As November conjurs up sentiments of food, family and Thanksgiving for many, I’ve found my admittedly perverted mind revisiting the late great economist Arthur Okun. Why? Because his brilliant presentation of the operations, strengths and weaknesses of the competitive marketplace in Equality and Efficiency: The Big Tradeoff (1975) continues to provide valuable insights for thinking about contemporary issues. Sharing some of these insights first requires outlining some fundamental economic principles within Okun’s basic context. That is the purpose of this post. But please be assured that enlightenment will follow for those resilient readers who survive the Econ lesson, as my two followup posts will apply these economic principles to two intriguing and seemingly unrelated current issues: price gouging and net neutrality.
First the economics, in brief. Assuming sufficient competition and information, self-interested buyers (demanders) and sellers (suppliers) of let’s say widgets ‘come together’ in a marketplace to exchange buyer money for seller widgets. In this familiar process a ‘market-clearing price’ for the widgets (let’s call it ‘mcp’) is established that equates supply and demand. Textbook Econ 101.
Somewhat less recognized are various important corollaries of this process. They include:
- Some sellers of widgets choose to restrict production because the mcp is not high enough to make additional production profitable.
- Some buyers cannot afford to buy many if any widgets at the mcp.
- Other buyers would actually be willing to pay more than the mcp but don’t have to because there’s only one price.
- Sellers would prefer to charge each buyer the maximum price they would be willing and able to pay (economists call this price their ‘reservation price’ and this process ‘price discrimination’), but they can’t because with competition and free information all buyers will seek out the mcp.
- Since widgets and the resources used to produce them are inevitably scarce, the mcp serves as an efficient rationing device to allocate widgets to those most able and willing to pay for them.
- While individual buyers and sellers are motivated solely by their own self-interest, competition ensures that society benefits from this allocative efficiency (essentially Adam Smith’s ‘invisible hand’).
- On the other hand, the unequal distributional impacts on individual widget buyers and sellers are treated as essentially irrelevant. Some sellers can sell many widgets profitably at the mcp, while others cannot. Some buyers can afford to buy many widgets at the mcp, while others can buy none. In this process no value judgments are made about the fairness of the results. The system is ‘value-free,’ and therefore amoral.
To generalize, the resources necessary to provide widgets and all other products/services are inevitably scarce, and given this scarcity every society must have some rationing mechanisms/criteria for choosing what, how and for whom it produces. A market-oriented capitalistic society blindly uses prices (mcp’s), and the ability and willingness to pay those prices, as its primary rationing criterion. The results are efficient and unequal (see Okun’s title), as well as morally neutral.
Note also that in theory a society could choose many other rationing criteria instead of prices. For example a central authority could determine that 100 widgets will be produced, and then distributed free on a first come-first served basis. Here the queue is the rationing device. Arguably more equal or fair, but less efficient (see Okun’s title once again).
Of course, in the real world the rationing process is often more complex and hybrid in nature. Societies identify some ‘public goods or services’ that must be provided free or at a subsidized price, e.g., public parks or K-12 education. Another variant is the so-called ‘public utility’ such as electricity or water provision, whose extensive infrastructure requirements necessitate treatment as a regulated monopoly.
In addition, because market information is not perfect many businesses generate a product or service and then choose a price, mcp or not, that covers its costs including a reasonable profit. Such businesses typically do not try to continuously adjust their prices in search of the mcp. Rather, they also employ queueing as a rationing device while adjusting production if the product sells out. For example, Apple recently introduced its new iPhone X at a price of $999, a price that is unlikely to change anytime soon. Is this the mcp for the iPhone X? Probably not, but if the demand exceeds the supply lines will form at Apple Stores and some buyers will need to wait until production increases.
But the fundamental principles remain. A capitalist system uses market-clearing prices, and the ability and willingness of buyers to pay those prices, as the primary criteria for rationing scarce goods and services. So long as markets are sufficiently open and competitive, scarce resources are efficiently allocated among competing uses. In fact, individual self-interest drives the system to this result. While the allocative result is efficient and socially beneficial, the morality of using what Okun calls ‘dollar votes’ to determine what is produced and who gets what is left unanswered.
If you’ve made it this far without dozing off, congratulations! The basic Econ lesson is over. As noted at the outset, these principles can provide insight into many current issues, but I have chosen two. My first followup post within the next couple of days will consider the efficiency and equity of price gouging (Teaser: Should sellers be able to drastically increase the price of basic consumables during a crisis?). Stay tuned.
Garygrams 