Transcript Theory of Capitalism

Theory of Capitalism
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I. The basic of markets
1. Adam Smith and the “Invisible Hand.”
a) “The wealth of Nations,” 1776.
• A man pursuing his own self interest is “led by an invisible hand
to promote an end which was not part of his intention. Nor is it
always the worse for the society that it was no part of it. By
pursuing his own interest he frequently promotes that of the
society more effectually than when he really intends to promote
it.”
• “Every individual is continually exerting himself to find out the
most advantageous employment for whatever capital he can
command. It is his own advantage, indeed, and not that of
society, which he has in view. But the study of his own
advantage naturally... leads him to prefer that employment
which is most advantageous to the society.”
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2. The Role of Prices
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prices convey information
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About relative scarcity or abundance of goods and inputs to households and firms
prices ration scarce resources
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By equating supply and demand
prices determine income
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Hhld income from the market depends on prices of the inputs and supplies to market
3. Markets and Efficiency
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Market supply is horizontal sum of each firm’s marginal cost curve
-supply reflects firms’ marginal costs (MC)
MC is the increase in total cost resulting from an unit increase in output
•
-if firms account for all the costs, then market supply is society’s marginal cost (MSC)
MSC is the cost of producing one additional unit of output, including the costs of the
producer and any other costs, indirectly occurred by any other member of society. MC
incurred by the producer of a good together with the MC imposed as an externality on
others.
Market demand is horizontal sum of each consumer’s demand
-consumer’s demand reflects marginal value (MB)
MB is the increase in total benefit resulting from a one unit increase
-if consumers receive all the benefits, then market demand is society’s marginal benefit
(MSB)
MSB is the dollar value of the benefit from one additional unit of consumption,
including the benefit to the buyer and any indirect benefits occurring to any other
member of the society.
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•Equilibrium maximizes society’s net benefit
--competitive markets
the production will take place where MSC=MSB
firms produce the level of output that P=MC
many buyers and sellers are price takers
--ability of markets to use info efficiently
mkt economies efficiently generate information in the form of mkt prices, which enable
producers and consumers to plan their actions in rational manner;
the buyers and sellers have perfect information
$
MSC
D
A
C
Pe
At Q1 society loses
opportunity to gain ABC.
At Q2 society incurs CDE
net cost relative to Qe.
E
B
MSB
0
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Q1
Qe
Q2
Q
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Pareto Efficiency
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A state of the world is Pareto efficient if all opportunities to make some
better off without having to make anyone worse off have been exhausted
Implies no waste (min cost)
Implies maximization of net benefits
Capitalist economies have a strong tendency to equilibrium and
they generate and process information efficiently
4. Markets and institutions
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the rule of law
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Prevails when participants in society and the economy agree on the legal rules
concerning social and econ behavior, they behave according to these rules, and
there is a punishment mechanism when the rule of law is violated.
Constitution establishes the basic political, econ and social rules of the game for
a society
Economies must also establish agreements for monetary & fiscal policy.
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Monetary policy- conducted by the central bank, which determines the quantity
of money
Fiscal policy-relates to how the state collects taxes & spends revenues.
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II. State Intervention
1. Monopoly
monopolist underproduce and overcharge relative to competitive producer
$
MC
Pm
Deadweight loss
MCm
D
0
Q
Qm
MR
The no optimality of monopoly is demonstrated by:
•Price not equal to MC (MC=MR)
•Monopoly “deadweight loss”—the reduction in econ surplus from a mkt not being
competitive
•Monopolist producing less than a perfectly competitive industry
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Approaches to control monopoly:
• To tax the producer and subsidize the consumer to correct the
underutilization of resources by monopolistic producer
• Direct regulation of monopoly
– To force the monopoly to change P=MC
• To leave natural monopolies alone
– M. Friedman—the unregulated monopoly desires to max profits and keep
potential competitors out of the market, would supply a larger quantity at
lower price than that charged by regulated monopoly
• Antitrust, anticarter legislation
– The state can transform the industry from monopolistic to competitive
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2. External effects
--Occur when one producer or consumer directly affect the costs or utility of a second producer or consumer,
and this producer max profits on the basis of the private costs of production, not on the base of social costs.
--When externality is present the company base their decisions on private MCs. The perfectly competitive
firm produces where P=private MC, not where P=full MC. This externality causes firms to produce more
than the optimal Q.
Marginal social costs
with external costs
Private
marginal cost
Price
•Cost or benefit not accounted for by decision maker
•e.g., pollution
•Externalities can be negative (costs) or positive (benefits)
•They can be the result of production or consumption
•Usually a result of conflict in use of a resource because of inability to define/enforce
property rights
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• How to correct the misallocations caused by external effects:
– Internalization (merging the firms producing external costs and those being affected
by them)-external costs are made a part of the firm’s costs
– Tax or subsidy to equate private and social costs
• a tax of $ per unit will correct the misallocation
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hard to know how much to tax
not much use of corrective taxes in U.S. (gasoline tax a crude corrective tax)
– State regulation and standards
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requirements to use pollution control devises
pollution limits
violators fined
regulations and standards commonly used in U.S.
generally inefficient approach
– Voluntary agreements among the parties involved
• If the transaction costs of reaching an agreement are small, private agreements can correct
the misallocation of resources caused by external effects
• Problem if the number of parties is large
– Markets for pollution rights
• A mkt based system of exchange permits or “rights” to release pollution residual into the
environment. These permits will be bought and sold in an organized mkt
• define air quality standard for each area
• define rights to pollute up to this limit
• distribute rights to polluters
• allow trading of rights
• much more efficient
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those polluters able to reduce easily will sell their rights to those for whom reduction is more costly
• in use and being developed in U.S. under the Clean Air Act
• being proposed for the international treaty on greenhouse gas reductions
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3) Public goods
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Characteristics
– non-excludable
• no feasible way to keep anyone from consuming the good
• no one would be able to charge a price since no one would have to pay it to consume the
good
– non-rival
• one’s consumption does not alter the availability of the good for others to consume
– zero cost to provide good to an additional consumer
• efficient price is zero, so no one would provide it
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Examples
– national public good
• national defense
– local public good
• police protection
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Capitalism is associated with democratic political institutions. The democracy would
insure good public choices.
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4) Income distribution—how equally or unequally should income be distributed
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Private ownership of the factors of production raises the likelihood of an uneven distribution
of income & wealth among the members of capitalist society.
Exactly how uneven the income and wealth distribution are depend on the distribution of
human and physical capital, and also on the distributive role of the state
Welfare programs
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Only the state can alter the distribution of income through government income distribution programs
5) Macroeconomic Stability
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John Keynes, General Theory of Employment, interest and money, argues against Say’s
law. It is the responsibility of the government to ensure full employment through fiscal and
monetary policy and to counteract fluctuations in investment spending.
– Say’s Law – that supply creates its own demand – requires perfect information and perfectly
flexible prices to restore full-employment.
– Keynesian economics advocates policy activism-the discretionary use of monetary and fiscal
policy to try to prevent or ameliorate the business cycle.
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Macroeconomics after Keynes:
– Monetarists (Milton Friedman)—importance of money’s role in destabilizing the economy, and
promote rule-based policies rather than unpredictable government intervention.
– Rational expectations hypothesis (Robert Lucas) – people are correct “on average” in predicting
the future, market prices embody all available information, and government can only stimulate
economy by fooling everyone, all the time.
– Real business cycle theorists argue that the business cycle is caused by random shocks and
cannot be controlled by factors other than the self-correcting mechanism.
– The Monetarists, rational expectations economists and real business cycle theorist believed that
capitalism is much more stable than Keynes thought and that activist policies are likely to harm
the economy. Government intervention in the economy is not necessary stabilizing and thus11
should be minimized
III. Growth and State policy
• Schumpeter saw growth as a process of creative destruction.
– Argue that mkt economies can grow on their own and can be trusted to select
those industries that will grow more rapidly than others
• Industrial policy can manage growth
– The state promote, subsidize and manage growth.
IV. Performance of Capitalist economies.
1. Efficiency
– the more competitive the economy the more efficient the economy
2. Stability
– periodic inflation, unemployment, growth fluctuations
3. Income distribution
– uneven distribution of income & wealth among the members of capitalist
society.
4. Economic growth
- lower savings rate than planned socialism, slower rate of growth of factor inputs
and hence of econ growth; but greater efficiency
-greater efficiency vs potentially lower capital formation
5. Viability
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