Wednesday, February 1, 2012

Perfect Market and Non-Market System

This is a blogpost on the insights I gleaned from the book "The Undercover Economist" by Tim Harford. It is a captivating read and sheds new light on the Economics that I learnt.

Perfect Market is a the world of truth. It is a world where markets are complete, free and competitive. But it is an economist's fantasy. However, this fantasy will help us understand why economic problems arise and also helps us to move in the right direction. So when real-world economies malfunction, we know to look look for the marekt failures - and to do our best to patch them up. Market failures occur due to scarity power, missing information and externality (i.e. decisions that have side effects on bystanders).

Life without markets refer to goods provided outside the market system. An example will be the local police force, which is paid for by a non-market system of taxation. We do not need to pay for the service. It is provided by the government as the government is supposed to afford the same level of protection to the rich and poor.

However, the non-market system also has some disadvantages. You cannot shop around for another police force, if you are not happy with the current one. Neither can you spend more if you will like extra services.

Another example is Government-provided schooling. Due to the absence of pricing, parents line up, haggle and protest. They move to districts with better schools.

The non-market system has the cosy advantage of concealing the fact that the poor don't get the same quality education that the rich do. However, the non-market system suffers from a serious problem: the truth about values, costs and benefits. In a market system the truth will emerage about how much it costs to provide good schools and who would be willing to pay for them.

It seems that there is a willingness to pay for good schools, as we see it emerge because house prices are higher near good schools. So we see that the non-market system channels the money that parents are willing to pay for a good school into the hands of property owners near these schools instead of the schools themselves.

Prices perform two functions, not just one. In a market system, prices provide a way of deciding who gets to enjoy a limited supply of schools - those who are able to pay. This is an uncomfortable state of affairs, which the government-school system is designed to prevent. But prices also give the signal to build more schools, hire more teachers or raise their pay if they are in short supply, and better materials.

In a non-market system, the loss of pricing means a loss of important information. This loss is offset by gains in equality or stability.

Efficiency vs fairness
Let's define efficiency in the context of economics. When economists say the economy is inefficient, they mean that there is a way to make somebody better off without harming anybody else.

While the perfectly competitive market is perfectly efficient, efficiency is not enough to ensure a fair society, or even a society in which we would want to live. That is why, we have taxes and subsidies which are common causes of inefficiency.

This is a good example of why taxation is inefficient.
- Cost of a cuppa of coffee: $1.00
- Price of a cuppa of coffee in perfectly competitive market: $1.00
- Price after tax: $1.10
- Willing to pay for a cuppa of coffee: $1.05
- Coffee sold: none
- Tax raised: zero

There could have been a sale that created 5 cent of efficiency gains but did not happen due to tax. What is worse is that the tax wasn't even paid. If the government were able to waive the tax in such circumstances, they would be no worse off, but the coffee buyer would be better off: a clear efficiency gain.

But it is hard for tax officials to know when to charge the tax and when to waive. In general, taxes are often higher when price-sensitivity is low. E.g. fuel and cigarettes.

So a key question is whether there is a way to make our economies both efficient and fair?

According to eminent economist, Kenneth Arrow, the youngest man ever to win the Nobel Prize for Economics, there is a way. He has proved that all efficient outcomes can be achieved using a competitive market, by adjusting the starting position. We shall term it the "head-start theorem". In essence, the trick is to make lump-sum payments and levying one-time taxes. By so doing, we can give a "head-start" to those who need it so as to put everyone on the same footing. At the same time, it will not blunt the incentive for anyone to work hard as in the case of taxation thereby continuing the state of efficient economy.

However one will have to be judicious in the application of the "head-start theorem". A practical example could be used to prevent elderly people from getting cold in winter, without damaging the environment. This could be in the form of giving money to the pensioners. Some may use the money to insulate their homes. Those who did not feel the cold in the first place can spend the money on other things. Nobody will burn extra fuel unless they need to.

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