What Do Econ 1 Students Need to Remember Second Most from the Course?
What is the second most important thing for you come one student remember? It is how stringent the requirements for any form of "market efficiency" are: how many ways a market economy can go wrong and go badly wrong. I count seven ways that market economies can and do go badly wrong:
First, the market will go wrong if the wealth distribution is wrong. The market judges value by willingness to pay, and the rich are much more willing to pay them the poor, and those without wealth or income have no willingness to pay at all. If your wealth and income are zero, then the market literally does not care whether you live or die--it is of no interest to it at all.
Second, the market will go wrong if commodities do not have the proper characteristics. Remember: rivalry, excludability, and also information--people have to know what they are buying. An absence of or imperfect rivalry--increasing returns to scale in production or consumption of any sort--and the market will go wrong. An absence of or imperfect excludability--free-rider problems of any sort, or any failure of property rights definition or enforcement--and the market will go wrong. An absence of good information about exactly what you are buying or selling--adverse selection or moral hazard problems of any sort--and the market will go wrong.
Third, the market will go wrong if market agents do not take the prices at which they buy and sell as given but rather have some control over the prices at which they transact. The belief that the market is efficient hinges on the absence of market power--as well as on the proper income distribution, and on the proper characteristics of commodities.
Fourth, the market will go wrong if prices do not equalize quantities supplied and quantities demanded at every moment. "Price stickiness" for any sociological or psychological reasons disrupts the market's ability to function.
Fifth, the market will go wrong if Say's Law breaks down. If there is substantial downward pressure on spending on currently-produced goods and services because of an excess demand for financial assets of a kind that the private sector cannot immediately and instantaneously generate on a large scale, then the market will go wrong and we will have a downturn and a depression. If there is substantial upward pressure on spending on currently-produced goods and services because of an excess supply of financial assets of a kind that the private sector cannot immediately and instantaneously shed, then the market will go wrong and we will have a burst of inflation that will disrupt the functioning of the price system.
Sixth, the market will go wrong whenever its prices function as forecasting mechanisms. A proper forecasting mechanism would weigh each individual's opinion by the precision of his or her knowledge. A market tends on the contrary to weigh each individual's opinion by his or her wealth. This means that whenever economic processes tend to revert to seem average level that the market is likely to get things wrong, for when prices rise above average those who are optimistic become richer and their opinions carry more weight and so prices tend to rise further above their likely long-run fundamental values. Bubbles and crashes, manias and panics, are thus built into the system.
Seventh, the market will go wrong whenever individuals are bad judges of their own long-term interests--note that I say when, not if. Humans are very bad at assessing and dealing with risk. Humans are not that great at appropriately weighting different conflicting pieces of information. And humans are absolutely horrible at dealing with substances or patterns of behavior that can be addictive.
Whenever the system falls into any one of these seven arenas of psychological, behavioral, or institutional myopia and market failure, the market will go wrong. A good government will put its thumb on the scale in order to offset all of these seven forms of market failure. A great government will have foresight and take care to structure political-economic institutions to make these seven arenas of myopia and market failure as small as possible.
Remember this too. Keep it as an active process running on your wetware always. Lay up this idea in your heart and in your soul. Bind it for a sign upon your hand, that they may be as frontlets between your eyes. Teach it to your children when thou sittest in thine house, when thou walkest by the way, when thou liest down, and when thou risest up. And write them upon the door posts of thine house, and upon thy gates: that thy days and the days of thy children--or at least the commodities they own--may be multiplied.
