Lectures 4 & 5 The Market: How it Actually Works January 26 & 31, 2017 The Market: How it Actually Works

Summary from last lecture: I. Four Virtues of Markets Freedom: Markets are an expression of the value of individual freedom: exchanges are voluntary Coordination of complex systems: Markets accomplish this remarkable result through supply, demand and the price mechanism. Efficiency: Unfettered markets result in allocative efficiency (“Pareto Optimality”) Innovation and Growth: Markets create strong incentives for risk-taking and innovation II. The Free Market versus Government Moral issue: State regulation is an affront to freedom Pragmatic issue: State incompetence and malevolence

Three Themes for discussion of how markets really work: How well does the free market perform around its core moral value: freedom? Pragmatic problems: inefficiency and market “failures.” The impact of free markets on nonmarket social interactions and social values

I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others.

I. The Market & Freedom Negative Freedom: “Freedom from” = no one can physically force you to do things. Positive Freedom: “Freedom to” = the actual capacity to do things, to realize your goals Conclusion 1: The market is a pretty good institution for partially realizing negative freedom. No one directly forces you to buy something. Conclusion 2: Employees lose negative freedom within work. Conclusion 3: The free market generates great inequalities in positive freedom – it is enhances it for some people and undermines it for others. RAGES-TO-RICHES: Of course, one can cite many wonderful rages-to-riches stories to refute this. This is rather like observing that some people escape from prison -- and undoubtedly these are the prisoners who are the cleverest and most committed to escaping -- and then concluding that the people who do not escape are therefore not really in prison. Free markets inherently generate very large disparities in resources available to people. If everyone started out in the same position with the same assets and these differences were just the result of effort and choice, then perhaps it wouldn’t really contradict positive freedom. In fact, most people who accumulate great wealth started with considerable wealth. I think it is reasonable to say that they have greater freedom, not just more stuff, than someone born poor.

Faulty consumer information II. PRAGMATIC ISSUES: INEFFICIENCY & MARKET FAILURES Sources of Market Inefficiency #1 Faulty consumer information Markets only allocate products efficiently if people have perfect information about what they buy, but this is often very difficult for consumers, especially because firms have incentives to distort information. Because of this severe information problem, we have laws that regulate false advertising, and ALSO we require firms to provide certain kinds of information to consumers which they would not provide if there was a perfectly free market. Food labeling is an example: laws that require labels of nutrition on food violate the free market. Laws that prevent firms from false advertising violate the market as well. Imagine how information would be organized in a perfectly “free market”:   In a perfectly free market, firms could make whatever claims they liked about their products. If consumers felt that it was valuable for them to know the truth, then there would be a market for better information about products, and consumers could buy that if they wanted to. Of course firms would not want to distort information too much or they would lose customers. Reputation matters for firms, and thus the market itself would impose some constraint on distorted information. And consumers could always sue corporations for fraud. But would this really be adequate?

The Case of the Ford Pinto (late 1960s) The problem: because of faulty placement of gas tanks, tendency for cars to explode in some rear-end collisions Cost of change: roughly $11/car Ford’s calculation: more profitable not to make the change. Ford’s strategy: obstruct accountability and regulation Results: the legislation to require higher safety standards was delayed from 1961 to 1966 and effective implementation of regulations delayed until 1977. Hundreds of lives lost as a result. THIS IS NOT ANCIENT HISTORY: SUV rollovers in the 1990s. Air Bag failures in the present. Key issue: Automakers complain all the time about the burden of government regulation for “standards”; but imagine what the failure rates would be in the absence of such regulation.

Sources of Market Inefficiency #2 Concentrated Economic Power Allocative efficiency depends on perfect competition, but American capitalism is dominated by giant corporations, and giant corporations exert real power over firms and individuals in markets. It is an inherent feature of market dynamics that winners in competition will tend to become larger and larger, and when they become very large they exert real power inside of the market. Microsoft, Wal-Mart, BP, Boeing, and many other corporations do not just make things and sell them on a market; they shape the market through their exercise of power. The large corporation is not just like the corner grocery store, but bigger; it has the ability to make strategic choices that massively affect the lives of people and communities, the choices they face and the kinds of lives they can lead. EXAMPLES: Microsoft is notorious in this regard: it is so big that it can force people to buy products that they don’t want by bundling them with their windows operating system. Wal-Mart forces suppliers to squeeze their workers wages to ruthlessly cut costs. BANKS: Gigantic financial institutions can engage in risky financial dealings that jeopardize the livelihood of tens of millions of people. Big Tobacco for decades obstructed regulation of tobacco even after they knew (a) it was addictive, and (b) extremely harmful. SUGAR: We now know that this was true for the sugar industry as well.

Sources of Market Inefficiency #3 Negative Externalities Market efficiency depends on prices reflecting the true costs of producing things, but firms often systematically displace costs and risks on others in many ways. Definition: a negative side-effect of an activity that affects other people. basic idea = ability to impose costs and risks on others in many ways. This is a very big deal – a fundamental problem in capitalist market economies.   Basic problem = The profits of a firm are basically the difference between their total costs and the prices that they receive for the things they sell. The lower the costs, therefore, the higher the profits. If you are a smart capitalist, you try to displace as many costs as possible on others. Note: this does not mean that capitalists who behave this way are evil people. The problem is not mainly a failure of integrity; the problem lies in the institutions which make it rational for people to act this way. Classic Examples: Pollution: air pollution, water pollution, nitrogen run off

What are some other examples of Negative Externalities? Plant closing even when the plant is profitable, just because greater profits can be made elsewhere: house prices Limited liability: protects the personal assets of investors but not employees Wal-mart destroys local businesses  destruction of the vitality of a community, devaluation of property values

Negative Externalities Other implications of Negative Externalities Violates value of fairness: it is unfair that I can impose risks and costs on you for my own benefit. Violates freedom: I coercively impose costs on your with voluntary consent.

Sources of Market Inefficiency #4 Short Time Horizons Competition among profit-maximizing firms leads firms to have relatively short time-horizons. This imposes costs on future generations for our present production and consumption. (Intergenerational negative externalities).

Sources of Market Inefficiency #5 Under-provision of Public Goods Profit-maximizing firms in competitive markets will fail to produce adequate public goods, even those public goods which are necessary for maintaining healthy markets. Definition of Public Goods: a public good is a good which, if it is produced, provides a benefit to people even if they do not pay for it. Public sanitation is an example: if you have clean water and good sanitation, every one benefits. Or consider national defense: once it is produced, everyone benefits from it, regardless of whether or not you contributed taxes to pay for it. Public vs private goods: The contrast here is with a private good: this is a good in which all of the benefits are experienced by the person who pays for it. A sandwich is a good example. Some goods have both private and public aspects. Consider education: you reap great benefits from being educated – you personally earn more money, for example. But everyone benefits from having a more educated population. An educated skilled labor force benefits all employers whether or not they contributed to the education and training of the workers. And here is the problem: in general markets by themselves will not produce such public goods, or at least not enough public goods, since people will generally benefit from the public good without having to pay for it.

What are some other examples of public goods and quasi-public goods? Basic infrastructure: highways, airports, etc. Parks and recreational facilities Performing arts centers Libraries Noncommercial broadcasting Scientific research Free vaccinations Public transportation

THE PRISONERS DILEMMA PRISONER X Silent Confess Y A B C D Both get 2 years A X gets 0 years Y gets 10 years B X gets 10 years Y gets 0 years C Both get 5 years D THE PRISONERS DILEMMA Self-interested preference ordering for X: B>A>D>C

THE TRADGEDY OF THE COMMONS Everyone else’s choice Your choice Graze 1 sheep Graze 2 sheep Everyone else’s choice Everyone earns $10 A You earn $20 Others earn $10 B You earn $4 Others earn $8 C Everyone earns $8 D Example #2 = fish stocks. Another example of the tragedy of the Commons that is very relevant in the world today: fishing. A healthy stock of fish in a body of water is a public good: everyone who fishes benefits from this. Suppose you have a lake in which you can catch roughly 10,000 fish a year and still have the fish stock reproduced year after year. Suppose there are 1000 fishermen fishing in Lake. If everyone catches 10 fish a year, the fish stock will remain stable from year to year and all the fisherman will be able to continue to catch fish, so there is a sign posted at the Lake which says: “fishing limit per fisherman, 10 fish per year”. You are one of those fishermen, and you know that if you catch 20 fish this will not have a significant effect on the fish stock. You figure, whether 10,000 fish are caught a year or 10,020 are caught a year won’t matter. So you ignore the sign and catch twenty. You want to be a free-rider on everyone else’s restraint. Every other fisherman behaves the same way, so in all 20,000 fish are taken, and the following year there are almost no fish in the lake. Now suppose you are an honest, moral person (but no one else is) so you decide to obey the sign. You catch 10 fish the first year and none the second. Everyone else has caught 20 the first year and none the second. You feel like a sucker (maybe a virtuous sucker, but a sucker nonetheless). This is precisely what has happened in the great fishing banks in the North Atlantic. Your self-interested preference ordering : B>A>D>C

Free-riding & Public Goods problem: You provide training YES NO All other firms provide training $20,000 A $30,000 B -$10,000 C $0 D Free-riding & Public Goods problem: Firms Providing Training for Workers All of these are called the “collective action problem in the provision of a public good”: if you are a selfish individualist, only out for yourself and not giving a damn about anyone else, then you will abstain from cooperating. Why should you make a sacrifice when you get the benefit without doing so? But note: if everyone is a competitive individualist just like you, the result is worse than universal cooperation: the public good will not be provided because everyone abstains and you get a big Zero. The under provision of public goods is an example of a prisoner’s dilemma. In actually existing markets, there tends to be an undersupply of public goods. This is pareto suboptimal because everyone would be better off and no one worse off if the public good were provided.   It’s not surprising that a society governed purely by markets is characterized by private affluence and public squalor (crime, congestion, pollution etc...). Training costs = $10,000 Extra Gross Profits with trained workers = $30,000 Net extra profits if you provide training and keep workers = $20,000 Net extra profits if you provide training and workers leave = -$10,000

Negative Externalities vs Free-rider Problem Contrast: Negative Externalities vs Free-rider Problem Negative externalities: I benefit from imposing costs on you. Free-riding problem for public goods: Everyone is harmed – including me – because of free-riding, but I am even worse off if I individually refuse to free-ride. This is a “Pareto suboptimal” situation.

Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government produces the public good and regulates free-riding. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government blocks free-riders through regulations and government provision of public goods paid by taxation. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

Solutions to Free-rider Problem Government provision of public goods Instead of relying on the market, the government blocks free-riders through regulations and government provision of public goods paid by taxation. Conditional Altruism: People may not be purely selfish and can want to cooperate, thus their preference ordering is not like the prisoner’s dilemma.

CONDITIONAL ALTRUISM and THE TRADGEDY OF THE COMMONS Your choice Graze 1 sheep Graze 2 sheep Everyone else’s choice Everyone earns $10 A You earn $20 Others earn $10 B You earn $4 Others earn $8 C Everyone earns $8 D Your self-interested preference ordering: B>A>D>C Conditional Altruist (cooperative) preferences: A>D/B>C

III. The Free Market & Social Values Key idea: institutions shape values Effects of under-regulated markets on salient values: Erosion of community Commercialization of morally salient aspects of life Skills of “exit” and “voice” The logic of the market revolves around one specific dimension of human personality, values and social interaction: the rational pursuit of one’s self-interest as a separate person. People do act this way, some of the time, in some places, under some circumstances. But humans are also characterized by Cooperation, solidarity, generosity, kindness. Human beings are characterized by the search for meaning and companionship, by caring for the wellbeing of others and not just themselves. The specific mix of these human characteristics -- in particular, how important is greed and competitive individualism relative to other values -- is not something given once and for all by “nature”, but is created by our social institutions in complex ways. A crucial question for sociology and for politics is thus how our institutions either reinforce or undermine these other kinds of values. Or to say it even more simply: the kinds of people we get in a society is not given by nature, but by the ways our institutions encourage some traits and discourage others. So the question becomes: what kinds of people and traits does a hyper market, hyper capitalist society foster?

III. The Free Market & Social Values Key idea: institutions shape values Effects of under-regulated markets on salient values: Erosion of community Commercialization of morally salient aspects of life Skills of “exit” and “voice” The market cultivates a sense of individual responsibility, of looking out for #1. The market also cultivates mistrust: everyone is out to take advantage of you, to make a fast buck, so you need to be wary. Nice guys finish last. Life is competition. Life is shopping. All of this has big spillover effects for the quality of life in general, not just the efficiency of markets.   What I am calling the value of community is very close to certain core values in many religious traditions. The aphorism “love thy neighbor” is basically an expression of this idea. So the first point here is that free, highly competitive markets tend to encourage the pursuit of self-interest and the overriding motivation for action.

III. The Free Market & Social Values Key idea: institutions shape values Effects of under-regulated markets on salient values: Erosion of community Commercialization of morally salient aspects of life Skills of “exit” and “voice” Religion & spirituality: the mega-church as a commercial enterprise selling religion Childcare: for-profit capitalist childcare centers The value of a “human life”: the market criteria for compensation in 9/11 The arts

III. The Free Market & Social Values Key idea: institutions shape values Effects of under-regulated markets on salient values: Erosion of community Commercialization of morally salient aspects of life Skills of “exit” and “voice” Markets cultivate exit strategies   Now here is the point about markets: Markets encourage a style of dealing with problems through exit. Voice is difficult. It requires skills of negotiation, communication, coalition building. This is hard. Exit is easy. Markets cultivate skills of exit, not of voice. Shopping as a model for getting what you want rather than community participation and deliberation. This has very broad ramifications in the society: marriage is defined by many people as a “marriage market” and finding a spouse is like shopping. Is it any surprise that divorce is a common solution to marital dissatisfactions: if you don’t like a marriage, exit and shop for another spouse. Great irony for conservatives who believe both in the sanctity of marriage and in the unregulated free market: their attack on the affirmative state regulation of the market intensifies the sense of individualistic competition and exit strategies, which reinforces the idea of marriage as a competitive market. Interesting example = “school vouchers” vs strong community involvement in schools. School choice is a market solution to the problem of school quality: make schooling more like a market, give parents the power of exit. Exits will force administrators and teachers to improve their schools in order to attract students. Alternative = increasing parent and student involvement in running schools.