204 newest micro notes for macro course part i

8/8/2019 204 Newest Micro Notes for Macro Course Part I

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ECONOMICS

Economics has many definitions. Three of the best are given below:1. Scarcity Problem(the Robbinsian definition)--The study of how a society uses its

scarce resources to satisfy very greatsometimes unfortunately formulated as unlimited human wants;2. Choice Problem(the Buchanan definition)--the study of individual and collectivedecision-making in the face of restricted alternatives.3. Coordination/Information Problem(based on F.A. Hayeks approach)--The studyof how the production and consumption decisions of countless decision makers arecoordinated through a decentralized planning system in which the knowledge or information that is relevant to decisions regarding the efficient use of scarce resources isdispersed across of minds of all of the market participants;

Emphasis here will be placed on the third definition although all three definitions are

useful and represent particular emphases within a broader discipline. The third definitionmay be understood as an information problem because at the heart of the coordination problem is the problem of dispersed information, i.e. the information is not amenable tothe usual kinds of problem solving techniques with which we are most familiar. Thelatter techniques are applied to solving jigsaw puzzles: all the information needed tosolve the problem may be held in the mind of one person, i.e. like the pieces of a jigsaw

puzzle. Thus all that is needed is to apply the appropriate decision-making techniques andthe puzzle can be solved by one person. Economic order is not like solving a jigsaw

puzzle because the information (the pieces of the puzzle) are dispersed across millions of people and are forever changing. This information can never be held in the mind of oneor a few people. Given the problem of dispersed information, a much more complex kindof problem solving technique is required to continuously solve the problem, i.e. tocoordinate economic activity.

Our concern is with how men order their lives in a community with particular referenceto those aspects of life which bear directly on the provision of material goods andservices. This is not to suggest that material goods are a substitute for moral or spiritualgoods, but they do nevertheless form part of the good to which humans are drawn bytheir nature. While the sphere of material goods is the primary focus of economics, it really cannot be segregated from the other spheres of human good. Human happinessmust in some sense be the key purpose of any study of human action, and that requiresa concept of human nature the fulfillment of which constitutes happiness. The

philosophical and religious traditions of human civilizations support the view that human happiness requires a balancing of material, moral, and spiritual goods. Theunstated or implicit view of human nature in modern economic theory is the view that emerged in the 15 th to 17 th centuries as exemplified in the political philosophies of

Nicolo Machiavelli and Thomas Hobbes. For Machiavelli and Hobbes human beingsare driven by material concerns of which the fear of death is greatest. Models of human behavior are reduced to an explanation of human behavior based on material desire the satisfaction of which constitutes happiness. Modern economists will claimthat spiritual and moral concerns such as concern for the well being of other people

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can be incorporated in the model of the satisfaction or utility maximizing individual,i.e. I gain greater satisfaction because I do things for other people. Of course thismisses the entire point because the concern for others is still being filtered through the

prism of self-satisfaction. Modern economic theory cannot escape this conundrumbecause of its view of human nature.

There is another tradition in economic thought, however, which does not yield to the Machiavellian-Hobbesian tradition. It can be traced back to the late medieval Spanish scholastic philosophers and to the Scottish enlightenment philosophers of the 18 th

century. The latter includes such authors as Lord Shaftesbury (Characteristicks of Men, Manners, Opinions, Times), Francis Hutcheson (An Essay on the Nature and Conduct of the Passions and Affections, with Illustrations on the Moral Sense), and

Adam Smith (The Theory of Moral Sentiments and his better known Inquiry into the Nature and the Causes of the Wealth of Nations). In this tradition material concerns are given their due in the explanation of economic behavior without at the same timereducing human nature and human happiness to the level of a beast. It has the great

merit of allowing us to take seriously those questions which found at the intersections of material, moral, and spiritual concerns.

I. ECONOMICS AND SOCIAL ORDER

A. ANARCHY, CHAOS, AND SOCIAL ORDER

We begin by making a distinction in the use of terms which guides us toward a proper understanding of the source of economic order (or coordination) in a community. Theterms are:

Anarchy defined as the absence of authorityversus

Chaos defined as the absence of orderliness (or coordination)

These terms are often conflated, but they have entirely different first meanings. Chaos isdisorder. Anarchy understood as the absence of authority leaves open the question of the

primary source of orderliness in a community. Authority consists of the powers of command and coercion and is normally associated with government. What is implied bythe above definitions is that authority should not be conflated with order. Authority or command is not the fundamental source of order in an economy, and it in fact may be asource of disorder in economic affairs. In the place usually accorded authority as thesource of orderliness in a community, we will place enlightened self-interest, i.e. thefreedom to act in accordance with one's own interests properly bounded by a regard for the welfare of others and the preservation of the institutions of civil society (note that oneof those institutions is government). Without the moderating effects of a proper concernfor institutions and for interests other than one's own, social order deteriorates under theweight of the tyranny of appetites. Of particular interest is what Wilhelm Roepke calledthe "wonder" of market coordinated activity, i.e. the superiority of voluntarism over command as a means for ordering or coordinating human actions which are based onenlightened self-interest. The actions of literally billions of people are coordinated

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primarily through an incredibly complex mechanism which functions without anyoneconsciously directing it. At the same time, Roepke argued that markets alone would not

provide a sustainable market order unless they were surrounded by the appropriate political and moral/cultural institutions.

B. AUTHORITY VS. SPONTANEOUS SOCIAL ORDER

The two fundamental ordering, i.e. organizing, principles in human society are whatthe Greeks called Cosmos and taxis . Cosmos refers to a free society that grows upspontaneously. Taxis is a man-made arrangement that is designed to accomplish humanobjects. Terms that are employed more often today are hierarchy and spontaneous order.Hierarchy, or taxis, is a form of organization that employs superior and subordinaterelationships. Its technique or method is authority/command. Obvious examples of theuse of this principle include families, and the armed services. The hierarchical

principle is simply the use of this method as the basis for human relationships, i.e. theway people relate to one another. This principle is certainly applied in businesses. The

boss consciously creates order within the firm by using authority. This act is likesolving a jigsaw puzzle because the decision-maker proceeds as if he has all the pieces of the puzzle (all the while knowing that some information is always missing and/or changing). His task is to apply the appropriate decision-making technique to solve the

puzzle. Techniques such as this are taught in courses on quantitative methods for businessdecisions. Of course it should be noted that his authority is established and delimited bya voluntary act, i.e. by the contract that the subordinate has freely entered into and mayend at any time. In a firm, authority is not only severely constrained, but is also guided

by forces which do operate by the principle of hierarchy. This brings us to the secondordering principle.

The second principle of social order is spontaneous order, or cosmos. Spontaneous order is the tendency for order (by which we mean orderliness, or coordination) to be created insocial life without the deliberate, conscious effort of any single person or of an authority(government) to construct that order. In the economic realm, the method of spontaneousorder is trade or exchange. The simple act of trading one good for another is the basis for a complex but highly coordinated set of production and consumption activities. The

business firm may be understood in context now as an island of limited hierarchyoperating in an ocean of spontaneous order. When the nature of the firm is studied later in this course, the reasons for the internal use of authority rather than trade as a way of allocating resources within the firm will be made clear.

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Consider the illustration above as a way of depicting the nature and number of relationships that exist under hierarchy (on the left) compared to the same under spontaneous order (M. Polanyi, The Logic of Liberty, 146-147 ). In this instance, thehierarchy has three subordinates responding to each superior. Such a system is clearlyintended to communicate what the person at the top or the central planners want to

produce and consume. On the other hand, the spontaneous order suggests lateralrelationships that are more numerous and in which the preferences of all of the participants are included in the information which is transmitted to all interested parties.The system with spontaneous order includes many more relationships, many more ties.This suggests the need for a means of communication that can handle the volume of information necessary to coordinate the actions of so many participants. It is for thisreason that the price system, i.e. the market system which relies on prices to coordinate,is also understood to be an information system.(see appendix 2 in lecture notes III where

prices are described as having three functions: transmit information, provide incentive torespond to the information, distribute income in society in accordance with each personscontribution to the income/output of society).

As noted earlier, the discipline of economics may be thought of as an investigation of thespontaneous forces at work in a society which generate orderliness in economic affairs,i.e. those dealing with the use of resources to produce and consume material goods andservices. Exposing the fundamental weaknesses of authority(command and coercion) ingenerating economic order is a part of that study as is an exposition of the weaknesses,albeit less frequent, of spontaneous order.

The Broken WindowHenry Hazlitt used a story to illustrate the idea that economics is concerned with both the

short run and long run effects of an act on all parties . Hazlitt, an economic journalistand a long time editor of Time magazine, borrowed this idea from Claude FrdricBastiat (1801-1850), a nineteenth century proponent of free-trade whom the greateconomist Joseph Schumpeter called "the most brilliant economic journalist who ever lived." Hazlitt pointed to the impact of economic actions on the "forgotten man"animpact which is sometimes called the "third party effect"to illustrate what commonlyhappens when authority tries to order, i.e. coordinate, economic activity. A third party in economic activity is simply someone who is affected by an act but is not a direct

participant . An example of a third party would be the case where your neighbors buy adog and the dog barks all night and keeps you awake. The parties directly involved in thetransaction are the buyer and seller of the dog. You are the so-called third party.

Hazlitt tells the story as follows: a young hoodlum throws a brick through the window of a baker's shop. The shopkeeper is unable to find the culprit. A crowd gathers, and beginsto stare at the broken window. After a while people in the crowd begin to reflect. Theyconclude that this act of vandalism will create business for a glass company. A new plateglass window costs two hundred and fifty dollars. The glass company will then have$250 more to spend than it would have had if the window had not been broken. Whenthe glass company makes purchases from other merchants, the broken window will

provide growing output and employment in ever-widening circles. The so-called logical

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conclusion from all this is that the hoodlum who threw the brick is not a public menace but a public benefactor! This is of course a fallacy which is easily exposed.

The crowd is right in its first conclusion. The act of vandalism will mean more businessfor the glass company. However, the baker will be out $250 that he was planning to

spend for a new suit. In order to replace a window, he will have to go without the suit. Now he has only a window rather than a window and a new suit. The baker, and in alarger sense the community, has lost a new suit that would otherwise have been producedand is that much poorer as a result. There has been a net reduction in wealth (the stock of material goods) in the community.

The glass companies gain of business is merely the tailor's loss of the same. There isno net gain in employment. There is only employment shifting away from the tailor and to the glass company, and the net loss of wealth mentioned earlier. The mistake of the

people in the crowd is that they were thinking only of two parties directly involved in thetransaction involving the new window, i.e. the baker and the glass company. They have

forgotten the third party, the tailor. In a sense one might say that they see only what isdirectly observable. Is it possible that an authority (government) could make a policymistake grounded in an inability or a refusal to recognize "third party" effects?

The Weaknesses of AuthorityThe basic weaknesses of authority in ordering economic activity may be categorized asinformational and institutional . The informational flaw of authority is its inability toacquire, much less use, the dispersed information which is needed to generate economicorder. The central planning arrangements in totalitarian societies and their economicfailures are a good example of the consequences of this flaw. However, one may alsofind this flaw in democratic countries. An example of this is described below in thedecision of the U.S. Congress to influence the flow of credit in an economy is madewithout the capacity to know the opportunity costs of such an action. Institutional flawsare present in the mechanisms of democratic governments in the form of voting and

bureaucracy. The flaws in these arrangements are especially glaring when flawed decisions are made even under circumstances where it at least seems that much of theinformation needed to make economically rational decisions is in the hands of decision-makers.

Flawed PoliciesConsider, for example, a typical argument for tariff protection, i.e. the protection of jobsin the home market. What usually escapes attention is that foreign demand for domestically produced goods is dependent upon domestic purchases of foreign goods. Inorder to purchase domestic goods and services, a foreign buyer must acquire the currencyof the country which produces the good. Such currency will be offered for sale only

because the seller of the domestic currency wishes to acquire the currency of the foreigncountry. The seller of domestic currency will only wish to do that if he also desires to usethat foreign currency to purchase goods or services from foreign producers. Thus whendomestic purchases of foreign goods and services are artificially limited or prohibited, theeffect may indeed be to increase employment in the now protected domestic industry, butit will also cause third party effects in the form of decreased employment in domestic

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industries which export goods and services to foreign countries. Like the case of a brick through a window , a tariff decreases both the imports and the exports of the countrywhich imposes the tariff . (The same is true for the trading partner whose good is being taxed.)

The informational and institutional flaws of authority account for such a policy.Although one may reason that domestic export industries will be hurt by such a policy,ordinarily it is not possible to say precisely which export industries will be hurt, muchless which particular firms in those industries will be most affected. These "third partyeffects" are easy to ignore. This informational flaw is compounded by the institutionalflaws known as the special interest effect and the short-sightedness effect . The specialinterest effect applies whenever each member of a small group of people may acquirelarge individual benefits at the expense of a large group of people each member of whichsuffers small individual losses. Particular domestic industries such as steel, auto, andtextile producers, or crayfish and catfish producers in our own state, will "invest" inlegislation which will benefit them significantly while costing each individual consumer

a relatively small amount.As a hypothetical example, suppose that 10,000 domestic producers (including ownersand employees) of textiles could spend ten million dollars (a one time expense) to

promote the passage of a tariff on imported textiles that increased the domestic price of shirts from $15 to $15.50, while permanently increasing the income of each domestic

producer by $5000 each? The individual gain of each producer is $5000. The total gainsof domestic textile interests is $50,000,000 (ten thousand gainers x $5000). Certainly thedomestic producers would gain from spending $10 million one time in order to generate$50 million more income for themselves every year. Suppose now that there are 100million consumers and each one purchases five shirts per year at the higher price for shirts. The individual loss of each consumer is $2.50 (5 shirts x a 50 cent higher price)and the total loss of all consumers is $250,000,000 (100 million consumers x 5 shirts x a50 cent increase in the price of a shirt). The cost of resisting such legislation is perceived by each consumer as being greater than simply paying up the extra $2.50 for shirtsevery year. Even domestic exporters may not resist such legislation because the costs of a single piece of tariff legislation are not high enough to justify such an effort. Of courseefforts are sometimes made to reduce the individual cost of resisting such legislation byforming additional lobbying groups which allow the domestic exporters to distribute thecost of resisting across a larger number of firms. In our example, suppose a civicallyminded person forms a STOP THE TEXTILE TARIFF lobby and asks people tocontribute money for the lobbying effort. How many consumers will send this lobbyistmoney to counter the effects of lobbying by domestic textile producers? After all, thistime gift would save him from paying $2.50 for shirts every year in the future. Thelobbyist would need 4 million consumers to send $2.50 to generate the same amount of money for counter-lobbying as the domestic textile producers are spending on lobbyingfor the tariff. Too optimistic? How about 1 million consumers sending $10 each? All of this leads to still another problem: the free rider problem . An individual consumer can buy shirts at the same old price without contributing anything to counter-lobbying if he free rides on the giving of other consumers to the counter-lobbying effort. Under

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the circumstances, it will be difficult to find enough consumers who will contributesufficiently to fund the counter-lobbying effort. Note too that even if counter-lobbying isfunded sufficient and succeeds in stopping the tariff legislation, $20 million in resourceshave been used up in the battle over the use of government power to impose a tariff. It isan institutional flaw of authority that such battles take place, i.e. that the power of

government is exploitable through the special interest effect .

The short-sightedness effect also comes into play in the case of a tariff. This effectexists in those situations where it is possible to emphasize the short-run benefits of a

policy while disguising the long run costs. The possibility of retaliation by other countries will be downplayed by industries seeking protection (There are, of course, casesin which retaliation from other countries can take place quickly. Nevertheless, if the

perception is that the possibilities of retaliation are remote, then the shortsightednesseffect is still operative). In addition, because the negative employment effects of a tariff on domestic exporters may not be felt immediately, it will be likely that voters will think that these negative employment effects have not been caused by the tariff implemented

earlier.Another example of the effects of institutional flaws (another brick through a window) isthe use of government loan guarantees to "bail out" failing businesses. These guaranteesare simply promises to repay the bank loans of companies which might be unable to payoff their loans in the future. The government does not lend the money, but it does standready to pay back the loan made by a bank if the borrower cannot do so. The Chrysler corporation was given this type of aid in the early 1980s. Such guarantees caused creditto flow to Chrysler and away from other borrowers because banks faced zero risk for loans made to Chrysler. Even the highest rated borrowers cannot offer zero risk conditions to the lender. The informational flaw arises in this case from the fact thatgovernment cannot know which firms and individuals failed to receive loans becauseChrysler moved ahead of them in line for loan money. As long as credit is a scarce good,i.e. not available in unlimited amounts, this kind of credit reallocation will take place.Chrysler management had in effect "proved" that it was not credit worthy but wasnonetheless rewarded with loans because the federal government guaranteed them. Other

businesses and individuals who had greater credit worthiness were penalized. Of courseneither those losers nor anyone else could identify the potential borrowers who weredenied loans because of the Chrysler loan guarantees.

The institutional flaws of democratic government worked very strongly in the Chrysler case through both the special interest and the short-sightedness effects. Both effects werecompounded by informational flaw, something which is quite common. Theinformational flaw in this case is the fact the government cannot know who the loserswill be. That ignorance is compounded by the fact that it isnt even possible for thelosers themselves to know that they are losing because of the loan guarantees! Howwould a potential borrower know that no loan is forthcoming because Chrysler received aloan due to government interference in the credit market. On the other hand, theidentities (and the voting districts!) of the owners, unions, employees, and creditors of theChrysler corporation were well known. The effect of the "bail out" was certainly to

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maintain employment at Chrysler, but employment that would have been createdelsewhere was pre-empted. As with tariffs, in the long run loan guarantees only serve toshift employment opportunities rather than maintain or expand them. At the same timethese policies reward inefficient and uncompetitive producers while penalizing efficientand competitive producers. These policies reduce the total wealth of a society through

their negative effects on efficiency. Loan guarantees and tariffs work in ways that areanalogous to the role of the brick in the story of the Broken Window. These exampleshelp us to identify the failings of the hierarchical principle when it is used to organizeeconomic activity. It quite another matter, however, to demonstrate how trade achieveswhat hierarchy cannot. That is what we turn to next.

How would you evaluate the bailouts that have taken place in the last few years? Hugeamounts of money have been used to bailout banks and other financial institutions as wellas automobile manufacturers and other producers. Do you think they are any differentfrom these past actions? If so, why? Be very specific.

C. SCARCITY, RATIONING, OPPORTUNITY COST, AND DECISIONS ATTHE MARGINThe underlying problem that is addressed in economics is the problem of

scarcity , i.e. the inability to satisfy all wants. Notice that the term needs is not usedhere. While we quite rightly make distinctions between wants and needs in our everydaylives, economic theory itself does not make that distinction. Economists commonly arguefor this on the basis of a fallacious distinction between statements concerning what is,i.e. positive statements, and statements that address questions of ought to be, i.e.normative statements. Usually economics texts make some comment regarding thescientific standing of is statements and reduce all statements of ought to matters of opinion. This is a philosophical position called logical positivism which philosophersabandoned long ago but unfortunately has remained alive in the social sciences. We donot have time here to examine the pernicious effects of logical positivism on the study of economics. However, we can of course accept the practical distinction between positiveand normative statements which recognizes 1) that it is often much easier to reachagreement about is statements than ought statements, and 2) that agreement aboutwhat ought to be is often made much easier by first answering the relevant isquestions. For example, reaching an agreement about whether government should regulate or control the prices of goods is greatly facilitated by knowing what will actuallyhappen as a consequence of the control. Wishing that price controls would make a goodless scarce doesnt mean that it will make the good less scarce. In fact, a price controlusually produces exactly the opposite effect. When it comes to making distinctions

between wants and needs, economists steer clear because they know that reaching anagreement about that question is difficult to do and because it may be possible to explainhow production and trade work without having to make that distinction. There are, of course, economic questions that cannot be addressed without making that distinction, e.g.are needs really different from wants and if so does the difference justify the use of authority to answer questions of what, how, and for whom to produce? Such questionsare addressed by introducing other disciplines such as philosophy and theology to theanalysis.

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SCARCITY => RATIONING => OPPORTUNITY COST

In economics the existence of scarcity implies the necessity of rationing , i.e. the act of distributing or allocating scarce things across alternative uses. There different types of

rationing mechanisms/methods which will be discussed below. The key here is tounderstand that because scarcity exists, so does rationing. It is not a question of whether but rather of how rationing is to be done. Even if is entirely random with no rhyme or reason to it, rationing will take place. What economics helps us to understand is howdifferent ways of rationingof making decisions about using scarce things to satisfy

peoples wantswill affect the outcome. For example, one rationing system might causemuch more output to be produced than another, or it might cause much more of one

particular type of good to be produced than would produced under a different kind of rationing system.

A further development in this chain of economic ideas is the concept of opportunity cost . Again, regardless of the type of rationing system used any action that

affects the allocation or distribution of scarce things has an opportunity cost , i.e. thehighest valued alternative activity for which those scarce things could have been used .Opportunity cost guides or influences decisions in markets that determine what, how, andfor whom to produce. In situations in which a certain bundle of already existing goods isa given (a starting place for analysis), opportunity cost affects decisions that determinethe particular amounts of each good that each person consumes. In fact, opportunitycosts exist whether or not anyone is paying any attention to them. Ignoring them doesntmake them go away. You may chose to ignore the impact of study time on your gradeswhen deciding how much of you day to spend at the gym or the movies, but that wont

prevent your decisions from affecting your grades.Of course it should come as no surprise that the manner in which rationing is

actually accomplished affects the outcome. Economists argue that if rationing decisionsare made with opportunity cost in mind and at the margin, those decisions willmaximize what may be accomplished with a given amount of time and resources. For example, assume that your goal is to maximize your grade point average, and that it isequally difficult to earn points on tests in each class. Heres an example of how many

points may be earned for a given hour of study in each class:Points Earned/study hour

Subject 1 st hour 2 nd hour 3 rd hour 4 th hour 5 th

hour Economics 35 30 20 10 5History 35 30 20 10 5English 35 30 20 10 5Math 35 30 20 10 5

The opportunity cost of studying one additional hour of economics is the number of points you do not earn by spending that hour on another subject. Notice the pattern of point distribution. In this example, you will maximize your G.P.A. by giving eachsubject the same amount of study time. For example, you do not spend a second hour onmath if you have not spent any time on English. After giving one hour to each subject,

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you give a second hour to each subject, and so on. By doing so you are taking intoconsideration the highest number of points you will not earn by the choice you are aboutto make concerning the next , or marginal, hour of study. For example, you use one hour to study economics. Each subject is equally attractive to study in the first hour of effort.

Next is the decision about how to spend a second hour of studying. Do you spend it on

economics? No, because that will generate 30 points on a test but studying the first hour for one of the other subjects will generate 35 points. The opportunity cost for a secondhour spent on economics is higher than the additional benefit of studying a second hour of economics at this point in the decision making process . This will continue to be thecase until you have allocated one hour of study time to each subject. When you reach thedecision about how to spend a sixth hour of study, you can choose any of the subjects andgenerate another 30 points on your exam in that subject. This process of comparing opportunity costs at the margin, or marginal decision-making , will enable you tomaximize your average score across all classes. If you have 12 hours to use for study, inthis example you should give each class 3 hours. You will have an 85 average in eachclass. If you shift an extra hour to math and take one hour away from English, you will

lose 20 points in English and gain only 10 points in math. That cannot possibly raise your average score all classes. That is because the opportunity cost of those 10 points gainedin math is the loss of 20 points in another subject such as English.

You can see that if the distribution of points earned in each hour is altered, i.e. thenumerical amounts in the table are changed, the allocation of study time that maximizesyour average score across all classes will be affected. Again you have 12 hours of studytime to allocate.

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Revised Points Earned/study hourSubject 1 st hour 2 nd hour 3 rd hour 4 th hour 5 th

hour Economics 35 33 30 25 10

History 35 30 25 10 5English 35 30 20 10 5Math 35 30 15 10 5

How many hours must be spent in each subject to maximize your average score acrossalls subjects?

There are, of course, some economic decisions that are all or nothing decisions, butmost purposes economic decisions can be taken at the margin if you remember to usethis technique. From this point we will employ these concepts (scarcity, rationing,opportunity cost, and marginal decision-making) in the explanation of production and

consumption activity that is coordinated through trade.D. THE BASIS FOR EXCHANGE IN A NON-PRODUCTION ECONOMYSince we have argued that authority is not the source of economic order, it is our task now to explain how economic order spontaneously devolves within a community. We

begin with the simple example of an economy with no production and then move toincreasingly more complex models or theories of economic order which encompass

production as well as exchange.

Necessary Conditions for ExchangeIn order for voluntary exchange to take place it is necessary that Mr. A possessessomething which Mr. B values more highly than what Mr. B currently possesses, and thatMr. B possess something which Mr. A values more highly than what Mr. A currently

possesses. Mutual gains from trade are available simply by exchanging these two goods.We will argue from this simple example that trade will spontaneously generatecoordinated consumption , i.e. the pattern of consumption that yields the greatest want

satisfaction given the initial pattern of resource ownership/income distribution .Coordination may be broadly defined as harmonizing in a common action or placing in

proper or best relative position. In our example there are only two patterns of consumption possible, i.e. either the ex ante or pre-trade pattern of consumption whichconsists of consuming what you already have, or the ex post or post-trade pattern of consumption which is generated by trade.

To begin we must know the original endowment of goods/resources . Who has what to begin with? In our example, Mr. A has one box of good X and Mr. B has one box of goodY. We must also know the transactors preferences. In the chart below, the satisfactionor utility that two people receive from two different goods is stated in terms of utils , asubjective measure of satisfaction. Economists proceed on the assumption that peoplehave some method of gauging the satisfaction they receive from goods, and that they canmake comparisons in their own minds that allow them to rank units of goods according to

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the amount of satisfaction each unit of each good provides. These measures of satisfaction are taken to be subjective, i.e. the unit of satisfaction, or util, used by one

person to gauge satisfaction may be entirely different from the unit of satisfaction used byanother person. Thus interpersonal comparisons of utility (comparisons of satisfactionthat different people receive from a good) are invalid in economic theory. One may,

however, properly compare utility measurements across goods for one person. Indeed,that is how a person decides how much of each good he will trade to acquire. More will be said about this later. For now, each of the two transactors has only one unit of onegood in his possession. Each person gauges the satisfaction he receives from each goodand determines that he would receive more satisfaction from one unit of the good he doesnot currently possess.

Transactors PreferencesUtils (units of satisfaction)from Consuming Each Good

Transactor Good X | Good Y

Mr. A 10 utils | 15 utilsMr. B 90 utils | 30 utils

What will Mr. A gain by a simple exchange of one unit of good X for one unit of goodY? What will Mr. B gain? (Hint: what one person gains is not determined by how highlythe other person values the good. Rather it is determined by what satisfaction he gives upand what satisfaction he gains through trade). Mr. A would sacrifice 10 utils of satisfaction to acquire 15 utils of satisfaction. His net gain would be 5 utils of satisfaction. Mr. Bs net gain would be 60 utils. Since both transactors can gain thenecessary conditions for exchange are met. Note that the net gains (5 utils for Mr. A and60 utils for Mr. B) cannot be compared so there is no way to know whether one persongains more from trade than the other. The point is that they will both gain in their owneyes and thus will have an incentive to engage in trade. Since both parties gain, it is

possible to understand how trade, even in the absence of additional production, createswealth. The same quantity and type of goods is present both ex ante and ex post, but thetotal level of satisfaction of material wants is greater. Trade creates new wealth evenwithout the production of new goods! We are accustomed to thinking of the creation of greater material wealth as synonymous with the creation of additional material output.While that is certainly a common method of creating additional wealth, it is not the onlymechanism for doing so. This is an aspect of the coordination problem faced by everysociety that often escapes attention, i.e. the coordination of consumption activity .

Now consider the problem below. It expands our understanding of trade by allowing usto answer the question of whether mutual gains from trade are precluded if both parties

prefer one good over the other. Unlike the first example in which both parties prefer thegood that they do not currently possess, in this case both Mr. A and Mr. B prefer good Xto good Y. Are the necessary conditions for exchange met? Work the problem and seeusing the three exchange rates listed.

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Necessary Conditions for Exchange ProblemOriginal Endowment: Mr. A has numerous boxes of Good X & Mr. B has numerous

boxes of Good Y. Preferences : To simplify the analysis, it is assumed that Mr. A receives the same

satisfaction (measured in utils) from every box of Good Y regardless of how many heconsumes. Similarly he receives the same additional satisfaction from every box of GoodX that he consumes. The same applies for Mr. B and the additional utils he receives fromeach additional box of Good X or Good Y that he consumes. This assumption makes itunnecessary to take diminishing marginal utility into account, i.e. the fact that theadditional utils each transactor receives from consuming additional boxes of each gooddecreases as more boxes are consumed. Note: in this case both people prefer Good X toGood Y but there may still benefits to exchange.

Transactor Good X Good YMr. A 30 utils 15 utilsMr. B 80 utils 30 utils

Your task is to determine whether it is possible for Mr. A and Mr. B to make gains fromtrading at one or more of the following prices. Note that transactors will only agree totrade when they receive net gains from trade. Breaking even is not an incentive to trade

because of unstated transaction costs, i.e. costs associated with the act of trading, thatwould actually leave the transactor with net losses if the direct net gains from trade werezero. In this problem, net gains or net losses are measured in terms of utils. At this point,you may use trial and error to make these determinations. (Later you may see how torecognize a pattern which would make trial and error unnecessary. Hint: Compare

personal tradeoff rates measured in utils to the market tradeoff rate given as a barter price.)

1X:1Y

Mr. A has Good X and does/does not want to trade it for Good Y at a price of 1X:1Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 1Y.

Mr. B has Good Y and does/does not want to trade it for Good X at a price of 1X:1Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 1Y.

1X:2.5Y

Mr. A has Good X and does/does not want to trade it for Good Y at a price of 1X:2.5Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 2.5Y.

Mr. B has Good Y and does/does not want to trade it for Good X at a price of 1X:2.5Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 2.5 Y .

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1X:3Y

Mr. A has Good X and does/does not want to trade it for Good Y at a price of 1X:3Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 3Y.

Mr. B has Good Y and does/does not want to trade it for Good X at a price of 1X:3Y because he will experience a net gain/loss of _____ with each transaction, e.g. each time1X is traded for 3Y.

Now here are the solutions:Mr. A does not , loss of 15 utils 1X is traded for 1Y.Mr. B does, net gain of 50 utils 1X is traded for 1Y.

Mr. A does, net gain of 7.5 utils 1X is traded for 2.5Y.Mr. B does, net gain of 5 utils 1X is traded for 2.5Y.

Mr. A does, net gain of 15 utils 1X is traded for 3Y.Mr. B does not, net loss of 10 utils 1X is traded for 3Y.

The fact that Mr. A and Mr. B prefer Good X to Good Y does not preclude mutual gainsfrom trade if the price to which they bargain is mutually beneficial. As you can see fromthe solution, there are also exchange rates or prices which are not mutually beneficial.

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The Effects of Diminishing Marginal Utility (Optional )The phenomenon of diminishing marginal utility accounts for why people do not

purchase unlimited amounts of just one good. If a person liked all units of all goods withequal intensity he would have no basis for choosing one good over another. Choicewould be meaningless. If a person liked all units of one good more than any units of any

other good, he would consume only one good. Of course that does not conform to our real experiences. What does match up with reality is that people like to consume morethan one good. Thus, the consumer may like the first glass of chocolate milk more thanthe first unit of any other good and so would chose it over any other purchase. But thesame could not be said for the third or fourth ortwentieth glass of chocolate milk. Atsome point a person will spend part of his income on something other than chocolatemilk. This is due to the fact that the consumer receives smaller increases in satisfaction(smaller additional satisfaction) from additional glasses of chocolate milk. Eachadditional glass provides less additional satisfaction (marginal utility) than the last. Wewill delve into the reasons for this later. For now we can focus on the effect of diminishing marginal utility on barter trade between Mr. A and Mr. B. As Mr. A trades

away boxes of good X, his consumption of that good is falling. He begins by sacrificinggood X under circumstances where he receives 30 utils from a box of X. But as hereduces his consumption of good X the additional satisfaction from good X (marginalutility of X) increases, i.e. recall that MU is higher for previous units. Similarly, he

begins consuming good Y under circumstances where he receives 15 utils from a box of Y. But as he increases his consumption of Good Y the additional satisfaction from goodY (marginal utility of Y) decreases, i.e. recall that MU is lower for subsequent units.To understand this better, consider the table below. It depicts Mr.As preferences under conditions of diminishing marginal utility. Mr. As original endowment of goods is also

provided.

Original Endowment of Goods : Mr. A possesses two boxes of good X and no boxes of good Y.

Preferences: Box of X consumed Utils from X Box of Y consumed Utils from Y First box 35 utils First Box 15 utilsSecond box 30 utils. Second Box 14 utils

Third Box 13 utilsFourth Box 12 utilsFifth Box 11.75 utils

Assume that Mr. A and Mr. B have bargained to a price of 1X:2.5Y. Mr. A loses 30 utilsof satisfaction from trading away one box of X, the so-called marginal box of X. Mr.A gains 35.5 utils (15 + 14 + 6.5) in his acquisition of 2.5 boxes of Good Y. His net gainis 5.5 utils. However, if he trades away another box of X, Mr. A sacrifices 35 utils. Thisis not due to a difference in the boxes of good X. They are identical boxes. It is that factthat as he trades away more boxes of X he has less of it left to consume. Likewise, the

boxes of good Y are identical to each other. The decrease in marginal utility is due to thefact that he is consuming more of this good. Would Mr. A trade away another box of

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good X at the price 1 box X: 2.5 boxes of Y? No, because he would forfeit 35 utils andgain 30.25 utils (6.5 + 12 + 11.75). Mr. A would experience a net loss of 4.75 utils.

Mr. B would also experience a decrease in marginal utility from consuming additionalunits of good X and good Y. The effect would be similar, i.e. he would likely not trade

away all of the good he has (Good Y) but would keep some of it to consume along withthe box of good X he purchases. Is it possible that someone would want to consume onlyone good? Certainly, but we must account for al outcomes including the one morecommonly experienced in which both people consume both goods after trade.

Given the conditions outlined above, it is possible to generalize about how far trade will proceed. A trade equilibrium is reached when the following condition is met:

Mr. A Mr. BMarginal Utility of X Marginal Utility of XMarginal Utility of Y = Marginal Utility of Y

Both Mr. A and Mr. B will both experience dimishing marginal utility. For Mr. A, theMUx is greater when he trades away units of good X and is left with fewer units of thisgood after trade. However, the MUy is decreasing for him because he is acquiringadditional units of that good. Thus as Mr. A trades away good X to acquire good Y, theMUx/MUy for Mr. A is increasing. For Mr. B, the opposite is true. He is trading awaygood Y and acquiring good X. For him, the MUy is increasing and the MUx isdecreasing. As long as the ratio of their marginal utilities are different, i.e. not equal tothe market price or exchange rate available, they will make gains by trading and willthereby cause their ratios of marginal utilities to move toward equality at the leveldefined by the market price. If the market price is 1X:2.5Y, then they will end up tradinguntil

Mr. A Mr. BMarginal Utility of X Marginal Utility of XMarginal Utility of Y = Marginal Utility of Y = 1/2.5

Recall that we cannot compare utils across consumers. However, we can take each person to have the same meaning if each tells us that he likes good X twice as much asgood Y. If the relative intensity of preference for both goods is the same for Mr. A andMr. B there is no longer any way to make gains from trading. Suppose we borrow fromthe problem above but change the initial preference information to the following:

Transactor Good X Good YMr. A 30 utils 15 utilsMr. B 80 utils 40 utils

Is there any basis for trade here at any price? No, because their private tradeoff rates arethe same, i.e. 2X:1Y. To make a gain, one person must request an exchange rate thatautomatically results in in a net loss for the other party. At less than 1X:2Y, e.g. 1X:1.9Y,

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Mr. B gains. This is because he originally possesses good Y and at this exchange rategood Y is more highly valued in the market than in either of their preferences. You cansee this if you realize that in the market it good Y is sufficiently valuable that it onlytakes 1.9 boxes of Y to purchase 1 box of X. For both Mr. A and Mr. B, however, goodX is worth more than that, i.e. it is worth 2X. Of course Mr. A is not going to agree to

this.

On the other hand, Mr. A would gain at more than 1X:2Y, e.g. 1X:2.1Y, because he possesses good X , and good X is more highly valued in the market than in either of their preferences. You can see this if you realize that in the market it good X is sufficientlyvaluable to acquire 2.1 boxes of good Y whereas Mr. A and Mr. B personally only valueit at 2 boxes of Y. Since Mr. B possesses good Y he is certainly not going to agree to thisexchange rate.

In this problem there can be no gains from trade because the relative intensity of their preferences for the two goods is the same . How does this help us to understand trade

under conditions of diminishing marginal utility? It is simply this: In our original problem Mr. A and Mr. B begin trade because they do not have equally intense relative preferences for good X and good Y. Mr. As preference rate was 30:15 and Mr. Bs was80:30. Both persons preferred good X to good Y, but the intensity of that preference wasstronger for Mr. B, i.e. more than twice as strong a liking for good X as for good Y. Inthe original problem this never changed because we assumed away the diminishingmarginal utility that both persons would experience. However, as trade proceeds under conditions of diminishing marginal utility , the relative intensity of preference for good X over good Y (MUx/MUy) decreases for Mr. Y because he is consuming more of X andless of Y, i.e. acquiring more of good X by trading away good Y. On the other hand, therelative intensity of preference for good X over good Y (MUx/MUy) increases for Mr. A

because he is consuming less of good X and more of good Y, i.e. is trading good X awayto acquire good Y. At some point as Mr. A and Mr. B trade, the relative intensity of their

preferences for goods X and Y will be the same and be equal to the market exchange rate.At that point Mr. A and Mr. B will have exhausted all of the mutually beneficial tradesand there will be no additional trading.

The P.O.W. Camp ExampleThe example above establishes the conditions which must exist if voluntary exchange isto take place. Essentially trade must be mutually beneficial given the originalendowment of goods and the relative intensity of preference for each good in the initialendowment. Consider now a more complex example drawn from the experience of aneconomist who was incarcerated in a P.O.W. camp during WWII. R. A. Radford was anAmerican POW during the Second World War. Life as a POW had been so restrictedthat any social order of the prisoners might have appeared to be the consequence of thecaptors' actions. Radford saw, however, how a market for goods and services (i.e. asystem of exchanges) emerged within the camps and how the prisoners' materialconditions were improved. This happened in exchange based economies with little or no

production. In this case, the Red Cross gave each prisoner a package containingessentially the same items. These items included such items as cigarettes, toiletries, soap,

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chocolate, tinned milk, butter, jam, biscuits, and sugar. Although the Red Crossdistributed supplies equally among all POWs, each item was not equally prized by everyrecipient. Thus the condition which prevailed was the same as that described above withMr. A and Mr. B.

Types of RationingBefore proceeding, it is important to note that the scarcity of goods in the campnecessitated rationing. Rationing is simply the distribution of scarce things acrossalternative uses or purposes. There different types of rationing mechanisms/methods.The Red Cross might simply put the boxes on the ground and leave the strongest and thefastest to take what they want first. This would be an unjust method and would generatean unjust outcome. Instead the Red Cross uses the hierarchical method that relies onthe use of authority to decide who is to receive goods and in what amounts. This methodmay be desirable to establish the initial endowment of goods under these circumstances,

but it does not yield coordinated consumption, i.e. the pattern of consumption thatyields the greatest want satisfaction. We know this because the POWs immediately

begin to trade with one another. Trade is a mechanism of spontaneous order. It is arationing method that changes the pattern of consumption. ( Recall the pre and post-trade patterns of consumption in the example of Mr. A and Mr. B with their initialendowments of good X and good Y.) One might also use the term efficient/inefficient todescribe the outcomes of these alternative rationing methods.

Rationing in turn implies the existence of competition defined as the effort to outdo or outmaneuver someone. Competition is not the cause of scarcity and rationing but rather the consequence. Of course it is possible to respond to respond to the rationing problem(need to distribute scarce things across alternative purposes) in other ways, but we willsee later in lecture that competitive behavior may serve us better by stimulating us to dothings that better serve other people. Competitive behavior discovers or revealsinformation that cooperative behavior alone is not likely to do. Of course one may arguethat just forms of competition are also ways of cooperating with others to achieve someend or purpose. However, if one defines cooperative behavior as inherently non-competitive, then we may find that it alone does not always generate the best results. Itis desirable under many circumstances but in the economic realm we may find ourselves

better served by relying more heavily on competitive behavior.

Barter Trade and Price FormationPOWs began to satisfy their wants through an informal system of sharing or gift-giving.Soon, however, they realized that trading was a more effective means of maximizingindividual satisfaction. Pure Barter emerged quickly (trading good for good) and alongwith it barter prices, i.e. the price of a good stated in terms of an amount of another good for which it may be traded. Pure barter requires a coincidence of wants betweenthe two trading parties, and that is an impediment to trade. It is eventually overcome bythe emergence of intermediate trading or trading that is done to make trading easier todo. POWs trade for a good which they turn and use to purchase other goods. Later, theeffects of intermediate trade will be examined in more detail.

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Barter trade gives rise to barter prices. In a trade system, prices measure the relativescarcities of goods . (We examine below the problem caused by the emergence of multiple barter prices.) That is certainly how we understand prices in our day to daylives. No one has any difficulty understanding that a gallon of milk is less scarce than aDVD player. The prices of milk and DVD players tell us that and we know that at least

intuitively. Yet while price measures relative scarcity, it does not determine it. It is thedata or information of the market which determines the relative scarcity of goods. Inthe camp that data consists of the relative intensity of peoples preferences for eachgood (recall the example from the necessary conditions forexchange), and the relativequantities of each good present in the camp. The latter is secondary but we will includeit because in the camp, unlike normal economic conditions, it is not possible to changethe relative quantities of the goods produced. The data of the market is determined themoment the goods arrive in the camp, i.e. prior to any trading or even to distribution bythe Red Cross. The data is determined at that moment, and thus the relative scarcitiesare determined but they are not known to any yet. Those scarcities have to bediscovered or revealed and it is trade that accomplishes this. Trade incorporates the data

of the market into the prices of goods even though no one is trying to do that. It is anexample of spontaneous order. The act of trading accomplishes this without thedeliberate, conscious effort of any person or of the authority in the camp. Tradeovercomes the problem of dispersed information (knowledge) . The data of the marketis not held in the mind of any one person or authority. It cannot be pieced together likethe pieces of a puzzle that are laying on a table. In the case of a puzzle, all of theinformation is held in the mind of the puzzle solver and he has only to apply theappropriate puzzle solving techniques to solve the puzzle. In the market the pieces of thepuzzle are dispersed and they remain that way. So, how does trade solve the puzzle?Trade, including arbitrage and and speculation, accomplishes this through disequilibrium

prices which lead to equilibrium prices that contain all market data.

As trading begins in different parts of the camp, multiple barter prices for the same goodsare formed. However, multiple barter prices contain incomplete information. Theydo not contain all of the data of the market and thus they communicate false informationabout the relative scarcity of a good. The higher price for a given good communicatesthat the good is more scarce than is really the case and the lower price communicatesthat it is less scarce than is really the case. What is really the case is something in

between. How is that true relative scarcity discovered and communicated to people in themarket so that they do not make decisions that they regret a few minutes later? Thetransactions they made were mutually beneficial, but market some participants quicklyrealize they could have done better. That outcome is inconsistent with the concept of coordinated consumption.

The existence of multiple barter prices (disequilibrium prices as they will be calledlater) communicates the existence of opportunities to earn arbitrage profits.Entrepreneurial traders will be alert to the existence of multiple barter prices and will

begin to engage in arbitrage (buying low and selling high across distance) . It isimportant to note that arbitrageurs are not trying to generate coordinate consumption inthe camp. They are not trying to cause single prices for good to emerge. In fact, it is

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contrary to their own interests to cause single prices to emerge because that eliminatedthe opportunity to earn arbitrage profits. Their actions are inherently competitive becausethey must engage in competitive price changing behavior in order to be successful. Theymust bid up the price of the good where it is low and cut price where it is high in order tooutmaneuver the other market participants, i.e. arbitrageurs compete with buyers where

the relative price is low and compete with sellers where the relative price is high.

If the price of 1 piece of chocolate is 3 crackers at the south end of the POW camp and 5crackers at the north end of the camp, then chocolate is scarcer at the north end of thecamp than at the south end. Arbitrageurs will increase the demand for chocolate at the

south end. For example, an arbitrageur will offer slightly more than 3 crackers for a piece of chocolate at the south end, e.g. 3.5 crackers for 1 piece chocolate, and then carrythe chocolate to the north end of the camp where he will offer it for sale at slightly lessthan 5 crackers, e.g. 4.5 crackers for 1 piece of chocolate. The supply of chocolate isincreased at the north end of the camp by arbitrage. Notice that the arbitrage profitsfrom these trades is 1 cracker for each purchase and sale of 1 piece of chocolate.

The same actions may be viewed as increasing the supply of crackers at the south end of the camp where crackers are scarcer, i.e. in the beginning 1 cracker trades for 1/3 of a

piece of chocolate at the south end of the camp. This action is paired with an increase indemand for crackers at the north end of the camp crackers are less scarce, i.e. 1/5 of a

piece of chocolate for 1 cracker. The initial price changes can be restated as follows:From this new perspective, the change in price at the south end from 3C:1Ch to 3.5C:1Chis restated as 1C:0.33Ch to 1C:0.29Ch. In other words, an increase in the price of chocolate (relative to crackers) may also be described as a decrease in the price of crackers (relative to chocolate). At the north end, the change from 5C:1Ch to 4.5C:1Chis restated as 1C:0.2Ch to 1C:2.22Ch. Again in other words, a decrease in the price of chocolate (relative to crackers) may also be described as an increase in the price of crackers (relative to chocolate)

Arbitrage ultimately causes a single price across distance to emerge that accuratelyreflects the relative scarcity of the good. The single price contains all of the data of themarket, i.e. all the dispersed information concerning relative intensity of peoples

preferences and relative quantities. The emergence of a single price also signals theemergence of coordinated consumption . With a single barter price for each good acrossthe camp, trades made in part of the camp at a given hour are not regretted. This iswhat we expect prices to be like. When we go to the store to buy milk, we do not expectto be disappointed an hour later because we could have had a better deal around thecorner. We usually take prices we see to be single pricesprices that accurately reflectthe relative scarcity of a goodand they usually are. That is what coordinates activity.

The single or "equilibrium" price established through arbitrage reveals accurateinformation about the relative scarcities of goods that is necessary if all market

participants are to make consumption decisions which yield the greatest possiblesatisfaction. Through the actions of all traders a full set of equilibrium barter pricesemerges, i.e. each good has a barter price vis-a-vis every other good. This represents a

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full coordination of consumption of all barter goods. The term equilibrium refers to asituation in which there is no tendency for change to occur, and as it applies to market

prices it means that all market information has been built into the price of the good andthus coordinated supply and demand decisions have been achieved. Under theseconditions price will not change unless some relevant piece of market information

changes, e.g. people's preferences for chocolate change. Suppose, however, that thesingle prices arbitraged into existence on the first day of trading do not last to the end of the month? There is a missing piece of market data that has not been built into the priceof each good, i.e. the relative intensity of preference of the POWs for consuming goodsover time. Another form of specialized trading will emerge in response to thisdiscoordinationspeculation.

Speculation works in fashion similar to arbitrage by bringing into existence a single price for each good across time. In effect, arbitrage is buying low and selling high acrossspace and while speculation is doing so across time. It is done for individual gain, but it

benefits all by revealing how scarce each good is vis-a-vis every other good throughout

the time period during which the stock of goods is to be used to satisfy consumptionrequirements. Obviously, superior consumption decisions will not be made if one is told by a low market price that a good is extremely abundant at the beginning of the relevanttime period only to become extremely scarce by the end of the time period. Relative toconsumers' wants, the good is being under valued at the beginning of the time period andover valued at the end of the time period.

A low relative price causes POWs to consume a good rapidly. At the same time, if onegood has a low relative price in terms of another good, the second good has a relativelyhigh price in terms of the first, e.g. 2 package of crackers: 1 chocolate bar also means that1 package of crackers: of a chocolate bar at the beginning of the month. Suppose that

by the end of month #1 the price is 6 packages of crackers: 1 chocolate bar, and 1 package of crackers: 1/6 th of a chocolate bar. Chocolate starts out cheap relative to thePOWs preferences so they consume it rapidly. Crackers start out expensive relative toPOWs preferences so the POWs consume those slowly. By the end of the monthchocolate has been depleted too rapidly compared to POWs preferences and Crackerstoo slowly. The high price of chocolate at the end (6 packages of crackers rather than 2

packages of crackers) and the much lower price of crackers at the end (1/6 th of achocolate bar rather than of a chocolate bar) shows that the POWs have consumedthese goods at rates other than those which would satisfy them most. They actually

prefer to consume these goods more "evenly" across time. Consumers would not makethe same consumption decisions if they knew that such differences in price were going toemerge.

As POWs experienced this phenomenon some of them simply began to conserve their useof certain items as the Red Cross distributes them in future deliveries. While theywithhold some supplies of chocolate from the market at the beginning of month #2, other POWs begin to purchase units of chocolate at the beginning of month #2 to hold for saleat a higher price at the end of that month. The latter "professional" speculators seek speculative profits by purchasing units of goods to hold and then sell later at a higher

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price. All of these forms of speculation cause the difference in price across time to besqueezed. Thus, when compared to the beginning and ending prices of chocolate for month #1, the beginning price in month #2 will be higher, e.g. 3 packages of cracker for 1chocolate bar, than its counterpart in month #1, and the ending price, e.g. 5 crackers, will

be lower in month #2 than its counterpart in month #2. This slows down the

consumption of chocolate and speeds up the consumption of crackers during the courseof the second month. At any given moment in that month, the amount of chocolate in thecamp will be greater and the amount of crackers smaller than at the same time in the

previous month. Over the course of future delivery times, the beginning and ending prices for each consecutive month will be driven together, e.g. to an exchange rate of 4 packages of crackers for 1 chocolate bar throughout the month. The rates of consumptionof chocolate and of crackers will be adjusted so that the beginning and ending price will

be unchanged. Note that this is accomplished by shifting the supply of some goods(chocolate) from the front end to the back end of the month, and shifting the supply of other goods (crackers) from the back end of the month to the front end of the month . The

price changes that occur in this stylized example are described in the table below.

Pattern of Price Changes Over Time (within & between months)Month #1 Month #2 Month #3

6C:1Ch Ending price5C:1Ch Ending price

4C:1Ch Ending & BeginningPrice

3C:1Ch Beginning price2C:1Ch Beginning price

These are the speculative actions which make it possible for the POWs to fulfill their desire to consume chocolate and crackers evenly or at the same rate over the entiremonth. Even if the difference in beginning and ending price were not entirely eliminated(the cost of storing goods across time would alone prevent that), one can see that suchspeculative actions bring about a greater coordination of consumption across time thanwould otherwise exist.

The single price for a good across distance and time is a correct measure of therelative scarcity of the good. It is important to note that both in the case of arbitrageand speculation, the entrepreneur does not want to reveal what he knows regarding theexistence of multiple barter prices. However, the competitive price bidding revealsthat the good has a different price elsewhere and encourages other to beginarbitrage and speculation. Ultimately, competition discovers the new equilibriumprice and quantity. This is what is meant by the invisible hand which Adam Smith,author of The Wealth of Nations , and other writers of the Scottish enlightenment in the18 th century.

Intermediate Trade and MoneyThe emergence of money and money prices is an even more impressive example of thespontaneous devolution of institutions which makes coordination of complex economic

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activity possible. Pure barter, i.e. trading good for good with no intermediate exchanges,requires a coincidence of wants. If I want to trade crackers for milk, I must find someonewho wants to trade milk for crackers. This is extremely cumbersome and leads to effortsto circumvent this impediment to trade. In other words, it leads to actions that result inthe creation of the institution of money. It is especially important to note that the

institution of money is not created by an authority. Neither is it consciously agreed upon by the camp members at a meeting. Cigarettes become money through intermediatetrade , i.e. the individual efforts of people who are trying to make their trading easier todo. They simply try to acquire first the good or goods which are easiest to trade for other goods. Such qualities as durability, transportability, general use in consumption, anddivisibility, i.e. the ability to divide the good into smaller units without destroying itsvalue, account for individual efforts to acquire cigarettes that will in turn be used to

purchase all other goods. Cigarettes become money--a social institution or arrangement--when POWs recognize that other traders are doing the same thing that they are doing.Collectively, they become aware of everyone's efforts to make trading easier by usingcigarettes as a medium of exchange. Since all goods including cigarettes already have a

full set of barter prices, it is a simple matter of expressing prices in terms of units of money, i.e. cigarettes, by ceasing to use all other barter prices.

The importance of money as a tool to facilitate trade is not adequately expressed in theterm "medium of exchange". Complex forms of production and exchange are simply not

possible without money and money prices. One has only to consider the informational problems that emerge in barter as the number of goods and services expands. Even theactivity of a non-production economy such as the POW camp could not be effectivelycoordinated without the use of money prices by individual decision-makers. Thefollowing algebraic formula expresses the relationship between the number of barter goods that exist in an economy and the consequent number of barter prices to be used indecision making: where n= # of barter goods; the number of barter prices = n(n-1)/2

n | # of barter prices3| 3

13| 7825| 300

50 | 1225100 | 4950

1000| 499,500

In a monetized economy the number of money prices is equal to the number of goods andservices to be produced and traded. The sheer complexity of calculating and comparing

profits from alternative uses of resources in a pure barter economy would beoverwhelming once the number of goods and services exceeded a few dozen. In a worldwhere only a few goods and services are produced this information problem ismanageable. However, in a world of many goods it is simply too costly to acquire anduse the information necessary to make utility or profit maximizing decisions. All of thesecalculations are greatly simplified, however, by the use of money prices. For example, ina world of only 100 goods and services to be traded, the number of single pure barter

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prices that a transactor would have to keep track of is 4,950. Under monetized exchangethe number of single money prices is only 1000.

Monetary problems in the POW Camp emerged despite the overall usefulness of cigarette money. Distinctions amongst the various brands of cigarettes became blurred.

All cigarettes were not equally desirable to smokers, but all were equal as money. Thussmokers held the desirable brands for their personal use and spent the others. The lessdesirable cigarettes therefore were the ones used as money' the "good" cigarettes weresmoked. This is an example of Gresham's Law. First stated by an Elizabethan financier named Sir Thomas Gresham (1519-1579), it is usually expressed as: "Bad money drivesout good." In this case, "bad" cigarettes drove "good" cigarettes out of circulation asmoney. (The good cigarettes were smoked instead.) A formal statement of Gresham'sLaw might be that when there are two types of money whose values in exchange areequal but whose values in consumption are different, the more valuable item will beretained for consumption and the less valuable item will circulate as money.

Another bad money problem arose as POWs began pulling out a few strands of tobaccoto make another cigarette before using a cigarette in exchange for another good. Thiswas the equivalent of "clipping" coins by chipping off pieces of gold. This practicemade exchanges more uncertain and induced at least mild inflation . The multiplicationof the number of monetary units or debasement of the currency was further worsened bysome enterprising prisoners who rolled cigarettes from pipe tobacco. Governments havefrom time to time done the same thing by melting coins down and reissuing them with asmaller gold content.

The greatest problem, however, was not debasement but rather the decrease in the moneysupply caused by a failure to restock the supply of cigarettes or by intense smoking thattook place when Allied bombers flew bombing runs close to the camp. Fearful that the

bombers might accidentally bomb the camp, the POWs smoked heavily in their bunks.All of the cigarette prices of commodities that existed the night before when tradingended were incorrect in the morning after the POWs had consumed much of the existingstock of cigarettes. The value or purchasing power of cigarettes was greater although noone knew what that value was until at the beginning of trade the next day. All prices of goods stated in cigarette terms were too high. To accurately reflect the greater scarcity of cigarettes, other goods would have to be tradable for fewer cigarettes, i.e. a pricedeflation would have to take place. A piece of chocolate that previously sold for 4cigarettes would drop in value the next morning to 2 or 1 cigarettes. The problem, of course, is that not all goods would drop in price by the same amount and there was notway to discover the correct lower cigarette prices for goods except by trading and makingmistakes. The lower cigarette prices of commodities had to be arbitraged and speculatedinto existence with a resulting discoordination of consumption in the mean time. Themonetized exchange system worked well as long as there were no sudden and substantialchanges in the money supply, i.e. the quantity of cigarettes in the camp compared to thequantities of other goods present in the camp.

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Radford recognized that the social order (i.e., how the interactions of people areorganized) in the POW camp emerged spontaneously rather than being "commanded"into existence. The institutions and behaviors that emerged spontaneously rather thanthrough the actions of the authority present in the camp, i.e. the military hierarchy of either the prisoners or the captors, included barter, barter prices, entrepreneurship

(arbitrage and speculation), money, and money prices. The role of authority in the campwas limited to enforcing property rights and contracts. The enforcement of propertyrights and contracts is vital to the operation of the spontaneous order and is part of the

political framework that allows trade to produce coordinated outcomes. E. PRODUCTION AND EXCHANGE: THE PRINCIPLE OF

COMPARATIVE ADVANTAGE AND ITS IMPLICATIONS FOR ECONOMIC ORDER

We now advance to the next stage of our analysis of market coordination. Up to this point we have considered only the coordination of consumption activity. It is necessaryto add to our explanation how markets coordinate production with consumption. These

are not separate problems, although it may appear so at certain stages of our analysis. Itis, however, the coordination of the use of resources to satisfy human wants that we wishto explain. Part of this task is to generate as much output as possible in a pattern which isconsistent with human wants. Thus we consider the principles governing productionwhich explain how the greatest amount of output possible may be produced, and then goon to explain how trade actually causes this to take place, i.e. causes resources to be usedin a manner which assures maximum output relative to people's wants.

Before examining how trade answers "what to produce, how to produce, and for whom,"it is necessary to define the categories of resources or inputs (factors of production)which are used to produce the output which is then "distributed" to market participants.These categories are labor, capital, natural resources ("land"), and entrepreneurship.

Labor includes all non-entrepreneurial human physical and intellectual abilities; capitalincludes all man-made aids to production; the category of natural resources includesmaterial resources found in nature such as soil, water, petroleum, etc.; andentrepreneurship is the human ability described as alertness to opportunities to makegains or to avoid losses. Entrepreneurship is also understood by some to include the roleof organizing the actions of other resources.

The Three Basic Economic QuestionsOne way of describing the problem of coordinating production and consumption activityis through the "three basic economic questions". Scarcity necessitates answering three

basic questions. These are what, how, and for whom to produce. What refers to whichgoods and services will be produced and in what amounts. How refers to questions of which resources will be used to produce each good and service, how much of eachresource will be used in the production of each good and service, and the particular technology (method of production) will be used to produce each good and service.Scarcity necessitates choice or deciding between alternatives, and choice implies theexistence of opportunity cost. For Whom refers to the question of the type and amount

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of each good and service that each person will consumer. Scarcity necessitates answeringeach question (making each choice), and opportunity cost influences or guides the

process of answering these questions. Opportunity cost is the highest valued alternativewhich is forgone, i.e. the highest valued act of production or consumption which is givenup in order to produce or to consume what has been chosen. Trade is the process which

people commonly employ to answers these questions. Through the act of trade, decisionsof what, how, and for whom to produce are made.

WHAT TO PRODUCE --The decision of what to produce is based on relative intensityof people's preferences as seen in the POW Camp discussion. It is sometimes said that

production decisions are based on preferences and on the relative cost of producing thoseitems. However, the resource cost or cost of producing a particular good or service isactually determined by the intensity of peoples preferences for other goods which thosesame resources could be used to produce. Thus, the opportunity cost of using resourcesto produce good X is determined by the intensity of peoples preferences for goods Y andZ. Cost or more accurately Opportunity Cost is a reflection of competing

preferences. A good which is costly to produce is one for which the other uses of theresource create goods that are highly valued by consumers. A good which is not costly to produce is one for which the competing use of resources leads to the production of goodsthat are not highly valued by consumers. In effect, peoples preferences for usingresources to produce Good X are pulling the use of resources in that direction while other

preferences are pulling the use of resources goods toward the production of Good Y.You can see how the intensity of preferences would matter in this tug of war.

The diagram below illustrates how households direct the use of resources. They pullresources toward the production of different goods and the intensity of their preferencesfor goods is reflected in the price that firms pay to bid resources away from the

production of other goods. What firms pay for resources in the resource market isdetermined by the intensity of the demand for what they sell in the commodity markets.Money cost of producing one good is a reflection of how much people value resourceswhen used to produce the other good. Thus household demand for commodity Y isreflected in the price of resources determined in the resource market and in turn in thecost of producing commodity X. Household demand for commodity X is reflected in the

price of resources determined in the resource market and in turn in the cost of producingcommodity Y.

It is helpful to remember too that it is not simply peoples preferences that matter here but also their ability to act on those preferences, i.e. to make offers of payment or rewardto resource owners for responding to their preferences, that determines the pattern of resource use. Decisions about resource use are made in response to willingness (intensityof preference) and ability (income) to pay.

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CommodityX Market

CommodityY Market

Household demandfor commodity X

Firmsdemand for resour ce

Firmsdemand for resour ce

Householddemandfor Commodit Y

ResourceMarket


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Understood in this way, it is easy to see why a good which is costly to produce, i.e.there are strong preferences on the part some people for using the resources elsewhere ,and for which people have a weak preference, will be produced in relatively smallamounts or not at all. On the other hand, goods for which the cost of production are

low, and for which there are strong preferences will be produced in larger amounts.

HOW TO PRODUCE AND COMPARATIVE ADVANTAGE Productiveefficiency consists of producing maximum output from a set of resources, i.e. it is acondition or situation in which it is not possible to rearrange the use of resources and

produce a more highly valued set of goods and services. Another way of saying this isthat productive efficiency entails producing at minimum opportunity costs. Productiondecisions (what resources to use, in what amounts, and with what technology) are made

based on the relative degree of suitability of resources for particular tasks. Resources,sometimes called inputs or factors of production, are not equally well suited to every task.The difference in suitability must be taken into consideration if productive efficiency is to

be achieved. This is accomplished through markets by 1) comparing the opportunity costsof using different resources to produce each particular good or service, and 2) choosing to produce a good with the resource which has the lowest opportunity cost for that particular task. Allocating resources in this way is also described as using them according to their comparative advantages.

The opportunity cost of using a resource to produce good A depends on the value that people attach to the other outputs that could be produced with that resource and on howmuch of that other output the resource is capable of producing. It may be physically

possible to use a resource to produce good B, and good B itself may be very highlyvalued by people. However, if the resource is poorly suited to the task of producing goodB, but is well suited to the production of good A (i.e. contributes relatively little to thequantity of good B that is produced but contributes substantially to the amount of good Athat is produced), then it wont take much effort for producers of Good A to bid the useof the resource away from the production of good B and toward the production of goodA. The resource will satisfy more material want, the preferences of consumers, in the

production of good A than in the production of good B. Up to a point, this situation couldhold true even if good B is highly valued by consumers while good A is not very highlyvalued by consumers. In such a situation, the resource is said to have a comparativeadvantage in the production of good A and markets will allocate that resource to the

production of good A. In markets, the same reasoning is applied to the use of everyresource. A resource well suited to the production of good B, and, when compared to theother available resources, poorly suited to the production of good A will be bid awayfrom other uses by the producers of good B. Thus each resource will be used inaccordance with the principle of comparative advantage, i.e. all output will be produced at minimum opportunity cost.

FOR WHOM TO PRODUCE Decisions regarding who is to receive the output that is produced are again guided by consumer preferences. The owners of the resources whichare most highly valued for what those resources can producefor what they contribute to

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the satisfaction of consumer preferences/wantswill be paid relatively large moneyincomes. The owners of resources that contribute less to the satisfaction of consumer

preferences/wants will be paid smaller incomes. Resource owners with large incomes will be able to make a larger claim on output than other resource owners. Thus trade"allocates" the total output of an economy to resource owners according to the market

value of the contribution that their resources make to the creation of that total output.Left unanswered here is the manner in which the original endowment of resourceownership is determined.

We will examine what coordinated production and consumption activity looks like andhow trade accomplishes this coordination (i.e. how trade answers the three basiceconomic questions) in the upcoming section on comparative advantage. Before

proceeding further, however, it is necessary to address the concept of economicefficiency and explain how efficiency is achieved in the POW camp economy throughtrade.

Economic Efficiency and the POW CampEconomic efficiency is defined as a situation in which it is not possible to make anychange that satisfies one person's wants more fully without causing some other person'swant to be satisfied less fully. Any change in the use of resources, the combination of goods produced, or in the amount or types of goods people currently consume wouldresult in one or more people being worse off than before. It is important to note thateconomic efficiency is defined relative to the initial endowment of resourceownership/goods . Economic efficiency has nothing to do with

204 newest micro notes for macro course part i

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