Foundations Of Economics Analysis Lecture Part 2

The Business Sphere The business sphere is made up of firms that are expected to look for opportunities to buy and manage resources in such a way that, after their product is sold, the owners of the firm will earn profits. Whereas the core sphere responds to direct needs, and the public purpose sphere responds to its constituents, business firms are responsive to demands for goods and services, as expressed through markets by people who have the resources to buy the firms’ products. business sphere: firms that produce goods and services for profitable sale It is sometimes thought that maximizing profits is the only goal of businesses. But firms may have motivations beyond profit maximization. They may consider social and ethical aspects in making business decisions, and may aim to be a good “corporate citizen,” with regard to their workers, communities, or the environment. Additionally, the activities of “the firm” are made up of the activities of many people, including its stockholders, board of directors, mid- and top-level managers, and employees. The interests of the various individuals and suborganizations may be in conflict. Sometimes, top officers and managers may act, for example, not in the profit-making interest of the owners but according to their personal self-interest such as maximizing their own prestige and incomes. Profits, and even the long-term survival of the company itself, may be sacrificed in a race for individual high salaries and lucrative bonuses. One strength of businesses is that because they have at least one clear goal—making a profit—their efficiency in reaching that goal may be greater than the efficiency of actors in the other two spheres. The profit motive of businesses also encourages innovation: People are motivated to come up with clever new ideas when they know that they may reap financial rewards. We all benefit from innovations when they bring us improved products at lower prices. We should note, however, that the public purpose sphere has also often played a critical role in innovation (see Box 2.2). The relative weakness of the business sphere comes from the fact that business interests do not necessarily coincide with overall social well-being. Firms may act to enhance social wellbeing—for example, by making decisions that consider the needs of their customers and their workers, as well as taking into account environmental impacts—but business sphere production has no built-in correction for adverse social and environment impacts. A more detailed discussion on some of the key limitations of the business sphere can be found in Section 3.4. BOX 2.2 THE GOVERNMENT’S ROLE IN INNOVATION Much economic analysis focuses on entrepreneurship and innovations in the business sector as the key drivers of the economy. Proponents of the free market sometimes argue that the private sector—motivated by the profit-maximizing goal—is more efficient and more innovative than the public sector. They therefore advocate for an expansion of the private sector into sectors like education and health care. Others argue that these activities are normally better undertaken in the public sector, as universal access to education and health care are essential for a healthy society. Evidence indicates that government plays a key role in supporting the business sector in the United States. Not only does the public sector provide the physical and informational infrastructure on which businesses rely, but also many well-known success stories in the business sector have depended on government inventions. Take, for example, the case of iPhone. The success of iPhone has been largely attributed to Apple—a private corporation. However, each of its core technologies, including capacitive sensors, solid-state memory, the click-wheel, GPS, internet, cellular communications, Siri, microchips, and touchscreen, are innovations that came from research supported by the U.S. government and military. Economist Mariana Mazzucato argues that long-term and steady government funding in technological research has been a nearly invariable prerequisite for breakthrough innovations. She points out that the public sector is, in fact, often more innovative than the private sector, as the government is more willing to make riskier investments.3 In the health care sector, also, the government has taken a lead in research and innovation, with almost 75 percent of all important new drugs coming from funding through the National Institutes of Health. Major pharmaceutical companies do develop innovative drugs, but they also invest heavily in advertising, and in developing “me-too” drugs to try to undercut their competitors. Data from GlobalData, a healthcare research firm, shows that nine out of the top ten pharmaceutical companies spent more on advertising than on research.4 This is partly the result of the United States being one of only two countries where it is legal to market prescription drugs directly to consumers.5 The Size of the Three Spheres Figure 2.5 presents estimates of the monetary value of the annual production of goods and services in the United States by the three spheres in 2018, in dollar and percentage terms. The business sphere contributed 64.6 percent of production, the core sphere 21.1 percent, and the public purpose sphere 14.3 percent. The dollar figures add up to more than the GDP in that year ($20.6 trillion) because an estimate of the value of unpaid household labor as equal to 18 percent of GDP has been included.6 This differs from government estimates of GDP in the United States, which do not currently include the value of household production. Figure 2.5 Estimates of the Size of the Three Spheres in the United States, 2018 Sources: U.S. Bureau of Economic Analysis, GDP and Personal Income database, and authors’ calculations. In addition to the three spheres discussed so far, all countries have, to some extent, an informal sphere. The informal sphere is composed of market enterprises, normally small in scale, operating outside government oversight. Although this sphere could be classified as “business” because it involves private production for sale, it is also similar to the core sphere in that the activities are very small-scale and often depend on family and community connections. Economic activities in the informal sphere may be illegal, as in the case of illicit drugs or prostitution. Other informal sphere activities are legal but do not appear in GDP statistics, such as house cleaning services provided “off the books.” Barter transactions are also part of the informal sphere. informal sphere: businesses, usually small in scale, operating outside government oversight and regulation. Though accurate data on the size of the informal sphere are difficult to obtain, the average size of the informal economy in 158 countries between 1991 to 2015 was estimated to be 31.9 percent.7 A 2018 study estimates that 60 percent of the world’s employed population are in the informal economy, with 93 percent of those living in emerging and developing countries.8 Discussion Questions 1. Education is sometimes provided within the core sphere (at-home preschool activities and home schooling), often provided by the public purpose sphere (public and nonprofit schools), and sometimes provided by for-profit firms (“charter schools” or firms offering specific training programs). Can you think of some possible advantages and disadvantages of each of these three ways of providing education? 2. Describe three situations in which economic activities could affect their environmental context and three ways in which economic behavior could affect their social context. How might these influences that the economy exerts on its contexts result in changing how the contexts, in turn, affect (either support or constrain) economic activity? 3. THE ROLE OF MARKETS Having discussed the three major spheres of economic activity, we now take up the more specific issue of how markets work. We begin by defining precisely what we mean by “markets.” Then we look at ways to make markets work smoothly and consider the various advantages and limitations of markets as a way to conduct economic activities. 3.1 THE MEANING OF MARKETS When you think of the word “market,” you probably think of a store where you buy groceries. But in economics, the word “market” is defined more broadly and has at least three different meanings, ranging from very concrete to very abstract. The appropriate meaning of market must be judged from the context in which it appears. The most concrete and commonsense definition of a market is that it is a place where people interact physically or virtually to buy and sell things. Historically markets have been physical locations such as the Grand Bazaar in Istanbul, Turkey, or African village produce stands where people meet and engage in exchange transactions. In the modern age, the market “location” could be a physical place such as a shopping mall or a stock exchange building. But it could also be virtual, such as Amazon or eBay, where buyers and sellers can come together to make market transactions. Most stock exchanges have also moved to electronic trading, although a role remains for brokers on the floor of the New York Stock Exchange. market (first meaning): a physical place or Web location where there is a reasonable expectation of finding both buyers and sellers for the same product or service A more general definition of market is that it is a concept that covers broad product categories. For example, we can speak of the “real estate market” in a particular city, the market for used cars, or the market for wind turbines. Economists often study trends in specific markets, such as heating oil or AT&T bonds, to try to forecast what might happen in the future, or advise on the specifics of market structures. market (second meaning): the interaction of buyers and sellers defined within the bounds of broad product categories, such as the market for used cars or the real estate market In the most abstract terms, people refer to markets as an economic system, for example, describing the United States as having a “market economy” or indicating a preference for “free markets.” In this macroeconomic sense, a market economy is one that relies heavily on markets (according to both our first and second definitions) to conduct economic activities. market (third meaning): an economic system (a “market economy”) that relies on markets to conduct many economic activities One alternative to a market economy is a system that relies on central planning to conduct economic activities, as was the case in the Soviet Union. China retains many elements of a central planning system, though the role of markets in China has expanded significantly in recent decades. But even in modern market economies, not all activities are structured by markets. For example, the distribution of resources within the core sphere is mainly based on social or family relationships, and decisions about resource management are often based on scientific evidence or political preferences rather than market forces. Differing views on the role of markets within an economic system underlies many current debates in economics. Economists who have a “pro-market” view believe that market systems function fairly smoothly and are largely self-regulated, and that a laissez-faire economy (one with very little government regulation) is most likely to lead to economic growth and prosperity. Other economists recognize the effectiveness of markets but believe that problems such as poverty, inequality, environmental degradation, and declining social ethics may be caused or exacerbated by unregulated markets. They therefore advocate for government policies and other forces of culture and ethics to ensure that markets serve the broader goals of human well-being. As we examine different issues throughout this book, we frequently refer to these perspectives. laissez-faire economy: an economy with little government regulation 3.2 THE INSTITUTIONAL REQUIREMENTS OF MARKETS Contemporary markets do an amazing thing: They allow many separate decision-makers, acting on decentralized information, to coordinate their behavior, resulting in highly complex patterns of economic activity. However, markets depend on institutions to operate smoothly. An institution refers to a formal or informal rule that structures human interactions. They include laws, customs, norms, routines, and operating procedures. In other words, they encompass everything from a national constitution to table manners. institution: formal and informal rules that structure the relationship between individuals and groups Organizations (for example a hospital) are sometimes called institutions, but it makes more sense to consider organizations as sets of particular institutions. For example, a hospital’s operations are structured by federal and state laws; customary procedures for doctor visits; and rules and procedures concerning patient admissions; care, and discharges. Organizations are usually housed in buildings and contain physical infrastructure, yet an organization’s essence is represented by the formal and informal institutions that govern it, not physical infrastructure. This is why even when an organization relocates to a different building, it can essentially be the same organization. Many institutions help markets work more smoothly. For example, credit cards are an institution that facilitates purchases without the use of cash. Consumer protection laws are an institution that defines certain exploitative business practices as illegal. The ability to return purchased items for a refund can also be viewed as a widely accepted institution. We classify institutions that facilitate the functioning of markets into three broad groups: 1. institutions related to property and decision-making 2. social institutions of trust 3. money as a medium of exchange. Institutions Related to Property and Decision-Making For markets to work, people need to know what belongs to whom or at least who can or cannot have access and control over something. Ownership is usually defined through systems of property rights set out in law and enforced by courts and police. Private property is the ownership of physical or financial assets by nongovernment economic actors. Common property is ownership of physical or financial assets by the government or particular subsections of society. private property: ownership of assets by non-government economic actors common property: ownership of assets by government or particular subsections of society Within a market economy, actors must be allowed to make their own decisions about how to allocate and exchange resources that belong to them. Prices, in particular, must not be controlled by a central planning agency; generally, they should be set by the interactions of market participants themselves. The institutions of private property and individual decision-making exist both formally, in codes of law, and informally, in social and cultural norms. For example, some Western economists expected markets to grow quickly in the countries of the former Soviet Union as soon as communism was dismantled and opportunities for markets opened up. This failed to occur, partly because many people living in these countries were accustomed to being told by the state where to work and what to do. Norms of individual initiative and entrepreneurship, it turns out, do not just arise naturally but need to be fostered. Nor did other sorts of market infrastructure appear quickly, and the post-Soviet Russian economy went into a severe decline for some time. When market institutions did develop, they were often designed to facilitate the concentration of power and oligarchy (control by a few very wealthy people). The difficult transition to capitalism in the former Soviet Union indicates that institutions matter and that good institutions do not emerge quickly, naturally, or easily. Social Institutions of Trust A degree of trust must exist between buyers and sellers. When a buyer puts down her payment, she must trust that the seller will hand over the merchandise and that it will be of the expected quality. A seller must be able to trust that the payment offered is valid, whether it is in the form of currency, a personal check, credit card, online payment, or a promise of future payment such as an installment loan. The establishment of direct, one-on-one exchanges between customers and businesses help to build trust and make future transactions smoother. Consumers are more likely to choose sellers with whom they have had good experiences in the past. They may also rely on reputation of firms based on online reviews such as Yelp, or on perceptions about the quality and prices associated with brand names to make consumption decisions. Cultural norms and ethical or religious codes can also help to establish and maintain an atmosphere of trustworthiness. In some cases, the terms of trade between different parties may be established informally, based on verbal terms or cultural and social expectations. However, in cases where market transactions take place in large, complex, mobile societies where buyers and sellers may not know each other, a more formal, usually written, contract may be needed to legally enforce the terms of exchange. Hence, legal institutions provide an important basis for many market transactions. Even with a system of formal contracts, social norms are still essential, as it is costly to write and enforce detailed formal contracts, and it is impossible to cover every conceivable contingency. The legal system can work smoothly only if most people willingly obey most laws and believe that it is dishonorable to cheat. In other words, formal institutions usually depend quite heavily on the presence of good informal institutions, particularly good norms of behavior. In highly marketized economies, many other institutions have evolved to deal with the issue of trust. For example, credit bureaus keep track of consumer credit trustworthiness, Better Business Bureaus keep track of complaints against businesses, and money-back guarantees give consumers a chance to test the quality of a good before they commit to purchasing. Government agencies such as the U.S. Food and Drug Administration and local boards of health are charged with monitoring the quality and purity of many goods that are sold. Clearly, relationships, social norms and government-created laws are all institutions that are essential to make market activity possible. Money as a Medium of Exchange The final basic institution required to facilitate the operation of markets is a generally accepted form of money. Many different things, such as carved stones or particular types of seashells, have been used as money in the past. Gold, silver, and other metal coins were the most common choice for many centuries. More recently, paper currency became important. Today, the use of checks, credit cards, debit cards, and electronic payment systems further facilitates making payments for goods and services. What makes something money? Three criteria are necessary for something to be defined as money in a market economy. 1. Money must be widely accepted as a medium of exchange. 2. Money must provide a durable store of value. Imagine the problems that would occur if heads of lettuce, which rot within a week or two, were proposed as money. The value of money must be relatively stable over time, and money must have minimal handling and storage costs. By this criterion, paper currency is better than coins, and electronic transactions are better still. 3. Money must be accepted as a unit of account. When people say that something is worth $1,000, that does not necessarily mean that they are proposing to buy or sell the item. Money serves as a way of valuing things, even if no market exchange takes place. money: a medium of exchange that is widely accepted, durable as a store of value, has minimal handling and storage costs, and serves as a unit of account In most cases, money is created by the banking system, with oversight by national governments. However, this is not always the case. For example, cigarettes have been used as a form of money by prisoners of war. Also, communities smaller than national governments can create their own money. These local currencies are typically exchangeable for goods and services within the community by participating merchants and individuals. In recent years, local “timebanking” currencies have appeared in some communities in the United States and elsewhere. People earn time dollars by performing valuable services for others or for the community as a whole, such as child care, tutoring, or building repairs. Time dollars can then be used to pay for other services or used instead of “normal” dollars to purchase products from local merchants (see Box 2.3). BOX 2.3 TIME BANKING Time banking is a system of exchange where time, not money, is the unit of value. Time banks bring together unused human resources with unmet human needs.9 When you join a time bank, you indicate what services you might be able to offer others: financial planning, computer debugging, handyman repairs, child care, and so on. For each hour (or fraction of an hour) you spend helping others, you accrue “deposits” in the time bank. Then when you require services, you can “withdraw” accumulated time to request help from others. Time banks differ from exchange through markets in several important ways. First, everybody’s time is normally considered equally valuable. Whether one is performing nursing services, tutoring new immigrants in English, or driving someone on errands, all activities earn time credits at the same rate (1 hour = 1 credit). Second, exchange through time banks helps build social relationships and community spirit. Many time bank members note that performing activities eventually become viewed as spending time with friends rather than work. In fact, according to one time bank director a majority of members don’t claim credit for all hours logged.10 Another interesting feature is that time banks can particularly flourish during economic downturns when traditional employment is difficult to find. Thus participants can still feel they are contributing to society, and accruing credit for needed services, without paid employment. According to the organization TimeBanks, there are about 1,000 time banks in the world, with about half of these being in the United States.11 In 2017 a time bank was created in the United Kingdom, partially funded by the UK government to provide care and companionship for elderly people. In this system, people contribute time helping others to eventually be redeemed when they themselves need assistance later in life.12 Time banking has become popular in New Zealand, where businesses and organizations can also participate, offering goods and services in exchange for time credits rather than money. 13 3.3 INFRASTRUCTURE FOR FLOW OF GOODS AND INFORMATION Another requirement of markets is physical infrastructure to enable the smooth flow of goods, services, and information. Physical infrastructure includes such things as roads, ports, railroads, and warehouses, but also telecommunications and utilities. physical infrastructure: roads, ports, railroads, warehouses, and other tangible structures that provide the foundation for economic activity The function of infrastructure is not just to allow the movement of goods; it is also required for information to flow freely. Producers and sellers need information on what, and how much, their customers want to buy to be able to decide on what, and how much, should be produced and offered for sale. At the same time, consumers need to know what is available, and how much they will have to pay to get the products that are on the market. Ideally, consumers should be able to compare all potential purchases to decide what will best suit their needs. It seems unlikely that this condition for perfect markets will ever be reached, but Web-based exchange systems such as Amazon and eBay have brought it much closer to realization. Note that infrastructure can be provided by both private and government entities. While private companies normally own things like warehouses, delivery trucks, and computers, governments normally construct and maintain roads, ensure air traffic safety, and make bandwidth available on the Internet. Even in an economic system that primarily relies on private markets, the role of government is critical in supporting market activity. 3.4 TYPES OF MARKETS Markets take a wide variety of forms. The two basic market types—product and factor markets— that we defined in the neoclassical model can be further categorized into different groups based on what is sold, as described in Table 2.2. Table 2.2 Different Types of Markets Market Type Retail markets Description Markets where goods and services are purchased by consumers from businesses, generally in small quantities. Retail markets deal in tangible goods such as food, books, and clothes, as well as non-tangible objects, including services such as banking or a haircut. Wholesale Markets where final goods are purchased by retailers from suppliers, markets normally in large quantities. For example, Wal-Mart and most other retailers don’t actually produce the goods they sell, but purchase them in bulk from suppliers in wholesale markets. Intermediate goods markets Markets where unfinished products are exchanged between businesses, such as the purchase of sheet metal by an automobile company. Resale markets Product markets for items that have been previously owned. Examples include used-car markets, and markets for antique furniture. Most shares traded in stock markets are also being resold, having been previously owned by other investors. Commodities markets Markets where raw materials such as agricultural products, minerals, or petroleum are bought and sold. Labor market A type of factor market, defined as the set of institutions through which people who wish to work offer to sell their services to employers. Unlike a physical object, labor cannot be produced first and then handed to the buyer; rather, the worker promises to do something in return for a promised payment of wages. Financial markets Markets for loans, equity finance, and financial assets such as stocks and bonds. Chapter 13 will focus on financial markets. Underground markets (black markets) Illegal markets, where either the good or service traded is illegal (such as heroin, or smuggled antiquities), or the goods and services are legitimate but the trading occurs through illegal ways. For example, smugglers may sell cigarettes or imported perfume at prices that do not include payment of required taxes. Auction markets Markets in which an item is sold to the highest bidder. Auction markets are often used when the price for an item is relatively unknown and there are many possible buyers or sellers. Although auction markets were commonly limited to goods such as antiques and artwork in the past, the advent of online auction sites such as eBay have made auction markets much more prevalent. Markets can also be categorized based on how prices are determined. At first glance, it might seem as if many prices set in consumer retail markets do not involve interactions of market participants themselves. In an open-air bazaar or flea market, buyers and sellers haggle about prices. But in a typical retail setting in an industrialized society, you do not “interact” directly with the retailer. The price is listed on the shelf, a tag, or directly on the product. Either you pay the posted price set by the seller, or you do not buy the item. posted prices: prices set by a seller Even though you do not haggle with the cashier at the supermarket, the fact that you can decide whether to buy is itself a form of interaction. Over time, retailers will take note of what moves off the shelf most quickly and will then order more of it and may also raise its price. They will also take note of what does not sell so quickly and will then reduce their order from wholesalers or mark the items down. The retailers’ purchases from the wholesalers, in turn, give the suppliers information that they can use in deciding how much to order or produce and how to set their prices. So while you may not be able to bargain directly, your actions, in combination with the actions of other customers, ultimately affect the prices and quantities offered in the market. These adjustments should tend, at least in theory, to lead posted prices to reflect what economists call the market-determined price, or market price, of the item. Market price, discussed in detail in Chapter 3, is the prevailing price for a specific good or service at a particular time in a given market. The posted price will normally reflect the market price if markets are competitive, the flow of information is good, the adjustment process is given enough time, and no big changes in market conditions occur in the meantime. market price: the prevailing price for a specific good or service at a particular time in a given market In some cases, a single buyer and a single seller negotiate the price of an item through bargaining. Residential real estate, for example, is generally sold by using such negotiated agreements, as are used cars. (Sometimes there is also a posted price, but both parties understand that it is merely a starting point for negotiation.) Salaries of high-level managers, professionals, and unionized employees—and, notably, of sports and entertainment stars—are commonly set by bargaining. The presence of potential other buyers and sellers, however, is obviously important in determining the relative bargaining strength of the two parties. A seller who knows that he or she can easily find other eager buyers, for example, will quickly walk away from an unfavorable deal. A seller with fewer options will have less ability to hold out for good terms. bargaining: an activity in which a single buyer and a single seller negotiate the terms of their exchange 3.5 THE ADVANTAGES AND LIMITATIONS OF MARKETS Markets clearly have many advantages. Competition among sellers in markets means that goods and services can often be provided to people at affordable prices. Markets often encourage innovation, continually leading to new products such as iPhones, electric cars, and streaming video. Of course, many workers have jobs producing goods and services for sale in markets. Markets also foster a steady flow of information, in terms of prices and volumes of sales, that encourages producers to respond flexibly to consumer desires. Profits provide feedback to sellers about whether resources are being used in ways that individuals are willing (and able) to pay for. Markets also give people a considerable amount of freedom in deciding which activities to engage in, although this freedom may be severely constrained by the resources to which people have access. Markets can also be thought of as a type of democracy in which all participants can express their views by buying some items and not others. Against these advantages, markets have a number of limitations. As we have noted, the idealized model of a completely free private market (as in the basic neoclassical model) rarely exists in practice. Actual market-oriented economies always include a mixture of decentralized private decision-making and more public-oriented decision-making. This is because real-world economies include a number of important, complex factors that are not taken into account in the basic neoclassical model. These include social and environmental issues, as well as problems in the way that markets work in certain circumstances. We will briefly discuss some of these issues here, and will expand on them more fully in later chapters. Public Goods Recall from our discussion earlier in the chapter that a public good (or service) is one whose use by one person does not diminish the ability of another person to benefit from it and whose benefit it would be difficult to keep any individuals from enjoying. Examples of public goods include public roads, parks, libraries, schools, clean air and water, other environmental goods and services, police protection, and the national defense system. Because it is difficult to exclude anyone from benefiting from public goods, they are generally not offered through markets. Even if individual actors would be willing to pay for them if necessary, they have little incentive to pay because they cannot be excluded from the benefit. Economists call people who seek to enjoy a benefit without paying for it free riders. Because of the problem of free riders, it often makes sense to provide public goods through government agencies, supported by taxes, so that the cost of the public benefit is also borne by the public at large. free riders: people who seek to enjoy the benefit of a good without paying for it Externalities Some market activities create externalities—spillover effects on parties that are not directly participating in the market exchange. These effects can be either beneficial (“positive externalities”) or harmful (“negative externalities”). Sometimes positive externalities are referred to as “external benefits” and negative externalities are referred to as “external costs.” Externalities are one of the primary reasons the true social value of a good or service can differ from its market value. externalities: side effects in which the market does not make economic actors feel the full consequences of their actions—consequences that, however, are felt by unrelated persons or entities (such as the environment) Examples of negative externalities include a situation of a manufacturing firm that dumps pollutants in a river, degrading water quality downstream, or a bar that plays loud music that annoys its neighbors. Examples of activities that have positive externalities include child rearing by parents who, out of love for their children, raise them to become law-abiding citizens, thereby creating benefits for society at large; and providing habitats for beneficial insects (such as bees and other pollinators), which then provide services to neighboring landowners. In both of these cases individual actions have social benefits. Well-educated, productive citizens are an asset to the community as well as to their own families, and without pollinators and other beneficial insects many crops would fail. Some of the most important externalities relate to the economic activity of resource management. Relying on markets alone to coordinate economic activities may allow activities that deplete the natural environment to take place, because the cost of pollution may not be felt by the economic actor that created it. Environmental regulations attempt to counteract this, using fines or other disincentives to allocate the true social cost to the economic agents creating those costs. If economic activities affected only the actors directly involved in decision-making, we might be able to think about economic activity primarily in terms of individuals making decisions for their own benefit. But we live in a social and ecological context, in which actions, interactions, and consequences are generally both widespread and interrelated. If decisions are left purely to individual self-interest, then from a societal point of view too many negative externalities and too few positive externalities will be created. The streets might be strewn with industrial wastes, while children might be taught to be honest in dealings within their family but not outside it. Market values and human or social values do not always coincide. Transaction Costs Transaction costs are the costs of arranging economic activities. In the basic neoclassical model, transaction costs are assumed to be zero. If a firm wants to hire a worker, for example, it is assumed that the only cost involved is the wage paid. In the real world, however, the activity of reaching a hiring agreement may involve its own set of costs. The firm may need to pay costs related to searching, such as placing an ad or paying for the services of a recruiting company. The prospective worker may need to pay for résumé preparation or transportation to an interview. Because of the existence of such costs, some economic interactions that might lead to greater efficiency, and that would occur in an idealized, transaction cost-free, frictionless world, may not happen in the real world. transaction costs: the costs of arranging economic activities Market Power In the basic neoclassical model, all markets are assumed to be “perfectly competitive,” such that no one buyer or seller has the power to influence the prices or other market conditions that they face. In the real world, however, we see that many firms have market power. For example, when there is only one firm (a monopolist) or a few firms selling a good, they may be able to increase their prices and their profits, creating inefficient allocations of resources. Workers may also be able to gain a degree of market power by joining together to negotiate as a labor union. A government, too, can have market power, for example when the Department of Defense is the sole purchaser of military equipment from private firms. market power: the ability to control, or at least affect, the terms and conditions of a market exchange The potential for social harm grows when firms gain excessive market power—that is, when they come to dominate the market in their area. They may then be able to charge socially inefficient prices or to squelch socially advantageous innovations by competing firms. Large firms also have considerable power to harm the natural environment on which they ultimately depend. Businesses may also gain power by their sheer size. The decisions of individual large corporations can have substantial effects on the employment levels, economic growth, living standards, and economic stability of regions and countries. Governments may need to factor in the responses of powerful business groups in making their macroeconomic decisions. National or state leaders may fear, for example, that raising business tax rates or the national minimum wage may cause companies to leave their country or state, and go elsewhere. Corporations frequently also try to influence government policies directly, through lobbying, campaign contributions, and other methods. We explore the implications of corporate size at more length in Chapter 6. Information and Expectations In the basic neoclassical model, in which purely decentralized decisions lead to efficient outcomes, people are assumed to have easy access to all the information that they need to make good choices. This analysis does not consider the time taken to obtain information or make decisions. In the real world, obtaining good information and dealing with future uncertainties may make economic decision-making difficult. A manufacturing business, for example, might be considering whether to borrow funds to build an additional factory. If the company’s managers were able to know exactly what the demand for its products will be like in the future and what interest rates will be—along with additional information about things such as future wages, energy costs, and returns on alternative investments—the decision would be a simple matter of mathematical calculation. But the managers will have to guess at most of these things. They will form expectations about the future, but these expectations may turn out to be incorrect. If their expectations are optimistic, they will tend to make the new investment and hire new workers. Often optimism is “contagious,” and if a lot of other business leaders become optimistic, too, then the economy will boom. If, however, people share an attitude of pessimism, they may all tend to cut back on spending and hiring, thus precipitating the very downturn they feared. Because no one business wants to take the risk of jumping the gun by expanding too soon, it can be very difficult to get a decentralized market economy out of a slump. How people get their information, how they time their actions, and how they form their expectations of the future are all important topics that are not addressed in the basic neoclassical model. Taking these factors into account suggests why markets sometimes do not work as smoothly as that model suggests. Human Needs and Equity Another important issue concerns distribution of income and the ability to pay for goods and services. In the basic neoclassical model, the only consumer demands for goods and services that can affect the market are those that are backed up by a consumer’s ability to pay. This has several implications. First, there is nothing in the model that ensures that resources are distributed in such a way that people can meet their basic human needs. If a few rich people have a lot of money to spend on diamonds, for example, while a great number of poor people lack the money to pay for basic health care, “free markets” will motivate producers to respond to the demand for diamonds but not to the need for basic health care. For this reason, governments often adopt more deliberate policies of economic development, government provision, subsidies, or income redistribution to try to ensure that decent living standards become more widespread. These policies can sometimes incorporate market mechanisms and sometimes replace them. Second, the model does not take into account nonmarketed production, such as the care given to children, the sick, and the elderly by family and friends. There is nothing in the basic neoclassical model that ensures that these sorts of production will be supplied in adequate quantities and quality. Nor does the market model recognize the ways in which caring activities may be disadvantaged by a market culture in which these activities are considered greatly inferior to the status and money gained through formal employment. Last, it is also the case that problems such as unemployment and inflation tend to affect some people more than others, so how a country deals with these problems also has distributional consequences. Clearly, although market systems have strong advantages in some areas, they cannot solve all economic problems. Economists sometimes use the term market failure to refer to a situation in which a market form of organization leads to inefficient or harmful results. Because of the various limitations of markets discussed above, economic systems cannot rely on “free markets” alone if they are to contribute effectively to present and future human well-being. market failure: situations in which markets yield inefficient or inappropriate outcomes To some extent, private nonmarket institutions may help remedy “market failure.” For example, a group of privately owned factories located around a lake may voluntarily decide to restrict their waste emissions, because too much deterioration in water quality hurts them all. Likewise, a widespread custom of private charitable giving may help alleviate poverty. But sometimes the problems are so large or widespread that only government, public actions at the national or international levels seem to offer a solution. Exactly how much government action is required, and exactly what governments should do, has been a much-debated question within contemporary economics. Market economies today face a major conundrum: How can societies continue to benefit from the strengths of the business sphere while ensuring that this sphere supports the kind of world that will sustain the livelihoods and the well-being of future generations? This question suggests that it is necessary to think both about regulatory issues as they apply to the business sphere, and about what goods and services should be provided by the business sphere and which ones should instead be provided by either the core or public purpose spheres. 3.6 ASSESSING MARKET OUTCOMES Unfortunately, too often the debate about markets comes down to one side being “pro-market” while the other side is “anti-market.” We seek to avoid such a polarizing and simplistic distinction in this text. Such broad generalizations often reflect a lack of knowledge about when markets do, and do not, work effectively at enhancing well-being. So rather than trying to decide whether you are “pro-market” or “anti-market,” we encourage you to think of the following three broad categories of market outcomes: 1. Situations in which market outcomes are reasonably efficient, fair, and sustainable, with only limited government involvement required. The market for T-shirts in the United States, for example, would fall into this category. Significant competition among many producers means that T-shirt prices are low and virtually anyone can afford them. Though there are some environmental impacts of producing and transporting T-shirts, and labor standards need to be upheld, there is limited government involvement in the T-shirt market 2. Situations in which market outcomes are reasonably efficient, fair, and sustainable only with significant government involvement. The market for gasoline in Europe is an example of a good in this category. While gasoline is provided by private companies in European markets, it is heavily taxed (typically $3-$4 per gallon) to account for its negative externality of environmental pollution.14 An unregulated gasoline market outcomes is both inefficient and unsustainable 3. Situations in which market outcomes are not efficient, fair, and/or sustainable, necessitating provision through non-market institutions (such as government). Goods such as national defense and major highways—which are nearly always provided by governments rather than private markets—fall in this category. In many countries, services such as education or health care are provided by the government and funded by taxes. In the United States, health care in particular is often provided by private markets, but whether these markets are efficient and fair is a subject of debate. In short, we need to assess markets contextually. We need to understand the contexts in which markets work well, the contexts in which government regulation of markets is needed, and the contexts in which markets do not result in acceptable outcomes. Discussion Questions 1.When you shop on-line, how do you know that you can trust the seller to deliver the goods as promised? What is necessary for the social institution of trust to work, and how might in break down, in on-line transactions? 2.On a sheet of paper, draw two columns. In one column, list some historical and contemporary advantages of market exchanges, and in the other, list some disadvantages. Can you give examples beyond those listed in the text? REVIEW QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. What are the two main modes of economic investigation? Describe each. What is a positive (direct) relationship? What is a negative (inverse) relationship? What is a model? How does the ceteris paribus assumption simplify the creation of a model? What are some of the assumptions of the basic neoclassical model? Why are markets said to be efficient according to this model? What are some of the shortcomings of the neoclassical model? In what ways does the contextual model overcome these shortcomings? What are the three spheres of economic activity? What are some major characteristics and functions of the core sphere? What are some major characteristics and functions of the public purpose sphere? What are some major characteristics, and strengths and weaknesses, of the business sphere? What is the informal sphere? Where is it most significant? What are the three different meanings of the term “markets”? What are the four institutional requirements of markets? What is a public good? Why will private markets generally undersupply public goods? What are negative and positive externalities? Give examples of each. Besides public goods and externalities, describe four real world factors that can cause market outcomes to be less than ideal. EXERCISES 1.Consider the following data, taken from the Federal Reserve Bank’s website. Perform the graphing exercises below using either pencil and graph paper or a computer spreadsheet or presentation program. Year Unemployment rate (%) Inflation (% per year) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 9.3 9.6 8.9 8.1 7.4 6.2 5.3 4.9 4.4 3.9 -0.4 1.6 3.2 2.1 1.5 1.6 0.1 1.3 2.1 2.4 a. Looking at the data listed in the chart, can you detect a trend in the unemployment rate during these years? In the inflation rate? If so, what sort of trends do you see? b. Create a time-series graph for the unemployment rate during 2009-2018. c. Create a scatter-plot graph with the unemployment rate on the horizontal axis and inflation on the vertical axis. d. Using your graph in part (c), do the two variables seem to have an empirical relationship during this period, or do the points seem to be randomly scattered? If there appears to be an empirical relationship, is it inverse or direct? 2. Identify the sphere in which each of the following activities takes place. Could some involve more than one sphere? a. Recycling is picked up at curbside in a community b. Tomatoes are grown in a home garden c. A fire department answers an emergency call d. People purchase groceries at a supermarket e. An environmental protection group lobbies for stronger pollution control laws 3. Match each concept in Column A with an example in Column B. Column A a. Theoretical investigation Column B 1. The apple tree that you plant for your own enjoyment also pleases people passing by b. A core sphere activity 2. Perfectly competitive markets c. A positive externality 3. The production of apple pie creates water pollution that harms downstream communities d. A public purpose sphere activity 4. Einstein develops the theory of relativity e. A public good f. An assumption of the basic neoclassical model 5. Police Services g. Ceteris paribus 7. Home care for the elderly h. Historical investigation 8. All variables except one are held constant i. Negative externality 9. An economists studies the Great Depression j. Market power 10. A city park 6. There is only one apple producer who is able to make very high profits