Some Advantages of the Market

$ Simplicity of objective (profit).

$ Good at satisfying individual wants; responsive to demands: consumer sovereignty.

$ Adaptability/flexibility.

$ Innovation.

$ Lack of external political or policy meddling.

$ Tighter internal controls; more effective implementation.

$ Control over the employee incentive system.

Some Disadvantages of the Market

$ Ignores public or community interests.

$ Ignores disparities in original endowments; no mechanism of redistribution to the poor.

$ Transaction, information, and bargaining costs can cause it to fail to function effectively.

$ No mechanism for resolving disputes or conflicts of interest other than economic power.

$ Cannot protect employees lacking market power from exploitation.

Pareto optimality: Any trade that makes at least one actor better off while no other actor is harmed is a Pareto efficient transaction.

The Stakeholder Paradox:

Consumer sovereignty?

Shareholder sovereignty?

Some Forms of Market Failure

• Characteristics of goods Public or collective goods; the free rider problem. Demand for goods: congestion effects. Evaluating goods: search, experience, credence or trust goods.

• Characteristics of market participants Agent-principal information and judgment problems: adverse selction (adverse claims and adverse performance) and moral hazard.

Inability to evaluate risks; biases of social cognition.

• Characteristics of market structure or performance Externalities

Transaction, information, and bargaining costs

Monopoly (one seller); monopsony (one buyer)

Business cycles

Tulipomania

“The tulip next appeared, all over gay, But wanton, full of pride, and full of play; The world can’t show a dye but here has place; Nay, by new mixtures, she can change her face; Purple and gold are both beneath her care- The richest needlework she loves to wear; Her only study is to please the eye, And to outshine the rest in finery.” ~ Cowley

Carolus Clusius (1526-1609), hortulanus, or head botanist of the Hortus in Leiden, the first botanical garden in western Europe, introduced the tulip to Europe.

Tulipomania

Value of a Viceroy Tulip in 1636 (in florins):Two lasts of wheat.............. 448Four lasts of rye............... 558Four fat oxen................... 480Eight fat swine................. 240Twelve fat sheep................ 120Two hogsheads of wine........... 70Four tuns of beer............... 32Two tons of butter.............. 192One thousand lbs. of cheese..... 120A complete bed.................. 100A suit of clothes............... 8OA silver drinking cup........... 6O

Total: 2500 Passionale Tulip

Bubble as a Market Defect: Tulipomania

- Tulip comes to Holland from Turkey; scarce initially.

- Socially constructed value soars in a poorly informed social contagion; the commodity (the tulip) is seen as unique, scarce, nonsubstitutable.

- Futures markets appear for bulbs that are not yet grown; "wind" markets – speculation takes over. Investors plan to useexpected gains from futures to pay off present purchases, which are on credit, while still making huge profits from the run-up.

- Wealth floods in from investors ignorant of the characteristicsof the product, but greedy to gain quick wealth.

Bubbles burst when one or more of the following occur:

- Liquidity dries up – no more wealth to buy.- Commodity no longer seen as unique, or scarce, or nonsubstitutable.- Natural or scheduled deadlines force a resolution.- Intervention by government or other outside actors set rules or affect market behaviors so as to cause collapse.

The tulip market crashed in 1637 as traders found that the drying of liquidity and the poor availability of quality product, together with the natural deadlines of the growing season, conspired to burst the bubble.

Bubble of the 1990s: Federal Reserve Board Chairman Alan Greenspan calls it "irrational exuberance" in a 1996 speech.

Bubble of the early 2000s: the housing market. Greenspan calls it “froth;” avoids the “b” word, but the bubble bursts anyway.