution of consumer preferences through process
  of innovation
• Static efficiency is relatively unimportant
• It is the dynamic success of market capitalism
  that is its most important economic feature