Hahnel ABCs of Political Economy Modern Primer

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But socially counterproductive rent seeking behavior is not only engaged in at the expense of parties external to market exchanges. The real world bears little resemblance to a game where all buyers and sellers are equally powerful, in which case it would be pointless for sellers or buyers to try to take advantage of one another. In the real world it is often easier for powerful firms to increase profits by lowering the prices they pay less powerful suppliers and raising the prices they charge powerless consumers than it is to search for ways to increase the quality of their products. In the real world there are consumers with little information, time, or means to defend their interests. There are small, capital poor, innovative firms for giants like IBM and Microsoft to buy up instead of tackling the hard work of innovation themselves. There are common property resources whose productivity can be appropriated at little or no cost as they are overexploited at the expense of future generations. And finally, there is a government run by politicians whose careers rely principally on their ability to raise campaign money, begging to be plied for tax dodges and corporate welfare programs financed at taxpayer expense. In other words, in the real world where buyers and sellers are usually not equally powerful, the most effective profit maximizing strategy is often to outmaneuver less powerful market opponents and expand one’s slice of the pie at their expense rather than work to expand it.

Snowballing inefficiency

To the extent that consumer preferences are endogenous the degree of misallocation that results from uncorrected external effects in market economies will increase, or “snowball” over time. As people adjust their preferences to the biases created by external effects in the market price system, they will increase their preference and demand for goods whose production and/or consumption entails negative external effects, but whose market prices fail to reflect these costs and are therefore lower than they should be; and they will decrease their preference and demand for goods whose production and/or consumption entails positive external effects, but whose market prices fail to reflect these benefits and are therefore higher than they should be. While this reaction, or adjustment, is individually rational it is socially irrational and inefficient since it leads to even greater demand for the goods that market systems tend to overproduce, and even less demand for the goods that market systems

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tend to underproduce. As people have greater opportunities to adjust over longer periods of time, the degree of inefficiency in the economy will grow, or “snowball.”4

Market disequilibria

Nobody knows where the equilibrium price in a market is. What the micro law of supply and demand says is that self-interested behavior on the part of frustrated sellers when there is excess supply because the actual price is higher than the equilibrium price, and selfinterested behavior on the part of frustrated buyers when there is excess demand because market price is below the equilibrium price, will tend to move markets toward their equilibria. But as long as a market is out of equilibrium the quantity bought and sold will be less than the quantity that would be bought and sold if the market were in equilibrium. Since the equilibrium quantity is the same as the socially efficient quantity to produce and consume in absence of external effects, this means markets do not yield efficient outcomes when they are out of equilibrium even in absence of external effects. So the first problem is the slower markets equilibrate the more inefficiency we will endure while they do.

The second problem is if market participants interpret changes in prices as signals about further changes in prices it is unlikely they will obey the “laws” of supply and demand. If I believe that even though the price of apples just rose, any further change in the price of apples is just as likely to be down as up, that is, if I do not interpret the rise in price as a signal that the price is rising, I will probably demand fewer apples at the new higher price as the law of demand predicts. But if I think that because the price just rose it is more likely to go up than down the next time it changes, I should buy more apples now that I think the chances are greater than I thought before that the price of apples will rise. If I want apples I should buy more apples now before they become even more expensive later. And even if I don’t want apples, I should buy more now and sell them tomorrow when the price is even higher. Similarly, if sellers in a market interpret price changes as signals of what direction prices are headed in, they should offer to sell more when the price falls and sell less

4.For a rigorous demonstration that endogenous preferences imply snowballing inefficiency when there are market externalities see theorems 7.1 and 7.2 in Hahnel and Albert, Quiet Revolution in Welfare Economics.

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when it rises, the law of supply notwithstanding.5 In this case, when actual buyers’ behavior is represented by an upward sloping demand curve and actual sellers’ behavior is represented by a downward sloping supply curve, self-interested behavior on the part of frustrated buyers when there is excess demand will raise a price that is higher than the equilibrium price, not lower it. And self-interested behavior on the part of frustrated sellers will lower a price that is lower than the equilibrium price, not raise it. In other words, there will be disequilibrating forces in the market pushing it farther away from equilibrium, not toward it.

A rising price that becomes, at least temporarily, a self-fulfilling prophesy is commonly called a market “bubble,” and a falling price that becomes a self-fulfilling prophesy is often called a market “crash.” As we will discover in chapter 7 where we study banks and international finance, this kind of disequilibrating dynamic occurs more often than market enthusiasts like to admit, particularly in financial and foreign exchange markets, with disastrous effects on real economies, i.e. on employment, investment, production and consumption. Finally, there can be a different kind of disequilibrating dynamic that operates between markets that are connected in a particular way. When one market is initially out of equilibrium it can cause another market to fall out of equilibrium. When this second market falls out of equilibrium it can push the first market even farther away from equilibrium, which in turn pushes the second market farther out of equilibrium as well. The result can be a “vicious” interaction in which each market pushes the other farther away from its equilibrium, and it is possible for this disequilibrating force to be stronger than the equilibrating forces of price adjustments within markets described in the micro law of supply and demand. In chapter 6 on macro economics we focus on how the market for labor and the market for goods in general interact. One of Keynes’ greatest insights was his discovery that disequilibrating

5.Mainstream texts persist in treating such behavior as if it was not the obvious violation of the “laws” of supply and demand that it clearly is. Instead of admitting that demand is not always negatively related to market price, and supply is not always positively related to market price, mainstream texts resort to the subterfuge of saying that the change in expectations about the likely direction of future price changes shifts demand curves and supply curves that still do obey the laws of supply and demand, yielding actual results that contradict what those laws lead us to expect. This is sophistry at its worst.

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dynamics that operate between goods and labor markets can push both markets farther away from their equilibrium faster than price and wage adjustments within them push them toward equilibrium. This insight allowed Keynes to explain why production and employment keep dropping in a depression even though there are more and more workers willing to work – if only someone would hire them – and plenty of employers anxious to produce goods – if only someone would buy them.

Conclusion: market failure is significant

In sum, convenient deals with mutual benefits for buyer and seller should not be confused with economic efficiency. When some kinds of preferences are consistently under-represented because of transaction cost and free rider problems, when consumers adjust their preferences to biases in the market price system and thereby aggravate those biases, and when profits can be increased as often by externalizing costs onto parties external to market exchanges as from productive behavior, theory predicts that free market exchange will often result in a misallocation of scarce productive resources. Theory tells us free market economies will allocate too much of society’s resources to goods whose production or consumption entail negative external effects, and too little to goods whose production or consumption entail positive external effects, and there is every reason to believe the misallocations are significant. When markets are less than perfectly competitive – which they almost always are – and fail to equilibrate instantaneously – which they always do – the results are that much worse.

MARKETS UNDERMINE THE TIES THAT BIND US

While political economists criticize market inefficiencies and inequities, many others have complained, in one way or another, that markets are socially destructive. In effect markets say to us: You cannot consciously coordinate your economic activities efficiently, so don’t even try. You cannot come to efficient and equitable agreements among yourselves, so don’t even try. Just thank your lucky stars that even such a hopelessly socially challenged species such as yourselves can still benefit from a division of labor thanks to the miracle of the market system. Markets are a decision to punt in the game of human economic relations, a no-confidence vote on the social capacities of the human species. Samuel Bowles explained

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markets’ antisocial bias eloquently in an essay titled “What Markets Can and Cannot Do” published in Challenge Magazine in July 1991:

Even if market allocations did yield Pareto-optimal results, and even if the resulting income distribution was thought to be fair (two very big “ifs”), the market would still fail if it supported an undemocratic structure of power or if it rewarded greed, opportunism, political passivity, and indifference toward others. The central idea here is that our evaluation of markets – and with it the concept of market failure – must be expanded to include the effects of markets on both the structure of power and the process of human development. As anthropologists have long stressed, how we regulate our exchanges and coordinate our disparate economic activities influences what kind of people we become. Markets may be considered to be social settings that foster specific types of personal development and penalize others ... The beauty of the market, some would say, is precisely this: It works well even if people are indifferent toward one another. And it does not require complex communication or even trust among its participants. But that is also the problem. The economy – its markets, work places and other sites – is a gigantic school. Its rewards encourage the development of particular skills and attitudes while other potentials lay fallow or atrophy. We learn to function in these environments, and in so doing become someone we might not have become in a different setting ... By economizing on valuable traits – feelings of solidarity with others, the ability to empathize, the capacity for complex communication and collective decision making, for example – markets are said to cope with the scarcity of these worthy traits. But in the long run markets contribute to their erosion and even disappearance. What looks like a hardheaded adaptation to the infirmity of human nature may in fact be part of the problem.

Markets and hierarchical decision making economize on the use of valuable but scarce human traits like “feelings of solidarity with others, the ability to empathize, the capacity for complex communication and collective decision making.” But more importantly, markets and hierarchical relations contribute to the erosion and disappearance of these worthy traits by rewarding those who ignore democratic and social considerations and penalizing those who try to take them into account. It is no accident that despite a

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monumental increase in education levels, the work force is less capable of exercising its self-management potential at the end of the twentieth century than it was at the beginning, or that people feel more alone, alienated, suspicious of one another, and rootless than ever before. Robert Bellah, Jean Bethke Elshtain, and Robert Putnam among others have documented the general decay of civic life and weakening of trust and participation across all income and educational levels in the United States. There is no longer any doubt that “the social fabric is becoming visibly thinner, we don’t trust one another as much, and we don’t know one another as much” in Putnam’s words.6 While it is easier to blame the spread of television than a major economic institution, the atomizing effect of markets as they spread into more and more areas of our lives bears a major responsibility for this trend.

Market prices are systematically biased against social activities in favor of individual activities. Markets make it easier to pursue well being through individual rather than social activity by minimizing the transaction costs associated with the former and maximizing the transaction costs associated with the latter. Private consumption faces no obstacles in market economies where joint, or social consumption runs smack into the free rider problem. Markets harness our creative capacities and energy by arranging for other people to threaten our livelihoods. Markets bribe us with the lure of luxury beyond what others can have and beyond what we know we deserve. Markets reward those who are the most efficient at taking advantage of his or her fellow man or woman, and penalize those who insist, illogically, on pursuing the golden rule – do unto others as you would have them do unto you. A mathematics instructor at a small college in Liaoyang China who had doubled his income running a small fleet of taxis summarized his experience with marketization as follows: “It’s really survival of the fittest here. If you have a cutthroat heart, you can make it. If you are a good person, I don’t think you can.”7

6.Putnam made this remark when interviewed at the 1995 annual meeting of the American Association of Political Scientists in Chicago (Washington Post, September 3, 1995: A5).

7.Reported in “With Carrots and Sticks, China Quiets Protesters,” Washington Post, March 22, 2002: A24. John Pomfret covered the downside of China’s conversion to a capitalist economy in a series of eye opening articles published in the Washington Post during March 2002. Most whom Pomfret interviewed protesting layoffs, lost back pay, and rampant corruption declined to be identified by name, knowing this would almost surely lead

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Of course, we are told we can personally benefit in a market system by being of service to others. But we know we can often benefit more easily by tricking others. Mutual concern, empathy, and solidarity are the appendices of human capacities and emotions in market economies – and like the appendix, they continue to atrophy as people respond sensibly to the rule of the market place – do others in before they do you in.

to their arrest. Pomfret ended the above article with a quote from a rare exception. Wang Bing offered the following assessment of China’s conversion to capitalism: “They say the country is heading in the right direction. Maybe. But for the average guy here, things are definitely getting worse. The workers used to be the masters of this country. What are we the masters of now?”

5Micro Economic Models

This chapter presents some simple micro economic models that illustrate important themes in political economy. While the rest of the book can be read without benefit of the models in this chapter, readers who want to be able to analyze economic problems themselves from a political economy perspective are encouraged to read this chapter.

THE PUBLIC GOOD GAME

The “public good game” illustrates why markets will allocate too few of our scarce productive resources to the production of public, as opposed to private, goods. Assume 0, 1, or 2 units of a public good can be produced and the cost to society of producing each unit is $11. Either Ilana or Sara can purchase 1 unit, or none of the public good – each paying $11 if she purchases a unit, and nothing if she does not. Suppose Sara gets $10 of benefit for every unit of a public good that is available and Ilana gets $8 of benefit for every unit available. We fill in a game theory payoff matrix for each woman buying, or not buying, 1 unit of the public good as follows: We calculate the net benefit for each woman by subtracting what she must pay if she purchases a unit of the public good from the benefits she receives from the total number of public goods purchased and therefore available for her to consume. Ilana’s “payoff” is listed first, and Sara’s second in each “cell.” For example, in the case where both Ilana and Sara buy a unit of the public good, and therefore each gets to consume 2 units of the public good, Ilana’s net benefit is 2($8) – $11, or $5, and Sara’s net benefit is 2($10) – $11, or $9.

	SARA
	Buy	Free Ride
Buy	($5, $9)	(–3, $10)
ILANA
Free Ride	($8, –$1)	($0, $0)

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(1)Will Sara buy a unit? No. Sara is better off free riding no matter what Ilana does. If Ilana buys Sara is better off not buying and free riding since $10 > $9. If Ilana does not buy Sara is also better off not buying than buying since $0 > –$1.

(2)Will Ilana buy a unit? No. Ilana is also better off free riding no matter what Sara does since $8 > $5 and $0 > –$3.

(3)Assuming that Sara and Ilana’s benefits are of equal importance to society, what is the socially optimal number of units of the public good to produce? 2 units since $5 + $9 = $13 is greater than $10 – $3 = $8 – $1 = $7 which is greater than $0 + $0 = $0.

Suppose the social cost and price a buyer is charged is $5. The game theory payoff matrix for buying or not buying 1 unit of the public good now is:

	SARA
	Buy	Free Ride
Buy	($11, $15)	($3, $10)
ILANA
Free Ride	($8, $5)	($0, $0)

(4)Will Sara buy a unit? Yes. Buying is best for Sara no matter what Ilana does since $15 > $10 if Ilana buys, and $5 > $0 if Ilana does not buy.

(5)Will Ilana buy a unit? Yes. Buying is best for Ilana no matter what Sara does since $11 > $8 if Sara buys, and $3 > $0 if Sara does not buy.

(6)Assuming that Sara and Ilana’s benefits are of equal importance to society,whatisthesociallyoptimalnumberofunitsofthepublicgood to produce? Two units yield the largest possible net social benefit of any of the four possible outcomes: $11 + $15 = $26.

Finally, suppose the social cost and price a buyer is charged is $9. Now the game theory payoff matrix for buying or not buying 1 unit of the public good is:

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	SARA
	Buy	Free Ride
Buy	($7, $11)	(–$1, $10)
ILANA
Free Ride	($8, $1)	($0, $0)

(7)Will Sara buy a unit? Yes, since Sara is better off buying no matter what Ilana does: $11 > $10 when Ilana buys, and $1 > $0 when Ilana does not buy.

(8)Will Ilana buy a unit? No, since Ilana is better off free riding no matter what Sara does: $8 > $7 when Sara buys, and $0 > –$1 when Sara does not buy.

(9)Assuming that Sara and Ilana’s benefits are of equal importance to society, what is the socially optimal number of units of the public good to produce? It is 2 units since $7 + $11 = $18 is greater than $8 + $1 = $10 – $1 = $9, which is greater than $0 + $0 = $0.

What the “public good game” demonstrates is the following conclusion: Unless the private benefit to each consumer of a unit of a public good exceeds the entire social cost of producing a unit, the free rider problem will lead to underproduction of the public good. When the cost is $11 the private benefit for both Sara and Ilana is less than the social cost, and neither buys – although buying and consuming 2 units is socially beneficial. When the cost is $9 the private benefit for Ilana is still less than the social cost so she does not buy, and only 1 unit is bought (by Sara) and consumed (by both women) – although producing and consuming 2 units would be more efficient. Only when the cost is $5 is the private benefit to both Sara and Ilana sufficient to induce each to buy, and then and only then do we get the socially efficient level of public good production. Obviously for most public goods the private benefit to most individual buyers will not outweigh the entire social cost of producing the public good, and we will therefore get significant “underproduction” of public goods if resource allocation is left to the free market.