Micro Part 4 Beyond Micro

Micro Part 4 Beyond Micro In 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 and intermediaries on whom he depends and in turn all of whom depend on what he does. The key new element for theory is the nature of the dependence relationship. This relationship is not intellgible within the notion of optimization. We must embrace the idea of entrepreneurship to understand the character of the dependency relation in the context of exchange, 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 and whose kind constitutes means of payment (pensation for short).

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18 18.0 18.1 18.2 18.3 18.4

Entrepreneurship and Price Setting

Chapter Overview Paradoxical behavior of entrepreneurs Entrepreneurs differ from optimizers Arbitrage Price setting

Chapter Overview The near universal popularity of Marshallian price theory (the idea that demand-supply interaction dtermiens equilibrium price) is comparabel to the near universal superstition before Copernicus: 15. Explain how price setting is an entrepreneurial process. Price setting is the outcome of a bargaining process between the buyer and the seller. Bargaining is an entrepreneurial process, because the participants in a bargain do not have any specific objective function or any given constraint or any specific alternative choices. The participants face a range of choices and they engage in guessing the other side’s bargaining strength before deciding where to reach a compromise. The key to the entrepreneurial distinction of a bargain is that it involves an agreement that settles a conflict of interest. In contrast, optimization requires no agreement and involves no conflict of interest. Optimization models conveniently assume a fixed price and income for the optimizer who has freedom only to choose the quantity. But entrepreneurs engage in bargains to get 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 two parties. Each party wants to win as much as possible. The seller starts with asking a high price, and the buyer wants to offer a low one. Round after round of bargain, the buyer may offer higher and higher price while the seller may ask lower and lower price until they agree. There is a constraint that the other side must agree to a deal, but it is not like 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 3 dollars, it means that the buyer has no option to ask for a lower price to his advantage. Bargaining exists if the buyer is able to ask for a lower price. How much 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, but still leaves some profit). The buyer’s own strength of desire for the good means that he is also willing to pay a high price rather than forgo the purchase and hence miss the benefit of consumption. It is not possible to say ahead of time how the creative process of haggle or bargain unfolds in each case, just because it is creative. Every bargain episode may be a unique experience of compromise after a session of negotiation. (253)

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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 by agreement between the buyer and the seller. The bargain process fixes the price 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 good or 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 the consumer will refuse to buy at any price higher than marginal benefit. So the actual 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 are different 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 given amount of his resources such as labor and land and capital. The marginal cost of an apple to him counted in units of bananas is 3/2. However, suppose that there is another person Eve, who can produce apples at a lower cost, say at ½ of a banana. That is, given the same productive resources, Eve can produce either ½ of a banana or 1 apple. Now, in isolation, the best that Adam can do is to consume 1 apple at the cost of 3/2 bananas. If he chooses to do so, his marginal 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 ½ 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 ½ and 3/2 banana per apple, ½ being the floor and 3/2 being the ceiling. What will be the actual price cannot be told in advance. It depends on how intensely they can bargain. If Eve figures out that Adam is desperate for apples and would go as high as 3/2 bananas per apple, she may try to get a high price. Likewise, if Adam figures out that Eve may be desperate to sell and may go as low as ½ bananas, he may take a stand to keep the price low. Where they will strike a compromise is not known ahead of time: it depends on each case. The price core exists because there is a bargaining option to choose the price anywhere between the two extremes of the floor and the ceiling. (343) 17. Why do you think the price is arbitrary within a range defined by the price core? 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 arbitrary point is chosen because there is nothing to lead to a specific point, unless one knows ahead of time what the relative bargaining strengths of the two opponents are.

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It is not possible to remove the arbitrariness of the price by assuming special rules of bargaining. Though various bargaining models have tried to presume different bargaining rules, those presumed rules have no basis other than arbitrary idea of the authors. The essence of a game is that the outcome is 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 produce the same result because each game is played independently of other games. In short, 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 price and the means of payment in an exchange between the original producer and the final consumer. Though it may seem that direct trade does not involve an intermediary, it is not true that there is no intermediation. The key to this insight is that both the buyer 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 the producer. The same way that he sells his own product, he could sell that of another 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 action while production is optimizing action. The entrepreneurial role of a seller is precisely that of the intermediary who is a pure seller (who does not produce anything but sells goods produced by others.) Therefore, we conclude that there can be no exchange without intermediation. (195) 19. *What is pure intermediation? Does pure intermediation have a budget or endowment constraint? Justify your answer. Pure intermediation involves selling without being a producer and buying without being a consumer. This means that the intermediary is pure when he sells products on behalf of the producers and buys products on behalf of consumers. He is an intermediary because he occupies an intermediate or interim position: he sells after the producer already sold the good to him, and he bys before the consumer finally buys them from him. Pure intermediation has no budget or endowment constraint as applicable to the consumers and the producers, just because the intermediary is neither a producer 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 he can 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 different prices to different customers for the physically identical product.

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Price discrimination is an entrepreneurial process. An entrepreneur as seller tires to get as high a price as possible to maximize his profit. However, he realizes that different customers have different budgets and strengths of desire for the product, namely, that some customers are willing to pay higher prices than 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 he guesses that the customer will not buy at the high price, he agrees to take a lower price. Because it is hard to make a correct guess of the strength of desire of the buyer, price discrimination takes the form of a game. Discriminatory sellers try to categorize customers into different brackets to choose what price they will charge. (156)

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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 been produced. Transport and storage are considered parts of production cost. However, the cost of gathering information, and organization of the actual transaction (such as sitting in a fair or shop or selling by peddling or mail-order), the innovation to organize new type s of transactions and the 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 buying and selling without being either the producer or the consumer of the traded goods). Intermediaries or middle men make themselves useful to society by cutting down transaction costs which the original 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. If the buyers have access to competing supplier within a reasonably short distance, implying that the cost of going to another competing supplier is not high compared to the excess price paid by the customer, 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 the competition 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 to search c competing sources of supply get coupons, so the same store sells the goods at a lower price to those who would otherwise go to the competitor. 155 22. Do you think full information alone is able to eliminate price discrimination? I don’t think that full information alone is able to eliminate price discrimination. There are other elements of transaction cost that may provide a ground for price discrimination. Classical economists had vague ideas about information. They supposed that if all customers were 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 that different customers may face different costs of organizing the transactions, namely, to visit the shops or order the goods. They may face different costs of legitimization. Neighborhood grocers are often called convenience stores, because they are at a convenient distance and impose a lower cost of going to major business centers. This is why they are able to charge a higher price. They make it less costly to organize the transaction from the buyer’s side. 145 23. *What are the four major elements of transaction cost? Briefly illustrate each.

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The four major elements of transaction cost involve (1) the collection of information, (2) the organization 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 the buyer and the seller. The buyers must gather the information about the availability of the products and 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 to inform the customers. Advertisement massively reduces the costs of buyers in connection with information gathering. There are specialized providers of business information. Government regulators also provide some information, mainly to assist customers buy safe products and make secure payments. 102 (2) The organization of the transaction: To organize a transaction is to find a suitable place where 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 the agreements or contracts when so required. Ronald Coase thinks of the firm as an organization that cuts down transaction cost by putting many people to combine their efforts to produce something and deliver it to customers. This way the firm internalizes external costs. Merchants have created market 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 of payments to arrange transactions over time. 127 (3) The innovations in transaction technology and systems: Arranging transactions often require innovations for new products, for launching products in new areas and for adopting newer business practices such as the use of credit cards, self-checking, paperless e-tickets for travel and so on. Along with innovation comes the inherent risk of starting new business, and intermediaries have enabled the proliferation of products by bearing the risks. Without this, most industrial products and commercial services would never be introduced in the first place. The cost of taking risk is minimized by intermediaries. The society as a whole would be unable to bear the risk owing to adverse selection and moral hazard problems. 110 (4) The legitimization of the trade: Traditions often go against the launching of many new kinds 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 of payment. Merchants had to struggle hard to legitimize the businesses. Many trades are still not considered legitimate. For example, providing VOIP technology in Bangladesh has been kept in limbo because the authorities do not give permission to start them. Many businesses are banned or restricted. Legitimization also includes overcoming people’s resistance on grounds of ethics or of novelty or frivolity. Most industrial goods were initially thought of as frivolities, and also they were seen as threats to some occupations. Thus the mechanical typewriter made handwriting obsolete and scriveners resisted it. Without entrepreneurs risking much to secure legitimacy, most products 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. For example, merchants undertake advertising to massively reduce the customer’s cost of getting the information on the product. The reason business corporations spend massive sums on advertising is that they have found that without advertisement, they fail to sell the products beyond a very small amount. Merchants created markets, shopping centers, and various systems to organize the transactions at the lowest cost for the customer. Usually customers are scattered all over the place and it is difficult for them to know where to go and at what time to get something from sellers.

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Fairs are especially important to launch new products. A whole class of intermediaries has evolved 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 where retailers go to get their supplies from wholesalers. Had there been no wholesale market, the retailer would incur much higher cost of getting the supplies. The aratdar or auctioneers in the marketplace 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 new products and enter new markets. Many people have lost fortunes trying to launch new products and services that failed. The intermediaries have undertaken the role of risk taker and venture capitalist to finance the introduction of new products, launching into new markets and introducing new transaction systems. 64 Legitimization is basically a political and cultural struggle to persuade the powerful authorities that trading in some new products should be allowed. For example, almost all nations had to undertake severe struggles to introduce birth control devices against the wishes of conservatives. The advent of radio and television met with much resistance from guardians of old culture who feared that there old ways of life were under attack. Vested interests always oppose the introduction of competing products or suppliers. The CBA guys do not want banks to become private 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 their contribution to the reduction of transaction cost. Pure intermediaries do not take part in production. Until 2003, no economist had ever been able to give a justification for the existence of pure intermediaries beyond use of otherwise scattered information. The intermediaries were traditionally regarded as parasites who grabbed a profit in between the original producer and the final customer. The communist revolution was largely directed towards the elimination of intermediaries, because they were regarded as the very incarnation 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 than from original producers. 130 Note: In a modern commercial economy, as high as 85% of the price paid by the customer goes to intermediaries, only 15% being left to producers. This is because production cost is far smaller than the transaction cost of finding the customer who will wish to buy it at a high enough price. If middlemen were stopped, the market economies would simply collapse, the volume of production would fall so greatly that people will return to virtual Stone Age. It is out of question. For example, for an illiterate Bangladeshi girl to sell her stitch-work to an American shirt user directly will be nearly impossible. If the middlemen do not exist, she will be unable to produce and 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 first lesson 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 manner of setting prices. Attempts to forcibly keep prices low in order to make them affordable have always had the opposite effect. If sellers are unable to earn profits, they stop production, and the supplies go down, and the pressure is create dot raise the prices even higher than before. 84

The prices in the market are not dictated by one side. The seller cannot get a price unless the buyer agrees to pay it. The government has no reason to interfere in this agreement process. Sellers always want high prices, but they cannot get more than what buyers can afford to pay. The idea that some people cannot afford to pay high price is starkest 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 the goods 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, traditional fishermen and trappers (in the Hill Tracts). These are the poorest people. To increase their income, the prices of their products, namely food, must go up. All developed nations have programs to raise the food prices up by various regulations. Farmers in Bangladesh are not organized, and hence they have long been victims of political robbery in the hands of relatively affluent urban folks who raise a hue and cry whenever inflationary pressures raise the prices of food items just a little bit. It is politically 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 for keeping prices of foods low? Of course there are poor people who do not have enough income to buy food, no mater what the prices are. The proper solution is to give income subsidy to the poor, and this must be done by forcible taxation of the rich. It is politically unjust and cruel to reduce the prices of food and make food cheaply available to rich customers who heartlessly rob the farmers when they come for medial or educational or engineering 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 punished producers by refusing o give them good wages or prices. The so-called workers were fooled into believing that capitalist were shot to death or driven out of country, and their capital were nationalized by the government. Behind this heroic words were the terror of party bureaucrats who enjoyed lavish lifestyles as bosses while the ordinary workers lived pathetic poor lives, with long queues at state run shops even for the simple things like bread or egg, and had no access to even ordinary industrial products, not to talk of ever 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 corrupt bureaucrats 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 hole industry of corruption.

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

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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 also numerous buyers for the same product and the buyers try to persuade sellers to sell to the individual buyer rather than to the other buyers. Competition means that for the same good, there are many customers who would like to get it, and if one got it, the others would not get it. 20.2 Competition is entrepreneurial, and has no constraint The analysis of competition is a part of the theory of intermediation. Prevailing economics has next to nothing to say in this regard. This is because prevailing economics does not recognize that competition is thoroughly entrepreneurial and no concept of optimization 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 is essential that the entrepreneur must reach an agreement with the opposite side. In theory of competition, if optimization is not relevant, the idea of constraint is also not relevant. A competitor has no constraint in choosing some minimum or maximum: he is free to choose anything within a range of possibilities. Thus an individual seller who knows that there are other sellers and the customer is free to go to other sellers doe s not necessarily see this as a situation where he is forced only to ask the lowest 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 gives him some profit, but he is under no constraint to maximize it in some specified sense. He of 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 customer will pay is not the same for different customers, there is no way to say that a certain price is the one he must charge to maximize profit. He will discriminate and reach his maximum profit by taking the maximum from each customer, and differently from each different 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 playing the role of the intermediary. A pure intermediary buys what he does not consume and sells what he does not produce. An ordinary impure intermediary also buys and sells, but sells what he has produced and buys what he has consumed. But his role as buyer is different from his role as consumer, and his role as seller is different from his role as producer. Prevailing economics does not recognize the entrepreneurial nature of buying and selling. It confuses production with selling and consumption with buying. 87

20.4 Legitimacy, Entry and Exit The opposite or obverse side of entrepreneurship is transaction cost, and legitimacy is one of the elements of transaction cost. Competition involves work with respect to legitimization 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 give monopoly power to some individual and prevent others form competition. Competitors are people who also would like to earn a profit by selling the same product to the same customers, but at a price low enough to lure away the customer. Had economist been clear about the idea of legitimacy, they would have studied the mater of entry and exist as an institutional feature of the market. The state and legal authorities have some work to do with respect to empowering potential competitors. The right of entry to the market is ideally fully valuable to anybody who would like to compete. One who lose sin competition because as a seller he fails to make a profit by offering 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 to entry and exit. The progress has been little worth noting, because the starting point is missing: fame theory does not see the institution behind the right of entry and the pressure to exit. Many businesses enjoy some degree of monopoly because authorities help them prevent competitors from entering the market by way of legitimization hurdles. Some competitors are not given trade licenses. Others are burdened with unduly harsh entry qualifications. For example, any body that is willing to lose his money by importing something is fully qualified to be an importer, but the government may add arbitrary and unreasonable 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, licenses were issued on political favor. The opponent of a political regime would not be given the legitimacy to compete. 20.5 Perfect Competition versus non-competition Prevailing economics is fond of the idea of perfect competition, which is something without a corresponding reality, and is an entirely fictitious matter. Perfect competition is d said to exist for a given good if all buyers and sellers have full information about all other competing buyers and sellers. In such a situation, no seller is able to charge a price higher than any other seller, and no seller has any reason to offer a lower price. The idea is 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 outcome is the result of not thinking of the market as market at all, but of confusing subsistence with exchange. A producer who does not sell the good to anybody but only to himself must necessarily n sell it at a price equal to marginal cost. This has nothing to do with the market. In a market, people who buy the good instead of producing it do so because they incur 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.

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Questions 30. 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 many different 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 called monopsony. Competition is neither monopoly nor monopsony. No seller has full control over the market, but must compete with other sellers to take only a share of the sales, just like customers must also compete with buyers to gain a share of product. Traditional theory has reached the theorem that under perfect competition, the output of the good is the maximum, and the price of the good at that level is the minimum. It is equal to marginal cost of production, and obviously the price cannot be any lower because 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 possible price. The monopolist cannot charge an infinitely high price to get all the income of the buyers 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 equal to the highest level of consumer utility. From this comparison, economists argue that monopoly should be prevented to increase social welfare, which will come from a larger real output available at a lower price. 31. What would you do to improve competition in Bangladesh? Improving competition in Bangladesh requires a strict decision to open the market to all who would like to compete. Trade licensing should be made open to all, subject only to reporting 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: most people have no access to institutional credit, and they do not have bank accounts and abilities to get money against the stock of their inventory of goods. To permit competition at full swing, it is necessary to enable all potential sellers to get unhindered access to money and credit. Information plays a very crucial role in competition. While the burden of providing information really belongs to the sellers who need to inform the potential buyers, the state should also provide information to potential buyers to protect them form deceptive advertising and other market crimes. In addition the government should promote the wide dissemination 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 to compete.

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32. What is the biggest obstacle towards competition? What would you do about it in Bangladesh? See 31 above. The biggest obstacle towards competition in Bangladesh is the lack of access to money and credit. People must have access to capital and money to undertake production and selling. The microcredit experiment in Bangladesh broke the old barrier, and made credit in small amounts available to many people who e were otherwise unable to compete as producers. To set up shop or business also requires capital and credit. The most desperate competitors who would truly sell at the lowest possible price are shut out of the market. Ye the whole idea of credit is that they deserve to get credit and they are credit worthy, namely, if they could get the credit, they could utilize it productively and pay it back. The heart of the problem is perpetual shortage of liquidity or low financial depth. Goods must be sold for money and not directly through barter. The creation of money is nearly costless, and yet the shortage of money means that the bulk of our poor producers are unable to undertake production and marketing because the little money there is moves very slowly. One of the necessary methods of raising incomes of the poor is to increase the prices of their products, and that cannot happen without incretions the supply of money and enabling a tolerable degree of inflation. Low price means that many producers are unable to survive at that low price: it just does not give them enough income. In short, the supply of money must go up reasonably to ensure full employment and permit full competition.

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21 Monopoly, Oligopoly, Imperfect Competition 21.1 The Competitive Struictur of the market 21.2 Monopoly 21.3 Oligopoly 21.4 Imperfect Competition 21.5 Perfect Competition 21.6 Monopoly 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. If there 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 a syndicate 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 degree of control on some customers. If they could exercise no control, it would become perfect competition. Perfect Competition Perfect competition occurs when there are many sellers and no individual seller has any control or influence on the price. Effectively, they are forced to become price takers, who follow 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 entrepreneurially to give rise to competition: they must seek to seize available opportunities for profit and must also bear the risk of losing the same.

Questions Criticize the concept of perfect competition The traditional concept of perfect competition fails to consider the entrepreneurial basis of competition. It looks at it from the viewpoint of optimization, which is the negation of entrepreneurship. 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 no real life example of perfect competition of this nature. The model is unrealistic and not worthy of any serious attention. But this model is the core of prevailing price theory on the presumed existence 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 leave them and go to competitors. They also have no reason to reduce the price even slightly,

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because at the same price, they can get as many customers as they want. From this, they think 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 a markup 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 fact a 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. Accounting is right. Traditional economists make this lame excuse because they do not understand the difference between production and selling. It is factually false to say that merchants make no profit in equilibrium. They are talking about an imaginary market that does not exist and 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 to the second nearest, because there is additional transaction cost of organizing his buying. Price discrimination occurs, and remains a possibility because the customers are not identical in terms of all elements of transaction cost even if they all have the same information. Indeed, real customers do not have the same information either. Thus even in the most thoroughly competitive retail rice market, with millions of sellers and readily available information on prices for whomever wants to hear, the sellers and buyers engage 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 no reason 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 neighborhood all affect the prices so that prices are not the same throughout the market. To suppose that it is the same is to deny the difference in the location involves difference in transport cost, and that some areas are oversupplied while some others are undersupplied relative to demand. Most importantly, each pair of buyer and seller brings different costs and preferences 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 a myth. Of course sellers always want to raise prices, and all professions are syndicated, such as teachers collectively striking for a pay raise, or government employees complaining to the wage board and so on. The issue however is that sellers alone cannot raise the prices unless buyers are prepared to pay higher prices. The theoretical problem is between the interpretations of high price versus higher price. If a syndicate exists, it will ask the highest possible price at the outset, and it cannot raise it any higher. Why would the syndicate raise the price during the Ramadan and then reduce it later: do they suddenly become good people devoid of greed?

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The existence of syndicates in Bangladesh is very largely a creation of the government, which restricts licenses only to few politically favored businessmen. The restrictive 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 competing to sell the stuff. Prices of all other goods and services have increased by leaps and bounds but the prices of food items have increased very slowly. Medical, educational and legal services, for example, are certainly essential, but nobody says anything about the murderous fees doctors are charging, which is many times higher than it was 40 years ago, and yet nobody mentions it. This is a very unfair stand taken by the elite who have freely 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 politically motivated conspiracy against farmers. It is a conspiracy against the largest number of producers, 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 in Bangladesh 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, and tax 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 the price. The government is a political entity which may for political motives take the side of either the buyer or the seller in a price battle. Any change in price affects the buyers and sellers in opposite ways. If the government takes the sides of the consumer to keep the price low, it unjustly hurts the producer by refusing to give them high enough price to justify sufficient supply. Thus when the government fixes rents, the builders of rental houses suffer losses and stop building more houses, exacerbating the housing problem. It permits corruption because there are few houses and a lot of applicants who want them. A wholly unnecessary army of bureaucrats feed upon the helpless public, and years pass by before one can get a low rent house. It creates homelessness just because there are not enough homes. The government may also take the side of the producer and hurt the consumer. One of the oldest robberies on the consumers is done in the name of protection of domestic industry against foreign competition. Foreigners are forbidden or restricted to offer the same good at lower prices or goods of better quality at the same price. The domestic producers have the customers as captives to them, like prisoners. The customers end up paying excessive prices for shoddy products. Protection has always hurt economic growth, because once protected the monopolistic or oligopolistic domestic producers do not increase supply or improve quality. For example, the energy crisis in Bangladesh is almost entirely the outcome of restricting private and foreign production of electricity. The state-owned electricity producer has no interest in increasing supply: it can deny electricity to customers and undertake load shedding, while free to carry on massive corruption as monopolists. Once again, price control is really the royal road to corruption.

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The political argument that domestic producers have a superior right to sell the goods even if they hurt the customers is a sentiment that hurts the voiceless public as consumers, to allow a few dishonest people rob them. The so-called national producers are not friends of the nation at all, because they refuse to increase supply and improve quality 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 helpless customers. Price control always supports the enemies of the people.

22

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22 Market Efficiency, Failure, and Intervention 22.1

Market: Mechanism or Institution? 22.2

Judging Market Efficiency

22.3

Efficnet market Hypothesis 22.4

22.5

Market Failure

Market Intervention

22.6 Market Liberation Market Efficiency The term market efficiency is a misnomer; it is the result of not understanding that the market is not a machine and it is not possible to judge its efficiency or lack of it. What is the market supposed to do if it is efficient? Nobody knows the answer, and the idea remains 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 market one individual or a defined group that acts as one individual? No. How do we know that the market has acted efficiently? Fama thinks that if the investor cannot do any better than others to predict the market, he is unable to make fuller or more efficient use of information. This iffy suggestion begs the question: is there any evidence that investors who have made billions in the stock market are unable to make buying and selling decisions to improve their wealth position? No, they are not unable at all. They have improved their positions. On the whole, the value of the same stocks has increased vastly over the years. The hypothesis is confusing reality with a hypothetical situation and has no use. The market is a social institution in which many people interact. As soon as one recognizes interactions of many people the issue of efficiency becomes meaningless. Is there a meaningful sense of the term ‘efficient interaction’? No, because each instance of interaction will have a different outcome depending on the individuals. The market interaction involves a conflict of interest: buyers want to pay a low price to reduce expenditure while sellers want to raise the price to increase income. There is no way 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 are sore losers who work profitlessly? Or is the market efficient when the price is equal to marginal benefit, meaning that customers are driven to the wall to pay the highest possible price, and hence have no reason to buy rather than produce it? What is the efficient outcome: should producers lose profits or customers lose benefits? The problem is that people did not think of pricing as entrepreneurial behavior, a continuous process of bargain, sometimes gaining a little and sometimes losing a little in the bargain. It has nothing to do with market efficiency. 95

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 of economics is to explain whatever happens in the market and not to whine that the market fails 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 anything nor 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 the one that has no reason to change. Therefore price flexibility, which is the actual observed feature of any real market, seems to mean that the market fails. The presence of unemployment is a serious issue and here again the thinker is confused: unemployment has reason and there is no theory of unemployment to identify the reason (except 2003 book 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 in the 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 prices are changing, one must look at the money supply behind it and the causal changes in incomes, productivities, and costs. People who think that the market fails are the ones who fail to think why and how the market events occur. They have no good reason to expect the market to do something that does not actually happen. Making prices stable or ensuring full employment is not the duty of the market. There is a process of interaction between buyers and sellers, and the process may be hampered by certain causal factors from attaining full employment or price stability. In short, it is useless to claim that the market is efficient and does not fail, or that it fails. These statements have no useful meaning because nobody has been able to say what the market is supposed to do. Therefore they have no ability to say whether the market has done what is was supposed to do, or failed to do so. Thus people who expect the market to set a stable price do not understand price determination and the bargain process that 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 what determines 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 the detriment of the other side. This is always harmful and counterproductive. It takes away the right of one party to engage in a bargain. Thus when the government intervenes on behalf of buyers to control the price of food and keep it to low compared to when there is no intervention, it definitely hurts producers who are punished. Their right to ask for a price high enough to maintain their income or increase income is denied to them. In the opposite case, when the government intervenes on behalf of the producers, the consumers are denied the right to buy from the cheapest source. Market liberation is the opposite of market intervention. It is the act of rescuing victims. Thus when there is monopoly and many competent producers are not allowed to enter the market, the market liberation would enable the hitherto barred competitors to

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enter the market, increase the supply and lure away captive customer victims of the monopolist. Market liberation is the most challenging task for the government in the poor countries where the financial sector is repressed. Financial repression is the result of excessive restriction on financial intermediation, and hence of monopoly. This allows the banks and other financial intermediaries to completely refuse any service to the majority of the people, especially the poor. Without access to financial services, the poor are unable to increase production and employment. The market must be liberated from this repression. All adults should be given access to financial services, with the right to borrow money against their stock of output. They should also get priority as borrowers in case of loans necessary to create self-employment of individuals or groups.

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23 Firms, Externalities, and Social Choice 35 What is the Coasian theme of firms as organizers of production? Read http://en.wikipedia.org/wiki/Ronald_Coase Ronald Coase thinks of a firm as an organization that reduces transaction costs by internalizing externalities. An externality is created when the action of one individual creates benefits (and costs) for another individual. For example, when a new girl joins the existing ones as a sewing operator, she increases the supply of stitched fabric or garments and 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 to reap part f the benefit she has created for the others: it remains external and inaccessible to her. But when she joins the firm as a member of its workforce, she can h earns a higher salary, because the buyer is now another member of the organization. The other buyers would iron and package the shirts and still others would transport them to the port, and another gang would export them, and still others would process the bank operations associated 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.htm What has become known as the Coase Theorem is the proposition that in the absence of transactions cost the level of production of goods or services in an industry in which there are externalities is independent of whether or not the party who perpetrates negative externalities is legally liable for the costs of the externalities on other parties. The income distribution does of course depend upon whether or not the perpetrator is liable, but that is a different matter. To illustrate Coase Theorem suppose there is a railway that runs coal-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 of running trains on a line next to a farming area is as follows: Number of trains Private Costs Crop Damage Social Cost per day 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 is required for crop damage? This question can be answered by comparing the revenue to the private costs and finding the number of runs which give the maximum difference between revenue and private costs; i.e.,

Number of trains

Revenue

Private Costs

Profit

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per day 1 2 3 4 5 6

$350 $700 $1050 $1400 $1750 $2100

$100 $200 $400 $700 $1100 $1600

$250 $500 $650 $700 $650 $500

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

Number of trains per day 1 2 3 4 5 6

Revenue

Private Costs + Damage Costs

Profit

$350 $700 $1050 $1400 $1750 $2100

$300 $600 $1000 $1500 $2100 $2800

$50 $100 $50 -$100 -$350 -$700

As the above table shows the maximum profit for the railway company is achieved with 2 runs per day. The profit of the railway company corresponds to the net social benefit of running the trains. In this case it makes a great deal of difference (in terms of the number of trains run) as to whether the railway company is liable for the crop damage. Two trains per day is the socially optimal number of train runs, but four trains seem to be what would occur in the absence of legal liability concerning the crop damage. What Ronald Coase did was to examine what alternatives there might be to government-enforced legal liability to deal with the externality problem. Coase suggested that the farmers could pay the railway not to run trains. To keep matters simple suppose the farmers told the railway that they would be will to pay the railway $1200 not to run any trains and deduct $200 from this payment for every train run. The revenue to the railway would consist of the revenue made from operating the trains plus the payment received from the farmers. The profitability picture for the railway would be as follows: Number of trains per day

Revenue

0 1 2 3 4 5 6

$0 $350 $700 $1050 $1400 $1750 $2100

Payment from farmers $0 $100 $200 $400 $700 $1100 $1600

Private Costs

Profit

$1200 $1000 $800 $600 $400 $200 $0

$1200 $1250 $1300 $1250 $1100 $850 $500

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

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of Coase Theorem: The same levels of production are achieved whether the perpetrator of the negative externalities is legally liable for the externality costs or is the victims of the negative externalities make a payment to the perpetrator that is reduced by the amounts of the externalities. Note that the level of production of crops is determined as well as the number 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 socially optimal. Of course the profits of the farmers and the railway are drastically different depending upon whether the railway is legally liable for crop damage. The above illustration made use of the total revenues and total costs, both private and external. The quicker method to determine the number of train runs that would be most profitable uses the marginal revenues and marginal costs. These marginal quantities are shown below: Number of trains 1 2 3 4 5 6

Marginal Revenue $350 $350 $350 $350 $350 $350

Marginal Private Costs $100 $200 $300 $400 $500 $600

Marginal Crop Damage $200 $200 $200 $200 $200 $200

Marginal Social Cost $300 $400 $500 $600 $700 $800

If the marginal revenue at n runs per day is greater than the marginal costs at n then the total profit is higher at n+1 runs than it is at n runs. On the other hand, if the marginal revenue at n runs per 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 railway company's profit is higher at 4 runs than at 3. But at 4 runs the marginal revenue of $350 is less than the marginal runs the marginal private cost of $400 so the profit is higher at 4 runs than it is at 5. Therefore the maximum profit occurs at 4 runs per day. Finding the maximum profit level of production is a matter in this case of finding a level at which the marginal cost switches from being 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 is greater than the marginal revenue of $350 therefore 3 per day is a more profitable level of operation than 4. However in this case the marginal revenue of $350 at 2 runs is less than the marginal cost of $400 therefore 2 runs is more profitable than 3 runs. The marginal cost at 1 run per day $300 is less than the marginal revenue of $350 therefore 2 runs per day is more profitable than 1 run per day.

Questions 37 Distinguish social choice in a barter context from individual choice in subsistence context.

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In the barter context, two individuals form a society to make a social choice on the kinds and quantities of two goods that they will exchange. Suppose that the exchange is between two goods x and y between two individuals Ali and Baby. While Ali alone decides how much x to buy, and hence the quantity demanded is the result of individual choice, Ali’s 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 to allocate the resources to production and allocates the income to consumption without consultation or agreement with anybody else. In an allocation, there is substitution but no exchange. This if Ali is a subsistence producer of two goods x and y, he must be an optimizer. Given his preferences, he will decide how much x and y to consume, having measured his income in view of his own ability to produce them. And then he will generate 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 utility and equal marginal cost can be substituted at the margin of decision. But the whole point of 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 no opportunity to gain anything: he merely allocates what he already has, first in the form of resources for production, and then converted into products for consumption. But social choice in exchange is entrepreneurial: each agent must seek to gain something from exchange, 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 even though he wants to consume x, and this is an entrepreneurial risk: he will be a loser if he fails to sell y and buy x, because he prefers x to y and yet produces y instead of producing x. The second distinction is that individual choice is linearly consistent but social choice is linearly inconsistent. If x and y are put on a line to measure relative utility, then Ali prefers x to y while Baby prefers y to x. Social choice is impossible without this linear inconsistency: one must sell what the other must buy and vice versa. Both cannot sell the same 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 the members of society intend to interchange. Each persons produces something he does not want to consume, and consumes something he does not produce, just the opposite of individual choice where each subsistence producer produces precisely what he intends to consume. Social choice must be based on agreement. On each element of the exchange, namely the kinds and quantities of both the first and the second good must be agreed upon by both parties, one being the buyer and the other being the seller. No exchange is possible if either the buyer or the seller refuses. Note: Prevailing economics never heard of agreement. Game theory models try to discuss social choice based on disagreement, such in case of prisoner’s dilemma: each part tries to harm the other. The fundamental problem is that rationality has been defined

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too narrowly such that if x is preferred to y, y cannot be preferred to x, as it will be inconsistent. But social choice is necessarily inconsistent. If Ali sells y to buy x, he must prefer x to y while the seller of x and buyer of y must do the opposite: he must prefer y to x. 39 Explain why exchange agreement is based on preference disagreement. The greatest drama of life is that agreement is based on disagreement over objects of exchange. Suppose that Ali has produced some y and Baby has produced some x. If they could 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 in production costs. First let us consider what happens if they have the same preference. Suppose that both Ali and Baby prefer x to y. This preference means that x gives more t utility than y. If both Ali and Baby prefer x to y, none will want to take y in exchange for x and suffer a loss of untidy: both will want x. In that case, there will be no demand for y at all. But as the producer 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 of endowment or production here: though Ali prefers y, he has produced x (which he dislikes compared to y) and though Baby wants x, she actually has less preferred y. Then they can gain if they exchange x for y: Ali will get more utility from x in exchange for the 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, there is no opportunity for pure gain from exchange. In that people have no reason to produce what they do not want to consume, and to consume what they do not produce. If all people prefer x to y, all will produce x and no y, and they will consume x but there will be no exchange. Note: For traditional people, this paradox is extremely hard to grasp. It seems that they have never even bothered to notice the paradox: why do people produce what they do not want to consume, and why do they not produce what they want to consume? The old answer (but without full explanation) is that they do so to make pure gains in utility (or income). 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: in micro models, equilibrium occurs when marginal cost is equal to marginal revenue, or the price 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 up one thing with another. They mix up optimization, which applies only to an isolated individual who has no option to engage in trade with entrepreneurship. Exchange occurs because entrepreneurs discover opportunities to get something better through buying rather than through production. They find out the dramatic possibility: the best way to get sari is to produce rice and exchange the rice for sari. Traditional economists cannot understand entrepreneurship at all. 40 *What is consistency of choice? Explain consistency for individual and social choice.

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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. It will 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 one must prefer x to z. This can be shown p by drawing a line, and putting x, y and z on utility scale: x has higher utility than y, and y has higher utility than z. In this case it is impossible for z to have higher utility than x, because x is at the top, below which is y and the bottom has z. Hence this can be called linear consistency. Consistency in social choice however cannot be shown by a line, which moves in only one direction. An exchange has movement in two directions: Ali’s y goes to Baby, and Baby’s x goes to Ali. To show reverse movement, it is useful to draw a circle, in which the clockwise movement shows Ali’s goods going to Baby and the counterclockwise movement shows Baby’s good going to Ali. Consistency in this case involves opposition 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 other way round: one must buy what the other must sell. 41 *Disprove Arrow’s Impossibility Theorem. Kenneth Arrow won the Nobel Prize partly for his very famous theorem named after him: Arrow’s impossibility Theorem. The gist of this theorem is that social choice is impossible. It is extremely strange. In reality, exchange occurs and buyers and sellers do make social agreements, and Arrow says that it is impossible. All economists accept Arrow without seeing the flaws at all. It is very easy to disprove Arrow by considering barter. A more elaborate disproof will consider three goods to match his example. (See handout titled: Though Arrow Says It Is Impossible. It Happens Everyday) Suppose that Ali has y and Baby has x. Suppose that Ali prefers x to y while baby prefers y to x. Then if Ali gives y to Baby and gets x from her in exchange, both will gain, 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 than from x. If they both have the same preference order, they will not undertake exchange as there will be no gain. Thus if both prefer x to y, both will produce x and not produce y: nobody will buy y at the expose of x. In the opposite case, if both prefer y to x, both will produce y 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 that Arrow did not think either of allocation or of exchange at all when he thought of social choice. His example goes like this: suppose that Ali and Baby prefer x to y, Baby and Charu prefer y to z, and Charu and Ali prefer z to x. Can the three people make a social choice? The answer is obvious to him: no they cannot, because if the majority (2 out of 3 people) 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 is inconsistent.

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Now, Arrow is not talking of allocation. Had there been allocation, the choice would be absurd. Why would Ali, Baby and Charu decide what to produce? Do they have budgets, or are they getting the thing for free? If they have budgets, it is very simple. Ali prefers z to x, and x to y, so he will produce x with his whole budget. Baby prefers x to y and 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 three people must make one choice, without any mention of budget is entirely frivolous and absurd. People do not ever face such choices. If there is exchange, then the choice is also very clear. Entrepreneurs are people who have an endowment anomaly: they have what they do not like and they do not have what they like. Thus Ali has x, but he prefers z to x, ( and he dislikes y as he prefers x to y), so he will gladly give up x to buy z. Charu prefers y over other goods and she will gladly take y in exchange for z that she has. Lastly, Baby has y, but prefers x, and she will gladly take 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 does not 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 a statement contradicts facts, reject it. Then check logic. If it makes no logical sense reject it. Reject Arrow first because his theorem ifs factually false. How can any sane person believe this nonsense that social choice is not possible? If not possible, how are people making agreements? Next, reject his theorem because it is illogical. It is illogical for anybody calling himself an economist to propose a choice without a budget. Do people ever have a choice between x, y and z where they don’t have to pay anything? And he is illogical because he does not at all consider exchange: in exchange, things go from one to another just precisely because people get rid of what they like less in order to get what h they 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 believe anything without factual proof. Even more so, do not believe yourself without proof: your mind is your most dangerous enemy: it lazily forms false intuition all the time. Make your brain do the work to learn about the real world, do not let it just come to a conclusion without data and without analysis. Secondly, when you decide something, consider all pertinent details. Do not ride a bus without knowing where it is going. People will try to fool you by telling absurd stories every day: be careful, check out before you trust them. Think, then think some more and rethink.

Good Luck

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