The Fundamental Problem of Economics The fundamental problem of economics is that of coordination of the dispersed and disparate activities

of millions of people pursuing their own goals in isolation from each other to generate order out of potential anarchy. Modes of coordination: 1. Command and obedience Central planning. Examples of smaller command systems. Central planning involves Collection of information. Costly and inefficient because of (a) volume of information required

(multiplies exponentially with size of economy) (b) need for agents who strategically distort reports to the principal to serve their private agendas (agency or principal-agent problem); Central processing and decision-making. Costly and inefficient because of (a) sheer volume of info, (b) problem of aggregating clashing opinions and preferences of central planners into a collectively rational set of decisions (Arrows Impossibility Theorem example Paradox of voting); Enforcement. Requires sanctions to punish deviants and an army of spies/policemen to report if people are complying with central commands and to discipline those who are not. Costly because these agents have to be diverted from productive activity. Inefficient because who will police the police? 2. The competitive price system The competitive market bypasses the information requirements of the command economy. Uses market price as the signal that conveys to everyone the minimum information he requires about external circumstances to make his own decisions (the other info he needs is his private information about his own tastes, capabilities etc of which he is the best judge). Everyone then decides by himself what he should do. Order in the market achieved through isolated individual action based on the price (the invisible hand). Question: How? Eliminates all three costs of a command system. However market transactions have their own transaction costs of: Search Negotiation/contracting Enforcement,

Search and contracting costs minimized by market which creates incentives for intermediaries to specialize in these functions (brokers, lawyers, accountants). But enforcement outside the purview of the market which lacks any coercive authority. Thus, without the infrastructure of coercive powers provided by the state, contracts cannot be enforced and the market cannot survive. Property rights, private and public goods More generally, market transactions consist of exchange of property rights the right of exclusive control over particular objects. If I cannot restrict the access of others to a good under current technology, it cannot become private property: so I cannot sell it and will not produce it for the market.

Distimction between private goods (excludable, therefore appropriable) and public goods (non-excludable). Examples of public goods: Law and order Defence Public health and civic hygiene Environmental protection Roads (not highways with tolls) Flood control Lighthouses.

Q. Why is each a public good? These constitute the economic basis of the state. Some goods are non-excludable but benefit only a subset of the individuals in society (eg.wage/price increases achieved by unions/cartels). Organizations that produce such goods face a free rider problem. They need some means of forcing their members to share the costs of their activities. Their strength depends on access to such means. Some public goods are not producible but exhaustible (natural resource goods), eg fish in open waters. Since it is impossible to restrict access to them, they tend to be overexploited and therefore depleted ( the tragedy of the commons). A common error is to describe public goods as non-rivalrous goods such that the amount consumable by one person is not diminished by the consumption of another (eg. viewership of a movie). Such goods are club goods: consumption by one club member does not affect what is consumable by another. However, entry to the club can certainly be restricted to those who pay for it. Coases Theorem Public goods (or bads) involve externalities discrepancies between the private or internal benefits (or costs) of an individual and the external benefits (or costs) simultaneously created for others. However, Coases Theorem asserts that the market always generates an incentive for a transfer of properties that would internalize any externality. Example : flood control. Q. How does Coases T work here? Qualification: the theorem assumes that the transaction cost of the transfer of properties is negligible. Not true in the flood control case because of the huge number of transactions needed and the possibility of hold-outs. However, for one-on-one transactions, Coases theorem works well.