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Analyzing Policy: Efficiency

Posted by Giorgio Tomassetti on 21:48 in , ,
This is a summary of chapter three of  the book Analyzing Policy: Choices, Conflicts, and Practice” by Munger, which is about the efficiency of the market.

The author defines a market as a set of institutions, rules or informal norms, that promote exchange. In order for a market to exist, people have to have diverse preferences and diverse endowments. Also, economies of scale and specialization should be a reality.
The reason why markets have been very successful in organizing complex human activities is because they are usually very efficient. Also, markets allow a reduction of transaction costs and the gains from trade result in improved welfare for all participants.
As Aristotle points out, money doesn’t necessarily mean wealth, but money represent all other commodities and they are efficient because they reduce transaction costs of the exchange.
When talking about markets it is important to consider the concept of opportunity cost, which is the benefits you could have received by taking an alternative action. In the chapter Munger discusses a case study in which students have to choose between selling some tickets they found on the sidewalk, or use them and go to the concert. To answer this question we need to consider not much the real price of the ticket, but the its opportunity cost. Another important concept in this unit is scarcity, which implies a desire for a good or service. Without scarcity there would not be trade.

Munger also identifies the sources of market inefficiency, one of which is the so called “Pingou’s conjecture”; here the inefficiency derives from the overuse or underuse of the resource. The solution would be having the opportunity cost as close as possible to the price of the resource. The other source of market inefficiency is the “Coases’s counter-conjecture”.

According to the author there are four mechanisms for dealing with scarce resources.

  • Price system (markets). Markets are considered very efficient mainly because they offer information through prices and they are able to align the self-interest of the individual with the collective interest of the society by using incentives. Also, they are able to maximise the value of resources.
  • Queing. Queing favor those who have time to spend in line and ultimately wastes these people’s time. It is also not an efficient system.
  • Chance. Everyone is traded the same and this might feel fair to some people, but the allocation of the resources is random and this usually results in inefficiency.
  • Authority. This system favors those who are in power and those who are close to them and this means that corruption and favoritism are very likely.

In terms of information, prices are able to signal scarcity and determine wealth.
Munger also describes in this chapter the advantages of a simple barter economy and he does that with the use of the Edgeworth Box where the indifference curves represent people’s preferences. The equilibrium point is where the indifference curves are tangent to each other, even though all points on the contract curve (the set of potential equilibrium points) are Pareto optima.
After stating the advantages of a barter economy, Munger introduces the function and the advantages of using money as an accepted medium of exchange. First of all, the use of money reduces transaction costs. Indeed money are both a unit of account and a store of value since they do not easily deteriorate.
In the last part of the chapter the author lists the characteristics of a good currency, such as being widely accepted and durable.

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