The Market and the Division of Labor

Coase and Ricardo

Where we are….

• We have been talking about the market system (group of institutions) as one form of resource allocation (the economy part of political economy) tight connections between property and liberty –property rights: Lindbloom definition

• Resources allocated on a free, quid pro quo basis—voluntary transactions

• Efficiency is achieved through the mechanism of human rationality and self-interest---we want the most for the least cost and effort ….achieved also by reducing transaction costs in exchange (how? Money, intermediaries, impartiality=blindness)

What IS the role of cooperation then? Why talk about cooperation when we are dissecting liberalism?

• I thought that Cooperation is not necessary for this system…just mutual adjustment–• What if Competition is sub-optimal--You get more meat by all chasing the stag together• But if you are rational, your incentives to cooperate are low because

– reduce your own freedom– You increase your own risk (we all want to be free, but we don’t like to take risks)

• reasons cooperation might be necessary in a market system:– Reduce fraud and cheating

• If we want the most through the least effort (freedom without risk, we are tempted to cheat (fraud, monopolies)• Cheating undermines the competitive market• You won’t ruin sports if everyone cooperates to reject doping

– Mitigate externalities• You can mitigate climate change if everyone cooperates to do so

– You need cooperation to create Trust. Why?• Trust is necessary for efficient exchange because it reduces transaction costs – if I don’t trust you, I won’t exchange with

you voluntarily. I don’t trust you because I know you are as rational and self-interested as I am I can’t risk that. • Trust lowers your perception of risk• Trust is easy in small groups where people know each other, interact frequently, have a future together• Harder in large groups like a market where impersonality rules (and rightly so, because the market encourages efficiency

through impartiality

So……You gotta have trust but it’s hard to get

• it is very hard to move from the low-trust situation, in which both prisoners confess, each hunter chases his own rabbits, --or everyone drives their car as much as they want---to the more trusting situation, in which both team up to get a light sentence, to bring down the stag—or everyone together stops climate change.

Breakdown of Trust causes market failure

• Trust reduces our “transaction costs” in groups

• That’s why we have institutions to help create cooperation

• institutions formalize trust and thus dramatically expand our ability to interact with those beyond our immediate neighbors.

• That’s why we have laws and law enforcement

• the U..S. government (an institution) decided to “bail out” the financial system when the market broke down

• It is a way to bring back trust.• Markets sometimes “fail” at coordinating economic activity

Trust

↑Failure Of TrustLots of anxiety

TrustProsperity Phase

So if cooperation is needed, even in a market system, how do you get it?

Any move to the high-trust environment is going to require its own, possibly costly, attempt at coordination.

Governments coordinate economic activity when uncoordinated markets “fail”

•Prosperity•Transition•Trough•Recovery

?

Governemt“bailout

But are governments really the best solution to cooperation in large groups?

Some liberals say No: Governments don’t have good information and they make big mistakes

Take this example• :• Pesticide Drift and the Coase Theorem• Two farms are next to each other. The brussels sprouts farm uses pesticides; the herb farm is seeking

organic certification. When the pesticide is deployed, the wind or fog may blow pesticide onto the herb farm, destroying its organic status. What result?

• According to this article, $1M in damages to the organic farm. At the same time, there is apparently a California code that says a pesticide user's responsibility ends as soon as the chemicals are deployed, and a county investigation exonerated the brussels sprouts farm of wrongdoing.

• So what gives? This seems like a classic application of the Coase Theorem, which says it shouldn't matter if the brussels sprouts farm has the entitlement to deploy pesticide or the herb farm has the entitlement to run an organic farm without worrying about pesticide drift because the parties will bargain with each other to achieve an efficient outcome. However, it's interesting to see that California law expressly gives the entitlement to brussels sprouts farm, privileging chemical use over organic farming. Sounds like maybe a little rent-seeking took place.

Herb Farm that wants organic certification

Brussels Sprouts farmer using pesticides

Coase Theorem

• . So, for example, I should have the right and freedom to play my piano whenever I want, but my neighbor has a right to peace and quiet. According to this theorem, if people could bargain at low cost, there would be no problem of externalities and, indeed, the outcome would be the same no matter who had the rights

• Or we could use the market to solve the problem• My neighbor calculates what his peace and quiet is worth and how much he is

willing to pay me for it• I calculate the cost of restrictions on my playing• We come to an agreement on the price of peace and quiet• And my neighbor pays me to restrict the times I’m allowed to play

Information can create trust

The problem with strategic action in an impersonal market is that it lacks a basis of trust:

Action

↑ ↑

Desires←Beliefs

↓ ↕

Information (Elster)

Let’s look again at the problem of illegal drugs and try to bring all these things together

Illegal drug trade represents a total breakdown of trust

• No enforced laws to create rational exchange, prevent externalities, prevent fraud and monopolies, provide good information

• It’s rationality gone wild!• By trying to PREVENT a market for addictive

drugs, the state does the opposite: creates externalities, creates monopolies, represses good information…

• Could the Coase Theorem help?

Supply is abundant…..

Production costs are low…..

Processing is easy and cheap….

Demand is High and steady despite illegality (repressed supply)

Market is large

Price should be low because production is cheap and demand high

• Assumption: price is determined by the quantity supplied and the quantity demanded

If supply and demand both become illegal….demand and supply are repressed,

raising the price

Risk of arrest, jail, destruction of supply

Illegality creates rational incentives to produce cocoa…..

Corn: $150 per acreLivestock: few $ per acreCocoa: $5-10,000 per acre

What crop would a rational farmer grow?

And it’s rational to sell it…..

So…applied to the drug trade: Illegality and high prices create drug lords with market monopoly. Monopoly

creates…..

Obscene profits for drug lords

At the very least, the state should legalize the drug trade because illegality leads to monopolies and

Monopolies oppose freedom

• Because they limit alternatives for consumers

• Because they block competitors from entering a market

• And therefore block freedom of exchange

And it gets worse: Govt. efforts to make the market illegal means using the military to try to get rid of the

market

And imposing Harsh Penalties for participating in the market

• Remember, the liberal believes that coercion in any form, by the state, is wrong. ---particularly whenever it can just as easily be replaced by voluntary exchange. Coercion cannot win the drug war without undermining human liberty and individual freedom.

And fostering corruption of law enforcement……

And creating a nightmare of jails filled with casual drug users…..

All adding up toGovernmentRepression of Freedom

So some Economic Liberals believe: The War on Drugs suppresses Freedom…

What would the Coase theorem say?

• When drugs are sold, we are in the presence of a voluntary transfer of property;• when the transfer is consensual, the risk of inefficiency is low because the parties are engaged in

interaction. • But the consumption and sale of drugs generate externalities that affect third parties. (what could those

be?: illnesses fostered by drug consumption, addiction leads to lack of productivity and responsibility etc.) Even if the two parties improve their circumstances in the course of a drugt exchange, they diminish the welfare of those who may have to suffer the consequences of consumption.

• Whose rights are more important? The rights of traders in the market or the rights of third parties to live in a world without drugs?

• The Coase theorem would say that drugs can be consumed but calls for compensation of victims in cases where drug consumption generates negative consequences for third parties. The parties should negotiate freely. Drug dealers must pay for addition treatment, just like cigarette manufacturers should pay for lung cancer treatment

Theory of Comparative Advantage

Specialization+

Trade

Production without specialization and division of Labor

Wine Cloth

England

3 5 (Total production =8)

Portugal

9 6 (Total production=15)

Total goods produced = 23

Production with specialization before trade

• Before Trade: Resources put where they are most efficient (specialization

Wine Cloth

England 1 10

Portugal 16 0

Total goods produced = 27 note: efficiency increases total number of goods available

With Specialization and Trade

Wine Cloth

England 5 6 (available goods =11)

Portugal 12 4 (available goods =16)

Total goods produced is still 27 but each country is better off than before trade and both are better off than before “efficiency”

England trades Portugal 4 units of cloth for 4 units of wineExchange rate is 1 to 1.

Assumptions of Ricardo’s Theory

• assumes static givens in a country’s economy

• and doesn’t discuss technology as a factor of production.

• labor theory of value

• What?

David Ricardo

Labor Theory of Value (smity)

• The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.(Wealth of Nations Book 1, chapter V)

Hechscher-Ohlin-Samuelson modernizes Ricardo

• This model maintains that a nation’s comparative advantage is determined by the relative abundance and most profitable combination of its several factors of production, such as capital, labor, resources, management, and technology.

Krugman expands on Hechscher-Olin and wins Nobel Prize

• Krugman noticed that the accepted model economists used to explain patterns of international trade did not fit the data.

– The Hecksher-Ohlin model predicted that trade would be based on such factors as the ratio of capital to labor, with "capital-rich" countries exporting capital-intensive goods and importing labor-intensive goods from "labor-rich" countries.

• Mr. Krugman noticed that most international trade takes place between countries with roughly the same ratio of capital to labor.

– The auto industry in capital-intensive Sweden, for example, exports cars to capital-intensive America, while Swedish consumers also import cars from America.

Paul Krugman Defends Free Trade

• "Ricardo's Difficult Idea,”

• People will specialize in producing the goods and services in which they have a comparative advantage.

• The result is that we never need to worry about low-wage countries competing us out of jobs;

• the most they can do is change those goods and services in which we have a comparative advantage.

Free Trade leads to growth in Exports

Krugman: Free Trade is the cause of economic development in poor countries

• “The raw fact is that every successful example of economic development this past century--every case of a poor nation that worked its way up to a more or less decent, or at least dramatically better, standard of living--has taken place via globalization; that is, by producing for the world market rather than trying for self-sufficiency.” (Krugman in Slate 1999)

Comparative Advantage is Dynamic

• While the United States has long imported oil and other raw materials from the third world, we used to import manufactured goods mainly from other rich countries like Canada, European nations and Japan.

• But recently we crossed an important watershed: we now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages (Krugman 2007)

Sum: Effects of Free Trade

• Efficiency Growth Good life for everyone• Harmonious International Relations• Role of the State: To let producers produce most

efficiently—to separate politics and economics: • the key actors for liberals are firms and

consumers, not states.• Commerce Peace Why? • Efficiency should be the basis of all political

relations• Does Free Trade make the state obsolete?