Readings in Applied Microeconomics

The Power of the Market

Craig Newmark

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781135969448
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

A central concern of economics is how society allocates its resources. Modern economies rely on two institutions to allocate: markets and governments. But how much of the allocating should be performed by markets and how much by governments? This collection of readings will help students appreciate the power of the market. It supplements theoretical explanations of how markets work with concrete examples, addresses questions about whether markets actually work well and offers evidence that supposed "market failures" are not as serious as claimed.

Featuring readings from Hayek, William Baumol, Harold Demsetz, Daniel Fischel and Edward Lazear, Benjamin Klein and Keith B. Leffler, Stanley J. Liebowitz and Stephen E. Margolis, and John R. Lott, Jr., this book covers key topics such as:

• Why markets are efficient allocators

• How markets foster economic growth

• Property rights

• How markets choose standards

• Asymmetric Information

• Whether firms abuse their power

• Non-excludable goods

• Monopolies

The selections should be comprehended by undergraduate students who have had an introductory course in economics. This reader can also be used as a supplement for courses in intermediate microeconomics, industrial organization, business and government, law and economics, and public policy.

PART ONE

Information and Incentives

Introduction

The power of the market comes from prices. Prices do two important things simultaneously. First, they aggregate and transmit information—information about consumers’ demands and suppliers’ costs—cheaply and quickly. And second, they provide everyone incentives to act in ways that benefit not only themselves, but benefit others.

In the classic article, “The Use of Knowledge in Society,” Friedrich Hayek explains how important it is that prices transmit information and provide incentives. Hayek notes that solving the fundamental economic problem—coping with scarcity— would be easy for a “central planner” if the planner had perfect information about all the tastes, skills, and technologies in the economy. But the planner doesn’t have that all information. He doesn’t have it because much valuable information is known only at specific places and times by widely dispersed individuals.

A market economy, on the other hand, obtains that information through the price system. Prices induce people who have valuable information to use it, because using it will make them money. The information is thereby revealed in the market price.

And the market price then induces people to act in desirable ways. If a new source of tin is discovered, demanders will conserve tin and suppliers will produce more. These are the same actions a central planner would want to take, but they happen quickly and automatically through the power of market prices.

The other four readings in Part One provide examples of the power of prices at work. Leonard E. Read notes that a pencil is a simple product. So simple that pencils are extremely common: billions of them are sold each year.¹But Read’s article states a surprising fact about the simple pencil: there isn’t a single person on Earth that knows everything about how to manufacture one. The manufacture of a single pencil involves, directly or indirectly, literally thousands of people and dozens of technologies. To manufacture a typical pencil, cedar trees are grown in California, graphite is mined in Sri Lanka, and an oil is extracted from plants in Indonesia. Nobody can possibly know all the details about these processes, and all the others, needed to manufacture a pencil. How, then, does a pencil get made? Answer: it is made largely through the price system. As Hayek observed, the price system means that a single individual needs to know very little. A grower of California cedar trees or a firm mining graphite in Sri Lanka need only compare its costs to a market price. If the prices are high enough compared to costs, these firms will ship their products to other firms, who then repeat the process. The process works without central control, without explicit orders, and with no one person knowing all the details.

The process is so powerful, in fact, that as Charles Maurice and Charles W. Smithson discuss in two excerpts from their book, The Doomsday Myth, market prices have so far allowed us to avoid an economic Doomsday.The economic Doomsday that some people fear would come because we are using up our vital natural resources, such as oil. The amount of oil we have is finite. As the world’s population and economy grows, we might ask: won’t we run out of oil, and when we do, won’t the world economy suffer a massive blow, even “Doomsday”?

Maurice and Smithson note that people have had similar fears a number of times before. Two of the similar instances were a concern in the nineteenth century about running out of whale oil, and a worry in the early twentieth century U.S. about running out of timber. But in both cases, Doomsday didn’t arrive. It didn’t arrive because of the information and incentive effects of market prices. As use of whale oil grew and whales grew scarce, and as use of timber skyrocketed, prices for whale oil and timber rose. Higher prices gave people powerful incentives to change their behavior. Users reduced consumption. Producers tried to produce more efficiently, and more importantly, developed substitutes for the scarce resources. Whale oil was replaced by “rock oil”—petroleum or what we just call oil today—and the timber used by railroads was gradually replaced by steel. As with the production of pencils, these big, beneficial changes were accomplished without central control, relatively quickly, and efficiently.

Quick and efficient actions fostered by the market are emphasized in the article by Steven Horwitz about the aftermath of Hurricane Katrina. After Katrina devastated parts of Louisiana and Mississippi, residents desperately needed relief. Which organization provided especially effective relief? The huge retailer, Wal-Mart. According to Horwitz, Wal-Mart was effective because the market gave it “the right incentives to respond well and [it] could tap into local information necessary to know what the response should be” emphasis added.

Finally, following the tragic explosion of the U.S. space shuttle Challenger, a blue-ribbon panel of distinguished engineers and scientists determined that the explosion should be blamed on faulty parts manufactured by the firm Morton Thiokol. The panel took more than four months to reach that conclusion. The U.S. stock market, on the other hand, identified Morton Thiokol as the likely culprit, on the day of the crash, within less than five hours. The article by Michael T. Maloney and J. Harold Mulherin illustrates how the market is an extremely efficient processor of information.

Note

1 Baron D. (2007) “Don’t Write Off the Pencil,” Los Angeles Times, January 23, A-15.

Chapter 1

F. A. Hayek

THE USE OF KNOWLEDGE IN SOCIETY

I

WHAT IS THE PROBLEM, we wish to solve when we try to construct a rational economic order?

On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions. The conditions which the solution of this optimum problem must satisfy have been fully worked out and can be stated best in mathematical form: put at their briefest, they are that the marginal rates of substitution between any two commodities or factors must be the same in all their different uses.

This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solution of the economic problem of society, does not yet provide an answer to it. The reason for this is that the “data” from which the economic calculus starts are never for the whole society “given” to a single mind which could work out the implications, and can never be so given.

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.

This character of the fundamental problem has, I am afraid, been rather obscured than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics. Though the problem with which I want primarily to deal in this paper is the problem of a rational economic organization, I shall in its course be led again and again to point to its close connections with certain methodological questions. Many of the points I wish to make are indeed conclusions toward which diverse paths of reasoning have unexpectedly converged. But as I now see these problems, this is no accident. It seems to me that many of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.

II

In ordinary language we describe by the word “planning” the complex of interrelated decisions about the allocation of our available resources. All economic activity is in this sense planning; and in any society in which many people collaborate, this planning, whoever does it, will in some measure have to be based on knowledge which, in the first instance, is not given to the planner but to somebody else, which somehow will have to be conveyed to the planner. The various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process. And the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy—or of designing an efficient economic system.

The answer to this question is closely connected with that other question which arises here, that of who is to do the planning. It is about this question that all the dispute about “economic planning” centers. This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals. Planning in the specific sense in which the term is used in contemporary controversy necessarily means central planning—direction of the whole economic system according to one unified plan. Competition, on the other hand, means decentralized planning by many separate persons. The half-way house between the two, about which many people talk but which few like when they see it, is the delegation of planning to organized industries, or, in other words, monopoly.

Which of these systems is likely to be more efficient depends mainly on the question under which of them we can expect that fuller use will be made of the existing knowledge. And this, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans in with those of others.

III

It will at once be evident that on this point the position will be different with respect to different kinds of knowledge; and the answer to our question will therefore largely turn on the relative importance of the different kinds of knowledge; those more likely to be at the disposal of particular individuals and those which we should with greater confidence expect to find in the possession of an authority made up of suitably chosen experts. If it is today so widely assumed that the latter will be in a better position, this is because one kind of knowledge, namely, scientific knowledge, occupies now so prominent a place in public imagination that we tend to forget that it is not the only kind that is relevant. It may be admitted that, so far as scientific knowledge is concerned, a body of suitably chosen experts may be in the best position to command all the best knowledge available—though this is of course merely shifting the difficulty to the problem of selecting the experts. What I wish to point out is that, even assuming that this problem can be readily solved, it is only a small part of the wider problem.

Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation. We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and special circumstances. To know of and put to use a machine not fully employed, or somebody’s skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alternative techniques. And the shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.

It is a curious fact that this sort of knowledge should today be generally regarded with a kind of contempt, and that anyone who by such knowledge gains an advantage over somebody better equipped with theoretical or technical knowledge is thought to have acted almost disreputably. To gain an advantage from better knowledge of facilities of communication or transport is sometimes regarded as almost dishonest, although it is quite as important that society make use of the best opportunities in this respect as in using the latest scientific discoveries.This prejudice has in a considerable measure affected the attitude toward commerce in general compared with that toward production. Even economists who regard themselves as definitely above the crude materialist fallacies of the past constantly commit the same mistake where activities directed toward the acquisition of such practical knowledge are concerned—apparently because in their scheme of things all such knowledge is supposed to be “given.” The common idea now seems to be that all such knowledge should as a matter of course be readily at the command of everybody, and the reproach of irrationality leveled against the existing economic order is frequently based on the fact that it is not so available. This view disregards the fact that the method by which such knowledge can be made as widely available as possible is precisely the problem to which we have to find an answer.

IV

If it is fashionable today to minimize the importance of the knowledge of the particular circumstances of time and place, this is closely connected with the smaller importance which is now attached to change as such. Indeed, there are few points on which the assump...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Dedication
• Notes on Contributors
• Acknowledgments
• Preface
• Part One: Information and Incentives
• Part Two: Creating Value
• Part Three: Property Rights
• Part Four: Externalities and Coordination Problems
• Part Five: Non-Excludable Goods
• Part Six: Asymmetric Information
• Part Seven: Monopoly and Collusion
• Part Eight: Abuse of Firm Power