micro part 4 beyond micro

8/14/2019 Micro Part 4 Beyond Micro

1/28

Micro Part 4

Beyond MicroIn this part, we will try to go beoynd the confines of the individual and look at the

market, where the individual is placed in contact with suppliers, customers andintermediaries on whom he depends and in turn all of whom depend on what he does. Thekey new element for theory is the nature of the dependence relationship. This relationshipis not intellgible within the notion of optimization. We must embrace the idea ofentrepreneurship to understand the character of the dependency relation in the context ofexchange, a relation we call catallactic relation or exchange-based relation.

The base of the exchange-based or catallactic relation is the theory of gainful trade.Analytically, it is based on the notion of payment, whose quantity constitutes price andwhose kind constitutes means of payment (pensation for short).

77


2/28

18 Entrepreneurship and Price Setting18.0 Chapter Overview18.1 Paradoxical behavior of entrepreneurs18.2 Entrepreneurs differ from optimizers

18.3 Arbitrage18.4 Price setting

Chapter OverviewThe near universal popularity of Marshallian price theory (the idea that demand-supplyinteraction dtermiens equilibrium price) is comparabel to the near universal superstitionbefore Copernicus:

15. Explain how price setting is an entrepreneurial process.

Price setting is the outcome of a bargaining process between the buyer and theseller. Bargaining is an entrepreneurial process, because the participants in a

bargain do not have any specific objective function or any given constraint orany specific alternative choices. The participants face a range of choices andthey engage in guessing the other sides bargaining strength before decidingwhere to reach a compromise.

The key to the entrepreneurial distinction of a bargain is that it involves anagreement that settles a conflict of interest. In contrast, optimization requiresno agreement and involves no conflict of interest. Optimization modelsconveniently assume a fixed price and income for the optimizer who hasfreedom only to choose the quantity. But entrepreneurs engage in bargains toget a profit for which they incur no cost. (134)**How does bargaining occur?

The bargaining process occurs as a contest of will or as a game between twoparties. Each party wants to win as much as possible. The seller starts withasking a high price, and the buyer wants to offer a low one. Round after roundof bargain, the buyer may offer higher and higher price while the seller mayask lower and lower price until they agree.

There is a constraint that the other side must agree to a deal, but it is notlike a budget constraint which gives a specific limit what the individual can do.For example, if a standard budget constraint says that the price of x is 3dollars, it means that the buyer has no option to ask for a lower price to hisadvantage. Bargaining exists if the buyer is able to ask for a lower price. Howmuch lower he can persuade the seller to go? It depends on how desperate the

seller is to sell the product even at a lower price (which reduces his profit, butstill leaves some profit). The buyers own strength of desire for the good meansthat he is also willing to pay a high price rather than forgo the purchase andhence miss the benefit of consumption.

It is not possible to say ahead of time how the creative process of haggle orbargain unfolds in each case, just because it is creative. Every bargain episodemay be a unique experience of compromise after a session of negotiation. (253)

78


3/28

16. Explain the idea of price core. What is the ceiling and what is the floor of the

price core?

The price core is a range within which the market price is chosen byagreement between the buyer and the seller. The bargain process fixes theprice within the core. The idea is that the market price must fall within the

core.When counted in the same units of value as per a common reference goodor numeraire, the marginal cost of the producer is the floor of the core,because the producer will refuse to sell at any price lower than marginal cost.The marginal benefit of the consumer is the ceiling of the core, because theconsumer will refuse to buy at any price higher than marginal benefit. So theactual price cannot be lower than the floor or higher than the ceiling. (125)

**Why does the price core exist?

The key reason for the existence of the price core is that for different people,the marginal cost of production and the marginal benefit of consumption aredifferent magnitudes, when measured in a common unit of value (counting

marginal cost and marginal benefit in terms of the same reference good).Suppose that Adam can produce either 2 apples or 3 bananas with a givenamount of his resources such as labor and land and capital. The marginal costof an apple to him counted in units of bananas is 3/2. However, suppose thatthere is another person Eve, who can produce apples at a lower cost, say at of a banana. That is, given the same productive resources, Eve can produceeither of a banana or 1 apple. Now, in isolation, the best that Adam can dois to consume 1 apple at the cost of 3/2 bananas. If he chooses to do so, hismarginal benefit of apple must be 3/2 bananas in subsistence equilibrium.

Now, if Eve wants to sell apples, she can charge a price as low as banana,while if Adam wants to buy apples, he can pay a price as high as 3/2 bananas.

The actual price will therefore be between and 3/2 banana per apple, being the floor and 3/2 being the ceiling. What will be the actual price cannotbe told in advance. It depends on how intensely they can bargain. If Eve figuresout that Adam is desperate for apples and would go as high as 3/2 bananas perapple, she may try to get a high price. Likewise, if Adam figures out that Evemay be desperate to sell and may go as low as bananas, he may take a standto keep the price low. Where they will strike a compromise is not known aheadof time: it depends on each case. The price core exists because there is abargaining option to choose the price anywhere between the two extremes ofthe floor and the ceiling. (343)

17. Why do you think the price is arbitrary within a range defined by the pricecore? Can you remove the arbitrariness by assuming special rules of

bargaining?

The actual market price is arbitrary within the range defined by the price core,because it involves an arbitrage process or bargaining process. An arbitrarypoint is chosen because there is nothing to lead to a specific point, unless oneknows ahead of time what the relative bargaining strengths of the twoopponents are.

79


4/28

It is not possible to remove the arbitrariness of the price by assumingspecial rules of bargaining. Though various bargaining models have tried topresume different bargaining rules, those presumed rules have no basis otherthan arbitrary idea of the authors. The essence of a game is that the outcomeis uncertain, depending on how the two sides are able to play to their own

advantage. The same teams that play again and again do not always producethe same result because each game is played independently of other games. Inshort, there are no fixed rules to fix the outcome ahead of time. (158)

18. What is intermediation? Can there be any exchange without intermediation?

Intermediation is the action of an intermediary who tries to settle the priceand the means of payment in an exchange between the original producer andthe final consumer.

Though it may seem that direct trade does not involve an intermediary, it isnot true that there is no intermediation. The key to this insight is that both thebuyer and the seller or at least one of them must act as the intermediary to

settle the price and the means of payment, even though on his own behalf.Thus if a producer sells his own good, as a seller he is different form theproducer. The same way that he sells his own product, he could sell that ofanother producer. In short, he may be an intermediary on his own behalf,distinguishing his producer role form his seller role.

The fundamental distinction is that selling is an entrepreneurial actionwhile production is optimizing action. The entrepreneurial role of a seller isprecisely that of the intermediary who is a pure seller (who does not produceanything but sells goods produced by others.) Therefore, we conclude thatthere can be no exchange without intermediation. (195)

19. *What is pure intermediation? Does pure intermediation have a budget orendowment constraint? Justify your answer.

Pure intermediation involves selling without being a producer and buyingwithout being a consumer. This means that the intermediary is pure when hesells products on behalf of the producers and buys products on behalf ofconsumers. He is an intermediary because he occupies an intermediate orinterim position: he sells after the producer already sold the good to him, andhe bys before the consumer finally buys them from him.

Pure intermediation has no budget or endowment constraint as applicableto the consumers and the producers, just because the intermediary is neither aproducer nor a consumer. Because he does not consume what he buys, he needs

no income to consume them at all, but can buy as much as he can hope to sell.Likewise, because he is not a producer, he has no constraint on how much hecan produce. He can sell as much as buyers are willing to buy from him. (156)

20. What is price discrimination? Explain the entrepreneurial process in price

discrimination.

Price discrimination is a procedure in which the seller charges differentprices to different customers for the physically identical product.

80


5/28

Price discrimination is an entrepreneurial process. An entrepreneur as sellertires to get as high a price as possible to maximize his profit. However, herealizes that different customers have different budgets and strengths of desirefor the product, namely, that some customers are willing to pay higher pricesthan other customers for the same good. The entrepreneur tries to guess who

will pay a high price and accordingly asks for a higher price, while when heguesses that the customer will not buy at the high price, he agrees to take alower price.

Because it is hard to make a correct guess of the strength of desire of thebuyer, price discrimination takes the form of a game. Discriminatory sellers tryto categorize customers into different brackets to choose what price they willcharge. (156)

81


6/28

19 ECN 201 Transaction Cost and Intermediation

19.1 Beyond Production: The Evenet of Transaction

19.2 Transaction costs

19.3 Entrepreneurs and Transaction Cost

19.4 Social Exostence of Intermediaries

Note: What is transaction cost?

Transaction cost is the cost incurred by buyers and sellers after the good has already beenproduced. Transport and storage are considered parts of production cost. However, the cost ofgathering information, and organization of the actual transaction (such as sitting in a fair or shopor selling by peddling or mail-order), the innovation to organize new type s of transactions andthe legitimization of the trading process are parts of transaction cost. See Q 23 for more.

Note: What is the relation of transaction cost of entrepreneurship?

Transaction cost is the obverse side of intermediation as pure entrepreneurship (the act of buyingand selling without being either the producer or the consumer of the traded goods). Intermediariesor middle men make themselves useful to society by cutting down transaction costs which theoriginal producers and final customers are unable to reduce. See Q25 for more.

21. Can you connect price discrimination to the degree of competition?

Price discrimination may be connected to degree of competition in two respects. First is space. Ifthe buyers have access to competing supplier within a reasonably short distance, implying that thecost of going to another competing supplier is not high compared to the excess price paid by thecustomer, then the seller cannot discriminate. Id the seller tires to do so, he will lose the customer.

The other is the difference in information. Some customers are better informed about thecompetition than other customers, and the less well informed may agree to pay a higher price.Indeed, the coupon system in America builds upon the information asymmetry in clever ways.People who do not care much about prices pay full price while those who care and are likely tosearch c competing sources of supply get coupons, so the same store sells the goods at a lowerprice to those who would otherwise go to the competitor. 155

22. Do you think full information alone is able to eliminate price discrimination?

I dont think that full information alone is able to eliminate price discrimination. There are otherelements of transaction cost that may provide a ground for price discrimination.

Classical economists had vague ideas about information. They supposed that if all customerswere equally and fully informed, then the price of a particular homogeneous product would be the

same throughout the market, giving perfect competition. However, they did not recognize thatdifferent customers may face different costs of organizing the transactions, namely, to visit theshops or order the goods. They may face different costs of legitimization.

Neighborhood grocers are often called convenience stores, because they are at a convenientdistance and impose a lower cost of going to major business centers. This is why they are able tocharge a higher price. They make it less costly to organize the transaction from the buyers side.145

23. *What are the four major elements of transaction cost? Briefly illustrate each.

82


7/28

The four major elements of transaction cost involve (1) the collection of information, (2) theorganization of the transaction, (3) the innovations in transaction technology and systems and (4)the legitimization of the trade.

(1) The collection of information: The information cost or search cost applies to both thebuyer and the seller. The buyers must gather the information about the availability of the productsand their prices and qualities. The sellers also are anxious to inform the buyers what they are

trying to sell Modern economies have huge spectacles of advertisement by sellers who try toinform the customers. Advertisement massively reduces the costs of buyers in connection withinformation gathering. There are specialized providers of business information. Governmentregulators also provide some information, mainly to assist customers buy safe products and makesecure payments. 102

(2) The organization of the transaction: To organize a transaction is to find a suitable placewhere the buyer and the seller will meet, and specify the time, and make arrangements for all pertinent deals of transaction, such as arranging the means of payment or concluding theagreements or contracts when so required. Ronald Coase thinks of the firm as an organization thatcuts down transaction cost by putting many people to combine their efforts to produce somethingand deliver it to customers. This way the firm internalizes external costs. Merchants have createdmarket places such as shopping malls, bazaars, fairs, exhibitions and traveling sales practices to

help organize the transitions at the lowest cost. They have also created various methods ofpayments to arrange transactions over time. 127

(3) The innovations in transaction technology and systems: Arranging transactions oftenrequire innovations for new products, for launching products in new areas and for adopting newerbusiness practices such as the use of credit cards, self-checking, paperless e-tickets for travel andso on. Along with innovation comes the inherent risk of starting new business, and intermediarieshave enabled the proliferation of products by bearing the risks. Without this, most industrialproducts and commercial services would never be introduced in the first place. The cost of takingrisk is minimized by intermediaries. The society as a whole would be unable to bear the riskowing to adverse selection and moral hazard problems. 110

(4) The legitimization of the trade: Traditions often go against the launching of many newkinds of businesses. At one time, kings and priests opposed all business because the idea was to

give things for free and to get them for free according to system of honor rather than a system ofpayment. Merchants had to struggle hard to legitimize the businesses. Many trades are still notconsidered legitimate. For example, providing VOIP technology in Bangladesh has been kept inlimbo because the authorities do not give permission to start them. Many businesses are bannedor restricted. Legitimization also includes overcoming peoples resistance on grounds of ethics orof novelty or frivolity. Most industrial goods were initially thought of as frivolities, and also theywere seen as threats to some occupations. Thus the mechanical typewriter made handwritingobsolete and scriveners resisted it. Without entrepreneurs risking much to secure legitimacy, mostproducts and services of today would not be available at all. 160

24. **Link each element of transaction cost to entrepreneurial behavior in regard to it.

How do entrepreneurs reduce those costs?

The elements of transaction cost can be linked to entrepreneurial actions that reduce it. Forexample, merchants undertake advertising to massively reduce the customers cost of getting theinformation on the product. The reason business corporations spend massive sums on advertisingis that they have found that without advertisement, they fail to sell the products beyond a verysmall amount.

Merchants created markets, shopping centers, and various systems to organize thetransactions at the lowest cost for the customer. Usually customers are scattered all over the placeand it is difficult for them to know where to go and at what time to get something from sellers.

83


8/28

Fairs are especially important to launch new products. A whole class of intermediaries hasevolved to specialize in the art of organizing business at various business centers. For example,Krishi Market in Mohammadpur has become a center of rice trade in northern Dhaka whereretailers go to get their supplies from wholesalers. Had there been no wholesale market, theretailer would incur much higher cost of getting the supplies. The aratdar or auctioneers in themarketplace provide important cost savings by arranging wholesale and rapid sales. 133

The problem of innovation is especially a challenge for producers who want to introduce newproducts and enter new markets. Many people have lost fortunes trying to launch new productsand services that failed. The intermediaries have undertaken the role of risk taker and venturecapitalist to finance the introduction of new products, launching into new markets andintroducing new transaction systems. 64

Legitimization is basically a political and cultural struggle to persuade the powerfulauthorities that trading in some new products should be allowed. For example, almost all nationshad to undertake severe struggles to introduce birth control devices against the wishes ofconservatives. The advent of radio and television met with much resistance from guardians of oldculture who feared that there old ways of life were under attack. Vested interests always opposethe introduction of competing products or suppliers. The CBA guys do not want banks to becomeprivate because then their hariloot will stop. Some of the greatest entrepreneurs were people who

secured legitimacy of various businesses by a long and hard struggle. 114

25. Can you justify the social existence of middlemen as pure intermediaries?We can justify the social existence of middlemen as pure intermediaries by virtue of theircontribution to the reduction of transaction cost.

Pure intermediaries do not take part in production. Until 2003, no economist had ever beenable to give a justification for the existence of pure intermediaries beyond use of otherwisescattered information. The intermediaries were traditionally regarded as parasites who grabbed aprofit in between the original producer and the final customer. The communist revolution waslargely directed towards the elimination of intermediaries, because they were regarded as the veryincarnation of evil as parasites of society.

But intermediaries are not parasites. They reduce transaction costs. That is why producers

knowingly sell their goods to the merchants and consumers also buy from merchants rather thanfrom original producers. 130

Note: In a modern commercial economy, as high as 85% of the price paid by the customer goesto intermediaries, only 15% being left to producers. This is because production cost is far smallerthan the transaction cost of finding the customer who will wish to buy it at a high enough price. Ifmiddlemen were stopped, the market economies would simply collapse, the volume of productionwould fall so greatly that people will return to virtual Stone Age. It is out of question. Forexample, for an illiterate Bangladeshi girl to sell her stitch-work to an American shirt userdirectly will be nearly impossible. If the middlemen do not exist, she will be unable to produceand sell her shirt. This is true for almost everything. 123

26. *Should the government try to fix prices of essential goods? Justify your answer.The government should never try to fix the prices of anything. This was indeed the firstlesson of economics, as propounded by the first major economic scientist, Adam Smith.This is because the market does not listen to kings and the priests, but has its own mannerof setting prices.

Attempts to forcibly keep prices low in order to make them affordable have alwayshad the opposite effect. If sellers are unable to earn profits, they stop production, and thesupplies go down, and the pressure is create dot raise the prices even higher than before.

84


9/28

The prices in the market are not dictated by one side. The seller cannot get a priceunless the buyer agrees to pay it. The government has no reason to interfere in thisagreement process. Sellers always want high prices, but they cannot get more than whatbuyers can afford to pay. The idea that some people cannot afford to pay high price isstarkest economic illiteracy: some people have low income so that they cannot buy goods

at right prices. The task is to tax the rich and subsidize the poor to enable them to buy thegoods rather than punish the producers by imposing losses on them.

27. Explain why the price of food should go up in Bangladesh.

(Note: Economists as scientist do not pass opinions on what should or should not happen.Offering an opinion is unscientific work of ideologists. The reaction here is ideological,not scientific.)In Bangladesh, the largest number of producers includes the farmers, traditionalfishermen and trappers (in the Hill Tracts). These are the poorest people. To increase theirincome, the prices of their products, namely food, must go up. All developed nations haveprograms to raise the food prices up by various regulations.

Farmers in Bangladesh are not organized, and hence they have long been victims ofpolitical robbery in the hands of relatively affluent urban folks who raise a hue and crywhenever inflationary pressures raise the prices of food items just a little bit. It ispolitically scandalous that the fees of doctors have reached the sky without any protest,and so have these for the services of all skilled professionals such as engineers, teachers,entertainers, mangers and business organizers. How heartless of r these people to ask forkeeping prices of foods low? Of course there are poor people who do not have enoughincome to buy food, no mater what the prices are. The proper solution is to give incomesubsidy to the poor, and this must be done by forcible taxation of the rich. It is politicallyunjust and cruel to reduce the prices of food and make food cheaply available to richcustomers who heartlessly rob the farmers when they come for medial or educational orengineering or any other skilled service. 225 words

28. Write a short commentary on the statement that whenever the government tries

to keep the prices below equilibrium, the supplies dry up and corruption erupts.

Every instance of price control by the government opens up opportunities for corruption,and no instance of forcible price reduction has ever gone without massive corruption.

Communist societies were the most criminal societies which uniformly punishedproducers by refusing o give them good wages or prices. The so-called workers werefooled into believing that capitalist were shot to death or driven out of country, and theircapital were nationalized by the government. Behind this heroic words were the terror ofparty bureaucrats who enjoyed lavish lifestyles as bosses while the ordinary workerslived pathetic poor lives, with long queues at state run shops even for the simple thingslike bread or egg, and had no access to even ordinary industrial products, not to talk ofever dreaming of good industrial products such as color TV or cellular phone.

In socialist and capitalist countries that experimented with rent control (keeping prices of housing services low), there was always shortage of supply and corruptbureaucrats took bribes to decide who would get the subsidized houses. In Bangladesh,ration shops and other ways of selling food et cetera at a low prices gave rise a holeindustry of corruption.

85


10/28

Why is this so? As prices are kept low, producers are punished and they stopproduction and move to other products whose prices are not controlled.

86


11/28

20.Competition and Entrepreneurship

20.1 Competition as Reality

Competition is a reality or observed concrete feature of the market such that the same

product is sold by different sellers who try to lure away the customer. There are alsonumerous buyers for the same product and the buyers try to persuade sellers to sell to theindividual buyer rather than to the other buyers. Competition means that for the samegood, there are many customers who would like to get it, and if one got it, the otherswould not get it.

20.2 Competition is entrepreneurial, and has no constraint

The analysis of competition is a part of the theory of intermediation. Prevailingeconomics has next to nothing to say in this regard. This is because prevailing economicsdoes not recognize that competition is thoroughly entrepreneurial and no concept ofoptimization is applicable to it. Yet prevailing theory has form the beginning tried to think

of competition as if it is a matter of optimization.Optimization applies to a single decision maker who does not have to make

agreements with others at all, and who has full control over the decision.Entrepreneurship applies to market relation based on buying and selling, and it isessential that the entrepreneur must reach an agreement with the opposite side.

In theory of competition, if optimization is not relevant, the idea of constraint isalso not relevant. A competitor has no constraint in choosing some minimum ormaximum: he is free to choose anything within a range of possibilities. Thus anindividual seller who knows that there are other sellers and the customer is free to go toother sellers doe s not necessarily see this as a situation where he is forced only to ask thelowest price or else lose the customer. For each customer, he has a fresh bargaining

opportunity. It still remains that case that the seller is free to charge a price which giveshim some profit, but he is under no constraint to maximize it in some specified sense. Heof course gets the maximum in his view form each customer by trying a hard bargain,getting what he thinks is the most the customer will give him. Since the most a customerwill pay is not the same for different customers, there is no way to say that a certain priceis the one he must charge to maximize profit. He will discriminate and reach hismaximum profit by taking the maximum from each customer, and differently from eachdifferent customer.

20.3 Competition as a feature of intermediation

Competition is not applicable to optimizers like producers and consumers. It is a feature

only of entrepreneurs as buyers and sellers. All buyers and sellers are effectively playingthe role of the intermediary. A pure intermediary buys what he does not consume andsells what he does not produce. An ordinary impure intermediary also buys and sells, butsells what he has produced and buys what he has consumed. But his role as buyer isdifferent from his role as consumer, and his role as seller is different from his role asproducer.

Prevailing economics does not recognize the entrepreneurial nature of buying andselling. It confuses production with selling and consumption with buying.

87


12/28

20.4 Legitimacy, Entry and Exit

The opposite or obverse side of entrepreneurship is transaction cost, and legitimacy is oneof the elements of transaction cost. Competition involves work with respect tolegitimization of transaction.

The opposed of competition is monopoly, a case where there is just one seller and

nobody else to compete with him. Legal provisions and political power may givemonopoly power to some individual and prevent others form competition. Competitorsare people who also would like to earn a profit by selling the same product to the samecustomers, but at a price low enough to lure away the customer.

Had economist been clear about the idea of legitimacy, they would have studied themater of entry and exist as an institutional feature of the market. The state and legalauthorities have some work to do with respect to empowering potential competitors. Theright of entry to the market is ideally fully valuable to anybody who would like tocompete. One who lose sin competition because as a seller he fails to make a profit byoffering price low enough to attract customers then makes an exit or leaves the market.But if a potential competitor thinks he can make a profit, he tries to make an entry.

Game theory has been trying to analyze the nature of competition with respect toentry and exit. The progress has been little worth noting, because the starting point ismissing: fame theory does not see the institution behind the right of entry and thepressure to exit.

Many businesses enjoy some degree of monopoly because authorities help themprevent competitors from entering the market by way of legitimization hurdles. Somecompetitors are not given trade licenses. Others are burdened with unduly harsh entryqualifications. For example, any body that is willing to lose his money by importingsomething is fully qualified to be an importer, but the government may add arbitrary andunreasonable additional requirements for being an importer. It is mainly calculated to protect the monopoly or semi-monopoly position of existing importers and to put

pressure of bribes as a side payment for the grant of license. IN previous ages, licenseswere issued on political favor. The opponent of a political regime would not be given thelegitimacy to compete.

20.5 Perfect Competition versus non-competition

Prevailing economics is fond of the idea of perfect competition, which is somethingwithout a corresponding reality, and is an entirely fictitious matter. Perfect competition isd said to exist for a given good if all buyers and sellers have full information about allother competing buyers and sellers. In such a situation, no seller is able to charge a pricehigher than any other seller, and no seller has any reason to offer a lower price. The ideais that the perfectly competitive market price is equal to marginal cost; so that all people

are compete idiots who produce for zero profit, to sell the stuff at cost. This odd outcomeis the result of not thinking of the market as market at all, but of confusing subsistencewith exchange. A producer who does not sell the good to anybody but only to himselfmust necessarily n sell it at a price equal to marginal cost. This has nothing to do with themarket. In a market, people who buy the good instead of producing it do so because theyincur higher costs of production and are better off buying then producing. In real markets,despite high degree of competition, sellers make net positive profit, not zero profit,because buyers incur higher cost of production.

88


13/28

Questions30. What is competition? What is the difference between the price-output

equilibrium of monopoly and of competition?

Competition is a condition of the market such that the identical good is sold by manydifferent sellers and there are numerous customers buying the same good. If there is one

seller, the situation is called monopoly. If there is one buyer, the situation is calledmonopsony. Competition is neither monopoly nor monopsony. No seller has full controlover the market, but must compete with other sellers to take only a share of the sales, justlike customers must also compete with buyers to gain a share of product.

Traditional theory has reached the theorem that under perfect competition, the outputof the good is the maximum, and the price of the good at that level is the minimum. It isequal to marginal cost of production, and obviously the price cannot be any lowerbecause it will inflict losses upon the sellers and they then must reduce supply.

In contrast, a monopolist can minimize the output and charge the highest possibleprice. The monopolist cannot charge an infinitely high price to get all the income of thebuyers without giving them anything. The highest possible price is the one the consumer

will pay so that he will not pay anymore but rather forget about consumption. It is equalto the highest level of consumer utility.

From this comparison, economists argue that monopoly should be prevented toincrease social welfare, which will come from a larger real output available at a lowerprice.

31. What would you do to improve competition in Bangladesh?

Improving competition in Bangladesh requires a strict decision to open the market to allwho would like to compete. Trade licensing should be made open to all, subject only toreporting requirements to prevent crimes.

One of the most important and necessary prerequisite for effective competition is

access to both money and credit. Bangladesh is extremely repressed financially: mostpeople have no access to institutional credit, and they do not have bank accounts andabilities to get money against the stock of their inventory of goods. To permit competitionat full swing, it is necessary to enable all potential sellers to get unhindered access tomoney and credit.

Information plays a very crucial role in competition. While the burden of providinginformation really belongs to the sellers who need to inform the potential buyers, the stateshould also provide information to potential buyers to protect them form deceptiveadvertising and other market crimes. In addition the government should promote the widedissemination of information to encourage potential competitors to enter the market.

Competition is an institutionally supported process which gives the competitors the

freedom to compete. The idea of free enterprise supports the freedom of anybody tocompete.

89


14/28


15/28

21 Monopoly, Oligopoly, Imperfect Competition21.1 The Competitive Struictur of the market21.2 Monopoly21.3 Oligopoly

21.4 Imperfect Competition21.5 Perfect Competition21.6Monopoly

Monopoly means the existence of a single seller. When there is no other competing seller,the monopolist is able to charge the highest possible price a buyer is willing to pay. Ifthere were competitors, they would lure away the customers by offering lower prices.

Oligopoly

Oligopoly exists when there are several sellers. An oligopoly becomes a cartel or asyndicate when the few sellers have secretly agreed to cooperate and act collectively like

a monopolist. Each seller has significant market share and some control over prices.

Imperfect Competition

Imperfect competition is the case of many sellers, but each still with some small degreeof control on some customers. If they could exercise no control, it would become perfectcompetition.

Perfect Competition

Perfect competition occurs when there are many sellers and no individual seller has anycontrol or influence on the price. Effectively, they are forced to become price takers, whofollow the dictates of the market.

Note: Competition occurs when there are several contenders for the same opportunity,prize, or reward so that only one can get it. The contenders must behave entrepreneuriallyto give rise to competition: they must seek to seize available opportunities for profit andmust also bear the risk of losing the same.

QuestionsCriticize the concept of perfect competitionThe traditional concept of perfect competition fails to consider the entrepreneurial basis ofcompetition. It looks at it from the viewpoint of optimization, which is the negation ofentrepreneurship. The idea that under perfect competition, the seller takes the price as given and

has no power to change it robs the seller of the essential ability of a seller to bargain. There is noreal life example of perfect competition of this nature. The model is unrealistic and not worthy ofany serious attention. But this model is the core of prevailing price theory on the presumedexistence of a market wide single price.

The traditional idea of perfect competition is that no individual seller is a price maker:they are all price takers. If they charge even a slightly higher price, all customers leavethem and go to competitors. They also have no reason to reduce the price even slightly,

91


16/28

because at the same price, they can get as many customers as they want. From this, theythink that all sellers are forced to charge a price equal to marginal cost.

This is odd that optimization means that profit maximization leads to zero profit,because the first order condition equates price to marginal cost. This is a major blunder.The seller behaves differently from the producer. The producer chooses an output such

that the marginal cost is equal to marginal revenue, but the seller tries to add value by amarkup over the marginal cost.Economists have long used an invalid argument that profit is only an accounting

concept. They call the profit normal profit, and argue that it is not real profit, but is in facta cost: if the competitors do not get normal profit, they will refuse to stay in the market;namely, normal profit is the cost of keeping them in the market. This is false. Accountingis right. Traditional economists make this lame excuse because they do not understand thedifference between production and selling. It is factually false to say that merchants makeno profit in equilibrium. They are talking about an imaginary market that does not existand as such their model has no validity as part of science.

Perfect competition assumes the existence of full information. But even when every

customer has full information, he is still unable to forsake his nearest supplier and go tothe second nearest, because there is additional transaction cost of organizing his buying.Price discrimination occurs, and remains a possibility because the customers are notidentical in terms of all elements of transaction cost even if they all have the sameinformation. Indeed, real customers do not have the same information either. Thus evenin the most thoroughly competitive retail rice market, with millions of sellers and readilyavailable information on prices for whomever wants to hear, the sellers and buyersengage in bargains. It is unrealistic to suppose that perfect competition ever occurs.

The idea of perfect competition involves a single market wide price. There is noreason why the price would be the same throughout the market. Differences in locations,differences in the incomes of buyers and the density of competitors in the neighborhoodall affect the prices so that prices are not the same throughout the market. To supposethat it is the same is to deny the difference in the location involves difference in transportcost, and that some areas are oversupplied while some others are undersupplied relativeto demand. Most importantly, each pair of buyer and seller brings different costs andpreferences in the bargain. There is no real basis for a market wide single price.

We frequently hear of evil syndicates raising prices of essentials. How do you react

to this allegation?

The idea of evil syndicates conspiring against the buyers by raising prices is largely amyth. Of course sellers always want to raise prices, and all professions are syndicated,such as teachers collectively striking for a pay raise, or government employeescomplaining to the wage board and so on. The issue however is that sellers alone cannotraise the prices unless buyers are prepared to pay higher prices.

The theoretical problem is between the interpretations of high price versus higherprice. If a syndicate exists, it will ask the highest possible price at the outset, and it cannotraise it any higher. Why would the syndicate raise the price during the Ramadan and thenreduce it later: do they suddenly become good people devoid of greed?

92


17/28

The existence of syndicates in Bangladesh is very largely a creation of thegovernment, which restricts licenses only to few politically favored businessmen. Therestrictive licensing prevents many potential competitors from entering the market.

The allegation is particularly ominous as it mentions essentials, namely, food items.Food items in Bangladesh are one of the cheapest in the world, and food sellers are the

most competitive in every sense of the term: there are millions of farmers all competingto sell the stuff. Prices of all other goods and services have increased by leaps and boundsbut the prices of food items have increased very slowly. Medical, educational and legalservices, for example, are certainly essential, but nobody says anything about themurderous fees doctors are charging, which is many times higher than it was 40 yearsago, and yet nobody mentions it. This is a very unfair stand taken by the elite who havefreely raised the prices of their services, and are forever fighting against the poor farmers.There is no reason why the prices of essentials must not increase with inflation.

In fact, in the food market, there is no syndicate at all. The allegation is politicallymotivated conspiracy against farmers. It is a conspiracy against the largest number ofproducers, namely, the farmers. The idea that food is essential and everybody must buy it

and hence it must remain affordable is nonsensical. The largest number of people inBangladesh does not buy food: they grow and sell it.When food was cheaper, poor people could not buy it and they starved. The solution

is not cutting the price down to help the rich buyers. The solution is to raise the price, andtax the rich, and give income subsidy to the poor to buy food.

What is price control? Is it unjust? What makes it fail?

Price control is the act of restricting the freedom of either buyers or sellers to bargain theprice. The government is a political entity which may for political motives take the sideof either the buyer or the seller in a price battle. Any change in price affects the buyersand sellers in opposite ways. If the government takes the sides of the consumer to keepthe price low, it unjustly hurts the producer by refusing to give them high enough price tojustify sufficient supply. Thus when the government fixes rents, the builders of rentalhouses suffer losses and stop building more houses, exacerbating the housing problem. Itpermits corruption because there are few houses and a lot of applicants who want them. Awholly unnecessary army of bureaucrats feed upon the helpless public, and years pass bybefore one can get a low rent house. It creates homelessness just because there are notenough homes.

The government may also take the side of the producer and hurt the consumer. One ofthe oldest robberies on the consumers is done in the name of protection of domesticindustry against foreign competition. Foreigners are forbidden or restricted to offer thesame good at lower prices or goods of better quality at the same price. The domesticproducers have the customers as captives to them, like prisoners. The customers end up paying excessive prices for shoddy products. Protection has always hurt economicgrowth, because once protected the monopolistic or oligopolistic domestic producers donot increase supply or improve quality. For example, the energy crisis in Bangladesh isalmost entirely the outcome of restricting private and foreign production of electricity.The state-owned electricity producer has no interest in increasing supply: it can denyelectricity to customers and undertake load shedding, while free to carry on massivecorruption as monopolists. Once again, price control is really the royal road to corruption.

93


18/28

The political argument that domestic producers have a superior right to sell the goodseven if they hurt the customers is a sentiment that hurts the voiceless public asconsumers, to allow a few dishonest people rob them. The so-called national producersare not friends of the nation at all, because they refuse to increase supply and improvequality and charge a fair price (which would emerge under competition). The producer

who has no willingness to produce competitively is supported at the expense of helplesscustomers. Price control always supports the enemies of the people.

22

94


19/28

22 Market Efficiency, Failure, and Intervention

22.1 Market: Mechanism or Institution?

22.2 Judging Market Efficiency

22.3 Efficnet market Hypothesis

22.4 Market Failure

22.5 Market Intervention

22.6 Market Liberation

Market Efficiency

The term market efficiency is a misnomer; it is the result of not understanding that themarket is not a machine and it is not possible to judge its efficiency or lack of it. What isthe market supposed to do if it is efficient? Nobody knows the answer, and the idearemains nebulous and essentially meaningless.

It did not prevent Eugene Fama to propose the EMH (Efficient Market Hypothesis),which in a nutshell says that the market (for stocks) is efficient in the use of information.This is a meaningless statement because nobody knows who the market is. Is the marketone individual or a defined group that acts as one individual? No. How do we know thatthe market has acted efficiently? Fama thinks that if the investor cannot do any betterthan others to predict the market, he is unable to make fuller or more efficient use ofinformation. This iffy suggestion begs the question: is there any evidence that investorswho have made billions in the stock market are unable to make buying and sellingdecisions to improve their wealth position? No, they are not unable at all. They haveimproved their positions. On the whole, the value of the same stocks has increased vastlyover the years. The hypothesis is confusing reality with a hypothetical situation and hasno use.

The market is a social institution in which many people interact. As soon as onerecognizes interactions of many people the issue of efficiency becomes meaningless. Isthere a meaningful sense of the term efficient interaction? No, because each instance ofinteraction will have a different outcome depending on the individuals.

The market interaction involves a conflict of interest: buyers want to pay a low priceto reduce expenditure while sellers want to raise the price to increase income. There is noway to say what constitutes efficient market unless one can say what an efficient price is.

Is the efficient price the one that is equal to marginal cost, meaning that producers aresore losers who work profitlessly? Or is the market efficient when the price is equal tomarginal benefit, meaning that customers are driven to the wall to pay the highestpossible price, and hence have no reason to buy rather than produce it? What is theefficient outcome: should producers lose profits or customers lose benefits?

The problem is that people did not think of pricing as entrepreneurial behavior, acontinuous process of bargain, sometimes gaining a little and sometimes losing a little inthe bargain. It has nothing to do with market efficiency.

95


20/28

33 Do you believe that markets fail? Justify your answer.The idea of market failure is a failure to think properly about the market. The job ofeconomics is to explain whatever happens in the market and not to whine that the marketfails to do what it was supposed to do. What is the market supposed to do? Nothing. The

market is not an individual and it does not do anything. It neither accomplishes anythingnor fails in any work, because it has no job at all.The idea of market failure occurs to people who think that the market should be such

that there is continuous full employment. Others think that the price should always be theone that has no reason to change. Therefore price flexibility, which is the actual observedfeature of any real market, seems to mean that the market fails. The presence ofunemployment is a serious issue and here again the thinker is confused: unemploymenthas reason and there is no theory of unemployment to identify the reason (except 2003book Foundations of Economic Analysis). Why blame the market for it?

No, the market does not fail. The task of the theorist is to explain whatever happens inthe market. If there is unemployment one should check to see that low circulation of

liquidity is preventing the trade and employment volume from expanding. If the pricesare changing, one must look at the money supply behind it and the causal changes inincomes, productivities, and costs.

People who think that the market fails are the ones who fail to think why and how themarket events occur. They have no good reason to expect the market to do something thatdoes not actually happen. Making prices stable or ensuring full employment is not theduty of the market. There is a process of interaction between buyers and sellers, and theprocess may be hampered by certain causal factors from attaining full employment orprice stability.

In short, it is useless to claim that the market is efficient and does not fail, or that itfails. These statements have no useful meaning because nobody has been able to say whatthe market is supposed to do. Therefore they have no ability to say whether the markethas done what is was supposed to do, or failed to do so. Thus people who expect themarket to set a stable price do not understand price determination and the bargain processthat is always alive, as buyers and sellers are forever bargaining to change the price.These who imagine that the market should ensure full employment do not know whatdetermines the volume of employment.

34 Distinguish between market intervention and market liberation.Market intervention is the act of taking the side of either the buyer or the seller to thedetriment of the other side. This is always harmful and counterproductive. It takes awaythe right of one party to engage in a bargain. Thus when the government intervenes onbehalf of buyers to control the price of food and keep it to low compared to when there isno intervention, it definitely hurts producers who are punished. Their right to ask for aprice high enough to maintain their income or increase income is denied to them. In theopposite case, when the government intervenes on behalf of the producers, the consumersare denied the right to buy from the cheapest source.

Market liberation is the opposite of market intervention. It is the act of rescuingvictims. Thus when there is monopoly and many competent producers are not allowed toenter the market, the market liberation would enable the hitherto barred competitors to

96


21/28

enter the market, increase the supply and lure away captive customer victims of themonopolist.

Market liberation is the most challenging task for the government in the poorcountries where the financial sector is repressed. Financial repression is the result ofexcessive restriction on financial intermediation, and hence of monopoly. This allows the

banks and other financial intermediaries to completely refuse any service to the majorityof the people, especially the poor. Without access to financial services, the poor areunable to increase production and employment. The market must be liberated from thisrepression. All adults should be given access to financial services, with the right toborrow money against their stock of output. They should also get priority as borrowers incase of loans necessary to create self-employment of individuals or groups.

97


22/28

23 Firms, Externalities, and Social Choice35 What is the Coasian theme of firms as organizers of production?

Read http://en.wikipedia.org/wiki/Ronald_CoaseRonald Coase thinks of a firm as an organization that reduces transaction costs by

internalizing externalities. An externality is created when the action of one individualcreates benefits (and costs) for another individual. For example, when a new girl joins theexisting ones as a sewing operator, she increases the supply of stitched fabric or garmentsand reduces the cost for the others who buy the garments from the sewing operators.However, if the girl is not a member of an organized garment factory, she is not able toreap part f the benefit she has created for the others: it remains external and inaccessibleto her. But when she joins the firm as a member of its workforce, she can h earns a highersalary, because the buyer is now another member of the organization. The other buyerswould iron and package the shirts and still others would transport them to the port, andanother gang would export them, and still others would process the bank operationsassociated with the exports. If the separate parts were unorganized, each would be less

efficient, and each would incur more costs. By joining a firm, they reduced those costs.

36 Coase Theorem (Summarize the argument in 150-200 words).Copied from http://www.sjsu.edu/faculty/watkins/coasetheorem.htmWhat has become known as the Coase Theorem is the proposition that in the absence oftransactions cost the level of production of goods or services in an industry in which thereare externalities is independent of whether or not the party who perpetrates negativeexternalities is legally liable for the costs of the externalities on other parties. The incomedistribution does of course depend upon whether or not the perpetrator is liable, but thatis a different matter. To illustrate Coase Theorem suppose there is a railway that runscoal-burning steam locomotives through a farming area and caused fires in the crop fields

at harvest time. The crop damage from each train run is $200. Suppose the cost ofrunning trains on a line next to a farming area is as follows:

Number of trains

per dayPrivate Costs Crop Damage Social Cost

1 $100 $200 $300

2 $200 $400 $600

3 $400 $600 $1000

4 $700 $800 $1500

5 $1100 $1000 $2100

6 $1600 $1200 $2800

If the revenue from a train run is $350 how many runs would the railway runs if no compensation isrequired for crop damage? This question can be answered by comparing the revenue to the private costsand finding the number of runs which give the maximum difference between revenue and private costs; i.e.,

Number of trains Revenue Private Costs Profit

98
http://en.wikipedia.org/wiki/Ronald_Coasehttp://www.sjsu.edu/faculty/watkins/coasetheorem.htmhttp://en.wikipedia.org/wiki/Ronald_Coasehttp://www.sjsu.edu/faculty/watkins/coasetheorem.htm


23/28

per day

1 $350 $100 $250

2 $700 $200 $500

3 $1050 $400 $650

4 $1400 $700 $700

5 $1750 $1100 $6506 $2100 $1600 $500

As can be seen from the table the maximum profit is achieved running 4 trains. On the other hand if thecrop damage costs are imposed upon the railway company then the costs to the railway company areincreased by the amount of the damage. The profit picture for the railway changes to the following.

Number of

trains

per day

Revenue Private Costs

+ Damage Costs

Profit

1 $350 $300 $50

2 $700 $600 $100

3 $1050 $1000 $504 $1400 $1500 -$100

5 $1750 $2100 -$350

6 $2100 $2800 -$700

As the above table shows the maximum profit for the railway company is achieved with 2 runsper day. The profit of the railway company corresponds to the net social benefit of running thetrains. In this case it makes a great deal of difference (in terms of the number of trains run) as towhether the railway company is liable for the crop damage. Two trains per day is the sociallyoptimal number of train runs, but four trains seem to be what would occur in the absence of legalliability concerning the crop damage.

What Ronald Coase did was to examine what alternatives there might be to government-enforcedlegal liability to deal with the externality problem. Coase suggested that the farmers could pay therailway not to run trains. To keep matters simple suppose the farmers told the railway that theywould be will to pay the railway $1200 not to run any trains and deduct $200 from this paymentfor every train run. The revenue to the railway would consist of the revenue made from operatingthe trains plus the payment received from the farmers. The profitability picture for the railwaywould be as follows:

Number of trains per day Revenue Payment from

farmers

Private Costs Profit

0 $0 $0 $1200 $1200

1 $350 $100 $1000 $1250

2 $700 $200 $800 $13003 $1050 $400 $600 $1250

4 $1400 $700 $400 $1100

5 $1750 $1100 $200 $850

6 $2100 $1600 $0 $500

As can be seen from the above table the railway achieves its maximum profit with twotrain runs per day, which is the socially optimal number of train runs. This is the essence

99


24/28

of Coase Theorem: The same levels of production are achieved whether the perpetrator ofthe negative externalities is legally liable for the externality costs or is the victims of thenegative externalities make a payment to the perpetrator that is reduced by the amounts ofthe externalities. Note that the level of production of crops is determined as well as thenumber of trains run per day. The second part of Coase Theorem is that the levels of

production achieved under either legal liability or the payment scheme is sociallyoptimal.

Of course the profits of the farmers and the railway are drastically different dependingupon whether the railway is legally liable for crop damage.

The above illustration made use of the total revenues and total costs, both private andexternal. The quicker method to determine the number of train runs that would be mostprofitable uses the marginal revenues and marginal costs. These marginal quantities areshown below:

Number oftrains MarginalRevenue MarginalPrivate Costs Marginal CropDamage MarginalSocial Cost

1 $350 $100 $200 $300

2 $350 $200 $200 $400

3 $350 $300 $200 $500

4 $350 $400 $200 $600

5 $350 $500 $200 $700

6 $350 $600 $200 $800

If the marginal revenue at n runs per day is greater than the marginal costs at n then the totalprofit is higher at n+1 runs than it is at n runs. On the other hand, if the marginal revenue at n runsper day is less than the marginal costs at n then the total profit is higher at n-1 runs than it is at n

runs. In the above example, at 3 runs the marginal revenue is $350 but the marginal private cost is$300 so, in the absence of legal liability for crop damage or a payment from farmers, the railwaycompany's profit is higher at 4 runs than at 3. But at 4 runs the marginal revenue of $350 is lessthan the marginal runs the marginal private cost of $400 so the profit is higher at 4 runs than it isat 5. Therefore the maximum profit occurs at 4 runs per day. Finding the maximum profit level ofproduction is a matter in this case of finding a level at which the marginal cost switches frombeing less than marginal revenue to being more than marginal revenue.

When the marginal cost of crop damage is included the marginal cost at 3 runs is $500 which isgreater than the marginal revenue of $350 therefore 3 per day is a more profitable level ofoperation than 4. However in this case the marginal revenue of $350 at 2 runs is less than themarginal cost of $400 therefore 2 runs is more profitable than 3 runs. The marginal cost at 1 runper day $300 is less than the marginal revenue of $350 therefore 2 runs per day is more profitablethan 1 run per day.

Questions37 Distinguish social choice in a barter context from individual choice in subsistence

context.

100


25/28

In the barter context, two individuals form a society to make a social choice on the kindsand quantities of two goods that they will exchange. Suppose that the exchange isbetween two goods x and y between two individuals Ali and Baby. While Ali alonedecides how much x to buy, and hence the quantity demanded is the result of individualchoice, Alis demand alone will not lead to exchange unless Baby agrees to make the

same quantity of x available as supply.An individual choice occurs in subsistence under which the same individual is free toallocate the resources to production and allocates the income to consumption withoutconsultation or agreement with anybody else. In an allocation, there is substitution but noexchange. This if Ali is a subsistence producer of two goods x and y, he must be anoptimizer. Given his preferences, he will decide how much x and y to consume, havingmeasured his income in view of his own ability to produce them. And then he willgenerate the income by producing the goods. He does not need to consult anybody.

There is no substitution in exchange. In a substitution, things of equal marginal utilityand equal marginal cost can be substituted at the margin of decision. But the whole pointof exchange is that the two goods that exchange are of unequal utility or unequal cost.

Hence there are two key distinctions between individual choice and social choice.First, individual choice is a choice of optimization because an isolated individual has noopportunity to gain anything: he merely allocates what he already has, first in the form ofresources for production, and then converted into products for consumption. But socialchoice in exchange is entrepreneurial: each agent must seek to gain something fromexchange, as each bears the risk of producing something he does not want to consume,and refrains from producing what he wants to consume. In exchange Ali produces y eventhough he wants to consume x, and this is an entrepreneurial risk: he will be a loser if hefails to sell y and buy x, because he prefers x to y and yet produces y instead of producingx.

The second distinction is that individual choice is linearly consistent but social choiceis linearly inconsistent. If x and y are put on a line to measure relative utility, then Aliprefers x to y while Baby prefers y to x. Social choice is impossible without this linearinconsistency: one must sell what the other must buy and vice versa. Both cannot sell thesame thing or buy the same thing (as there is nobody else in a two-person society).38 **What is the social choice in an exchange? Explain the role of agreement in

social choice.

Social choice in an exchange is a choice over kinds and quantities of goods that themembers of society intend to interchange. Each persons produces something he does notwant to consume, and consumes something he does not produce, just the opposite ofindividual choice where each subsistence producer produces precisely what he intends toconsume.

Social choice must be based on agreement. On each element of the exchange, namelythe kinds and quantities of both the first and the second good must be agreed upon byboth parties, one being the buyer and the other being the seller. No exchange is possible ifeither the buyer or the seller refuses.

Note: Prevailing economics never heard of agreement. Game theory models try todiscuss social choice based on disagreement, such in case of prisoners dilemma: eachpart tries to harm the other. The fundamental problem is that rationality has been defined

101


26/28

too narrowly such that if x is preferred to y, y cannot be preferred to x, as it will beinconsistent. But social choice is necessarily inconsistent. If Ali sells y to buy x, he mustprefer x to y while the seller of x and buyer of y must do the opposite: he must prefer y tox.

39 Explain why exchange agreement is based on preference disagreement.The greatest drama of life is that agreement is based on disagreement over objects ofexchange. Suppose that Ali has produced some y and Baby has produced some x. If theycould agree that x is of exactly the same market value of y, they could exchange them.But this agreement on value can occur only if the disagree on the utilities and differ inproduction costs.First let us consider what happens if they have the same preference. Suppose that both Aliand Baby prefer x to y. This preference means that x gives more t utility than y. If bothAli and Baby prefer x to y, none will want to take y in exchange for x and suffer a loss ofuntidy: both will want x. In that case, there will be no demand for y at all. But as theproducer of x (Baby) refuses to sell x in exchange for y (as she prefers x to y), there will

be no supply of x. How can there be trade if nobody supplies x and nobody demands y?Next, suppose that Ali prefers y to x while Baby prefers x to y. There is an anomaly ofendowment or production here: though Ali prefers y, he has produced x (which hedislikes compared to y) and though Baby wants x, she actually has less preferred y. Thenthey can gain if they exchange x for y: Ali will get more utility from x in exchange forthe less utility of y, while Baby will get more utility from y then from x.This disagreement in the preference order is necessary for exchange. Without this, thereis no opportunity for pure gain from exchange. In that people have no reason to producewhat they do not want to consume, and to consume what they do not produce. If allpeople prefer x to y, all will produce x and no y, and they will consume x but there will beno exchange.

Note: For traditional people, this paradox is extremely hard to grasp. It seems that theyhave never even bothered to notice the paradox: why do people produce what they do notwant to consume, and why do they not produce what they want to consume? The oldanswer (but without full explanation) is that they do so to make pure gains in utility (orincome). Though trade theory says that people undertake trade because it is gainful,microeconomics is adamant to say that there is just no possibility of gain (profit) at all: inmicro models, equilibrium occurs when marginal cost is equal to marginal revenue, or theprice is equal to marginal benefit, namely, there is just no gain.

The source of the problem is that traditional people cannot think sharply, but mix upone thing with another. They mix up optimization, which applies only to an isolatedindividual who has no option to engage in trade with entrepreneurship. Exchange occurs because entrepreneurs discover opportunities to get something better through buyingrather than through production. They find out the dramatic possibility: the best way to getsari is to produce rice and exchange the rice for sari. Traditional economists cannotunderstand entrepreneurship at all.40 *What is consistency of choice? Explain consistency for individual and social

choice.

102


27/28

Consistency of choice is a logical idea to define rational choice. In case of an individual,if one says that he prefers x to y, he cannot logically chose y over x, for the same price. Itwill be irrational or unreasonable or unintelligible if one likes apples better than bananas,and yet buy bananas when he could buy the apples, for the same amount of expenditure.

Traditionally consistency of individual choice is explained in a situation of

contradiction by proposing transitivity. If one prefers x to y, and prefer y to z, than onemust prefer x to z. This can be shown p by drawing a line, and putting x, y and z onutility scale: x has higher utility than y, and y has higher utility than z. In this case it isimpossible for z to have higher utility than x, because x is at the top, below which is yand the bottom has z. Hence this can be called linear consistency.

Consistency in social choice however cannot be shown by a line, which moves inonly one direction. An exchange has movement in two directions: Alis y goes to Baby,and Babys x goes to Ali. To show reverse movement, it is useful to draw a circle, inwhich the clockwise movement shows Alis goods going to Baby and the counter-clockwise movement shows Babys good going to Ali. Consistency in this case involvesopposition of direction: social choice is consistent if what Ali sells is what Baby buys and

vice versa. No exchange is possible if both people buy x and no people sell y, or the otherway round: one must buy what the other must sell.

41 *Disprove Arrows Impossibility Theorem.

Kenneth Arrow won the Nobel Prize partly for his very famous theorem named after him:Arrows impossibility Theorem. The gist of this theorem is that social choice isimpossible. It is extremely strange. In reality, exchange occurs and buyers and sellers domake social agreements, and Arrow says that it is impossible. All economists acceptArrow without seeing the flaws at all.

It is very easy to disprove Arrow by considering barter. A more elaborate disproofwill consider three goods to match his example. (See handout titled: Though Arrow SaysIt Is Impossible. It Happens Everyday)

Suppose that Ali has y and Baby has x. Suppose that Ali prefers x to y while babyprefers y to x. Then if Ali gives y to Baby and gets x from her in exchange, both willgain, and it will therefore be easy for them to agree to such a mutually gainful exchange.Ali will get more utility from x then from y, and Baby will get more utility from y thanfrom x.

If they both have the same preference order, they will not undertake exchange as therewill be no gain. Thus if both prefer x to y, both will produce x and not produce y: nobodywill buy y at the expose of x. In the opposite case, if both prefer y to x, both will producey and no one will produce x, and no one will buy x at the expense of y.

The reason Arrow could not understand this and nobody else could either), is thatArrow did not think either of allocation or of exchange at all when he thought of socialchoice. His example goes like this: suppose that Ali and Baby prefer x to y, Baby andCharu prefer y to z, and Charu and Ali prefer z to x. Can the three people make a socialchoice? The answer is obvious to him: no they cannot, because if the majority (2 out of 3people) prefers x to y and the majority prefer y to x, then the majority must prefer x to z,but in the example, the majority (Ali and Charu, 2 among three people) prefer z to x. It isinconsistent.

103


28/28

Now, Arrow is not talking of allocation. Had there been allocation, the choice wouldbe absurd. Why would Ali, Baby and Charu decide what to produce? Do they havebudgets, or are they getting the thing for free? If they have budgets, it is very simple. Aliprefers z to x, and x to y, so he will produce x with his whole budget. Baby prefers x to yand y to z, and so she will produce x with all he budget. Lastly, Charu will produce y,

because she prefers y to z, and z to x, namely, she prefers y most. The idea that threepeople must make one choice, without any mention of budget is entirely frivolous andabsurd. People do not ever face such choices.

If there is exchange, then the choice is also very clear. Entrepreneurs are people whohave an endowment anomaly: they have what they do not like and they do not have whatthey like. Thus Ali has x, but he prefers z to x, ( and he dislikes y as he prefers x to y), sohe will gladly give up x to buy z. Charu prefers y over other goods and she will gladlytake y in exchange for z that she has. Lastly, Baby has y, but prefers x, and she will gladlytake x for y. This is exactly how indirect exchange happens.

Note: Do not fall for the fallacy of authority. This fallacy occurs when you believe that

somebody famous always says the truth. The fact that Arrow won the Nobel Prize doesnot mean that he is right. Bigger idiots were emperors and what not compared to Arrow.Whether a statement is true you should check against two things: first look at facts. If astatement contradicts facts, reject it. Then check logic. If it makes no logical sense rejectit.

Reject Arrow first because his theorem ifs factually false. How can any sane personbelieve this nonsense that social choice is not possible? If not possible, how are peoplemaking agreements? Next, reject his theorem because it is illogical. It is illogical foranybody calling himself an economist to propose a choice without a budget. Do peopleever have a choice between x, y and z where they dont have to pay anything? And he isillogical because he does not at all consider exchange: in exchange, things go from one toanother just precisely because people get rid of what they like less in order to get what hthey like more.

Course End Commentary:

You will most likely forget the nitty-gritty of microeconomics after you leave school,having resented the teacher for the torture upon you. But take something useful with you:how to use your brain to make sound judgment and good decisions. First, do not believeanything without factual proof. Even more so, do not believe yourself without proof: yourmind is your most dangerous enemy: it lazily forms false intuition all the time. Makeyour brain do the work to learn about the real world, do not let it just come to aconclusion without data and without analysis.

Secondly, when you decide something, consider all pertinent details. Do not ride abus without knowing where it is going. People will try to fool you by telling absurdstories every day: be careful, check out before you trust them. Think, then think somemore and rethink.

Good Luck

micro part 4 beyond micro

Documents