Hill – Mankiw 9th Edn Chapter 7 – Consumers, Producers, and the Efficiency of Markets
Mankiw, N. G. (2021)
Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 7 – Consumers, Producers, and the Efficiency of Markets
Here are some things to consider when reading this chapter.
- Maximizing social welfare/economic well-being and the distribution of income
The chapter begins with an example of a market for turkeys, asking if “there a ‘right price’ for turkey from the standpoint of society as a whole”. This is the same as asking whether “the quantity of turkey produced and consumed too small, too large, or just right”. Mankiw notes that this analysis, termed welfare economics, is normative, not positive. It asks “how the allocation of resources affects economic well-being” and thus “whether these market allocations are desirable” (p. 131). It shows that the “price that balances the supply and demand for turkey is, in a particular sense, the best one because it maximizes the total welfare of turkey consumers and turkey producers” (p. 131, my emphasis).
If we imagine an economy of perfectly competitive markets, the market prices and the quantities produced depend upon the demands of individual households. Among other things, their demands depend on their incomes which come from their ownership of the productive resources used by firms. Any distribution of income, from the egalitarian to the grossly unequal is possible. Each possible distribution would result in some equilibrium that would maximize the total surplus of consumers and producers.
In some equilibria, everyone would have enough to eat, in others, not. Perhaps this is why Mankiw is careful to say that the resulting prices and quantities are, “in a particular sense”, the “best” ones. The resulting allocation of resources is only deemed “desirable” in the narrow sense that it maximizes total surplus, given whatever distribution of income lies in the background.
For example, are the “right” number of superyachts being built these days? If efficiency, given the current distribution of income and wealth, is the sole social objective, the answer would be yes (if we also accept the unrealistic assumptions that all markets are perfectly competitive and that there are no ‘market failures’ as introduced briefly at the end of this chapter). If society has other final goals (e.g., including meeting everyone’s basic needs), then some of the resources used to build superyachts might be better employed elsewhere, for example by building more affordable rental housing.
- Consumer choice and consumer surplus: some unmentioned assumptions
The theory of consumer choice that underpins the demand curve is set out in detail in Chapter 21. Many courses may never get that far, so a few brief comments are needed here.
Textbook consumers are rational: they have objectives which they try to attain given their limited resources (p. 135). From this comes their willingness to pay, which determines consumer surplus. However, this framework contains simplifying assumptions. Let’s consider three, each of which raise questions about consumer surplus.
(i) No one cares what anyone else has.
Although it’s not apparent until Chapter 21, a person’s preferences (and thus willingness to pay) are not influenced by what others have. No one feels the urge to ‘keep up with the Joneses’. In reality, people can’t help comparing what they have with what others around them have. If all my neighbours acquire shiny new vehicles, my old car, although perfectly adequate for my transportation, now looks shabby. My willingness to pay for a new vehicle will rise. My apparent consumer surplus has risen, yet the result can be wasteful consumption spending as everyone tries to keep up with rising consumption standards.
(ii) Advertising doesn’t influence people’s willingness to pay by creating wants.
In the same way as social context in the previous example can change willingness to pay, so might advertising. Some advertising conveys useful information that people can use to make decisions. Other advertising attempts to create wants that did not exist before, for example through subtle emotional appeals to convince potential buyers that the product will give them popularity or attractiveness. If people’s preferences are changed, it’s unclear whether the preferences before or after the change should count when considering consumer surplus.
(iii) Willingness to pay is based on perfect information.
People’s willingness to pay for something is based on the benefits they expect to receive from it. Their expectations must be accurate if consumer surplus reflects the actual satisfaction they get from their purchase. If the purchase is disappointing, their willingness to pay overstated the surplus they actually received; if expectations are exceeded, consumer surplus would be understated in retrospect.
We can distinguish between three kinds of goods: inspection goods (goods for which the benefits are accurately known before purchase); experience goods (goods whose benefits are known only after having used the good or received the service); and credence goods – goods where the seller has more information than the buyer about what the buyer really needs. In this last case, buyers know the satisfaction they get after their purchase, but can’t judge whether the good or service they received is the one they really needed. (A classic example: you take a taxi ride in a city you’re not familiar with; did the driver take the shortest route? If you were cheated but you believed that that distance was necessary, your perceived consumer surplus would be greater than if you had perfect information.)
The theory of consumer demand simply assumes that all goods are inspection goods.
Here’s an exercise for the reader! Try making a list of goods and services that have been or would be experience and/or credence goods for you. (You should find that you can make a lengthy list.)
- “There is no such thing as a free market.”
The quotation is not from Mankiw, who uses the phrases “free market” and “free markets” 47 times in his book. Instead, it’s the title of the first chapter of Ha-Joon Chang’s book 23 Things They Don’t Tell You About Capitalism. As Chang points out, the concept of a ‘free market’ is incoherent.
The phrase “free markets” conjures up an image of buyers and sellers spontaneously getting together to trade. A government regulation, such as establishing a minimum wage or a price ceiling on rents, then appears as being imposed on the free market where buyers and sellers were willingly trading to their mutual advantage.
But as Mankiw himself describes in his Principle 7 (“Governments Can Sometimes Improve Market Outcomes”) in Chapter 1, governments establish and maintain the institutions and rules that permit markets to function (p. 9). They enforce individuals’ property rights over the resources needed to produce things and over the things produced and sold. This requires police and a judicial system, which is also needed to enforce contracts. Governments are also needed to promote efficiency and to reduce inequality, as noted briefly in Chapter 7. These goals require regulation of some markets and taxes that alter market outcomes.
In short, all markets exist within a web of rules and regulations. As Ha-Joon Chang explains: “If some markets look free, it is only because we so totally accept the regulations that are propping them up that they become invisible” (2010, p.3).
For example, people buying pharmaceutical products will take it for granted that they have been vetted by a government agency and that the pharmacist selling them has been licensed, as was the doctor who prescribed them. People going to grocery stores will take for granted the labelling requirements, the activities of food inspection agencies, the regulations on accurate weights and measures, and so on.
The concept of the ‘free market’ is invoked as a rhetorical device by those opposing some new law or regulation and by those seeking to remove regulations in particular markets. While never explaining what the phrase means, Mankiw sometimes uses it to imply a perfectly competitive market without any taxes or regulations on prices or quantities. But even in that limited sense, the outcomes in such a market would be influenced by taxes and regulations in other markets (such as minimum wages for the labour producers hire and taxes on inputs used in production).
Chang’s basic point: the boundaries of the market and the ‘rules of the game’ are politically determined. As he writes: “Recognizing that the boundaries of the market are ambiguous and cannot be determined in an objective way lets us realize that economics is not a science like physics or chemistry, but a political exercise” (2010, p. 10).
- Market efficiency and laissez-faire
Mankiw asks how a godlike benevolent social planner would go about her work. He writes: “The planner wants to maximize the economic well-being of everyone in society… one possible measure [of which] is the sum of consumer and producer surplus” (p. 141, my emphasis).
He concludes that if the social planner is concerned only with efficiently allocating resources, the planner can do no better than the equilibria produced by perfectly competitive markets (p. 143). The idea that “the social planner might also care about equality” is mentioned in one brief paragraph on page 141 before the analysis of efficiency continues.
(i) What is ‘economic well-being’?
Without any discussion of alternatives, Mankiw has his imaginary planner make the normative choice that economic well-being should be measured by the sum of consumer and producer surplus. Even consideration of equity is quickly swept under the rug to focus the reader’s attention on efficiency.
Let’s briefly consider just one alternative, developed by Canadian economists Lars Osberg and Andrew Sharpe. Their index of economic well-being consists of four major components: (1) annual per capita consumption, broadly defined to include not only marketed goods and services, but also government services, household production, leisure, and life expectancy; (2) the society’s net accumulation of productive resources, including natural resources, education and training, and research and development; (3) income inequality and measures of poverty; and (4) economic security from such things as job loss, unemployment, illness and poverty in old age (Osberg and Sharpe 2010, pp. 27-8).
This is just one of many indices that have been developed to move thinking beyond just a narrow focus on what happens in market exchange. Interested readers might like to have a look at the OECD’s Better Life Index for another example.
Exercise for the reader! If you had the powers of Mankiw’s benevolent social planner, what would be your priorities and objectives?
(ii) Laissez-faire and economists
Mankiw writes: “The benevolent social planner can, therefore, leave the market outcome just as she finds it. This policy of leaving well enough alone goes by the French expression laissez-faire… ‘let the people do as they will.’” The planner just lets the invisible hand do its job guiding “everyone in the market to the best outcome as judged by the standard of economic efficiency. It is a remarkable feat. This is why economists so often tend advocate free markets as the best way to organize economic activity” (p. 144, my emphases).
Mankiw was interviewed for a New York Times article by writer Sylvia Nasar in 1995, who was curious about why he was preparing the first edition of this text. After explaining that it could be very profitable, he remarked “with a smile, ‘all economists are proselytizers’.” Proselytizers attempt to convert their listeners to their faith or cause.
Recall that in Chapter 1, Mankiw wrote: “One purpose of studying economics is to refine your view about the proper role and scope of government policy” (p. 9). In the next chapter he added that “[o]ne purpose of this book is to help you understand the economists’ view on these and other subjects and, perhaps, to persuade you that it is the right one” (p.32). Here Mankiw asserts that economists “often tend to advocate free markets” and (implicitly) laissez-faire. Clearly, the reader is being invited to agree.
We’ve seen that there is no such thing as a ‘free market’, but does laissez-faire make any more sense? Traditionally, this term has meant that governments are strictly limited to a narrow set of activities: enforcing peace and property rights, providing national defence and essential public works that cannot be left to the private sector (Backhouse and Medema 2008, p. 3). This could be described as a libertarian view of the proper role of the state.
Even among American economists, few seem to subscribe to this extreme position. For example, in a 2021 survey of more than 1400 economists, only 14 percent disagreed with the statement: “Redistribution of income is a legitimate role for the US government”. 74 percent disagreed with the statement “Reducing the regulatory power of the Environmental Protection Agency (EPA) would improve the efficiency of the US economy” (Geide-Stevenson and La Parra-Perez 2022, p. 17 & 19).
In the conclusion to this chapter, Mankiw notes that public policy can potentially increase economic efficiency in cases of market failure (e.g., monopoly or externalities, such as pollution, or other causes). Although reducing inequality barely gets a mention in this chapter, addressing this requires a variety of taxes on incomes and sales of goods and services to finance public provision of goods and services and transfers of cash to households. Given the role of the modern state in addressing market failures and social and economic inequality, “notions such as ‘laissez-faire’ and ‘state action’, especially if this is seen as an either/or choice, are not particularly helpful” (Backhouse and Medema 2008, p. 11). As in the case of the ‘free market’, the role of the state is politically determined. Simple slogans like laissez-faire seem beside the point.
Nevertheless, Mankiw asserts: “Despite the possibility of market failure, the invisible hand of the marketplace is extraordinarily important. In many markets, the assumptions we made in this chapter work well and the conclusion of market efficiency applies directly” (p. 146, my emphases). No evidence is offered for this claim about “many markets”. Aside from market failures (which are ubiquitous), when other, more realistic, models of markets are developed in Chapters 15 through 17, we’ll see that there is little reason to expect an efficient outcome in any of them.
Backhouse, Roger, and S. G. Medema (2008) “Laissez-faire, Economists and” in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics. DOI 10.1057/978-1-349-95121-5_2206-1
Chang, Ha-Joon (2010) 23 Things They Don’t Tell You About Capitalism, Bloomsbury Press.
Geide-Stevenson, D., and A. La Parra-Perez (2021) “Consensus among economists 2020. A sharpening of the picture”, draft, December.
Nasar, Sylvia (1995) ’A Hard Act to Follow? Here Goes.’, New York Times, March 14.
Osberg, Lars and Andrew Sharpe (2010) “The Index of Economic Well-Being”, Challenge, Vol. 53, No. 4, 25-42.