How does the market produce and distribute goods efficiently

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How does the market produce and distribute goods
efficiently?
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The market does two things

• It produces goods using the resources that the
  economy has at its disposal
• Firms are motivated by profits
• Competitive firms have no control over prices
• They are forced to minimize costs
• It allocates the goods produced
• Everyone who really needs a good can get it
• On the margin, each good you buy gives you equal
  marginal utility per dollar

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Amartya Sen
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What Causes Famines?

• Amartya Sen has said famously, It is not
  surprising that no famine has taken place in the
  history of the world in a functioning democracy
  be it economically rich (as in Western Europe or
  North America) or relatively poor (as in
  post-independence India, or Botswana or
  Zimbabwe)
• Basically, there is a synergy between democracies
  and functioning markets

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Pareto Efficiency

• Consider a fixed supply of resources
• Say there is one dollar on the table
• An allocation is a list of what each person gets
• Pareto efficient allocations
• You get 0.01 and I get 0.99
• You get 1 and I get nothing
• You het 0.5 and I get 0.5

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Not Pareto efficient

• Here are some allocations that are not Pareto
  efficient
• You get 0.99 and I get nothing
• You get 0.40 and I get 0.40

Vilfredo Pareto
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Definition of Pareto Optimality

• Consider a fixed bundle of resources.
• An allocation is feasible if one can provide it
  within the constraints of the resources
  available.
• A feasible allocation is Pareto efficient if an
  only if there is no other feasible allocation
  that keeps everyone at least as well off but
  increases at least one persons well being

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What a Mouthful!

• Pareto efficiency is defined as a negative
• You need to ask yourself, Can I figure out some
  way to keep everyone equally happy and make at
  least one person strictly better off?
• If yes, then the original allocation was not a
  Pareto optimum

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Pareto Optimality

• It does not mean fairness!
• You get everything and I get nothing is Pareto
  optimal, as long as you are not sated
• It is a weak concept
• If the market cannot do this, it is really messed
  up
• There are usually many Pareto optimal allocations
• It means in essence that goods are not being
  wasted in the distribution process

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Some more subtle examples

• You are a vegetarian, and I hate broccoli. We
  both like wine
• There is one steak, one bottle of wine, and one
  floret of broccoli
• You get everything and I get nothing is not
  Pareto optimal
• You get wine and broccoli, and I get steak is
  Pareto optimal,
• So is you get broccoli, and I get wine and steak

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How does the Market decide who gets what?

• Taking prices as given, each of us tries to do
  the best he or she can with our income.
• Rich people will get more stuff, but no stuff
  will be wasted!
• A price-taking equilibrium always supports Pareto
  optimal allocations
• This is called the First Welfare Theorem.
• It is the foundation of all of economics

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Leon Walras
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Demand and Supply

• Consider the market for a bottle of wine.
• The price clears at 10
• You are upset because you would buy the wine if
  the price were only 9. But now you have to
  settle for a six-pack of beer
• Is this Pareto efficient?
• Yes, every person who buys wine values it at
  least as much as you do. So if the dictator
  gives it to you, then he is depriving and thus
  hurting someone else.

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Productive efficiency

• The first part of the lecture looked at
  efficiency in the distribution of goods that have
  already been produced.
• How do we know that goods are produced
  efficiently?
• What does it mean to say that goods are produced
  efficiently?

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Full Employment

• No resources are left idle.
• All workers are employed
• All capital is being used
• But this is not enough
• Resources must be used in the sectors were they
  are value the most
• Hence what a worker producers in the pizza
  industry must be equal in value to what the same
  kind of worker might produce in some other
  industry

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Perfect Competition in the Market for Factors of
Production

• The marginal benefit of hiring a worker is the
  price of the industries output multiplied by the
  workers marginal physical product.
• The marginal cost of the worker is the wage,
  which is the same across all industries
• So high priced industries will hire lots of
  workers until their marginal physical product is
  low
• Cost minimization by businesses leads to an
  efficient use of workers (and resources more
  generally) in every activity

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Two Theorems

• First Welfare Theorem
• The equilibrium allocations in a pric-taking
  equilibrium are Pareto optimal
• Second Welfare Theorem
• Assume that people have a taste for diversity
• Any Pareto Optimal allocation can be supported as
  a competitive equilibrium, as long as one is able
  to redistribute initial ownership of resources

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Adam Smith
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The Invisible Hand
Every individual...generally, indeed, neither
intends to promote the public interest, nor knows
how much he is promoting it. By preferring the
support of domestic to that of foreign industry
he intends only his own security and by
directing that industry in such a manner as its
produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many
other cases, led by an invisible hand to promote
an end which was no part of his intention. The
Wealth of Nations, Book IV Chapter II
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Even Deeper than the Invisible Hand

• Markets function within legal and cultural
  contexts
• It goes without saying that we need a stable
  legal system that allow the enforcement of
  contracts
• Likewise secure property rights are crucial
• Both of these issues are not within the purview
  of economics, but they both show how that markets
  function within an important external framework

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Trust

• Many economic transactions occur because of trust
• I dont expect my boss to pay me at the end of
  every lecture.
• My boss does not need to come watch everything I
  do
• Trust is a cultural norm. It is hard to build up
  and it is easy to dissipate
• Repeated interactions among people who know each
  other engender trust
• Trust between strangers is an important part of a
  well functioning society and economy

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What can go wrong?

• Lack of perfect competition
• Monopoly will deter the invisible hand
• Imperfect information
• We need to design mechanisms that elicit
  information when people have reasons to hide what
  they know
• Hayek emphasized that promoting the flow of
  information was an important function of markets

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Which Hayek?
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What Else Can Go Wrong?

• Public Goods
• Some things are not like pizza
• You and I both consume national defense
• You and I both like roads without traffic, but
  there is no easy way for us to keep the other
  jerks off the road when there is a traffic jam
• Externalities
• You like to play loud music at a party
• You keep my kids awake
• Its you apartment, but your use of it affects
  how my family enjoys our apartment next door to
  you.

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Conclusion

• Laissez-faire capitalism is the most widely
  admired social system in the history of humankind
• The two welfare theorems are the foundations of
  all economic analysis
• The very existence of markets depends upon
  important legal and social factors
• Markets can go wrong when there are public goods
  and externalities.