Jan 14 2008

When markets work…

Michael Munger, Bosses Don’t Wear Bunny Slippers, If Markets Are So Great, Why Are There Firms: Library of Economics and Liberty

The other day when we introduced our unit on market failure, we began by revisiting the concept of free markets as mechanisms for allocating scarce resources efficiently. As I was reading blogs tonight, I stumbled upon this blog post by Michael Munger, professor of political economy at Duke University, where he shares an anecdote he uses when introducing the allocating power of markets through the price mechanism:

When I teach political economy, I start with the neoclassical theory of consumption, and then cover production. And I show students how miraculous is it that the actions of millions of people who have never met can be directed by prices. Resources move toward their highest valued use, and consumption goods are delivered to the consumers who want them.

For example, the United States promoted ethanol as an auto fuel. This sharply increased the price of corn worldwide. As Brazilian reporter Kieran Gartlan put it: “Higher prices are leading Brazilian farmers to plant more second crop corn this year, and the country’s modest corn exports are expected to expand [from 42 million tonnes to 48 million tonnes, an increase of 230 million bushels.]” (DTN, March 2, 2007, emphasis mine).

No one directed the Brazilian farmers to shift to corn production. The article puts it perfectly: “Higher prices are leading farmers….” The leadership comes from the prices themselves! The farmers may have had no idea why the price of corn had increased, to $4.00 per bushel. (After all, Brazil uses sugar, not corn, to produce its ethanol.) But Brazilian corn production increased within a year, by nearly 15%. No one made the farmers switch; they made choices. Other corn producers, in Argentina, Mexico, and several African countries, followed suit. No one talked about it, no one gave any orders; prices led them.

The reason I post this excerpt from professor Munger’s blog now is that it serves as a great response to a student who on the first day of our market failure class posited that perhaps the government could do a better job of deciding what goods and services and how much of them should be produced in an economy.

Yes, markets fail, and for many reasons: a concentration of power among a few large firms, an underallocation of resources towards goods that have spillover benefits, the over-provision of goods that have spillover costs, the failure of the market to provide public goods: these are examples of how market fail.

But when markets work, they really work! The efficiency of resource allocation that results from free, competitive, markets is unrivaled by any central planning agency. Munger’s example above is a simple illustration of this allocative power of markets and prices.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

3 responses so far

3 Responses to “When markets work…”

  1. emilyyehon 14 Jan 2008 at 11:07 pm

    Normally it feels like everything we learn in economics has to be moderated in real life, it seems pretty cool that markets are really functioning solely on the concepts we learned in class. We're learning about socialism in AP Euro right now, which is the opposite of whats occurring in this article. This is a perfect example of the law of demand affecting the quantity supplied by producers. It also presents an example of how the demand for complimentary goods applies the supply.

  2. optional.xuon 14 Jan 2008 at 11:41 pm

    Yes, markets do really work… because everybody will be greedy. Greed in the end will make the day. Everybody will be worrying about how much they can get for themselves, and soon the Tragedy of the Commons will kick into play and the market will fail like no other as well.

    Can people switch from being greedy to being directed where resources are allocated in limited quantities such as the national park of Hardin?

    I have my doubts. Free market economics is the Tragedy of the Commons waiting to happen.

  3. Jo Loon 15 Jan 2008 at 9:59 pm

    Yo optional xu, the tragedy of the commons has already been kicked into play. The commons (land, water, air) are all already being polluted and have been for centuries. The world is running out of resources quickly but yet nothing really is being done to combat this (nothing that is making a huge difference).