7. What works?

Given the long list of defects in markets and governments outlined in this VSI, the world has not fared too badly. ‘What works?’ concludes that a mixed economy — where competitive markets or similar institutions generate information about scarcity and create incentives to alleviate the scarcity in a reasonably efficient manner, where antitrust policies keep the markets open to competition, where the government and other social organizations help overcome the inefficiencies of externalities, and where political competition acts as a corrective mechanism against abuses of power and serious errors of judgement — is the best way of organizing microeconomic activity.

6. Institutions and organizations

Markets are not the only place where transactions take place. ‘Institutions and organizations’ highlights other platforms and institutions — families, social groups and networks, industry associations, and governments — where some transactions work better. Successful specialization and transaction have two basic prerequisites: security of property and of contract. Property rights and contract enforcement, and the state and non-state institutions of governance that control them, are considered. The needs of some specialized transactions are best met by creating special markets or market-like platforms by intermediaries for the two sides in a transaction to meet. Market design, matching markets, and auctions are discussed.

2. Consumers

‘Consumers’ considers several concepts involved with, or influenced by, consumer activity and consumer choice — substitution, complements, demand curves, income effect, statistical estimation, cost-of-living indexes, the babysitter effect, time, budgets, opportunity cost, and risk and loss aversion. What thought processes are involved in budgeting decisions? Are consumers rational? The new view of ‘behavioural economics’ suggests not and is supported by Daniel Kahneman's work that proposes two different systems of decision-making in the brain — fast and slow. The effects of consumer behaviour can be significant; for example, loss-aversion and other features of decisions under risk can seriously affect the properties of financial markets.

1. What and why of microeconomics

‘What and why of microeconomics’ explains that microeconomics studies how consumers choose what goods and services to buy, how producers make decisions to meet these demands, and how the two sides interact. Mostly the transactions work fairly smoothly, but occasionally things do go wrong. Sometimes failures are drastic, like the gasoline shortages in the 1970s and the housing bubble and its collapse in the 2000s, so a basic understanding of microeconomics is important. When and how do transactions go well? When and why do they fail? What can be done if they fail? Information and incentive mechanisms to coordinate transactions and how prices work are the main subject matter of microeconomics.

4. Markets

‘Markets’ focuses on the supply-and-demand nature of markets. The supply–demand mechanism produces just the quantity that contributes positive social surplus, and no more. The outcome maximizes the total social surplus; it is economically efficient. If underlying conditions of demand and supply change, market equilibrium will shift. Whether the product price and the quantity produced increase or decrease depends on the type of shift of demand and supply that has occurred. One cause of equilibrium shift is the imposition of a tax. Cycles of booms and busts in housing and mining sectors are discussed along with price floors and ceilings.

3. Producers

‘Producers’ addresses production, an activity that transforms inputs (raw materials and other produced goods, as well as services of labour, land, and capital) into outputs. Producers must pay attention to the costs of these inputs — the prices of inputs that are used up, as well as wages, rents, and costs of capital — which involves judgement about uncertain prospects. Supply curves, pricing strategies, rivalry between firms, supply chains, and firm organization are considered. Firms buy some inputs to their production from other firms and make some inputs in-house. The choice is theirs. But why not produce each link of the supply chain in a separate firm? Or why not make everything in-house?

5. Market and policy failures

‘Market and policy failures’ begins with monopolies and oligopolies. What are the effects of monopoly power? Many actions of consumers or firms have beneficial or harmful side-effects such as pollution. These positive or negative externalities depend on whether a market puts the correct price on that action. For a market to function well, the transaction parties must know what they are buying or selling. But there are information asymmetries. The effects of these can be seen through the lens of externalities, and the market failures resulting from these externalities can be remedied by Coasian or Pigouvian methods. Moral hazards, adverse selection, collective goods, the political economy of policy, and the recent financial crisis are also discussed.