3. The Beauty of the Market

Question 1

What is the market created by?

Answer 1

Created by rational decisions by buyers and sellers.
Buyers rationally respond to lower prices by buying more of a good
Sellers rationally respond to higher prices by selling more of a good
A competitive market has many buyers and sellers.

Question 2

What information do prices reveal?

Answer 2

Reveal how much buyers and sellers value a particular good. Prices reveal information because they are optional. Buyers and sellers can always opt out, the sale simply would not have occurred. Both parties are better off and doesn’t harm anyone else. Free choice produces information about one’s priorities and preferences. The market aggregates everyone’s choices.

Question 3

Why does the price mechanism generate superior outcomes to the non-price mechanism?

Answer 3

In non-price mechanism, resources will be allocated in a different way. But in both cases, the rich still benefit. However, in non-price mechanism, the information about costs and benefits is lost.

Question 4

What is an advantage of non-price resource allocation?

Answer 4

gains in equality or stability.

Question 5

How does the education system work via a non-price mechanism?

Answer 5

Private: people who are willing and able to pay gets to choose. the school gets more customers. teachers get rewarded!! Can amass more money and improve their services.
Public: those who can afford house near the school gets to choose where to go! Spend some money to relocate. rich people get to spend their kids to better public schools!
EITHER CASE – the rich benefits! First case the reward goes to the schools, second case the reward goes to the landlords. first case is better! school makes effort! the landlords don’t, they just happen to be there!

Question 6

Why are taxes a common form of inefficiency?

Answer 6

They destroy information carried by prices – price no longer equals cost, so cost no longer equals value.
Sale never happened because of the tax. What’s worse is that the tax wasn’t even paid. Taxes are often higher when price-sensitivity is low: addictive products.

Question 7

What is an important characteristic of a competitive market?

Answer 7

Efficiency

• Allocative efficiency: goods are bought by people who are willing and able to buy.
• Productive efficiency: Firms are producing the right goods, in the right quantities, in the right way.

Question 8

Prices are true representations of __________.

Answer 8

costs to firms, and value to customers

Question 9

What is pareto efficiency?

Answer 9

A distribution of resources is Pareto efficient when it is not possible to make someone better off without making someone else off. Means we exhaust all resources and there is no wastage. (Zero-sum game = pareto efficient. → perfectly efficient economy)

Question 10

What does the invisible hand propose?

Answer 10

By pursuing one’s own self interest and minding their own business, buyers and sellers promote society’s interests in the best possible way. The invisible hand drives the best possible outcome. Legitimize selfish behaviour.

Question 11

How do competitive markets allocate resources efficiently? (4)

Answer 11

Allocate consumption of a good to potential buyers that have the highest willingness and ability to pay.
Allocate sales of a good to potential sellers that have the lowest costs of production.
Ensure that all transactions made are mutually beneficial
Ensure that all transactions not made are not mutually beneficial.

Question 12

What is the relationship between rationality and efficiency?

Answer 12

If market is competitive, rational behavior can lead to efficient outcomes. If market is not competitive, rational behavior will lead to inefficient outcomes.

Question 13

What is one limitation of pareto efficiency?

Answer 13

It may not always be fair. So we may try to correct the distribution of resources.

Question 14

Describe the tragedy of the commons.

Answer 14

People tend to overuse the common resource. Everybody behaves irresponsibly when repercussions of bad behaviour doesn’t fall entirely on the person who engages in the behaviour. (eg. overfishing, tree cutting) Although this is morally wrong, it is still rational. Perpetrators are few in number and they know they will get away with their bad behavior because losses are spread over many individuals and there’s little incentive for anyone to punish them.

Question 15

What can we do to prevent the tragedy of the commons? (2)

Answer 15

Government intervention

Privatisation

Question 16

Describe the prisoners’ dilemma.

Answer 16

Equilibrium – both prisoners are going to confess
But this is not the most efficient outcome for them! because we can afford to make both of them better off without making one person worse off (-1,-1) instead of (-3,-3). Shows how rational behavior can lead to inefficient outcomes.

Question 17

What does the Second Fundamental Theorem of Welfare Economics argue?

Answer 17

Argues that any Pareto efficient distribution can be achieved by a competitive market, after adjusting the starting position. All we need to do is redistribute the resources among the citizens and then let the competitive market take over. The market will eventually lead to the new desired distribution which will be Pareto efficient. “Head start theorem”

Question 18

What does the Arrow Impossibility Theorem argue?

Answer 18

Argues that we don’t have a way to decide collectively as a society what we consider a “common good” for all. We cannot know what we want because we cannot translate individual preferences into social preferences

Question 19

What is one way we can adjust the starting point of citizens in a competitive market?

Answer 19

Lump sum tax. doesn’t affect anybody’s behavior, because there is nothing you can do to avoid it. Move the starting point for each individual but doesn’t slow anyone down. Lets perfect markets do the rest, puts everyone on equal footing. No waste or inefficiency. But problem is that it is impossible to have taxes that only apply to one individual. A true lump-sum tax isn’t supposed to change behavior at all.

Question 20

Governments pay large amounts of taxpayers money to support industries that might be uneconomic without the subsidies. Explain how this demonstrates the tragedy of the commons.

Answer 20

The relatively few fishermen and growers lobby hard for the subsidies because it affects much of their income, while the losers (taxpayers) are less vocal because the subsidy is only a small fraction of their tax. Benefit a small minority at the expense of a large majority.

Question 21

How does introducing pike into lakes which destroys trout fishing demonstrate the tragedy of the commons?

Answer 21

Only the few pike fishermen will benefit at the expense of all the trout fishermen as the trouts get eaten by pikes.

Question 22

How does mining in Montana demonstrate the tragedy of the commons?

Answer 22

Montana has no law requiring companies to clean up after mine closure. So they just left it with its copper, arsenic, and acid leaking out into rivers.
Hence huge amounts of cleanup costs have to be borne by the citizens. Law permits such companies to advance their own profit-making interests while being a burden to society.

Question 23

Describe how overharvesting demonstrates the tragedy of the commons. (collective action problem)

Answer 23

Occurs when principal consumer has no long-term stake in preserving the resource but society as a whole does. Harvesting a communally owned resource (eg. fishermen catching fish in the ocean, herders grazing their sheep on a communal pasture). If everybody overharvests the resource, it will become depleted and thus decline ordisappear, and all consumers will suffer. It’s hence in everyone’s interest to not overharvest. But if there is no effective regulation of how much resource each consumer can harvest, each consumer would reason “If I don’t harvest this, others will do it anyway, so I should just harvest as much as I can”. Rational behavior is to harvest before others, even though the result is destruction of the commons.

Question 24

What are 3 possible solutions to the tragedy of the commons?

Answer 24

1) government intervention
2) privatise the resource
3) Let consumers recognise their common interests and to design, obey and enforce prudent harvesting quotas themselves.

Question 25

How does government intervention help to alleviate the tragedy of the commons? What are the limitations?

Answer 25

Enforce quotas

Limitations - Impractical due to excessive administration and policing costs

Question 26

How does privatizing the resource help to alleviate the tragedy of the commons? What are the limitations?

Answer 26

Divide it into individually owned tracts that each owner will be motivated to manage prudently in his/her own interests.
Limitations - Some resources are impossible to subdivide (eg. fish, migratory birds), difficult to exclude intruders (non-excludable)

Question 27

Let consumers recognise their common interests and to design, obey and enforce prudent harvesting quotas themselves. What conditions have to be met in order for this strategy to be successful? (4)

Answer 27

• groups must communicate and trust each other
• groups must expect to share a common future and pass on the resource to their heirs. Works better for isolated communities because Obvious to the whole group that they must survive on their own resources in the foreseeable future. Cannot make the excuse that “it’s not my problem, it’s someone else’s problem”
• allowed to and able to police themselves
• Boundaries of resource and its pool of consumers are well defined
  (eg. New Guinea highlanders)

Question 28

In what cases will the elites fail to solve perceived problems that affect society?

Answer 28

When the elites can isolate themselves from the consequences of their actions, they are likely to do things that profit themselves, regardless of whether those actions hurt everybody else.
Eg. Dutch’s high environmental awareness stems from the fact that both politicians and the masses all live on land lying below sea level, so if politicians have poor land planning, they too will be affected.