I’m now coming up to (what I hope will be) the most challenging part of my book-in-progress, Economics in Two Lessons. The core theoretical point the first part of the book (Lesson 1) is that, under a set of ideal assumptions, competitive equilibrium prices both reflect and determine the opportunity costs faced by consumers and produces. This means that there is no way to rearrange consumption to make someone better off unless someone else is made worse off. (I’ve already mentioned my reasons for avoiding the term “Pareto-optimal” in this context.
What I’m trying to do here is to spell out the logic underlying these results in a way that foreshadows the discussion of market failure and income distribution, in Lesson 2, but still shows the power of market mechanisms. I’ll probably need a few goes at this, and this is my first try. Critical comments on everything from the underlying theory to editorial nitpicks are welcome. Sincere praise is also welcome of course, but constructive criticism is best of all.
Let’s restate Lesson 1:
Market prices reflect and determine the opportunity costs faced by consumers and producers.
We’ve seen how market prices determine the opportunity costs we face in making economic decisions as consumers, workers and producers of goods and services. We can’t as individuals, change the market prices we face for goods and services in general, so we must take them as given in looking at the opportunity cost of different choices.
But Lesson 1 says something more, namely that market prices also reflect opportunity costs. That is, just as the opportunity costs of our choices are determined by market prices, those market prices are determined by our choices. Under ideal conditions, those choices, aggregated over all the members of a society, will reflect the opportunity costs for that society as a whole.
There is a large branch of economic theory devoted to proving results of this kind using formal mathematics. But the core of the idea may be approached using the idea of ‘no free lunches’ or, more precisely, ‘no benefits without equal opportunity costs’, discussed in the previous section.
As we saw then, this condition requires that all production be technologically efficient. If not, there is always a free lunch to be had by making production more efficient, producing more with the same inputs.
The second requirement ‘no free lunch’ requirement is that there should be no gains from mutually beneficial exchange remaining to be realised. It’s easy to see that this requirement is closely related to market prices.
Example 2: lets suppose that you own a new jacket that you would be willing to trade for tickets to tonight’s baseball game, while I have tickets and would be willing to trade them for your jacket.
Now lets look at market prices. If the market price of the jacket is greater than the price of the tickets, there is no need for you to trade with me. You can (assumption A) sell the jacket at the market price (which is unaffected by assumption C), use the proceeds to buy the tickets and have money left over. Since you make the best possible choices (assumption D) that’s what you will do. If I want to complete the trade, by selling my tickets and buying the jacket, I will have to make up the price difference. By assumption (E), no one else is affected.
On the other hand, if the market price of the jacket is less than that of the tickets, the fact that this price prevails indicates that there must be someone else willing to sell jackets, and buy tickets at those prices. So, I can sell my tickets and use the proceeds to buy a jacket, making an exchange that benefits both me and the other parties involved. You, on the other hand, am out of luck. At the prevailing prices, no one is willing to trade tickets for a jacket, and there are no remaining exchanges to be made.
This simple examples give a flavor of the argument that leads to Lesson 1. Intuitively, it suggests the conclusion that trade at market prices will capture all the potential gains from mutually beneficial exchanges, so that no free lunches will be left on the table. In other words, in market equilibrium, TANSTAAFL holds.
This is where casual presentations of Lesson 1 commonly stop. But the simple story above embodies a lot of assumptions about the way markets work:
The most important are:
(A) Everyone faces the same market-determined prices herefor all goods and services, including labor of any given quality, and everyone can buy or sell as much as they want to at the prevailing prices
(B) Everyone is fully aware of the prices they face for all goods and services, including how relevant uncertain events might affect those prices
(C) No one can influence the prices they face
(D) Everyone makes the best possible choices given their preferences and the technology available to them
(E) Sellers bear the full opportunity cost of producing the good, and buyers receive the full benefit of consuming it, no more and no less. That is, no one can shift costs associated with production or consumption to anyone else without compensation (for example, by dumping waste products into the environment) and no one else receives benefits for which they do not pay.
We can go back to the example to see where each of these conditions fits in
If the market price of the jacket is greater than the price of the tickets, there is no need for you to trade with me. You can (assumption A) sell the jacket at the market price (which is unaffected by assumption C), use the proceeds to buy the tickets and have money left over. Since you make the best possible choices (assumption D) that’s what you will do. If I want to complete the trade, by selling my tickets and buying the jacket, I will have to make up the price difference. By assumption (E), no one else is affected.
This more complicated version of the story can be formulated in mathematical terms to show that, under the stated conditions (and some additional technical requirements), a competitive equilibrium will arise in which there are no free lunches; that is, any potential benefit entails an opportunity cost that is at least as great.
In this ‘perfectly competitive equilibrium, the price of any particular good good is equal, for everyone who consumes that good, to the opportunity cost of a change in consumption, expressed in terms of the alternative possible expenditures. Similarly, firms can maximise profits only if the prices of the goods they produce are equal to the opportunity cost of the resources that could be saved by producing less of those goods.
This point is the core of Lesson 1. In a perfect competitive equilibrium prices exactly match opportunity cost. So, there are no ‘free lunches’ left. More precisely, any additional benefit that can be generated for anyone in the economy must be matched by an equal or greater opportunity cost, where opportunity cost is measured by the goods and services foregone, valued at the equilibrium prices. This opportunity cost may be borne by those who benefit from the change or by others.
Hazlitt, and many subsequent writers, implicitly assume something much stronger: that if prices reflect opportunity costs, there is no room for improvement in public policy. In particular, he assumes that any policy that benefits one group at the expense of others is undesirable. To put it more strongly, the distribution of income associated with competitive market equilibrium, based on existing private property rights, is assumed to be optimal.[^1]
This idea is false: as we will see there are a vast number (in the usual mathematical formulation, infinitely many) possible outcomes in which there are no free lunches, each corresponding to a different allocation of rights and a different market equilibrium.
We will discuss the issue of income distribution when we come to Lesson 2. Before doing this, we will consider a variety of examples to illustrate Lesson 1.
[^1]: Hazlitt’s reasoning is reinforced, in many economics texts, by the description of the competitive market equilibrium as “Pareto-optimal” or “efficient”. These misleading terms are discussed here.
fn1: Hazlitt’s reasoning is reinforced, in many economics texts, by the description of the competitive market equilibrium as “Pareto-optimal” or “efficient”. These misleading terms are discussed here.