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have been chosen by a planner (or regulator), whose objective was
to promote household interests by maximizing their joint wealth,
and who proceeded to do just that by instructing each ¬rm on
how much X to produce and each household on how much X to
consume. The proof requires a little bit of patience, but is worth
rehearsing. Let us suppose ¬rst that the plan the regulator
proposes is one in which the marginal costs of production of a
pair of ¬rms, 1 and 2, differ; say, the marginal cost for ¬rm 1
exceeds that for ¬rm 2. Total wealth could be increased by a slight
change in the regulator™s plan: reduce ¬rm 1™s output by one unit
and raise ¬rm 2™s output by one unit. Total output would remain
the same, but it would be produced more cheaply, thus increasing
the total wealth of households. So, the regulator™s best plan “ we
will call it the ef¬cient plan “ would involve equality in the
marginal cost of production among all those ¬rms that are

instructed to produce X.

Turning to households, let us suppose that the plan the regulator
proposes is one in which the willingness to pay for the marginal
units to be purchased by a pair of households, say 1 and 2, differ.
Imagine that household 1™s willingness to pay for the marginal
unit it is to consume exceeds that of household 2. Total wealth
could be increased by a slight change in the regulator™s plan:
reduce household 2™s consumption of X by one unit and raise
household 1™s consumption by one unit. No additional resources
would be involved in this reassignment; but total wealth of
households would increase, because household willingnesses to
pay are measured in terms of wealth. So, we have proved that the
ef¬cient plan involves equality in the marginal willingness to pay
among all households. A similar argument shows that the ef¬cient
plan also has the property that each household™s marginal
willingness to pay equals each ¬rm™s marginal cost of production.
But the regulator would want to ensure that the total quantity
produced equals the total quantity consumed. (Wealth would be

wasted if total production exceeded total consumption; and the
whole purpose of the planner would be frustrated if total
production fell short of total consumption.) It is simple to con¬rm
that there is a unique plan satisfying each of the above

Let the common value of the marginal costs of production and the
marginal willingnesses to pay be P. The regulator could implement
the ef¬cient plan by setting the price of X at P and requiring that
households and ¬rms transact on the basis of P. That P is, of course,
the PE of Figure 8. This completes the proof.

Although highly abstract, what I have sketched here was the basis
of a far reaching debate that took place among economists during
the 1930s: markets versus central planning. Advocates of the
institution of central planning, such as Oscar Lange and Abba
Lerner, argued that an enlightened planner could help to realize

all the virtues of markets while avoiding the weaknesses of actual
markets, such as lapses from competition. The term market
socialism has been associated with the Lange-Lerner vision.
Advocates of markets, such as Friedrich von Hayek, argued, on
the other hand, that the equivalence in the outcomes achieved
doesn™t amount to an equivalence in the amounts of information
required in the two systems for achieving the desired outcome.
Von Hayek observed that enlightenment on the part of the
central planner in market socialism amounts also to omniscience.
If the planner is to implement the ef¬cient outcome, he or she
needs to know each household™s demand curve and each ¬rm™s
supply curve. That™s a lot of information. How is the planner to
obtain it? Perhaps by sending polite questionnaires to households
and ¬rms. But why should respondents tell the truth about
themselves and their circumstances? Even if ingenious
mechanisms could be devised for eliciting that information,
there are costs involved in collating and transmitting the
information. Markets are far more parsimonious in the use of

One can argue though that the job of the planner shouldn™t be to
mimic the market, but to select policy weapons (such as taxes and
subsidies) that require less information than is available to an
omniscient being. Even with limited knowledge, a planner could
help to bring about states of affairs that are superior to those
brought about by unbridled markets (Chapter 8).

Interdependent markets
Marshall™s famous demand and supply curves mislead in one
important way. Figure 8 could lead one to think that in an ideal
market, the equilibrium price of X is unique. We con¬rmed that it is
unique (it was PE), but we had assumed the prices of all other goods
and services in the economy to be given. If those prices were to be
different, the demand and supply curves of X would be different,
which in turn would imply that the equilibrium price would be
different. But all those other prices depend on demand and supply
in their respective markets. As markets are interdependent, we

should study them together, not one by one, separately.

We continue to assume that transactions are veri¬able, as is the
quality of the goods produced, sold, and bought. In other words,
ideal markets don™t suffer from problems of adverse selection and
moral hazard. Moreover, markets open now for every commodity,
including primary factors of production, intermediate goods, and
¬nal consumption goods. Most commodities would be future goods,
which means that contracts over their purchases and sales are
signed in forward markets. Contracts in forward markets involve
agreements over purchases and sales today for delivery at speci¬ed
future dates. Saving and investing for the future and borrowing
from the future would take place in those markets. Many of the
commodities would be contingent goods. Contracts over their
purchases and sales would be signed in contingent markets.
Contracts in contingent markets involve agreements over their
purchases and sales today for delivery at speci¬ed future dates, if
and only if certain contingencies arise. The purchase and sale of
insurance would take place in contingent markets. There is

uncertainty about future events, but in contingent markets people
are able to purchase or sell goods and services at quoted prices that
are tied to each and every eventuality. As payments have to be made
now, no one faces uncertainty over their budget, nor do ¬rms face
any uncertainty over their pro¬ts.

What is the point of studying a world in which there is a market for
every conceivable good? There are three reasons. First, studying it
enables us to appreciate that certain features of economic life in the
world we live in arise because of missing markets (such as
bankruptcy; performance-related pay; limits imposed on you by
¬rms on the amount of insurance or credit you can purchase even if
you have the resources to buy more; unemployment (see below) ).
Second, we can gauge how much societies lose from the fact that
there are missing markets. And third, we can explore policies and
institutions that could partially compensate for the absence of
certain markets. That is why it makes sense to begin the study of

interdependent markets in our world by investigating a world
where there is a competitive market for every commodity.

We are studying a private ownership economy here. Firms are
owned by households. Firms™ pro¬ts are distributed to households
on the basis of the shares they own. Each household has a legal right
also to a set of commodities (their human capital). Therefore, for
any given set of prices, each household is able to compute its wealth.
Households are price-takers and are obliged to purchase goods and
services they can afford: their total expenditure must not exceed
their wealth. Firms are price-takers and choose their production
outlays so as to maximize their pro¬ts, which in the present context
means the capitalized value of the ¬‚ow of pro¬ts. (Traders can be
thought of as ¬rms too. Their purchases can be regarded as
˜production™ inputs, their sales as outputs.) A market equilibrium “
economists call it a competitive equilibrium “ is a set of prices
quoted today for each and every commodity, such that the total
demand for each equals its total supply. In equilibrium the
information households and ¬rms need to have in order to

participate effectively is parsimonious. A household needs to know
its own ˜mind™, its endowment of goods and services, and the
equilibrium prices “ nothing else. Similarly, a ¬rm needs only to
know the technology available to it, the prices it has to pay for its
inputs in production, and the prices of whatever it produces “
nothing else. Equilibrium prices coordinate the production and
allocation of all goods and services (who produces what and who
consumes what).

Are there circumstances in which an equilibrium exists?
Economists™ search for an answer to the question has a history,
dating back to the 19th century. The de¬nitive answer was provided
in the early 1950s, when several economists identi¬ed conditions
(on households™ and ¬rms™ characteristics) under which a
competitive equilibrium exists. It was also shown that there is a
close, but subtle, connection between the notion of a competitive
equilibrium and that of an equilibrium agreement in a community

(Chapters 2“3).

Excepting under very special circumstances, a competitive
equilibrium is not unique. It isn™t unique for much the same sort of
reason as why equilibrium outcomes in communities are not unique
(Chapter 2). Agreements in communities are mutually enforced by
the use of social norms. The existence of more than one
communitarian equilibrium re¬‚ects the fact that there is usually
more than one set of self-con¬rming beliefs that people can harbour
about one another™s intentions. In ideal markets, agreements
between buyers and sellers are enforced by the state exercising the
rule of law. The existence of more than one competitive equilibrium
re¬‚ects the fact that there is usually more than one set of prices at
which demands for goods and services equal their supplies. Beliefs in
communities and prices in markets are emergent features in two very
different types of institutions. In Chapter 2, I explained the sense in
which we don™t yet have a satisfactory understanding of how beliefs
form. You shouldn™t be surprised that we don™t yet have a satisfactory
understanding of how prices would emerge in ideal markets.

The ef¬ciency of ideal markets

Even though equilibrium in a market economy isn™t unique, every
competitive equilibrium is ˜ef¬cient™. As we are now studying all the
markets together, the notion of ef¬ciency is not as simple as in the
market for a single commodity (X), but it can be stated in words.

By an allocation of goods and services we mean a complete
speci¬cation of who produces what and who consumes what. We
say that an allocation is feasible if, given the economy™s endowments
of assets, it can in principle be created in the economy. Let ± be a
feasible allocation. We say that ± is ef¬cient if there is no feasible
allocation that all households would choose over ±. The concept was
introduced by the economist-sociologist Vilfredo Pareto, which is
why ef¬ciency in the above sense is widely known as Pareto-
ef¬ciency. It can be shown that a competitive equilibrium is Pareto-

As with households, so with nations. If there were no restrictions in
international trade, competitive equilibria of the world economy
would be Pareto-ef¬cient. Details aside, this is at the heart of the
theoretical case for free trade.

Market failure
Just as communities can fail to advance the interests of their
members, markets can fail to allocate resources well. What
households are able to achieve even in ideal markets depends on
what they bring to the market place. Presumably, some households
would be poorly endowed in goods and services, others richly so.
Those endowments are inheritances from the past and they
in¬‚uence the outcome in the market place. Even though market
allocations in competitive equilibrium are Pareto-ef¬cient, they
aren™t necessarily equitable or just. It shouldn™t be surprising that
Pareto-ef¬ciency is silent on distributive justice. Equity and
ef¬ciency are different ethical properties of allocations. An

allocation of goods and services where one self-regarding
household is assigned everything is Pareto-ef¬cient, whereas an
allocation in which households have equal shares is more equal.
An allocation could be at once egalitarian and not be Pareto-
ef¬cient; it could be both egalitarian and Pareto-ef¬cient; and
there are allocations that are neither egalitarian nor Pareto-
ef¬cient. It is this sort of reasoning, though abstract and technical,
that lies at the heart of a widely accepted role for government
(Chapter 8): devising and implementing policies that would be
expected to bring about outcomes that are Pareto-ef¬cient (for
practical purposes, read ˜tolerably non-wasteful™) and egalitarian
(for practical purposes, read ˜free of hunger, ill-health, and

Even if we were to leave distributional issues aside, markets don™t
operate ideally in the world we know. Why? Three reasons stand
out. First, as the production of public goods is vulnerable to the

free-riding problem, markets are less than effective in supplying
them. That said, there are deeper problems than ˜free-riding™ in the
case of public goods. Take the rule of law, which is a public good. In
the absence of the rule of law markets couldn™t function (Chapter 2),
which means that it would be absurd to allow it to be a marketable
commodity. There are also cases involving environmental services
(Chapter 7), where market transactions create externalities that
can™t be eliminated no matter how audaciously the state tries to
rede¬ne private property rights.

The second reason is that in some industries there is a single
producer (monopoly) or at best only a few producers (oligopoly).
Firms in an ideal market don™t have anything left over after every
production input has been paid for (wages, salaries, raw materials,
repair and maintenance, charges imputed to machinery and
equipment, interest payments on loans, and so on). Because a
monopolist doesn™t face competition from other ¬rms, it™s able to
charge a price higher than PE (Figure 8) and enjoy a pro¬t.

Monopolists have a bad press in consequence. However, we need
monopolists because pro¬ts from sales are the incentives ¬rms
must have if they are to spend resources in research and
development (R&D), so as to create new products and invent
cheaper ways of producing old products (which is a good thing).
Moreover, monopolists try to maintain their leading position by
engaging in R&D, thereby forestalling entry by rivals (a not-so-good
thing). Unless they are curbed, though, monopolists would wish
to more than just recoup those R&D expenses. In rich countries
anti-trust laws have been legislated so as to prevent ¬rms from
doing that.

Monopolies are a necessary evil for another reason. There are
commodities whose cost of production per unit produced declines
with output. Economists call this phenomenon economies of scale.

9. A shopping mall in Becky™s world

Infrastructure (road networks, rail tracks, power, sewage systems)
provides examples. Communities can™t afford to produce them
because communities are small. In contrast, the market would
produce them if its reach was large enough and the costs of
collecting fees from users was small enough. A ¬rm that produces
infrastructure has to be large in order to enjoy low production costs.
So private producers of infrastructure are often monopolies, or at
best oligopolies. As Becky™s world has grown richer and the reach of
the market has widened, societies there have increasingly relied on
private ¬rms to supply infrastructure even as they have directed
their governments to regulate producers in order that they don™t
earn monopoly pro¬ts. Transport networks are a case in point. Of
course, when households make use of such infrastructure as a
modern sewage system, they confer bene¬ts on others (positive
externalities), which may be why in Becky™s world the local
government usually provides the service. In Desta™s world


10. A market in Desta™s world

infrastructure, such as durable roads, are often absent because of a
vicious causal circle: in the absence of a reliable network of roads,
markets can™t extend their reach; in the absence of markets,
households are unable to engage in anonymous transactions; and
because government corruption is rampant in the construction
sector, roads that would last don™t get built; so households remain
in poverty.

Macroeconomic ¬‚uctuations
The third reason markets are far from ideal arises from a fact we
noted earlier, that markets can support transactions only when
transactions are veri¬able. Markets for different qualities of a
product, for example, can form only if quality can be veri¬ed. Moral
hazard and adverse selection prevent markets from being formed,
which is why few forward and contingent markets exist in the world
we know. Households and ¬rms are obliged to make decisions on
the basis of the current value of their assets, the spot prices they face

for goods and services, and the expectations they harbour about
the prices (including wages) they will face when spot markets form
in the future. As expectations can be held together by their own
bootstraps, there can be more than one set of self-con¬rming
expectations in the short run. Some lead to a reasonable utilization
of the economy™s productive capacity, others to slumps.

Analyses of slumps are the stuff of macroeconomics, which is
concerned with the study of (national) economies considered in
aggregate terms (Chapter 1). Historically, though, macroeconomics
as a subject was devised to study short-run ¬‚uctuations in aggregate
economic activity as measured in terms of such indices as output
(GDP), employment, and the price level (which is the level of
commodity prices, in the aggregate, in terms of money).

What are those ¬‚uctuations? Consider that since the Second World
War, Becky™s world has enjoyed improvements in the standard of
living in a fairly uninterrupted way (Chapter 1). But GDP has been
periodically less than potential GDP, which is the aggregate output

the economy would have produced if all the installed machinery,
equipment, and all the available labour force at the time were to
have been employed. During the Great Depression of the 1930s, the
economic slump in Europe and the US was so deep that not only did
factories and equipment lie idle, some 25“30% of the labour force
couldn™t ¬nd a job in the market place. What is the explanation
behind slumps and the labour unemployment that can go with

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