How Markets Works 2008

How Markets Work
Dedicated with Love to:

Falguni A. Sheth
How Markets Work

Supply, Demand and the Real World
Robert E. Prasch
Associate Professor of Economics, Middlebury College, USA
Edward Elgar
Cheltenham, UK Northampton, MA, USA
Robert E. Prasch 2008

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A catalogue record for this book

is available from the British Library
Library of Congress Cataloging in Publication Data
Prasch, Robert E., 1958
How markets work : supply, demand and the real world / Robert E. Prasch.
p. cm.
Includes bibliographical references and index.
1. Capitalism. 2. Free enterprise. 3. Markets. I. Title.
HB501.P69185 2008
338.521dc22
2007049440
ISBN 978 1 84720 613 8 (cased)
ISBN 978 1 84720 614 5 (paperback)
Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall
Contents
vii
Acknowledgements
PART I
THE THEORY OF MARKETS
Introduction
Economics today: is market fundamentalism in

decline?
3
Property, contract, and the theory of exchange
13
Commodity markets: the economics of a spot
contract
29
Lecture I
Lecture II
PART II
MARKET PROCESSES WHEN

INFORMATION MATTERS
Lecture III
Credit markets: the economics of a relational

contract
Asset markets: market dynamics when
expectations are a consideration
Lecture IV
PART III
LABOR MARKETS
Lecture V
Labor market dynamics when needs are a

consideration
Labor market dynamics when motivation is a
consideration
Lecture VI
55
65
81
97
PART IV
SOCIAL, ETHICAL AND POLITICAL

CONSIDERATIONS
Lecture VII
The economics of discrimination: the Chicago

School approach
111
The economics of discrimination: the
structural approach
123
Lecture VIII
vi
Lecture IX
Conclusion
Bibliography
Index
Contents
Values and prices: reintroducing ethical

considerations into economics
Some reections on economic policy
137
147
153
167
Acknowledgements
The following lectures have several sources. The most important,
although not always voluntary contributors, were the approximately
2000 Introductory Economics students whom I have been privileged
to teach at San Francisco State University, the University of Maine,
Vassar College, and now Middlebury College. I would like to thank
all of them for their patience and even interest as I developed my ideas
and pedagogy over the years. Particularly worthy of thanks are my
Economics 150 classes from the Fall of 2006 and 2007, who read
many of these chapters in an earlier form. All of my students, but
especially those from these last two fall semesters, have been an essential guide to what works pedagogically, and they have made a
material contribution to this book. I would like to thank those students who heard the rst lecture when I had occasion to present it at
one of my several alma maters, the University of Denver, in Spring
2000. I wish to thank two of my former professors, Tracy Mott and
David P. Levine, for that opportunity in addition to their inspiration
and support over many years.
With hindsight, it is evident that I was the beneciary of multiple
sources of inspiration as I worked through the ideas presented in this
book. One was a short paper that Professor Anne Mayhew encouraged, and saw t to publish, many years ago (Prasch, 1992). While
grievously mistitled, it represented an early eort to consider the
structures that distinguished one market from another. While I did
not know it at the time, Anne recognized that I was rediscovering
what serious thinkers within the American Institutionalist tradition
had previously understood. This is the proposition that not all
markets could or should be modeled on the basis of a narrow set
of abstract presuppositions and presumptively eternal verities. Later,
once I had done a lot more reading and thinking, I came to learn what
she already understood, which enabled me to complete several more
extended papers on the unique attributes of labor markets. I am
grateful to Anne Mayhew along with Professors Lonnie Golden,
Deborah Figart, Janet Knoedler, and Dell Champlin for soliciting,
vii
viii
Acknowledgements
encouraging, and publishing this work (Prasch 2000a, 2000b, 2004b).

Readers of those papers will readily identify some of those ideas represented in this book.
Several institutions have supported this book. Foundations have
not been among them. I am most grateful to my current employer,
Middlebury College, for providing me with two leaves, one at a little
over half pay for the academic year 20042005, in addition to an
unpaid leave for the Spring of 2007. These have greatly facilitated the
nishing of this work. After over 17 years of uninterrupted college
teaching across several institutions, these leaves were a wonderful and
welcome opportunity, to say nothing of a needed respite. I would like
to especially thank Middlebury Provost and Executive Vice President
Alison Byerly for granting those leaves. Additionally, I would like
thank Professor Michael Reich of another of my alma maters, U.C.
Berkeley, for sponsoring my stay as a Visiting Scholar at the Institute
for Industrial Relations for the Spring and Summer of 2007. This
visit was most useful, and it greatly accelerated my progress on
several projects, including this one. I also wish to thank my colleagues
at Middlebury College, especially David Colander and Sunder
Ramaswamy, for recruiting and encouraging a colleague whose ideas
are so at variance with current professional trends. Each of them
embodies the vision and ideals implied by the phase liberal arts, and
for this reason are a credit to the college and themselves.
A number of friends, family, and colleagues have contributed to
this book by reading over one or more chapters, perhaps in an earlier
format, or in the course of conversations about some of its ideas.
Despite my trepidation that any list will inevitably overlook some
friends and colleagues, I wish to especially thank Anne Mayhew,
Deborah Figart, Lonnie Golden, John Garber, Dell Champlin, Janet
Knoedler, Tracy Mott, David P. Levine, Michael R. Montgomery,
Oren Levin-Waldman, Jerey Carpenter, Peter Matthews, Thierry
Warin, Liz Lyon, David Colander, Kevin McCarron, William Steele,
Anita Balachandra, Uma Narayan, James K. Galbraith, Mark Lutz,
Sandy Thompson, Rebecca Edwards, Pinar Batur, and Bill Lunt for
their willingness to read, hear, and discuss various elements and
aspects of this book as its ideas were formulated and reformulated
over so many years.
Additionally, I would be remiss if I failed to thank the stas of
several cafs who so graciously, if unknowingly, supplied me with
tranquillity, coee, beer and wine as this book was reedited more
Acknowledgements
ix
times than I care to remember. These include Uncommon Grounds

and Muddy Waters of Burlington, Vermont; Raos of Amherst,
Massachusetts; Le Royal Jussieu of Paris; and several San Francisco
cafs including the Caf de Soleil, Being There, Jumpin Java, iCafe,
Kaleo, and the sorely-missed Canvas.
Finally, my deepest thanks and love are due to my sister Sandra,
and her family John, Alison, and Sophie Garber, for their kindness
and for always providing me with a place to have fun. For the same
reason, I am also in debt to my parents, Carolyn and Robert E. Prasch
of Grand Isle, Vermont, for their long-standing love, patience, and
support, in addition to providing me with that all-important and periodically essential weekend writing nook for quiet contemplation
and writing.
Another source of support came from an invisible community
without a formal name or identity. This is all the wonderful people
who continue to insist, despite the scorn of accepted and acceptable
opinion, that Another World is Possible. Knowing that a lot of
people do not think that were are at The End of History is a
thought, and during some dark times perhaps the only thought, that
has sustained my hope and eort over these past several decades.
Thank you for that.
Ultimately, the most important contributor to this book is the one
who has been a continuous source of support and inspiration. Her
reward has been to travel with me along a path that was longer and
more demanding than either of us imagined. But her unstinting love,
support, and willingness to endure trying times has enabled me to
retain a portion of my intellectual, emotional, and moral capacity
while continuing to work in an academic eld that has little use for
discussions of its own history or fundamental preconceptions. Her
contribution, in other words, goes well beyond her several readings of
various portions of the manuscript or our innumerable discussions of
all of the ideas presented in these lectures. It even goes beyond her
always-essential expertise on computer and printer technology, to say
nothing of the English language. Dante was blessed to be guided by
Beatrice, but I cannot believe that she provided more inspiration
than the person to whom I owe so much and to whom this book is
dedicated. Thank you Tina.
PART I
The theory of markets
INTRODUCTION
Economics today: is market

fundamentalism in decline?
Since the late 1970s American economic policy has been almost
exclusively informed by what Nobel Laureate Joseph Stiglitz has
labeled market fundamentalism (Stiglitz 2002, 2004). For a remarkable range of issues, from social security to education, public transportation, communications, electricity, water, and the provisioning of
other necessities, the conventional wisdom has been to aggressively
promote deregulation and privatization. This attitude has even
spread to quintessential state functions such as the stang of prisons
and even military occupations.
The underlying ideology, one that is now pervasive, is that an
unregulated private sector, operating through the legendary invisible
hand, is the only way to meet individual, community, and national
needs. As recently as the 1970s such views were exclusively those of a
rightist fringe. Things have changed. Today these views are what
Washington-based journalists and the sundry experts they favor in
their news stories and broadcasts call centrist or bi-partisan.
With such endorsements, these ideas have been rechristened as the
default position for all responsible and thereby worthy policy
commentary. As Stiglitz and others have noted, these narratives have
been especially dominant in the sphere of international economic
policy.
Parallel to this remarkable political and rhetorical shift, market
fundamentalist views have also become the default position of the
economics textbooks of our nations colleges and high schools. While
these books may set a few pages aside for the tepid presentation of a
counterpoint, the overwhelming ethos is to arm and rearm the
position that free markets are the strongly preferred approach to
resolving economic, and more than a few non-economic, issues.
3
Living in the center of these trends, todays economists may not have
noticed these changes, but by any external vantage point it is stating
the obvious to comment that in todays economics textbooks balance,
nuance, and respectful attention to counter-arguments, are marked
by their absence.1
In conversation, many professional economists have reminded me
that while these trends are indeed present, they have never been hegemonic in the realm of pure economic theory. Neither have they been
as hegemonic in the policy discussions of the higher learning as
exemplied in the professions academic journals. Of course, such
observations are contestable. But however such a discussion might
play out, it remains evident that professional economists strongly
favor market provisioning as the default position for a wide variety
of issues, and that their view is in contrast to that of much of the rest
of humanity.
Anticipating some objections to the previous paragraph, I wish to
immediately arm that yes, even as the profession was approaching
its apex of market fundamentalist modes of thinking around
the mid-1980s dissenting views were represented in the citadels of
the higher learning. Additionally, some of the work now routinely
invoked to criticize simple-minded applications of the venerable
theory of perfect competition were then being developed and discussed. Game theory, the economics of information, chaos theory,
and experimental economics were each getting some attention by the
mid-1980s, although they were then peripheral to the core curriculum presented to graduate students. Happily, since the late 1980s, professional economists have expanded the scope of what constitutes
accepted and acceptable modes of theorizing. Today, economists
remain opposed to the anything goes approach to science once promoted by the late Berkeley philosopher Paul Feyerabend. But it is
also evident that the theory of perfect competition no longer retains
unquestioned dominance over the journal literature or the education
of graduate students.
Despite these trends, market fundamentalism remains the perspective of virtually every introductory economics textbook. The reasons
for this will not be explored here as this introduction is not the place
to initiate a sociology of the economics profession although such a
study is clearly long overdue. What does need to be noted is that
despite the condence of market fundamentalists in the validity of
their favored theories and policies, most of the worlds citizens remain
Is market fundamentalism in decline?
unconvinced. Indeed, when non-economists make the sustained

eort required to understand their writings, they are often surprised
by the thinness of the arguments invoked to condemn popular and
long-standing public policies. Minimum wage laws, usury laws, truthin-advertising laws, laws to regulate fraud, health-and-safety codes,
anti-discrimination laws, building inspection codes, environmental
laws, investor protection rules, and many other rules and regulations
have each and severally been breezily, even haughtily, dismissed by
market fundamentalists and the many columnists and politicians who
invoke their arguments. In all likelihood, the refusal of market fundamentalists to be informed by evidence and experience would
embarrass Dr. Pangloss. Experience, intuition, and ethical considerations inform most thinking people that, in the absence of social institutions acting as a check on private property and market forces, we
will be treated to a hard lesson. As only he can, Mark Twain described
the most likely form that this lesson will take, The man who carries
a cat by the tail learns something that can be learned in no other way.
And these lessons are indeed being learned. Over the last ve years
and across the world people are electing and reelecting leaders, even
some leaders with clear aws, largely on the strength of their promises
to roll back the internationalist incarnation of market fundamentalism termed free markets or free trade in the United States, but
Neoliberalism or the Washington Consensus across most of the
rest of the planet.2 Nations as diverse as Argentina and Malaysia are
showing the world that countries that check or even roll back the nostrums of market fundamentalism will be rewarded with enhanced
economic performance. A particularly instructive and important
example is China, which has ignored virtually every policy recommendation of the Washington Consensus. Yet its experience is
rearming what the economic histories of Japan, the Republic of
Korea, and Taiwan (to say nothing of the United States or Germany)
have previously demonstrated, that laissez faire is not the formula for
prosperity.
In light of the above trends, it is apparent that new and revised
expositions of elementary economics are required. Such a revision
must feature an approach that is more accurate, substantive, and
thereby real world than that of the current crop of textbooks. For
this reason it is my hope that this book will be of assistance to those
teachers of economics wishing to present a more balanced course to
their students. To this end, it takes a forceful position in opposition
to that of the textbooks and the policies of the Washington

Consensus in order to provide a clear counterpoint. As in my own
classes, it is to be hoped that students will consider all the options and
formulate their own views on the basis of the merits of the arguments
presented. My additional hope is that these lectures will also be accessible to interested persons in other elds, including the general reader.
A THEORY OF MARKETS, NOT OF THE

MARKET
The dominant theme of the following lectures what in my classes
I describe as the story behind the story is that there is no single
theory of the market. The widely believed and, in my view, erroneous proposition that there is only a single theory of the market is
the core misunderstanding and failure of the received approach
to economics instruction and policy-making. As such, it follows
that any revised exposition of economics must begin by liberating
our minds from such a awed proposition. Thus freed, we will be
able to take the crucial rst step in abandoning the intellectual
biases and blindness of market fundamentalism and its disastrous
policies.
By contrast to the error identied in the previous paragraph, the
following lectures will recast the elements of economic theory from
the perspective that there are several theories of markets. Each theory
is thought to have its own realm and scope of applicability. This alternative premise can, I believe, be the basis of a coherent foundation of
the elements of economics, while providing a contrast to the received
vision.
The following lectures, then, encompass two distinct but related
tasks. The rst is to present an alternative introduction to the elements of economic theory. A second is to present the basis for a critique of the market fundamentalist perspective. But, I must include a
qualication. What follows is not a comprehensive treatise or handbook on economic theory or policy. These lectures do not present and
defend a laundry list of specic policies and programs. Rather, the
idea is to present the foundation of several theories that can be
applied to several types of markets. These lectures might best be taken
as guidelines or suggestive avenues of thought for further inquiry into
the several markets presented in addition to other markets that may
closely conform to one or more of them, or have dierent properties

altogether.
In developing a critique and reconstruction of elementary economics the following lectures will, through a reinterpretation and
reframing of the venerable theory of supply and demand, demonstrate that much of what today passes for economic theory
specically as it is now packaged and transmitted to initiates is not
only over-simplied, it is in fact simplistic. As a consequence of being
simplistic, much of the received theory is misleading and sometimes
even detrimental to the economic prospects of our communities, our
nation, and our world. It will be demonstrated that when more plausible assumptions concerning the actual behavioral and structural
conditions underlying several important varieties of markets are
introduced, the only defensible conclusion is that there are theories
(plural) of the behavior of markets (also plural).
A METHODOLOGICAL INTERLUDE
Before starting it will be prudent to ward o some simple misunderstandings by presenting a brief methodological caveat. First, when I
state that there are several types of markets, each with a theory most
suited to it, I am not making the trivial claim that each market is
dierent in the sense that there are details of fact or circumstance
unique to each. In its form and content, broccoli clearly has properties that distinguish it from an automobile, a corporate bond, a
designer handbag, or manual labor. This is understood, but it is most
emphatically not my point.
Second, I am not making the trivial claim that abstraction is an illegitimate activity. Abstraction from the inessential aspects of any
problem is a necessary rst step to all theorizing: natural, social
scientic, philosophical, or literary. If I wish to count the number of
coins in my pocket, I can with condence abstract from knowing which
of them are quarters, dimes, nickels or pennies. To learn whether or not
these same coins will purchase a subway ticket, the previous abstraction would impede our understanding. In each of these examples, the
question is an important consideration in establishing an appropriate
abstraction. A similar claim can be made for the theory of markets.
As will be evident, it is my view that our understanding of markets
can be improved through the development and analysis of what I will
term, following Max Weber, ideal types. Readers will nd that each
of the ideal types of markets developed here shares many, even most,
of the qualities of the others. Yet, as will be seen, each ideal type also
features an idiosyncratic quality of decisive importance for analysis,
understanding, and policy evaluation. While parallels and analogies
can be made across several of these ideal types, substantive dierences
remain. As will be seen, these distinctions and similarities have critical consequences for each particular market, and the theories and
policies that most plausibly ow from the analysis. Teachers of economics, particularly those over the age of 50, will immediately recognize that my suggested approach is strongly at variance with the views
once advanced by the late Milton Friedman (Friedman, 1953).
OVERVIEW OF THE BOOK

By time-honored convention, expositions of elementary economics
begin with a hypothetical exchange between two abstract persons in
an abstract setting. Soon thereafter, the reader encounters sweeping
generalizations concerning the causes of exchange, the theory of
demand and supply, the nature and meaning of economic activity,
and multiple ungrounded remarks on the futility of well-meaning
interventions in markets. Collectively, these lessons are presented as
The Law of Markets. Not covered by such an analysis is any insight
into what may be legitimately exchanged, or the rules under which
such articles may be exchanged.
This was not always the case. A hundred years ago the teaching of
economics, especially in the United States and Germany, began with
a discussion of property and contract law. This book will return to
this eclipsed pedagogical tradition. The reason is that a sketch of the
rudiments of the law of property and contract provides readers with
a sense of how the economy is embedded in a set of institutions and
norms, rules that may even come to be codied in the laws. For far too
long economists, and especially teachers of elementary economics,
have simply assumed that a stable and legal framework of markets
has been fully worked out. This presumption devalues the importance
of these rules and their critical role in managing, stabilizing, and legitimating market exchanges. Either intentionally or inadvertently,
long-standing pedagogical practice has contributed to the erroneous
belief that the economic realm lies outside of, and is in opposition to,
the spheres of law and politics. Such a dubious supposition has consequences few of them good, and none of them enlightening.
Moreover, a rudimentary knowledge of the principles of property
and contract law opens our minds to their inherent complexity, contingency, and importance. This knowledge, in turn, illuminates some
of the strengths and weaknesses of markets as economic and social
institutions.
Lectures II through VI develop several ideal types of markets.
Lecture II should be the most familiar. Indeed, readers with a background in conventional economics may wish to skip it. The ideal type
of market drawn in that lecture is for non-status goods used in everyday consumption, the essential properties of which can be discerned
through immediate inspection what in the pages of this book will
be termed commodities. It will be posited that these commodity
markets operate in the manner supposed in conventional introductions to economics. This exposition will be followed by successive lectures on the markets for credit, assets, and labor. In each instance it
will be demonstrated that when a critical element of the real world
is incorporated into the construction of the theorys core assumptions, the analysis must be modied. Readers will nd that these
modications arm what our personal and collective experience have
previously demonstrated. In this sense, these lectures are consistent
with our understanding of the institutions and practices of our
world. This is in contrast to the rhetoric of market fundamentalism,
which tends to hide its radical agenda for privatization and deregulation under a shroud of objective social science.
Each of the presentations of non-commodity markets credit,
assets, and labor will be analysed through a modied Supply and
Demand framework. I am aware that this depiction can, in itself, be
criticized. But such considerations and reservations will not be
addressed here. In this book it will be supposed that the Supply and
Demand framework can be generalized if it is done with care. But
full disclosure mandates that readers know that this venerable theory
has been subjected to important, if advanced and technical, criticisms. That said, I believe that it retains an important place in expositions of elementary economics. This, ultimately, is the reason that I
continue to believe that the best course is to restructure and reposition this theory, rather than to simply discard it.
From their number it is evident that labor markets are at the core of
the following lectures (numbers V through VIII). This is appropriate
10
for several reasons. First, most people earn their living by selling their
ability and willingness to work. Second, the object exchanged in such
a market, labor, can not be alienated from its possessor: its essence is
our time, our selves, in an important sense our very lives and persons.
Due to labors importance, and its unique personal and ethical qualities, a clear understanding of this market is central to any coherent
reformulation of the elements of economic theory.
Two lectures on discrimination, a specialized subject within the
larger theory of labor economics, are included as this issue has substantial political and economic consequence. Additionally, I believe
that this inclusion is important as economic arguments have held a
prominent place in the rhetoric of those opposed to addressing discriminatory practices through legislation. For these reasons clarity on
this sensitive subject is essential.
The last lecture makes a relatively simple point, but in light of the
hegemony of market fundamentalist thinking it needs restating. With
the market now dominating so many personal, political, and even
ethical discussions, it is ever-more essential to retain and rearticulate
the distinction between moral values and market prices. It may be
interesting to know that this lecture was originally presented on the
nal day of the Fall semester of 2001. Its inspiration was the following reection: in 2001, the starting wage of a New York City reghter was less than $40,000. Some of the last people to escape the
North Tower of the World Trade Center (the second to fall), told
interviewers that many of the reghters still inside the building knew
that the other tower had collapsed. Hence they must have known that
the tower they were in would, in all probability, soon do the same.
What, then, kept these brave persons at their stations? Clearly, it was
a sense of duty the immemorial duty of all reghters to rescue
people from burning buildings and other disasters. Sadly, the rhetoric
of economics, which has a tendency to conate values and market
prices, precludes ideas such as duty or identity. The unfortunate
spread of this conation into discussions of public policy arms that
a restatement of this distinction is essential. It may be the single most
important task of these lectures.
In hindsight, it was especially poignant that this reminder of the
existence of duties, duties beyond that of performing contracted-for
services for remuneration, took place in New York City. Let us recall
that this city had just been at the epicenter of a stock market bubble
in which legions of professionals who also had an obligation to
11
protect the public accountants, senior executives of corporations,

lawyers, brokers, and analysts had knowingly, cynically, and with
little in the way of social sanction or legal penalty, abandoned their
(substantially less dangerous) duciary duties. These nancial services professionals abandoned their duty, not out of an understandable fear for their own lives, but simply because they saw an
opportunity to supplement their already bloated incomes with other
peoples money. In such a context New Yorkers, along with the rest of
the world, were genuinely moved to discover that after two decades of
rampant greed and cynicism on the part of so many wealthy, pampered, and over-compensated professionals, a large number of otherwise humble, unknown, and underpaid residents of the city would
risk, and lose, their lives to do the right thing. That day, a number
of regular joes demonstrated that market prices do not reect
moral values. Inspired by such heroic deeds, this last chapter reexamines the several meanings that can, or should, be ascribed to the term
choice. Specically, it considers some of the non-economic elements that enter into consumption decisions and some of the implications that follow from them.
To reiterate, the premise of this book is that it would be an error to
presume that the lessons derived through a study of one type of
market can be transferred, without reection or modication, to
another. As economics students have observed for decades, the Real
World matters. Context, idiosyncratic uniqueness, and particularities can make a dierence. The question is what contexts, what
uniqueness, what particularities, are those that are critical? Moreover,
how can these be expected to impact the market? If these last questions are important, and I believe that they are, it follows that in
selecting or evaluating policies we must be careful to assess what kind
of market is being examined, its underlying structure, and how these
factors can be expected to modify expected outcomes.
Finally, a brief conclusion reects on some of the policy implications that plausibly follow from the reformulation of economics
presented in these lectures. What are the implications for our understanding of market regulations? What implications follow if we wish
to live in a society committed to individual liberty? Specically, what
are the implications for liberty in both its senses, that is to say our
freedom from arbitrary interference, in addition to the positive
freedom to strive to achieve our ends in life (Berlin 1969, Ch. 3)?
These crucial questions are, clearly, beyond the scope of a brief book
12
on the elements of economic theory. But the several suggestions or

implications advanced there may help to illustrate the several points
made previously in the text, and underscore their importance for
larger questions of economic policy-making. But, above all, even if I
fail to convince my readers of the merits of my arguments, I do hope
that I may nevertheless succeed in keeping them interested and
perhaps even motivated to question the fundamental preconceptions
of market fundamentalism. If I succeed in that, writing this book
would have been well worth the eort.
NOTES
1. A simple way to trace these trends is to compare earlier and more recent editions
of Paul Samuelsons Principles of Economics, a text that played an enormous role
in economics instruction from the early 1950s to the late 1970s. Indeed, one reason
for the decline in the hegemony of Samuelsons text was its identication with the
postwar Keynesian consensus and hence its inability, despite revisions, to fully
identify with the market fundamentalism that became so pronounced in the 1980s.
2. This latter term reects the long-standing and powerful consensus between the
World Bank, the International Monetary Fund, and the United States Treasury on
how Third World economies should be managed. A consequence of their collective economic power, especially in public and private credit markets, is that most
nations believe that they had little choice but to follow the dictates of these institutions. In this sense, what Americans have learned to call globalization is anything but inevitable. But this is the subject for another essay.
LECTURE I
Property, contract, and the theory of

exchange
The English economists have taken the laws of private property for
granted, assuming that they are xed and immutable in the nature of
things, and therefore needed no investigation. But such laws are changeable they dier for dierent peoples and places, and they have profound
inuence upon the production and distribution of wealth.
John Commons (1893 [1963], p. 59)
Wealth, in a commercial age, is made up largely of promises.
Roscoe Pound (1922 [1982], p. 133)
ECONOMICS AND THE THEORY OF THE

MARKET
While some changes have been evident over the last several decades,
the above observation by John Commons remains largely accurate.
Typically, and naively, most economists adhere to Jean Baptiste Says
dictum: Political Economy recognizes the right of property solely as
the most powerful of all encouragements to the multiplication of
wealth, and is satised with its actual stability, without inquiring
about its origins or its safeguards (Say, as quoted in Ely, 1914, p. 63).
To Say and most economists after him, property rights are a xed and
unproblematic set of laws or rules.
This failure is exacerbated by textbook presentations of market
relations that take the denition and meaning of a commodity to
be given and self-evident. This lack of concern for specics is aggravated when an abstract good, by tradition termed a widget, is used
to illustrate the essence of the market process. In this pedagogy, the
students attention is then directed to the theory of exchange and
13
14
price. It concludes once the student has been successfully drilled in

the theory of the market.
This overly-abstract pedagogy obscures the institutional structures
that are the foundation of market economies. One consequence of
this way of thinking is the often repeated and largely fatuous
dichotomy between government regulation and the free market
that has become a staple of American political discourse. Another
regrettable consequence is that in the making of economic policy, the
legal foundations of market systems are either overlooked or, even
worse, taken for granted. The debacle remembered as the Russian
transition to capitalism is only one, terribly tragic, manifestation of
this now-conventional error (Holmes, 1997).
The following observation might appear to be trivial: if exchange
is the fundamental event in a market economy, then this exchange
must be of some object, promise, service or privilege. Moreover, as
members of a society, it should be self-evident that we are not at
liberty to exchange anything at all. Even in a libertarian utopia
one must rst establish ones ownership of, or legal authority over,
any object, promise, service or privilege that one proposes to sell.
Furthermore, each party to an exchange must, at a minimum, be
judged competent to enter into it. Children and those adults legally
declared incompetent are examples of persons who may not enter
into legally binding contracts.
History teaches us that conventional denitions as to who qualies
as a legitimate owner of property has changed. For example, in most
western societies married women were long considered to be ineligible to own or exchange certain forms of property. Women in general
were often, and to a lesser extent still are, forbidden to enter into
certain kinds of labor contracts. In the United States most convicted
felons may not own (and therefore may not exchange) rearms.
Children are prohibited from engaging in a wide variety of labor contracts and, in the United States, may not legally purchase, own, or
possess tobacco or liquor.
In short, property is neither a simple nor immediate relation between
a person and a thing (Appadurai, 1986; Radin, 1996). On the contrary,
property is an artifact of a complex set of social relations: The essence
of property is in the relations among men arising out of their relations
to things (Ely, 1914, p. 96). As with all social relations, the conventional rules and laws governing property are subject to important
modications as values, norms, and technologies change. Like the
15
society in which they are embedded, property and contract law are constantly, and necessarily, in ux. Moreover, their specic manifestation
has a complex and potentially important impact on the performance of
markets, the productivity of the economy, the outcome of exchanges,
and the distribution of wealth and income that can be expected to
follow from economic activities (North, 1990; Lazonick, 1991).
PROPERTY LAW
What may be owned, and thereby exchanged, is contingent upon the
law of property. While complex in practice, property law is simple in
its conception. Traditionally, the law recognizes a property relation
when an object, promise, service, or privilege is thought to be owned
free and clear. The underlying principle at work, one that dates
back to the time of the famous legal scholar William Blackstone, is
that a property claim indicates that someone has a right of exclusive
disposal over the object in question. The importance of this denition, and its long-standing status, is evident in the following quotations by several prominent economists well-versed in the legal
foundations of market processes:
The institution of property, when limited to its essential elements, consists
in the recognition, in each person, of a right to exclusive disposal of what
he or she have [sic] produced by their own exertions, or received either by
gift or fair agreement, without force or fraud, from those who produced
it. (Mill, 1904, p. 278)
For our present purpose we may dene private property as the exclusive
control over valuable things by private persons. It is to be distinguished
from mere possession. The possessor has the use of the thing for the time
being, but unless he is at the same time the owner, he is dependent upon
the will of another for the use of it. Ownership implies the right of excluding other persons from the enjoyment of a thing. (Ely et al., 1914, p. 20)
The appropriation found in property is exclusive in its nature, and carries
with it as an attribute the right of the proprietor to control the action of
others in respect to the objects of property. (Ely, 1914, p. 132, emphasis in
the original)
If a persons right to exclusive control over his or her property is to

be substantial, they must be able to legitimately call upon the support
16
of the states police powers. This must be the case if property rights
are to be founded upon law rather than superior force. This latter
point is a core aspect of the denition of property:
The exclusive right must be recognized and guaranteed eectively by third
parties. If I defend my exclusive right of control over some valuable thing
against your claim simply by the strength of my right arm, I have not
thereby established the right of private property. My exclusive right of
control must be recognized by others and must be maintained by them.
(Ely et al., 1914, p. 20)
An implication of Richard Elys statement is that those who enjoy

the right of property have implicitly accepted an important social
duty: to respect and uphold the property rights of others. Again,
while this duty is easy to delineate conceptually, it is more challenging to describe what it means in actual practice indeed, this diculty
is one of the reasons our society has judges. Nevertheless, without the
mutual recognition of property rights, the concept has no operative
meaning:
The sphere of contract is made up of this mediation whereby I hold property not merely by means of a thing and my subjective will, but by means
of another persons will as well and so hold it in virtue of my participation in a common will. (Hegel, 1976, p. 57)
The scope of this recognition, and the duties that it implicitly

imposes, have presented the courts and the polity with a number of
dicult decisions over the years.
For example, as part of my right to exclusive disposal, I may
exchange my wristwatch for cash or drive over it with my car. No individual is legally entitled to interfere with either of these actions.
Indeed, I can legitimately anticipate and expect the state to act to
defend my right to engage in either course of action.
As is well known, this simple notion of property is presented with
an important limit when the exercise of my right to exclusive disposal interferes with another persons right to the use of their property. For instance, if I were to drive my car into your legally parked
car, I would be infringing on your right to dispose of your automobile as you see t.
Indeed, this simple vision of exclusive disposal begins to break
down when we consider more complex forms of property such as land
17
because, in most cases, it is dicult to isolate one persons land from

the surrounding community. It follows that the set of restrictions that
circumscribe the rights of an owner are relatively numerous in the
case of property in land. For instance, if I decide to host a rock-androll concert or locate a toxic waste dump on my property in a suburban neighborhood, I should anticipate legal challenges. This is
because virtually every community that we know of has enacted
restrictions on the use of land. These have varied widely. They include
prohibitions on the use of lawnmowers before the hour of noon on
Sunday, the establishment of businesses that feature nude dancing,
the sale of alcohol, the discharge of rearms, the posting of garish
signs, or the display of tacky commercial art. The list of restrictions
is close to endless.
Richard Ely (1914) distinguished between the extensive and
intensive rights of property. By an extensive right, Ely was referring
to the breadth and variety of objects, promises, services, or privileges
that one could claim as ones property. For instance, we know that we
currently enjoy the right to possess toys, food, computers, our own
labor, etc. That this extensive margin moves over time is evident when
we recall that we may no longer own persons, certain endangered
species of animals, several varieties of explosives and weapons
systems, and a select group of recreational intoxicants.
By intensive property rights, Ely refers to the variety of activities
for which we may use our property. As mentioned above, we may
drive our own cars over our own wristwatches or we may read our
own books. However, we may not build on our own wetlands without
attending to certain restrictions that were not in existence only a
couple of decades ago. History demonstrates that these intensive
margins of property rights are continually subject to modication
and change. An example of evolving intensive property rights
includes the many restrictions on the use of tobacco that have
recently swept across the United States. Previously one could smoke
virtually everywhere. This is no longer the case.
Finally, technical change means that new and unimagined property
rights, along with associated restrictions, are constantly emerging.
Technologies give rise to new experiences and products over which
society must establish property relations and, consequently, claims to
state protection. One striking example involves the airspace over the
Grand Central Terminal Building in New York City which is leased
to the owners of a separate building. Software and intellectual
18
property raise a host of new legal issues, many of which lack obvious
answers (cf. Lessing, 2001, 2004). A recent, and legally complex,
dilemma concerns the use of cell phones that can take photographs
which may then be loaded onto the internet. What restrictions can or
should be placed on this technology? What reasonable expectation
of privacy does one have when in public? At the beach or a public
pool? In a public changing room at that same pool? All of these questions will be addressed, sooner of later, by legislation, case law, and
lawsuits.
Decisions over the extensive and intensive margins of ownership
will always and, in the light of changing technological and social conditions, necessarily be the subject of ongoing political debate. This
debate will be inuenced by the actual qualities of the technologies
themselves in addition to the political and economic decisions of
large numbers of people. Throughout American history, judge-made
or common law has been concerned with expanding, contracting, and
adjudicating the domain of property rights in such a manner that,
ideally, is consistent with previous decisions while allowing for the
modications of rights and protections to account for changing
realities. Good, and lasting, decisions are typically those consistent
with the social practices, values, and welfare of the larger society
(Cardozo, 1922). But important exceptions to this principle can
readily be identied.1
It should be no surprise that some people, people with competing
interests, will be displeased with some of the decisions that emerge as
the laws of property evolve. One reason is that in almost every
instance a modication in the law of property results in a redistribution of wealth and opportunity. Even in the event that a decision is in
the overall interest of society, some persons will gain at the real or
perceived expense of others. Environmental laws are notoriously of
this quality. Restrictions that apply to building on wetlands or ban
clear-cuts on privately-owned woodlots, often reduce the wealth of
those rms or individuals who currently own claims on the lands in
question.
Consider, as a particularly dramatic example, the decision to emancipate the slaves. Two prominent economic historians have estimated
that at the beginning of the Civil War slaves represented 45.8% of the
total wealth of all the free residents of the ve primary cottongrowing Southern states. Clearly emancipation represented a tremendous loss for Southern slaveholders (Ransom and Sutch, 1977,
19
pp. 523). This being the case, it would have been surprising if
Southern planters did not vigorously resist the changing denition of
property law proposed by ante-bellum abolitionists.2
Another area of diculty concerns the ownership of ones own
body. Is it inalienable? Can one sell it, that is to say voluntarily enter
into a slavery contract? Can it be rented, as in the case of prostitution? If the answer to this last question is no, the implication is that
we do not have an absolute property claim in our own sexuality
(although under current law, one does in several Nevada counties).
By contrast to current practice, can individuals make a constitutional
claim to the absolute ownership of their own bodies in all jurisdictions and under all circumstances? Finally, if social norms and the
consequent rules of property and contract are to change, who is to be
assigned the task of formalizing these changes into law? Every society
must address such questions.
Some libertarian philosophers, such as Robert Nozick, argue that
property rights should be organized so as to allow individuals
maximum freedom dened as their ability to enter into binding contractual relations (Nozick, 1974). One of his most controversial positions is his argument that individuals should be allowed to sell
themselves into slavery. Nozick argues that this possibility would necessarily enhance freedom because it provides people with an additional choice. Such an argument presents us with an interesting
conundrum: are we more free if we can choose to become slaves? If
this seems self-contradictory and for that reason absurd, how about
self-enslavement for a limited period of time such as indentured
servitude? Technically, such contracts are no longer legal, but was it
not revived when we developed a volunteer Army? After all, signing
a contract with the Army is not like agreeing to work at a restaurant
or accepting a contract to teach economics at Middlebury College.
You cannot quit the Army if you decide that you no longer like your
platoon sergeant or are subjected to sustained enemy re. To muddle
things further, the militarys ability to unilaterally extend enlistments
through stop-loss orders, as the Bush administration did to sta its
adventure in Iraq, enhances the problematic qualities of these contracts (Hockstader, 2004).
Nozicks position can be refuted in the event that we advance what
is called a substantivist understanding of freedom. According to this
view rights, as opposed to privileges, are inalienable. Substantivists
would argue that the maintenance of each individuals capability to live
20
a full life, including his or her ability to enter into future contracts, is
fundamental to the states commitment to protect life, liberty, and
property (Mill, 1859; Pound, 1909; Nussbaum, 2000). It follows that a
persons liberty is absolute, or inalienable, and for that reason supersedes their decision to sell themselves into slavery.3 On the other hand,
services or privileges can be alienated. For this reason I can enter into
a contract to wash the car of my Dean, or extend to my students the
privilege of stopping by my oce, without compromising my inalienable liberties.4
CONTRACT LAW
According to libertarian political theorists, such as Nozick, the
States role should be limited to the protection of life, property, and
the orderly maintenance of freely negotiated contracts (Nozick,
1974). While it is clear that the protection of life and property are the
foundation of freedom dened in the negative sense of freedom
from the issue is more complex when we consider the law of contract. In a society such as ours, where markets are ubiquitous and the
notion of private property is widespread, it is evident that our personal development is dependent upon the acquisition and consumption of a certain mix of objects, promises, services, and privileges that
we collectively call property (Levine, 1988, 1995). Since we obtain
property through inheritance, transfer, creating it ourselves, or contract, it follows that the exchanges governed by contract law are at the
foundation of our ability to be free in the positive or substantive sense
of freedom to be.
This freedom to be enables us to have some control over who and
what we are. This is a personal and fundamental element of freedom
for each of us. This positive notion of freedom is more complex than
the simpler idea of the state defending our liberties from itself and
other individuals. This dual sense of freedom, freedom from and
freedom to be, is one of the factors that has made the law of contract so complex over the years.
In its simplest denition, contract law governs the conditions under
which property may be exchanged. Our everyday experience conrms
that most of the contracts that we enter into are implicit meaning
that they are neither negotiated nor written down. At most a receipt
will be oered to mark its completion. That said, many of our most
21
important contracts are explicit (rent, insurance, car payments, etc.).

In such cases, each side makes a deliberate eort to stipulate and
negotiate the terms of a pending exchange. Given the wide range of
contingencies and other considerations, these agreements can evolve
into highly complex documents. Even the seemingly mundane task of
dening a price can be surprisingly complicated (Morgenstern, 1963,
ch. 10).
Even in the case of a most explicit and detailed written contract it
is inevitably the case that many aspects of an exchange will remain
implicit and open to renegotiation and readjustment (Llewellyn,
1931; Macaulay, 1963; MacNeil, 1974, 1978). If a disagreement
over implicit understandings or conditions occurs, the law of contract rules by drawing upon precedent and conventional practice.
Fortunately, not every disagreement must result in litigation since the
value of an ongoing working relationship often acts as an implicit
control mechanism (Llewellyn, 1931; Axelrod, 1984; Milgrom et al.,
1990).
A variety of interesting dilemmas emerge in the law of contract
when we reect upon the specic circumstances of the labor market.
Labor presents unique diculties because supplying labor-power
almost always involves delivering the service in person. Unlike a
wristwatch, which we do not retain any rights over after an exchange,
the most that we can do with our persons is to rent our labor-power.
Moreover we, and the state in its role as the guarantor of our rights,
retain a compelling interest in our health and welfare while we are on
the job. This means that some protections or guarantees must be
mandated, negotiated, and/or compensated for. At a minimum, the
specic qualities of the work conditions will be of interest to both
parties. As Ely put it, The fact that the function of working is bound
up with the rest of a human personality gives the purchaser control
over other parts of the workers life than those which he has directly
bought (Ely, 1914, p. 627).
Since the state is obligated to protect its citizens life, liberty, and
property, and enforce contracts, labor law can be the object of intense
political interest and debate. Over the centuries, labor law has undergone some dramatic changes. Legislation and court decisions concerning maximum hours, health and safety, minimum wages, and the
right to unionize have each and severally had a profound impact upon
the form and content of American labor relations (Hovenkamp,
1988; Paulsen, 1996; Nordlund, 1997; Steinfeld, 2001; Linder, 2002).
22
Important and lasting changes in the distribution of wealth, income,

and opportunity have followed from these decisions.
THE CONDITIONS FOR A LEGALLY BINDING

CONTRACT
At its simplest level, a contract is an oer and an acceptance.
However, for a contract to be considered legally binding, in the sense
of being formally recognized and therefore enforceable by the legal
system, the following criteria must be met: (a) no coercion must be
exerted or implied, (b) consideration must be paid, and (c) the contract must be consistent with the laws of the land.
(A) No Coercion
The no coercion rule is easy to articulate. In practice, it has led to controversy and extensive debate. In its simplest form this rule arms our
common sense belief that our consent to the armed robbers terms of
your money or your life does not constitute a binding contract. Any
contract entered into under the threat of violence is not legally
binding.
While no coercion is an unambiguous rule, how do we assess an
implicit threat? What if an amorous boss invites his new executive
assistant to accompany him on a summer weekend to his beachside
house? What if the invitation comes with a suggested, if unspoken,
implication that it would be unwise to refuse such an invitation?
Alternatively, what if a large and physically t person asks you to buy
a brick for $40 on a dark lonely street? What if this same person insists
that you consider their oer while holding the brick in question up
in your face? In neither of the above cases has a threat been stated. But
is one implied? On what grounds should the courts decide? Does the
specic identity and role of each of the individuals, and the setting of
the negotiation, determine the case? Should an a priori abstract principle or rule decide the merits of each case? Many of us would agree
that context is an important element of justice, but what weight should
be assigned to it in matters of law? The complexity of each of the above
scenarios is related to the fact that context is dicult to account for in
matters of law since equality of treatment and reasonableness are
each highly valued as legal and social ideals (Rose, 1988).
23
Throughout American economic history the courts have had to

address situations wherein economic duress has led people to enter
into contracts that they would otherwise reject. People have accepted,
and still accept, contracts that amount to a condition of slavery in
everything but name as a consequence of their poverty or indebtedness at the time of its negotiation (Ransom and Sutch, 1977, ch. 8;
Bales, 1999). Should we conclude that such contracts are freely
negotiated and entered into? What of a case wherein a contract
agreed to in the face of poverty forces a person into even more
extreme misery in an inevitable and self-reinforcing cycle?
Some legal and political theorists have argued that economic desperation is in itself coercive and thus a form of injustice. Among
others, this argument was made a hundred years ago by a group of
British political theorists who came to be known as the New
Liberals (Hobhouse, 1911 [1994]; Green, 1881 [1986]). Here in the
United States, the economist Richard Ely termed contracts agreed to
under economic duress the new feudalism (Ely, 1914, pp. 71129).
Many Progressive and New Deal Era reformers agreed with him.
Among them was the prominent Catholic theologian and labor rights
activist Monsignor John A. Ryan:
When a labourer is compelled by dire necessity to accept a wage that is
insucient for a decent livelihood, his consent to the contract is free only
in a limited and relative way. It is what the moralists call voluntarium
imperfectum. It is vitiated to a substantial extent by the element of fear,
by the apprehension of a cruelly evil alternative. The labourer does not
agree to this wage because he prefers it to any other, but merely because he
prefers it to unemployment, hunger, and starvation. (Ryan, 1919, p. 329)
The concern to check the coercive nature of economic need motivated

the demand for laws regulating work hours and minimum wages that
began during the early decades of the twentieth century (Prasch,
1998b, 1999, 2000c; Levin-Waldman, 2001, ch. 3). This Progressiveera concern for the injustice that was a predictable consequence of
economic coercion later inspired the labor and welfare-state legislation that we now associate with President Franklin Roosevelts New
Deal. But this was not a seemless transition. Economic legislation
was treated most skeptically by the courts that, by 1900, had come to
favor a doctrine known as Liberty of Contract.
In an (in)famous United States Supreme Court decision, known as
The Bakers Case, the majority ruled, ve-to-four, that the State of
24
New York was infringing on bakery employees constitutionally protected Liberty of Contract when it enacted a law limiting their
working day to 10 hours (Lochner vs. New York, 198 U.S. 45 (1905)).
The court ruled that the Fourteenth Amendment to the Constitution
guaranteed that life, liberty, and property could not be taken
without due process of law. This decision was based upon an
expansive interpretation the Fourteenth Amendment, an amendment
originally passed to protect the rights of recently emancipated slaves.
As Justice Oliver Wendell Holmes argued in his dissent to the courts
majority, The Fourteenth Amendment does not enact Mr. Herbert
Spencers Social Statics . . . a constitution is not intended to embody
a particular economic theory, whether of paternalism and the organic
relation of the citizen to the State or of laissez-faire (Holmes, dissent
in Lochner, op. cit.). Nevertheless, the courts majority held that an
absolute liberty of contract was the relevant legal principle in this
case. Again, can a freely negotiated contract between a party that is
economically desperate, and another that is not, be coercive? After
all, the bakery owners were not forcing their employees to accept
onerous terms. These employees, according to the majority opinion
of the court, were free adult males who had freely contracted with
bakery owners. Employers could also, with reason, argue that they
were not responsible for the preexisting poverty, dicult circumstances, and reduced bargaining power of their employees. The claim
that the State of New York made, but failed to sustain in this case,
was that a labor market could be coercive even when the terms of
employment are the outcome of a formally free and fair negotiation.
Since the 1930s, legislatures and the courts have generally found
that an unequal bargain, with a detrimental result, can occur even
in the event of an otherwise freely negotiated labor contract.
Furthermore, they have held that the state, in its role as societys guarantor of its citizens liberties, can proscribe contracts that are
deemed, a priori, to be detrimental to the health and welfare of individuals and the market system considered as a whole. For this reason
protective labor laws, such as the minimum wage, have been upheld
(Paulsen, 1996; Nordlund, 1997).
By contrast with the dominant perspective of the American public
and the legal profession, over the past 50 years American economists
have generally rejected the proposition that systematically unequal
exchanges can occur in a free and fair market. Given their prior commitment to models of the market made up of free, autonomous, and
25
rational agents, economists have been critical of much of the labor

market legislation passed by legislatures and upheld by the courts
since the late 1930s (Stigler, 1946; Friedman, 1962). Much of the dissension between the economics and legal professions is a consequence
of these dierent visions. This debate has fueled the emergence of
a law and economics movement committed to reinserting the
liberty of contract perspective into legal discourse and, ultimately,
judicial rulings (Purdy, 1998).
(B) Consideration
Readers should be warned that the law of consideration is a very complicated subject, and for this reason what follows here should be
thought of as suggestive rather than denitive. With this caveat in
mind, at its most general level consideration is the price paid for the
promise (American Institute of Banking, 1940, p. 48). Often it is the
full amount owed, but it could be a down payment, a symbolic sum,
or even a gesture. Today, the latter is generally a signature, performed
to indicate the acceptance of the terms, and thereby the intention to
be bound by the terms of the contract. Historically, the terms of consideration were thought to be fullled when one party bestowed a
benet upon the contracts counter-party, thereby demonstrating that
one had incurred a detriment in exchange for the contract. Again, the
consideration oered need not represent the full value of the benets
promised under the contract and may even consist of a token such as
a single dollar. Today clear intent, as represented by a formal seal or
signature, is typically sucient to indicate acceptance. Under either
approach, consideration is a gesture that signals that you have knowingly, and with intent, bound yourself to fulll the terms of the
contract.
Consideration also serves to distinguish a contract from a gift.
Since the days of ancient Rome, contract law has tried to distance
itself from the task of ensuring that people keep promises to bestow
gifts upon one another (as always, exceptions can be found). A contract is legally distinguished from a gift in that the latter is thought to
be what lawyers call a gratuitous undertaking. By contrast, a contract
is an exchange negotiated between, and involving the agency of, separate and responsible parties. A gift, by contrast to a contract, is not
thought to involve intent, payment, or performance on the part of
those upon whom it is bestowed.
26
(C) Consistent with the Laws of the Land

Private contractual relationships cannot preempt the states laws. For
example, one cannot be released from prison or excused from the military draft by contracting to work at the local country club.
Additionally, if fullling the terms of a contract necessitates a violation of the law, then it will neither be recognized nor upheld by the
courts. The purpose of this latter provision is to disrupt the formation of orderly markets in illegal products or services. Absent any
recourse to the courts for adjudication of disputes, contract enforcement in such markets can be expected to be inecient, expensive, and
even dangerous. In short, the absence of legally enforceable contracts
and property rights collectively increase the costs associated with
operating an illicit business. As a consequence the total volume of
illegal business should decrease. Depending upon circumstances, the
total revenues that accrue to such businesses may or may not decrease.
The latter outcome depends upon several considerations that are
beyond the concerns of this lecture.
As an adaptive response to the lack of enforceable contracts, illegal
markets are often characterized by an emphasis on reputation. This
element of illegal markets has been popularized in books and lms
on the Italian Maa, which seem to marvel at these Codes of
Honor. Economically speaking having a reputation for integrity,
and the respect of everyone in a market, are substantial competitive advantages in the absence of legally enforceable contracts. A
credible reputation reduces both bargaining and enforcement costs.
Additionally, since one cannot sue for breach of contract in these
markets, violence is periodically visited upon those who are thought
to be in violation of the terms of their obligations (Bourgois, 1995).
The other side of this story is that persons who wish to break their
agreements must do more than simply appear in bankruptcy court.
They might be better advised to leave town so as to avoid the draconian penalties periodically exacted for non-compliance.
CONCLUSION
As is evident from the above, the social institution that we term the
market is a complex construction, based on an evolving system of
rights, property law, and contract law. While often overlooked, one
27
could plausibly argue that economic progress is as much the consequence of advances in the formation of the social institutions that
support the division of labor and exchange, including the law of
property and contract, as it is a consequence of technology or the
sum of individual or collective enterprising activities (Commons,
1924; Chandler, 1977; North, 1990; Lazonick, 1991; Steinfeld, 2001).
In this sense, the study of market relations properly begins with an
understanding of these laws and institutions. It follows that economic
policy and economic change should be at least as concerned with
getting institutions right, or getting the legal framework right.
An analysis of economic aairs necessarily begins with a study of
economic institutions the most important being the foundational
structures of the market itself property and contract law. It is also
evident that the social scientic and policy question is not whether the
law or the state is involved in the market. Rather the correct question
is just how it should be involved, and what laws and regulations make
the most sense. In short, regulation is not necessarily in conict
with the market. On the contrary, the social arrangement that is
conventionally called a free market has been built upon a long and
evolving tradition of legally framed rights, distinctions, and prohibitions that is continually interacting with an equally long history of
evolving ideas, legislation, and court rulings on property and contract
law.
NOTES
1. An interesting instance of these considerations taking place as I write is the eort
to convince Americans and the world that the use of le-sharing software to transfer music or movies is theft, even piracy! In this instance, technology has
created new possibilities for human behavior and action. For obvious reasons, the
lm and movie industries desire to control this process and have used their considerable inuence to achieve this result. Rhetorically, they have brought the
language of theft, against which there is a strong and lasting association with
immorality, to an issue which is really one in which new technologies have created
a legal vacuum. As a legal and social issue, this ongoing process is similar to that
of the colonial era in the United States when the new settlers found that they had
easy access to large stands of old-growth timber, including many trees with long,
straight trunks. The English crown claimed prior ownership of all such trees as
they were valuable for the masts of ships. The colonists valued them for building
homes and fences. Since the felling of trees on what settlers took to be unclaimed
land was something that colonists could readily do, and since the Crown had a
limited ability to enforce its claim, it is not surprising that many colonists harvested
these tall straight trees for their own use.
28
2. Adam Smith thought that such considerations were paramount even in relatively
pious societies: The late resolution of the Quakers in Pennsylvania to set at liberty
all their negro slaves, may satisfy us that their number cannot be very great (Smith,
1776 [1937], p. 366).
3. In Germany a person entered into a fully voluntary agreement to be killed and cannibalized. Later his killer presented overwhelming proof to the court that this individuals death was part of voluntary contract. The court nevertheless set aside
these agreements and found the defendant guilty of manslaughter (Landler, 2004).
4. Not everyone would agree with this sentence. Several economists have argued that
the labor contract is inherently a violation of a workers freedom, and that the
nations workplaces should be reorganized as worker-owned cooperatives to eliminate the need for them (Ellerman, 1990, 1992; Lutz, 1999).
LECTURE II
Commodity markets: the economics

of a spot contract
It needs to be stated at the outset that Supply and Demand is, at best,
a tendency and not a Law. Unfortunately, the rhetoric indulged in
by too many economists, paid consultants, opinion page writers, and
other sundry experts has so undermined our thinking that this must
be clearly stated. With this preliminary out of the way, we can state
that our collective experience with markets suggests recurrent tendencies or trends. Upon considering these tendencies, economists and
others have perceived persistent patterns. As a consequence, early
social scientists developed a set of metaphysical propositions concerning the innate nature of people and, by extension, market
processes.1 These metaphysical notions include propositions such as
people are rational and people are self-interested. From these
ideas it is deduced that people will invariably search out the best products at the lowest prices, all other things being equal.2 As discussed in
the introduction, I am partial to such views. However I also believe
that an accurate understanding of how markets work requires
Theories, rather than a single Theory, of Supply and Demand.
The market to be examined in this lecture will be labeled the commodity market. I need to emphasize, here at the beginning, that in
these lectures the word commodity has a specic denition. In
these lectures, commodities are commonplace or everyday items used
for personal consumption.3 It will be assumed that the use or display
of these items confers neither status nor superior reputation on those
owning, using, or displaying them.4 It follows that the exclusive
reason that a consumer buys a commodity is to satisfy a well-dened
want or need. Examples of commodities, in the sense I am using the
term here, would include dishwashing soap, broccoli, or athletic
socks.
29
30
Another critical quality of commodities, as they will be presented

here, is that they are inspection goods. These are best dened in
contrast to experience goods whose underlying or innate qualities only come to be revealed after purchase and use. Contrary to
experience goods, the relevant qualities of inspection goods can be
readily ascertained by relatively uninformed buyers through direct
observation.
Two important presuppositions are consistent with the above
considerations. First, consumers can be presumed to have reasonably
complete knowledge of the qualities of the several commodities competing in any given market. Second, aside from the inuence of broad
cultural norms, consumers demand for commodities are substantially formed independently of one another. The implication is that
each consumers choices and sets of nal demands are established
independently of the assessment of other consumers in the market or
society.5
THE THEORY OF DEMAND FOR

COMMODITIES
Demand is represented as a schedule depicting the quantities of a
good that people are willing to buy per unit of time, at varying prices,
all other things being held constant. When the price of a commodity
is reduced, people will exhibit a higher quantity demanded of a commodity. Again, all other things being equal. Similarly, the higher the
price, the less quantity demanded ceteris paribus (Translated, this
means the condition of all other things being equal).6
In Figure II.1, demand is presented as a schedule where the quantity demanded (D) is inversely related to price (P). Starting on the left,
we can see that when the price is relatively high (Pa), the associated
level of demand is low (Qa). As this price declines toward zero, the
quantity demanded (Q) increases. This tendency is illustrated by the
slope of the demand schedule (D), in which ever-lower prices (P) are
shown as corresponding to ever-higher quantities being demanded
(Q). (Read the above diagram like a book from left to right.)
It should be noted here that the convention for graphical formats
is that price movements induce changes in the quantity demanded, and
are depicted by movements along a xed demand schedule. This is
illustrated in Figure II.2 below by the movement from point A to
31
Commodity markets
Price per unit
Pa
S
D
0
Figure II.1
Quantity
Qa
Supply and demand of a commodity
Price per unit
Pa
Pb
D1
Qa
Qb
D2
Quantity
Figure II.2 Shift in demand (D1 to D2) vs. change in the quantity
demanded (A to B)
32
point B. By contrast, what is termed an increase in demand is graphically signied by shifting the entire schedule to the right. This is illustrated in Figure II.2 by a shift in the entire demand schedule from D1
to D2. To review, then, price changes induce changes in the quantity
demanded and are illustrated by movements along a xed demand
schedule. Changes in the level of demand from any cause other than
the price of the commodity are illustrated by shifting the entire schedule either outward to the right (for increases) or inward to the left (for
decreases).
The core principle underlying the theory of demand is the idea of
substitution. Customers are thought to be, explicitly or implicitly,
comparing and contrasting the price and qualities of this and other
commodities with the size of their budget and the intensity of the
wants or needs they are hoping to satisfy. Should it turn out that,
after all relevant prices are considered, a rival good with similar qualities would more completely satisfy the consumers wants, or satisfy
them more cheaply, then the customer will purchase in that other
market.
It is this all-important principle, called The Substitution Eect,
that accounts for the slope of the demand curve. The slope of the line,
moving downward to the right, graphically illustrates the idea of an
inverse relationship between price and the quantity demanded when
one rises, the other falls, and vice versa. The substitution eect is the
fundamental explanation for why quantity demanded declines as the
price of a commodity increases. When the market price rises, consumers less committed to this specic item will seek out cheaper
substitutes.
In this sense, high prices ration goods across all those who might
desire to have it. Markets, of course, do not ration by edict. Rather,
rationing occurs in accordance with both the willingness and, equally
importantly, the ability, to pay. This fact explains why this mode of
rationing ability to pay in the market is favored by people whose
incomes are plentiful relative to their leisure time that is to say
people with high incomes or substantial wealth. Stated simply, in a
market economy, desire, in the absence of cash, is exclusively a hope,
a wish, or a prayer. Adam Smith summarized the situation long ago,
A very poor man may be said in some sense to have a demand for a
coach and six; he might like to have it; but his demand is not an
eectual demand, as the commodity can never be brought to market
in order to satisfy it (Smith 1776 [1937], p. 63).
Commodity markets
33
As mentioned, changes in conditions other than market price are

represented by a shift in the overall demand schedule. When these
conditions change the entire schedule will shift either inward to the
left (meaning lower overall demand at each and every price) or
outward to the right (meaning a higher overall demand at each and
every price). Conditions that induce such a shift include changes in:
1.
2.
3.
4.
5.
The number and average income of current and potential buyers;

Buyers tastes and preferences;
The availability or price of goods that are either substitutes or
complements to this commodity;
The availability and price of consumer credit;
The state of consumers collective expectations as to future
market conditions, including the future price and availability of
this commodity.
Changes in any of these conditions are thought to induce a shift in

the demand schedule. The distance and form of this shift depends
upon (a) the size of the changing condition and (b) the responsiveness of consumers to the change in question.
Consumer income plays a crucial role in the demand for commodities. Ceteris paribus, higher incomes increase the demand for what are
called normal goods. When incomes rise, people desire more normal
goods such as comfortable housing, new automobiles, and Caribbean
vacations. People with low or falling incomes reduce their demand for
such items (similar dynamics apply to changes in wealth). When
incomes rise, the increase in demand is depicted as a shift from D1 to
D2 in Figure II.2 above. From this description it is evident that a meal
at one of the best restaurants in town can plausibly be thought to be
a normal good. If the communitys income rises, we can expect such
restaurants to gain additional business, ceteris paribus.
The opposite dynamic applies to inferior goods. Inferior goods
are items that we tend to consume less of when our incomes increase.
Examples include macaroni and cheese in a box, discount brands of
beer, rusted and damaged old cars, etc. If the commodity depicted in
Figure II.2 were an inferior good, an increase in income (or wealth)
would have the eect of shifting demand downward. In Figure II.2
this would be represented by a shift from D2 to D1.
Not surprisingly, an increase in consumers tastes and preferences in favor of this product shifts the demand curve from D1 to
34
D2. If an item that is consumed as a complement to this item is

cheaper, the quantity demanded of that other good will increase, and
the demand curve for the good we are analysing in Figure II.1 will be
shifted out to the right. The price of substitutes and the demand for
the above good, not surprisingly, are positively correlated. If the price
of a close substitute rises, the demand for the above good shifts out,
and vice versa. More and cheaper credit operates in a manner parallel to an increase in income and increases the demand for all normal
goods.
A nal, and important inuence on consumer demand comes
through expectations. If consumers expect the price of home heating
oil to increase in the near future, they will be inclined to rell their
home storage tanks today. The result will be an outward shift in this
commoditys demand schedule with an increase in the price of oil.
This is a direct consequence of the outward shift in the demand schedule, which was itself a consequence of the previously-posited expectation of a rise in price. It should be noted that economic events driven
by expectations can take the form of self-fullling prophesies. We
will return to this important issue in the lecture on asset markets.
DEMAND ELASTICITY
Understanding the broad causal relationships between price and
demand is often inadequate for business and public policy discussions. In addition to Which way? one often requires an answer, or
at least a defensible guess, as to How much? In the event that a rm
were to reduce the price of its goods, by how much can they expect
the quantity demanded to rise? This issue is addressed by a concept
called elasticity.
The conventional formula for elasticity, given below, is relatively
simple. The elasticity of demand (Ed) is the absolute value of the percentage change in the quantity demanded (%Qd) induced by a
1 percent change in price (%P). If, for convenience, we leave out the
signs for absolute value, the formula is as follows:
Ed %Qd / % P
Elasticity is the standard measure of the responsiveness of quantity demanded to changes in price. In plain English, elasticity is the
Commodity markets
35
absolute value of the percentage change of the quantity demanded

induced by a 1 percent change in price. Some numerical examples will
illustrate the point. If a 1 percent price reduction were to increase the
quantity demanded of an item by 2 percent, we would say that the
elasticity of demand for this commodity at this price is 2 and that its
demand is price-elastic or, more simply, elastic. Similarly, if a
1 percent decrease in another commoditys price were to induce onequarter of a percent increase in its quantity demanded, we would say
that this items elasticity is one-quarter and that it is price-inelastic
or, more simply, inelastic.
A high elasticity (by convention, an estimated elasticity greater than
1) implies that the quantity demanded of a particular commodity is
highly responsive to changes in price. This high level of responsiveness
suggests that consumers think of this commodity as either inessential,
in that they can get along without it, or that it has a substantial
number of close substitutes. For either of these reasons a 1 percent
increase in the price of this commodity will result in a greater than 1
percent decrease in the quantity demanded as consumers either stop
buying the item altogether or seek out a close substitute. Additionally,
a commodity may register a relatively high degree of elasticity when it
absorbs a signicant portion of the income of its median consumer.
The explanation for the latter tendency is that consumers will gather
more information and seek out more substitutes when they are spending a large portion of their income.
By contrast, a low elasticity of demand (by convention, a measured
elasticity less than 1), can occur when consumers believe that they
need this commodity and that its unique attributes render it dicult
to identify worthy substitutes over the short or medium period. Such
a commodity might even be said to represent a need as opposed to
a want. An extreme example would be the demand for insulin on
the part of a person living with diabetes.
A low elasticity of demand can also occur when the commodity in
question absorbs a trivial percentage of the income of the median consumer. Consumers are less likely to comparison shop if they are spending a minuscule portion of their income on a particular purchase. In
the United States today, bulk table salt has this quality. Most of us buy
a large container of salt every year or so at prices that, to most
Americans, are inconsequential. Since our pattern of salt use is determined by the intersection of lifestyle and cooking habits, and the outof-pocket cost is trivial, we pay little attention to changes in the price
36
of table salt. As a consequence of our lack of concern the demand for

salt is relatively inelastic. Our collective disinterest grants the rms that
produce and distribute it more discretion when setting prices.
By contrast to the above example, for most of history salt was
inelastic, not because of its low cost relative to peoples incomes, but
rather because it is necessary to sustain life. Additionally, for a long
time it was one of the few available food preservatives. For each of
these reasons, salt was often subject to tax, especially on the part of
despotic governments the Emperors of China and the British Raj in
India come immediately to mind. It is not a coincidence that when
Mahatma Gandhi began his campaign of non-violent resistance
against the British Raj one of his rst, and most symbolically eective
moves, was to march with his colleagues from his Ahmedabad home
to the Indian Ocean to produce his own salt. The British, of course,
had made it illegal to gather salt directly from the ocean as it was an
eective strategy for avoiding their salt tax.
To illustrate the concept of elasticity, consider the eect of a successful advertising campaign. Ostensibly, the purpose of advertising
is to notify or remind people of the existence, availability, or price of
certain products. Yet it is also evident that advertising is charged with
two other important tasks (Bernays, 1928 [2004]; Dawson, 2005).
The rst is to modify the underlying tastes of the target population
in a manner favorable to the supplier of the good or goods in question. This provides a larger number of buyers and for that reason
an increase in demand. Second, a successful advertising campaign
should convince at least a portion of the buying public that the item
in question is a necessity that is to say, convince the public that few
good substitutes exist. Ideally, customers will come to perceive the
commodity in question as a need, rather than as a mere want.
When an advertising campaign achieves such a result, the demand
curve becomes steeper.
A highly successful advertising campaign has the collective eect,
illustrated in Figure II.3, of shifting the demand schedule outward
from D1 to D2 even as, visually, it becomes steeper. In the shorthand language of economics, it is said that the demand schedule has
become more inelastic. From the perspective of the advertising rm
a most cheerful (and remunerative) consequence is that this steeper
demand schedule will enable its client to raise the price of its wares
without losing too many of its customers thereby increasing revenues (total revenues are simply price times quantity).
37
Commodity markets
Price
D2
D1
0
Figure II.3
Quantity
The eects of successful advertising on demand
THE THEORY OF THE SUPPLY OF

COMMODITIES
The supply schedule illustrates a set of prices and the hypothetical
quantity of commodities that rms would supply at each of them. In
drawing this schedule, it is conventionally supposed that the supply
of commodities is limited by at least one xed factor of production
(ie. the factory has a certain capacity, or the farmers elds are only
so large, etc.). This stylized fact implies that supply is not unlimited and that some kind of bottleneck will emerge as the production of that commodity increases. From this assumption, it is argued
that costs-per-unit will tend to rise with increases in the total quantity supplied. In the market for commodities, the price of a commodity and the quantity supplied are thought to be positively
related. This means that when the market price rises, the quantity
supplied to the market also rises. Graphically, the supply schedule
slopes upward to the right, reecting the increasing costs and, for
that reason, increased price that consumers must pay to induce rms
to expand supply.7 Assuming, for simplicity, a linear relationship
38
Price/unit
Supply
0
Figure II.4
Quantity/time
The supply schedule
between price and quantity supplied, the market supply curve is

depicted in Figure II.4.
An important theorem associated with the idea of perfectly
competitive markets is that at each and every point on the supply
schedule prices reect the additional cost to producers of supplying
one more unit of the commodity in question. The cost of this last
unit supplied is known as the marginal cost. This concept is
important because, as mentioned, it represents the cost to the rm
of producing one additional unit of a commodity. Likewise, it illustrates how much the rm would save if it did not produce that item.
In the event that the market price is equal to marginal cost of production, the producer is charging its last consumer a price exactly
equal to the direct expense associated with providing that last item.
The theorem that at any given moment the supply price is equal to
the rms marginal cost of production is, it cannot be overemphasized, an important conclusion from the perspective of political
economy.8 On the margin, customers get exactly what they pay for,
and suppliers are exactly compensated for their direct costs. On the
production and sale of this last, or marginal, unit of output neither
Commodity markets
39
party to the transaction can be thought to experience either an

excess gain or loss.
The core proposition of the previous paragraph is typically demonstrated through a counter-factual argument. Consider a rm operating in an environment featuring no costs associated with entering
or exiting a market, no costs to making transactions or gathering
information, and many competitors what economists call a perfectly competitive market. Now let us suppose that this rm charges
its customers a price greater than its marginal cost of production. In
such an instance a competing rm, perceiving an opportunity, will be
able to enter this market and supply the good for less than the rm of
our example. The original rm or even a third rm would then perceive an opportunity to present the item for even less, and so on, until
the competitive process forces the market price down to the point
where the item is sold at its marginal cost.
A parallel example illustrates what would occur in the event that
the market price were lower than the marginal cost of supplying it.
Experiencing a loss, rms would, again at no cost, withdraw such
items from the market and redeploy their productive assets to more
lucrative activities. Customers will then be forced to either pay a
higher price for these items or attempt to meet their wants through
the purchase of a substitute. The resulting combination of reduced
supply by rms, and enhanced price oers by consumers, will induce
the market price to rise enough to cover the marginal cost associated
with the last unit supplied.
As mentioned, the quantity supplied of a commodity is positively
related to its market price. If the market price rises, so will the quantity supplied. If the market price falls, so will the quantity supplied.
Besides changes in the market price, which cause movements along a
xed supply schedule, the entire supply schedule will shift as a consequence of changes in the market environment. These conditions fall
under one of the following headings:
1.
2.
3.
4.
5.
Changes in technology;
Changes in the unit cost of inputs into the production process;
Changing prices in related markets that rms could readily
supply;
Changes in the availability and price of business credit;
Changing expectations of future market prices and available supplies.
40
These environmental changes, and their eects, will be addressed in

order.
1. Changes in technology Technology, as used here, is to be understood in a broad sense that is to say it is more than simply improved
know how or machines. It includes new and innovative management styles, techniques for reformulating or reconguring the production process, etc. The stylized fact I wish to capture here is that
technology has the eect of enabling greater production with a xed
number of inputs or the same level of production with a reduced
quantity of inputs.9
When technology improves, the marginal cost of production for
each and every unit is reduced. As a consequence, the entire supply
schedule shifts outward and to the right (again, these graphs are read,
as books are, from left to right). This shift illustrates that producers
are able and willing to supply a greater quantity of goods at each and
every market price, ceteris paribus. This is illustrated in Figure II.5
below with the shift of the schedule from S1 to S2.
Price
S1
0
Figure II.5
S2
Quantity
Changes in supply
Commodity markets
41
2. Changes in the unit cost of production inputs Suppose the cost of

a critical input were to decrease, reducing the cost of production at
each and every level of output. In this case, the entire supply schedule would shift outward and to the right. This illustrates a lower marginal cost of production for each and every unit produced and
therefore an increased level of supply at each and every market price.
This is consistent with the shift illustrated in Figure II.5. Similarly, in
the event of a higher cost of inputs, the marginal cost of production
would increase. The supply schedule would be represented as shifting
inward and to the left, illustrating a reduced supply at each and every
market price, ceteris paribus.
High volatility has been a long-standing characteristic of many
primary goods that are essential production inputs. Oil, wheat, copper,
cocoa, bulk coee and many other primary goods and natural resources
have long exhibited dramatic price uctuations.10 These uctuations, in
turn, contribute some risk to the economic system as these price
changes impact the cost structure of producing rms, including the
average and marginal cost of supplying additional units of output.
3. Price changes in related markets that rms could supply The
stylized fact here is that the resources and talents at the disposal of
any given rm can be redeployed to related markets. Consequently,
prot-seeking rms can be expected to monitor prices in related
markets to see if potential opportunities emerge. Should a non-trivial
number of rms identify a more protable opportunity in a related
market, the supply schedule will shift inward and to the left, which is
consistent with a decline in the amount of goods for sale at each and
every market price. An example would be the eects of increasing
suburban housing prices on the market for locally-grown farm
produce. Suburban farmland becomes relatively scarce as it is turned
into housing, thereby reducing the supply, while increasing the price,
of fresh produce.
4. Changes in the availability and price of credit Firms generally
require credit to operate and expand their businesses. Bank credit is
important, but of equal if not greater importance is credit from suppliers. Products, machinery, spare parts and even labor are delivered
to rms in the expectation that bills (and wages) will be paid at a later
date. The period between receiving the items in question and the date
that payment is due represents credit to a rm. Unsurprisingly rms
42
at risk of bankruptcy have diculty convincing suppliers to deliver

goods without advance payment. This increases the cost of doing
business as such rms must have substantial cash available up front
to replenish inventories, buy parts, pay labor, etc.
In the previous paragraph it was mentioned that labor, like other
production inputs, is usually supplied on credit. This is largely unrecognized since it is rarely acknowledged and interest is even more
rarely paid. Typically, a new employee will work for an extended
period, often four to six weeks, before receiving their initial paycheck.
Accrued vacations and other benets, such as a retirement plans, represent additional forms of deferred compensation. Not surprisingly,
for many rms, labor is their most substantial creditor. Over the last
decades we have been reminded of this fact on almost a daily basis as
rms with substantial outstanding debts to their employees, such as
airlines or steel companies, have asked the courts to relieve them of
these contracted obligations. Be that as it may, the supply curve shifts
inward or to the left when less credit is available or more expensive. It
shifts outward and to the right when more credit is available or
cheaper.
5. Changing Expectations Firms form expectations as to how the
markets for inputs and nished goods will look in the near and distant
future. If a rm anticipates that the market for a given product is
likely to be depressed, they will move now to reduce their inventory
of that item. This can be accomplished by placing a greater quantity
on the market today. As in the case of demand, there can be an
element of a self-fullling prophesy to this. More supply today
means a lower price. Hence, the expectation of a lower price tomorrow can induce rms to take actions today (such as dumping extra
inventory) that induces just such a consequence. These dynamics
work in the opposite direction in the event that rms anticipate rising
prices.
DYNAMICS OF THE SPOT MARKET FOR

COMMODITIES
First, a denition: a spot market is one in which transactions
are negotiated and settled in the course of a single meeting or interaction. The paradigmatic example is the neighborhood garage sale.
43
Commodity markets
Price
Supply
A
Demand
0
Figure II.6
Quantity
The spot market for a commodity
Spot markets feature dynamics distinct from markets in which rms

or persons enter into ongoing relationships. Instances of the latter
include debt, insurance, or mortgage contracts. The importance
of this distinction will emerge in the lecture on credit markets.
Commodity markets, the subject of this lecture, will be assumed to be
spot markets. With this in mind, consider the graph in Figure II.6,
and in particular two points on this graph: Identied by the letters A
and B.
In Figure II.6 it is evident that the point marked by the letter A is
above the market equilibrium consistent with the market-clearing
price dened as the unique point where the supply schedule intersects the demand schedule. Since point A is above this equilibrium,
and because this graph is read from left to right, it is evident that at
point A the quantity supplied of this particular commodity is greater
than the quantity demanded. Indeed, in the region of the graph
around point A, the market is characterized by an excess of supply
(S D), otherwise known as a surplus. Given the desire of all protoriented rms to sell their wares, the expectation is that they will be
inclined to reduce their excess inventory by lowering their prices.
44
Lower prices will simultaneously increase the quantity demanded.

These adjustments will continue until the market clearing price and
quantity are established where the quantity demanded and the quantity supplied are equivalent. This is represented by the intersection of
these schedules in Figure II.6, which is considered to be the point of
market equilibrium. The point marked B is subject to a similar
analysis, with the problem being that this region of the graph features
a shortage in which market forces will increase the price until the
market clearing equilibrium is achieved.
Market equilibrium is the unique point where the two schedules
cross and therefore the quantity supplied is exactly equivalent to the
quantity demanded. At this point the market is thought to be in a
state of rest hence the term market equilibrium. This spot market
equilibrium has two properties of great analytical and metaphysical
importance. In the absence of any other disturbing cause the equilibrium is both unique and stable. It is stable because once it is achieved
there is no compelling reason for sellers or buyers to deviate from it.
Whoever attempts to do so will experience a loss relative to what they
would achieve by operating at the market price and quantity. It is
unique because the slope of each schedule has a dierent sign, one
positive and the other negative, and for this reason there can, logically, be only a single point of intersection.
Collectively, these two qualities (stability and uniqueness) are
important, perhaps the most important, lessons of the Theory of
Supply and Demand in commodity markets. In light of their importance, we should pause momentarily and reect on their implications
for political economy.
The theory of the market sketched above supports the prominent
political idea that government should have a limited role in the marketplace. The reason is that the theory indicates that freely operating
markets will automatically and autonomously establish a set of prices
that will coordinate (a crucial word) the decisions of all actual and
potential market participants such that all their decisions will be consistent with one another. Governments role would be reduced to
attending to the denition and protection of property rights and the
enforcement of contracts.
Such a statement is fairly sweeping, but to be fair it does not claim
that everyone is delighted with the outcome. Some people may have
wished, perhaps even needed, to have been supplied with this commodity at lower prices and, in light of the actually existing equilibrium
Commodity markets
45
price, now nd that they cannot purchase enough of this good. But,
whatever the plight of some individuals, the theory does suggest that
the market is ecient in the sense that, given the assumptions, customers are receiving the greatest quantity of supply at the lowest
possible price. This conclusion can be derived from the previously
summarized assumptions and the proposition that the market price is
equal to the marginal cost in equilibrium. This is the basis of the conventional claim that the free market is ecient and that any deviation from market prices, even deviations that may be valid for political
or humanitarian reasons, are ipso facto inecient. This is a powerful
normative claim, one with tremendous importance for the many economists who insist that laissez faire market policies should be given the
broadest possible application.
NEGATIVE FEEDBACK EFFECTS AND THE

THEORY OF MARKET EQUILIBRIUM
The above analysis of the spot market for commodities illustrates
another important aspect of the theory of commodity markets and
the lessons for economic and social policy that can be drawn from it.
But rst, a short digression into the language of engineering will be
necessary.
When engineers speak of adjustment mechanisms, they distinguish
between negative and positive feedback systems. This distinction is
crucial for mechanism design and performance. One should note at
the outset, and this is important, that these classications are neither
normative nor evaluative. Rather they are technical. A negative feedback system is one that features automatic built-in equilibrating
mechanisms. As a consequence, when such a system is disturbed from
a state of rest, one or more counter forces are automatically activated
that guide the system back to its initial equilibrium position. The level
of water in a bathtub illustrates such dynamics. When the surface is
disturbed, gravity will act to return the water level to its prior state
of tranquillity. Another example is the household thermostat. By
design, this mechanism regulates the heat inside of a home so as
to maintain the temperature within a preestablished target range.
Should the house become too warm, the thermostat directs the
furnace to shut o, thereby cooling the environment. Should the
house become too cold, the thermostat directs the furnace to run until
46
the environment is warm again. When functioning properly, the internal temperature of the house uctuates within a comfortable range.
In commodity markets, negative feedback is thought to operate in
an analogous manner. No matter what the initial price, the commodity market is thought to be self-correcting in the sense that market
forces induce, independently of any government directive, suppliers
and buyers to make decisions that collectively contribute to reestablishing and thereby sustaining the market equilibrium. If the price
is too high, surplus inventory will build up and rms will trim prices.
If the initial price is too low, inventories will fall and customers will
evince a willingness to pay higher prices thereby inducing rms to
raise prices and the quantity supplied.
Commodity markets, thanks to these negative feedback mechanisms, are depicted as being able to achieve a state of rest or market
equilibrium that is both unique and sustainable in the absence of any
new disturbance. That commodity markets are believed to have such
a strong self-equilibrating mechanism, one that requires a minimum
of information and overt coordination among and between its many
individual actors, is a crucial element of the argument for allowing
markets to distribute goods (Hayek, 1945; Friedman, 1962).
To further instantiate the role and importance of negative feedbacks in commodity markets, let us briey consider the opposite
proposition. This is a system (or market) that exhibits positive feedback. In a positive feedback system disturbances are thought to be
self-reinforcing and for that reason self-sustaining. When such a
system is disturbed from its initial equilibrium point, it continues to
move ever further away in a process that is self-reinforcing. In the
absence of any outside force that can reestablish and reinforce the
initial equilibrium, the inevitable consequence of a disturbance to a
positive feedback system is a cumulative process.
In the presence of a positive feedback mechanism, almost any disturbance of the system will continue until a structural transformation
occurs. In social, natural, and engineering settings, this almost invariably means that we can expect some sort of disaster. Returning to the
above analogy of the thermostat, in the event of a positive feedback
mechanism, a house that is too warm would become increasingly
hotter, and a chilly house would become increasingly cold. In either
case, such a positive feedback mechanism would cause signicant
damage to the house, damage that would become irreversible if it continued long enough (i.e. a house re or frozen pipes would result).
Commodity markets
47
For an example of a positive feedback operating in nature, consider

an avalanche. The snoweld begins in a state of rest, a condition analogous to the market equilibrium described above. A disturbance, say a
traversing moose, creates a disturbance. Under the correct snow conditions, such a small initial disturbance can become self-reinforcing
and self-sustaining. The initial disturbance of the snow dislodges more
snow, which dislodges even more snow, etc., with the eect of creating
an ever-greater movement that spreads to the entire snoweld. Once
the snow begins to move it is evident that a return to equilibrium
the snoweld in its original state of rest is unachievable. The cumulative eect is an avalanche which is a disaster for any people, buildings,
or villages in the valley. Either way, the result is the structural transformation of the ecology and economy of the valley. To review, the
lesson is that positive feedback systems, once in motion, move everfurther away from their initial point of stability.
These several presumptive qualities of commodity markets, as
described above, have had a long and distinguished history. Of most
importance, they suggest that a free market system can be both decentralized and sustainable. The political implications of positing the
existence of a free market featuring an eective negative feedback are
worthy of contemplation. In the presence of negative feedback
between the current price and the posited equilibrium price, selfinterest can be relied upon to generate actions that will collectively
cause the markets price to achieve and maintain a stable equilibrium.
Self-interested suppliers and buyers can be supposed to make a multitude of independent decisions that collectively have the eect of
bringing into existence this unique equilibrium with a minimum of
insight, reection, information, or coordination on the part of any
authority or the state.11 In this sense the market is an instrument, one
that signals complex conditions and incentives to economic actors.
These actors, in turn, do not need to understand the details of market
conditions or theories, but only aspire to achieve their own ends
through buying or selling protably. Since markets are thought to
convey knowledge of prices and quantities at little cost, they are
deemed socially ecient.
Commodity markets are the ideal type of market that has been
taught to generations of elementary economics students (again, by
commodities, I mean consumer-oriented inspection goods that
confer neither status nor future wealth on their purchasers). This
theory has not performed too badly in performing its core task to
48
explain short-term changes in the prices and quantities of commodities in the event of changes in the larger economic environment.
Problems, such as they are, are not so much with the theory itself, or
with what it sets out to accomplish. On the contrary, the problem is
that this theory, which was developed to understand markets for
simple consumer goods, is often deployed to explain and validate the
market price of virtually anything bought or sold in almost any kind
of market and almost any kind of circumstance. Such eorts are erroneous applications of this theory that merit the criticism they have
drawn from economists and the public.
The primary economic argument for deregulation, privatization,
and commodication has been the often-repeated mantra that the
free market has been proven to be an ecient means to allocate
goods and services.12 Clearly such a claim is closely linked to the
idea again, one initially borrowed from engineering that negative
feedbacks are ubiquitous in free markets. When American economists or opinion page writers tell us that they believe in the market,
what they are asserting is a belief that negative feedback systems are
close to ubiquitous in social and economic systems.13 Such an assertion is, of course, interesting and important. But it is also one that is,
or should be, subject to examination, discussion, and refutation.
A POSTSCRIPT: NATURAL MONOPOLY

Before closing this chapter a few observations should be made concerning the production of commodities that involve substantial
upfront investments before any revenue can be earned. Consider a
production process that requires substantial xed investments or
development costs before it is possible to produce goods or services
that are ready for sale (a railroad or a new automobile). As a consequence of this cost structure, the rst unit of output is prohibitively
expensive. Typically, unit costs fall quickly once the initial production
process has been put in place (new software is the quintessential
example of this kind of cost structure developing the rst unit can
cost tens or hundreds of millions of dollars, while the second can be
produced at the cost of mailing a disk or sending the program over
the internet).
For commodities featuring the above production qualities the marginal cost of the second unit of production is substantially lower than
Commodity markets
49
the rst, and the average cost of supplying additional units of the
item to the market decreases as the quantity supplied increases. In
graphical terms the supply curve will not look like the one drawn in
the gures above, rather it will slope downward to the right. This case,
while not developed here, is important because it represents a situation wherein an early entrant to the market can stake out a commanding position. The reason is that the costs of the rst rm in this
market will fall rapidly. These early rms will have the advantage of
working with average costs substantially lower than any market
entrant can hope to achieve for some time. In business schools and on
Wall Street, this is called a rst-mover advantage. When the production process of a commodity exhibits such a cost structure, and
many do, new entrants will face substantial costs and risks which are
at variance with the zero entry costs conventionally assumed for a
perfectly competitive market. New entrants will be discouraged
unless they, and the banks backing them, can aord large upfront
expenses. These expenses must include what can reasonably be
assumed to be substantial losses for an extended period.
When the conditions of supply resemble this case, the industry is
said to feature a natural monopoly. This would be an unimportant
addendum to the theory of commodity markets, except that we often
nd such cost structures in critical sectors such as transportation or
communications. In these industries, the existence of natural monopoly was once, some decades ago, considered a prima facie case for
either public ownership or their treatment as public utilities subject
to price regulation. By contrast with the political economy of the
Progressive Era, over the last 30 years the United States has been
remarkably tolerant of such monopolies (Lynn, 2006). Our collective
experience with deregulated electricity, airlines, and telecommunications all suggest that we need to rethink our current policies.
NOTES
1.
Metaphysical has come to be a term of disparagement among economists and

other social scientists who wish to be seen as scientic. This is a mistake. Here,
it is being used in its original sense of referring to concepts that are important to
the structure of our ideas and that we believe do exist, but that are necessarily
beyond our powers of direct observation. As David Hume once argued so convincingly, ideas of cause-and-eect are, in this sense, metaphysical.
50
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

It is not from the benevolence of the butcher, the brewer, or the baker that we
expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our
own necessities but of their advantages (Adam Smith, 1776 [1937], p. 14).
I wish to reemphasize that in this lecture commodity markets does not refer to
either the spot or futures markets for bulk primary goods, such as the Chicago
Board of Trade or the New York Mercantile Exchange. Structurally, these
markets are more accurately classied as asset markets, which are the subject of
Lecture IV.
Economists often express this last assumption by proposing the counter-factual
notion that people exclusively derive something they call utility through their
direct relationship to a product, and for that reason, utility can not be interdependent between people. For example, it is supposed that I will not be happier
wearing blue jeans just because you are wearing them, or vice versa. While this
assumption supports certain methods and conclusions of mainstream economics, it clearly leaves a lot to the side. For example, fashion, fads, and almost everything that we might term a culture become incomprehensible once we buy into
this somewhat solipsistic vision of consumer satisfaction.
This formulation of the theory of demand was subjected to an important, and
unjustly ignored, criticism by Oscar Morgenstern (1940).
The prior phrase is in Latin, and hence it appears that much more authoritative.
Using Latin in this context is important as it validates the several grade school
years I spent studying the subject.
The idea that the production process for consumer goods features decreasing
returns (increasing marginal costs), and the theoretical, empirical, and policy
implications of this assumption have long been subject to serious debate. Since
these are elementary lectures, the following references to the literature will have
to suce (Sraa, 1926, Lester, 1941, 1947; Prasch, 2007). See also the postscript
to this lecture.
Beginning in the 1960s, the term political economy took on an implicit interpretation as a politically left perspective on economics. That is not how I am
using the term here. Rather, I take it to identify the issues at the intersection of
political and economic theory.
Just to clarify the terminology being used here, a stylized fact is a generalization. It does allow for exceptions. What is being asserted is that history and experience largely support the characterization of causation or fact being put forward.
Indeed, this quality of volatility is one among several reasons why Third World
countries depending upon the export of primary products to earn the foreign
exchange they need to meet their international debt obligations so frequently run
into diculties. The solution has been to bridge shortfall periods with lending
underwritten by private banks and international development agencies. This
lending is often conditional on the receiving nation placing an even greater
emphasis on exporting its way to economic growth and specically relying on
those items that the IMF and World Bank consider to be that nations comparative advantage. In practice, this often leads to an ever greater dependence on
exporting primary products and low-wage manufacturing. A less diverse
economy means ever-greater exposure to price uctuations and more dependence
on international nancial markets. Not surprisingly, these cycles of boom, debt,
and bust are often repeated.
A reasonable question is whether such coordination could be dicult, even impossible, if people trade at false (non-equilibrium) prices. Investigating this nontrivial question was once an important research project in economics (Hicks, 1939,
ch. 9 Appendix; Clower, 1965; Barro and Grossman, 1971; Leijonhufvud, 1981).
Commodity markets
12.
13.
51
In not a few cases government ocials have supported privatization as a useful

way to circumvent rules concerning government transparency. Private rms do
not have the same daylight requirements that government agencies and, to
some extent, the military has. For example, if the executive branch of government
wishes to participate in a conict in Columbia, but would rather not have newspapers or the Congress discuss this decision, it could deploy what are today called
private contractors (formerly known as mercenaries) to y surveillance, locate
enemy forces, direct local forces into a eld of battle, etc.
My colleague at Middlebury College, David Colander, makes a valuable distinction between market failure, wherein it is supposed that the market is failing to
work, and failures of the market, which term he uses to describe cases in which
the market is working very well, but to an end or objective that we nd pernicious.
For example, ante-bellum American slavery would be classied as a case of the
failure of the market rather than market failure as the market for slaves
functioned all too eectively.
PART II
Market processes when information

matters
LECTURE III
Credit markets: the economics of a

relational contract
Considered as a market transaction, credit has several distinct properties. Collectively, these are of enough consequence that the market
for credit constitutes its own ideal type meriting an independent
examination. The place to begin is by revisiting a crucial, if often
implicit, assumption underlying the analysis of the market for commodities that these are exchanges of inspection goods in a spot
market.
To review, in a spot market the transaction is negotiated and settled
during a single meeting or interaction. The previous example was a
suburban yard sale. There goods are inspected, prices negotiated, and
cash tendered and accepted all in the course of single meeting.
Buyers and sellers neither require nor desire the identities, backgrounds, or references for the individual or individuals with whom
they conduct such exchanges. To reiterate, such spot transactions
are the implicit model underlying the textbook theory of supply and
demand.
Credit transactions are, and by their nature must be, qualitatively
dierent from the spot transactions that typify commodity markets.
When a person or rm enters into a loan contract, they are committing themselves to an ongoing business relationship with another
person or institution. Moreover, a loan is not an inspection good
as one cannot know at the outset if one will be paid back. The lender,
who above all wishes to see their money again, is shouldering the risk
that this may not occur. For this reason they are necessarily interested
in the background, character, and credit-worthiness of the person or
organization that is the counterparty to the loan.
But they are not alone in being interested in the qualities of their
business partner. The borrower will also be interested in the terms
55
56
Market processes when information matters
and conditions associated with repayment, renegotiation, and other

contingencies that may emerge over time.1 The arms length relationship through which we exchange inspection goods in a spot
market, where names and previous business performance mean little
or nothing, fails to depict critical aspects of the market for credit. The
reason is that the character and quality of the person or institution
with whom one is entering into a loan contract are of non-trivial
importance to both parties.
Agreements such as a credit contract, in which two parties have
entered into a business relationship expected to persist over an
extended period of time, are called relational contracts. In our contemporary economies most important transactions are relational
contracts. When an automobile company enters into an agreement
with a subcontractor, a parts supplier, or a major labor union, they
are establishing the terms and conditions under which they will purchase parts, inputs, or labor over a multi-year period. This business
relationship is governed by a relational contract. Individuals also
enter into a relational contract when they agree to rent a home or purchase heating oil for delivery over the course of the winter. Credit is
only a subset, albeit a most interesting subset, of the large number
and variety of relational contracts that exist in our society. It follows
that if we are to understand modern markets it is essential that we
develop an appreciation and understanding of the unique qualities of
such contracts (Llewellyn, 1931; Macaulay, 1963; MacNeil, 1974,
1978).
Now, if a rm or an individual is involved in a relational contract
it should not be assumed that they have decided to eschew, or in any
other way neglect, their own self-interest or desire to maximize
prots. What is true, however, is the generalization that once a business or a person has entered into a relational contract their selfinterest may dictate that it would be unwise to attempt to get over
on ones counterparty on each and every occasion that arises. A fuller
and deeper understanding of self-interest suggests that each partner
to the contract will perceive that their long-term interest may lie in
cultivating the trust and continued goodwill of their counterparty.
This trust will enhance the success and ultimate value of the mutual
project, and the business arrangement itself, so that each of the
involved parties may continue to participate in an ongoing and mutually benecial enterprise. But clearly the conditions for this to be
true vary from project to project and contract to contract. When
Credit markets
57
discussing incentives under a relational contract, the details are of the

most importance.
Indeed, even when each party can perceive the advantage of a successful ongoing relationship, it would still be incorrect to infer that
strategic behavior ceases to play a role in relational contracts. Over
the last 30 years the economics literature has come to acknowledge
that relational contracts, including debt contracts, routinely involve
situations of what is called asymmetric information (Stiglitz and
Weiss, 1981; Stiglitz, 1987). This term is meant to capture the idea
that many contracts involve less than perfect information. Of most
importance, one or both parties may have what is, in technical jargon,
termed non-public proprietary information that would be of interest to their counterparty. The side with this information may, but
most often may not, nd it in their interest to divulge it to the individuals or organizations with whom they have entered into a relational or credit contract. For example, you may have been tardy with
several loan payments in the past, and might not wish to share this
information with the bank with whom you are negotiating another
loan. Your bank, on the other hand, may be in the habit of routinely
raising interest rates on customer loans to extreme levels in the event
of trivial violations of the terms of the agreement. Or they might be
excessively dicult to contact on the telephone. The bank is unlikely
to divulge this information to customers with whom they are negotiating. In each of these instances information that is relevant to the
negotiation could be protably misrepresented or withheld.
Withholding crucial information and then using it to ones business
advantage after a contract has been negotiated is, regrettably, an alltoo-uncommon occurrence.2 The fact that such behavior routinely
occurs raises the cost of doing business and therefore increases the
a priori cost of transacting. The consequence is to reduce the total
number of transactions. Imperfect information means that prudent
persons are obliged to undertake costly precautions to protect themselves from unknown or unforeseen mishaps. At a minimum each
party will have to spend time, money, and eort gathering information before entering into a loan or other relational contract. Knowing
that they do not know, and cannot trust, their counterparty, some
people will avoid entering into relational contracts altogether. They
would rather get along without certain business relationships, and
the benets they might provide, than accept risks they can neither
quantify nor estimate with a sucient degree of precision.
58
Businesses, who are working repeatedly with a large number of

relational contracts, now routinely contract with outside databrokers and other professionals to evaluate the potential risks of counterparties. In this case the major asset of agencies that rate corporate
bonds or private individuals, such as Moodys, Standard and Poors,
Experian or Equifax, is their reputation for a fair and dependable
assessment. For this service they can charge a fee. The revenue of such
rms is, of course, conditional on the value of the average contract
that clients are negotiating, and the perceived cost of error to those
clients. Since the cost, to a corporation, of error in misrating a potential merger partner is greater than that from misrating a single customer, it should not surprise us to learn that there is substantially
more erroneous information in the rating of individuals than of corporations. But for a variety of reasons it would be unwise to believe
that this task is being done very well in either sector.3
An implication of asymmetric information is that its presence
can contribute to a problem known as moral hazard. This term,
which originated in the insurance industry, considers that the incentives faced by a counterparty are often changed by the fact that they
have entered into a contract. An example of moral hazard might be
the shopkeeper who is less attentive to re safety after paying for re
insurance. The stylized fact is that people with insurance, relative
to the uninsured, feel more comfortable cutting corners or postponing needed repairs. The extremes and we know that these occur
with some frequency are those instances in which business or home
owners deliberately set res, or arrange for others to set res, so as to
claim the ensuing losses from the insurance company. Such extreme
instances of moral hazard are, of course, punishable under the law as
arson and fraud. While statistics arm that such outcomes are fairly
common, it is often dicult to gather enough evidence to achieve a
conviction.
Another problem associated with asymmetric information, one
aggravated in the case of relational contracts, is that of adverse
selection. This is said to occur when a business or organization oers
a contract that disproportionately attracts undesirable counterparties. For example, stock-brokerages may disproportionately attract
employees who enjoy risk-taking and gambling. More immediate to
the subject of credit is the fact that dishonest, desperate, and irresponsible people are more likely than the population at large to
borrow money at high rates of interest rates. The famous Scottish
Credit markets
59
economist Adam Smith, among many others, has commented upon

this tendency:
If the legal rate of interest in Great Britain, for example, was xed so high
as eight or ten per cent., the greater part of the money which was to be
lent, would be lent to prodigals and projectors, who alone would be willing
to give this high interest. Sober people, who will give for the use of the
money no more than a part of what they are likely to make by the use of
it, would not venture into the competition. (Smith, 1776 [1937], p. 339)
The underlying problem is the reduced average quality of the mix

of potential borrowers remaining in a credit market featuring high
rates of interest. Smiths belief was that banks would be tempted by
these high rates of interest to overlook the changing mix of people
willing to take out loans. His concern was less for the irresponsible
bank, but rather for the tendency for one bank failure to cast doubt
on the reputation of nearby banks, thereby contributing to a potential crisis within the broader nancial system.
For the reasons summarized above, bank loan ocers, and those
who regulate them, may wish to limit their risks by refusing loans to
some, even many, otherwise willing borrowers. In economic terms,
this means that at the market rate of interest the demand for loans
will become greater than the supply. In the jargon of technical economics there is said to be an excess demand for loans.
Moral hazard and adverse selection collectively lead to the stylized fact that, beyond some threshold level, banks and other lenders
may be unwilling to supply additional credit as the rate of interest
rises. This is not true across the full spectrum of interest rates. Up to
this threshold point higher interest rates induce greater supplies of
credit. However, as interest rates rise beyond it, banks and other
lenders will be increasingly concerned with the underlying character,
judgment, and viability of those customers who remain willing to
borrow. Even if we could know that all of them are honest and well
intentioned, as rates rise borrowers monthly payments will be larger,
which in itself will increase rates of default. The reason is that
high interest payments increase costs. As such they reduce the
protability, and thereby the viability, of rms. In sum, the riskiness
of any given portfolio of loans rises as rates of interest rise. These
considerations are represented in Figure III.1. It captures, from the
lenders perspective, the relationship between the rate of interest
charged and the expected return on a dollar loaned. For the reasons
60
Expected returns per $ loaned
0
Figure III.1
i*
Interest rate
Expected returns/interest rate relationship
presented above, there is a rate of interest that maximizes the

expected return.
At rates of interest rise above i* the expected return on the portfolio of loans declines, and declines at an increasing rate. The reason is
that as the rate of interest charged increases, the quality of loans in the
portfolio declines and the expected amount of losses from defaulted
loans rises. While the bank earns a greater return on those loans that
are paid back, it also experiences increased losses from defaulting
loans. The above relationship suggests that banks will become more
selective in making loans as rates of interest rise above i*.
With the above considerations in mind, we can draw a schedule
depicting the supply of credit. It is drawn from the perspective of
lenders since they are the ones actually or potentially extending loans.
Of interest here is that this schedule is backward bending at higher
rates of interest. This eventuality is illustrated in Figure III.2.
To interpret this Supply of Credit schedule, consider the following
scenario. At higher interest rates, many of the people that Adam
Smith once described as sober and industrious will decide to forgo
borrowing. If possible, these potential borrowers will take their
61
Credit markets
Rate of interest
Supply of credit
Quantity of credit
0
Figure III.2
The supply of credit
business elsewhere. Alternatively, they will forgo the project that was
motivating their desire to borrow. Either decision is most sensible. But
the explanation is not yet complete. From the perspective of the bank,
and that banks regulator, it is necessary to reect on the qualities of
those persons and businesses that remain in the pool of potential borrowers. Introspection and experience each suggest that those who are
dishonest, desperate, or overly optimistic, are less likely than their
peers to drop out of the loan market as interest rates rise. Each of
these borrowers represent a poor credit risk.
Let us consider, in turn, each variety of potential borrower. If they
are dishonest, that is to say they are frauds, they are planning to skip
town with the money soon after the loan is made. Perhaps it is
obvious, but it needs to be stated, that high rates of interest will fail
to discourage fraudulent borrowers. The second category is made up
of borrowers who are honest and well intentioned, but desperate. By
denition desperate people lack good choices. People without good
choices are, sad to say, likely to be poor credit risks (There is an old
banking adage that says, Do not lend to anyone who needs the
money). Finally, we have that subset of potential borrowers who are
62
overly optimistic. Such optimists believe that their business prospects

are so certain and so remunerative that even high-interest loans
cannot present an obstacle to what they believe is their assured
success. They could, of course, be correct. But, even more often, they
are not. In any of the above instances, the fraudulent, the desperate,
and the overly-optimistic, banks and their regulators are well-advised
to be wary. The history of banking, especially over the past 30 years,
reveals that this has not always been the case.
We should not leave this topic before reviewing the likely eects of
higher interest rates on the quality of the loans themselves, even if we
make the extreme and unlikely assumption that the mix of actual borrowers remains constant. Suppose the identical set of customers all
borrow the same quantity of money after interest rates have risen.
The probability of default must rise. The reason is that higher rates
represent higher periodic loan payments and thereby higher nancing
costs to rms. After the increase, all rms will experience lower
prots. Ceteris paribus, lower prot margins mean that all rms will
be more vulnerable to the routine mishaps or setbacks that can occur
in any business or industry. If we assume some sort of normal distribution of returns to business, it will be evident that with higher
interest rates more rms will fail, and others will begin to struggle. In
the event of higher rates of interest, and therefore higher business
costs and less prots, those rms who are in the lower tail of an otherwise normal distribution of protability over any given period will
be more likely to face bankruptcy. As Adam Smith and Joseph Stiglitz
have each observed, high interest rates disproportionately increase
credit risks. This, by itself, can reduce expected revenues and give
banks an additional prot-oriented reason to turn down loans to
individuals or rms who would otherwise be willing to borrow at
unusually high rates of interest (Stiglitz, 1987, pp. 1720).
In light of the above it is plausible that once interest rates achieve a
critical level, and depending upon circumstances this could be a rather
high level, the supply of credit may be reduced even as the real rate of
interest continues to rise. This possibility is illustrated in Figure III.3,
which combines the supply of credit schedule from Figure III.2 with
a demand for credit schedule (this latter takes on an appearance
similar to that of the demand curve for commodities, with lower interest rates correlated with a higher quantity of loans demanded). We
assume that there has been an increase in the demand for credit that
shifts its schedule from D1 to D2. As drawn, this higher rate of interest
63
Credit markets
Interest rate
S
D2
D1
Quantity of credit
Figure III.3 The credit market with an increase in the demand for
loans
increases the revenues accruing to banks, but it is also consistent with
a modest reduction in the volume of loans outstanding. However, we
would need to know more about projected bankruptcy rates, the overhead costs of banks, and the cost of funds, to know if the banks were
eventually better or worse o for this experience.
Unfortunately, even prudent business decisions on the part of
banks can have detrimental eects on the larger economy. Consider
what occurs when the real economy of this region or nation is
having diculties whatever its ultimate cause. With a recession,
the protability of the system as a whole is brought into question.
Prudent banks may experience an increased demand for loans on the
part of nervous or struggling rms. Yet, the weakened condition of
rms may induce prudent banks to deny loans, even to customers
who were previously judged to be eligible borrowers.4 Such a situation, conventionally known as a credit crunch, places additional
pressure on the economic system by diminishing the amount of cash
and loan credit available for business purposes. By denying credit to
businesses, prudent nancial sector decisions may amplify problems
64
in the larger economy with detrimental and even lasting real eects.
Many economists and bankers have attributed the severity of the
1991 recession to such dynamics.
NOTES
1. For several studies into the eects on a banks long-term protability from building a large, trusting, customer base in the market for credit cards see the several
articles by Frederick F. Reichheld (Reichheld and Sasser, 1990; Reichheld, 1993).
2. While this is not the place to develop this point at any length, one of the more striking trends of contemporary business practice has been to enter into relational contracts with customers and then aggressively pursue short-term strategies with the
aim of maximizing short-term prots. Thirty years ago business, especially larger
businesses, placed a higher value on longer-term strategies directed at growth and
market share, and for that reason made signicant investments in customer service.
After three decades of emphasis on shareholder value and quarterly targets
short-term prot maximization is virtually the only consideration. Such a
reconguration of business practice brings to mind an earlier and once-eclipsed
variety of capitalism one that was so ably described by Thorstein Veblen over one
hundred years ago (1904). Personally, I nd the term Got-ya capitalism to be
useful for describing the increasingly-conventional business practice of punishing
trusting or otherwise naive customers.
3. I cannot pass by this issue without observing that it is the height of arrogance that
the agencies that rate individuals will allow us, often for a fee, to access our own
credit reports for the purposes of correcting them! In this manner they charge us
to do their clerical work. Since few of us have ever granted permission, or
expressed a desire, to have these private sector rms gather sensitive and personal
information about each of us, I do not believe that it would be overly onerous to
place the burden of accuracy back upon them. To achieve this, consider a law
requiring them to pay $100.00 for every error on every credit report they send out
and for every instance of unauthorized access. Since a threat to their protability
is the only morality they acknowledge, such a law will likely dramatically enhance
their interest in the accuracy and accountability of their work. If it turns out that
these rms cannot comply with such a law and stay in business, I would conjecture
that few of us would miss their services. Perhaps we could return to the older
(and recently-revived) practice where only our government spied on us?
4. Some depictions of this process have banks maintaining a below-market rate of
interest and simply turning away a large number of applicants. The eect is an
excess demand for loans at this below-market rate. The graph in the text presumes that the cost of funds to the bank has also risen, and that they are following a simple mark-up rule in determining the rates they charge their customers,
but the backward-bending supply schedule indicates that they are extending
fewer loans.
LECTURE IV
Asset markets: market dynamics

when expectations are a
consideration
Financial assets are intangible claims on a future stream of earnings.
Examples include stocks, bonds, foreign exchange holdings, etc.
Assets are distinct from commodities in that we cannot directly use
or consume them. Tangible, as opposed to nancial, assets include
such delightful objects such as ne wine or rare paintings, are useful
in consumption or display, but the market for such items is rather
dierent from that for nancial assets. The point is that nancial
assets have no direct application in consumption as they cannot
satisfy a need or a want. Rather, they represent claims on wealth, that
is to say they are claims on future purchasing power (of course, the
anticipation of future wealth has an impact on current consumption,
but that is not the subject of this lecture). To sum up, an asset is a
claim on a future stream of revenue (that might or might not take the
form of a single lump-sum payment) in the event that a previously
agreed upon set of conditions and qualications are met.
The reason we purchase an asset is because we believe, in light of our
expectations at the time of purchase, that it represents the superior ow
of revenue based on our collective estimation of the inuence of such
variables as liquidity, the rate of return and riskiness of other assets,
the riskiness of the asset, and how this asset changes the risk prole of
our overall portfolio of holdings. The crucial point is that the value of
assets, by contrast with commodities, are determined by market participants collective assessment of the likelihood of future events. Such
understandings are called expectations and they are a, if not the,
critical element in the market for assets. For this reason, the market for
assets should be thought of as constituting its own ideal type.
65
66
As the reader may have already surmised, the problem is that our
assessment of an assets value is based on a number of uncertain
factors, including the interactions between the collective expectations
and the most probable actions of other market actors. The inherent
uncertainty of the future, conjoined with the inherent uncertainty of
human behavior, especially when acting in crowds, ensures that
this uncertainty will always be present. This reality reduces the predictability of asset markets, thereby raising the question as to how
eective these markets are at their socially-sanctioned tasks. This is
particularly the case if an otherwise meaningless change in some
minor circumstance or condition induces a cascade of actions that,
through a positive feedback mechanism, modies the structure and
stability of market expectations. This, in turn, can recongure the
quantity and allocation of nance and ownership claims across the
society. If this is the case, even a relatively meaningless event can substantially revalue an entire class of assets such as stocks, bonds, or a
nations currency.
THE STRUCTURE OF TIME AND THE

FORMATION OF EXPECTATIONS
As previously noted, a critical characteristic of assets is that people
and institutions rarely desire them as an end in themselves. The
reason is that one cannot use assets, such as stock or bonds, in consumption. They are even useless for conspicuous consumption. It is
not an accepted practice to display ones portfolio of stocks on a
T-shirt or in any other location where the public could see it. With the
exception of misers, few people have a demand for wealth-in-theabstract. However, it must be allowed that the eorts of some of the
super-rich to become ever-wealthier does cause one to ponder the
ultimate source of their motivation. But I digress.
Another important characteristic of a subset of asset markets, such
as certain varieties of stocks, bonds, and the foreign exchange of a
few nations, is their high degree of liquidity. This degree of liquidity
is an artifact of high volume in conjunction with low transactions
costs including insurance, storage, and other sundry carrying costs.
A high degree of liquidity means that, under normal trading conditions, traders can move their wealth in and out of these assets quickly
and at minimal expense. It is important to understand that every
Asset markets
67
person in the market is cognizant of its high liquidity. From this

knowledge it follows that the cost to waiting for more information,
or for price stability to emerge, can be prohibitively high in the event
of a sudden and widespread change in expectations. Especially if this
change induces a widespread desire to sell. In such a case, the losses
associated with hesitation can destroy the fortunes of an individual
or a rm, especially if they have outstanding loans secured by assets
that are now of substantially reduced value.
Considering the many uncertainties of such markets, and the pace
at which these circumstances can change, one does not always have
the luxury of considering all angles and implications. For this reason
it is not a surprise that many individuals and institutions have
adopted behavioral rules or rules of thumb to guide their decisions. For sophisticated individuals or rms, these rules may be highly
mathematical perhaps even programmed into computers. At times,
these rules of thumb have played a critical role, even a more critical
role, than the slower and more deliberate process of estimating fundamentals. For example, Diversify along with Buy quality stocks
and bonds for the long haul are rules often recommended to those
saving for their own retirement or their childrens college education.
Ideally, such an approach would be taken by their companys retirement plan. Chartists, the traditional term used to describe those
attempting to discern patterns in past market activity, have developed
and are continuing to develop, new and undiscovered trends from
which to prot.
Casual observation arms that many rms and individuals practice the relatively simple rule of buying when they see a rising market,
and selling when they observe a falling market.1 When such a rule
is pursued by a signicant number of brokerages, banks, and individuals, the market begins to exhibit a positive feedback between
changes in the price of assets traded and the level of demand.
Momentum could set in so that the demand for assets rises when asset
prices rise, and falls when asset prices fall. When any trading rule is
followed by a signicant portion of market participants, even if that
rule is sensible when followed by a few, it may become an additional
and independent cause of instability.2
To multiply their earnings some rms and speculators leverage
their holdings. This means that they have borrowed against their
initial holding of assets so as to buy an even greater amount. To illustrate the idea of leverage, let us take an example. Suppose that we
68
manage an aggressive stock fund with $100 million. Let us further

suppose that we retain 20 percent of all prots for our management
fees which represents, to be sure, a modest compensation for our
innate genius. Now, we could buy $100 million of stock. If it goes
up by 10 percent, we have $8 million for our clients and $2 million for
ourselves. Not too shabby.
Alternatively, we could take this $100 million in cash, and use it to
secure a loan of $300 million (say at 8 percent). Now let us place this
entire $400 million in the market. Let us suppose, once more, that the
market rises by 10 percent. With interest, we return the $324 million
to our lender and the original $100 million to our clients. Now there
is $16 million left over with $3.2 million for ourselves and $12.4
million for our clients. Notice that we have beat the market even
after accounting for the interest paid because the rate of return in the
overall market was 10 percent and our clients received 12.4 percent
(12.4/100). Clearly, evidence of our innate genius!
Now, let us suppose that the market declines by 10 percent. The
$400 million is now valued at $360 million. The lender to our fund is
contracted to receive $324 million, so we must give it to them. There
is now $36 million left. Even though our management fees will now
be zero, the return to our clients is a loss of $64 million for a rate of
return of 64 percent. The point of this example is that a fairly
common uctuation in the market on the underlying asset can induce
extremely high uctuations in reward in the event that investors are
highly leveraged. Naturally the sales-side rhetoric of money managers is that upswings are a sign of their genius for management, and
declines are simply bad luck. The point, however, is that genius was
never present in this example only leverage.
The above example illustrates why those whose money is being
managed by highly leveraged funds get so nervous during unanticipated price declines. This nervousness can become a demand for
repayment. This forces the fund to sell assets, placing further downward pressure on asset prices, which induces others to demand repayment, causing others to sell assets, and so forth. Those who have
loaned to highly leveraged funds also become nervous as they may
understand how quickly such a funds assets can evaporate, and do
not wish to be left holding the bag. In such an event, prices can fall
a considerable distance before the markets collective price expectations can stabilize around a new level or range. If expectations and
debt are structured in the manner described above, asset price
Asset markets
69
declines can be both self-generating and self-fullling. Leverage, in

short, is an important reason why asset markets can be notoriously
unstable on the downside (MacKay, 1852 [1980]; Minsky, 1986;
Kindleberger, 1996).3
If we consider the potential for calamity, and the absence of any
anchor to stabilize the price of any particular asset or class of assets,
a curious question arises. This is, as John Maynard Keynes correctly
suggested, the reason for the apparent stability of these markets over
relatively extended periods. The periodic booms and busts are easy to
understand. Of considerably more interest to social scientists are the
extended periods of relative stability (Keynes, 1936 [1964], Ch. 12).
An important source of stability is the conventional belief in a set of
abstractions labeled market fundamentals. Once an estimation of
these becomes widespread they can act as focal point that normalizes the expectations of traders. Since World War II or thereabouts
some credit for market stability has to be apportioned to the Federal
Reserve System. Wall Street writers and traders have now formalized
its support, and have called it The Greenspan Put. This term suggests, and experience arms, that when the prevailing level of asset
prices are threatened, as a consequence of a crash in another market,
or as a consequence of an important bankruptcy such as that of LongTerm Capital Management in 1998, the Fed will bring about a prompt
resolution, up to and including a bailout, so as to preserve the stability and integrity of the larger rms and the system as a whole. Such
interventions may or may not be wise when considered over the long
haul, but the fact that they now-routinely occur undermines the proposition that asset markets are a free enterprise aair. Either way,
what are conventionally termed fundamentals working in conjunction with periodic Federal Reserve decisions have, over the past several
decades, served as focal points or attractors that have materially
contributed to the formation or reformulation of stable expectations
for a substantial, usually hegemonic, majority of market participants.
ASSET MARKETS IN ACTION: FOREIGN

EXCHANGE (FX)
The fall of 1997 was a fascinating and illustrative moment in the
history of the worlds nancial markets. Several East Asian countries
that were then (incorrectly) celebrated as models of orthodox
70
economic development strategies, suddenly foundered under the

pressure of unexpected and dramatic ight from their asset markets
and from their currencies. Following a time-honored script, the
cure was for the United States Treasury, working in conjunction
with the International Monetary Fund, to impose draconian structural adjustment programs on these countries. This included reductions in government expenditure, increased interest rates, and general
deregulation, all accompanied by a good deal of unsolicited advice
on good economic fundamentals and the avoidance of crony capitalism (With the United States and the Clinton Administration
embracing the Dot.com bubble, this latter advice was more of an
instance of do as we say, not as we do).
The general principle underlying this response was, not surprisingly, the presumption that foreign exchange is a tradable good
similar to that of commodities as described earlier in this book.
Once it is assumed that the foreign exchange (FX) markets are orderly
and self-regulating, there is no compelling reason for any government
or international agency to employ resources to maintain any particular value of any particular currency (The classic exposition of this
position is Friedman 1953). Of course, as the reader may have surmised by now, a theme of these lectures is to question such presumptions. The rest of this lecture will argue that some important
distinctions exist, and for that reason laissez faire may not represent
the best approach to managing the worlds FX markets.
UNIQUE CHARACTERISTICS OF FOREIGN

EXCHANGE MARKETS
The logic underlying the received theory of the market process, which
makes that approach so intellectually compelling, is that no single
force operates simultaneously on both sides of the market. The decisions of buyers and sellers are thought to be formed independently
of each other, the market price, and changes in the market price.
Depending upon the market in question, such a presumption may be
more or less valid. A place where it is clearly invalid is the market for
foreign exchange. A distinguishing quality of the FX market is that
several factors operate simultaneously on both its supply and demand
sides. This has consequences for the idea of a uniquely determined
market equilibrium.
71
Asset markets
$/euros
S
0
Figure IV.1
Quantity of euros
The market for euros
To illustrate the importance of these concerns, let us consider the

market for the new European currency, the euro. In this market the
demand curve represents the quantity of euros demanded over a
given period of time, at a given price, as expressed in dollars. (For purposes of simplication, we are assuming that Europe and the United
States are the only nations in this market).
The overall demand for euros, which determines the position of the
demand curve illustrated in Figure IV.1, is inuenced by factors
such as:
1.
2.
3.
4.
5.
Expected changes in the $/ exchange rate;

Changes in the incomes of American residents;
Changes in the relative price level between the United States and
Europe;
Changes in the relative expected returns on assets between the
United States and Europe;
Changes in the preference for European-made goods by those
who currently hold American dollars typically American
residents.
72
The supply curve represents the potential supply of Euros that will be
oered by holders of euros at a given hypothetical price (in US$) over
a given period of time. As is the case with demand, the supply curve
is subject to changing market conditions. Phenomena that will induce
shifts in this schedule include:
1.
2.
3.
4.
5.
Expected changes in the $/ exchange rate;

Changes in the incomes of European residents;
Changes in the relative price level between the United States and
Europe;
Changes in the relative expected returns on assets between the
United States and Europe;
Changes in the preference for American-made goods by those
who currently hold euros typically European residents.
The above lists indicate that in the currency markets, domestic

incomes and consumer preferences within each individual country
are the only independent forces at work. Every other cause operates
simultaneously on both the supply and demand for that currency. The
implication is that a single cause can induce both curves to adjust
simultaneously. Moreover, the presence of price expectations on both
sides indicates that a shift in either schedule can be expected to induce
a further shift in both schedules. Finally, it is reasonable to suppose
that the value of foreign exchange depends on its current and anticipated asset value. In such cases, psychological propensities, including
herd behavior, constitute an important aspect of this market (Keynes,
1936 [1964], Ch. 12; Harvey, 1993; Davidson, 1997).
Joint and interdependent supply and demand adjustments in the
exchange rate add an important dimension of indeterminacy to this
market. The reason is that both sides of the market (current owners
of euros and potential buyers of euros) are responding to the same
economic stimuli. Moreover, each side is responding to the other
sides response to economic events. Actually, they are responding to
what they anticipate the other side will do. That, of course, depends
upon their expectation of what the rst side will do, which depends
on what the latter anticipates the former will do, and so on, into an
innite regress. In markets featuring such a structure, it should not
be surprising to nd that positive feedback loops periodically
emerge. The implication is the absence of a determinate result.
Equilibria, if they do emerge, cannot be considered unique or stable
Asset markets
73
(Eichengreen and Wyplosz, 1996). These tendencies are exacerbated by other factors that have not yet been discussed: the role
of speculation, and the role of low transaction and carrying
costs.
THE ROLE OF SPECULATION

In the foreign exchange market, as in most asset and money markets,
speculators prot by anticipating price changes. To this end, speculators will buy (or sell) a currency if they are convinced that the value
of a currency is rising (or falling), and they anticipate that they will
be able to reverse their position before favorable price trends reverse
themselves (Kindleberger, 1996, Ch. 3). Speculation, it must be
stressed, is a process distinct from arbitrage. The latter occurs when a
brokerage, bank, or relatively wealthy individual partakes of a riskfree prot opportunity by simultaneously selling an overvalued asset
in one market and repurchasing it elsewhere. Time, and the potential
for unfavorable changes in the relative value of the asset traded, is not
a factor in arbitrage whereas it is an important consideration in speculation. This distinction is important since it is blurred in too many
discussions of the speculative process. Worse, speculation may be
(incorrectly) presented as another instance of arbitrage. Indeed, one
reason for this widespread confusion of terms is that Wall Street
Arbitrageurs are almost always speculators, but to comfort the
wealthy individuals and banks that underwrite their trades, accurate
labels are avoided.
The fact that the foreign exchange market is somewhat unstable
provides an opportunity for speculation. Under certain conditions,
this speculation can contribute to the instability that attracts and
rewards even more speculative activity. Such a surfeit of speculation
would be innocuous if, like the horse track or the gambling casino,
these contests had little or no impact on the real economy.
Regrettably, we have no such assurance. The reason is that the bulk of
the worlds trade and international loans are negotiated, contracted,
and settled in just a few prominent currencies. Since developments in
the foreign exchange market can disrupt other markets, including the
markets in stocks, bonds, imports, exports, and many consumer
goods, the stability of these currencies can become an important
public policy concern.
74
THE ROLE OF LOW TRANSACTION AND

CARRYING COSTS
Transaction costs are the expenses associated with trading in a particular market. These include the time and costs of negotiating a contract, insuring the shipment of goods, the cost of actually delivering
the items to the buyer, etc. Carrying costs are the expenses that one
incurs by holding an asset. For example, if one owns a painting by
one of the great masters, the carrying costs include insurance, temperature control, the physical security of the painting, etc.
A prominent quality of the major foreign exchange markets is that
their transaction and carrying costs are low or negligible relative to
most other markets. This is a consequence of their large volumes
working in conjunction with modern computerized trading and settling processes and conventions all of which, by design, minimize
transactions and carrying costs. The contrast with the markets for
shoes or economics books could not be more stark. There are considerable costs associated with entering and leaving these markets.
These higher costs are an important reason why less speculative activity occurs in such markets.4
Economists have long stressed that people will, ceteris paribus, do
more of something if it is cheap. Consequently, we should expect
ever increasing amounts of speculative activity in foreign exchange
markets as transaction and carrying costs decline. Additionally, to the
extent that speculation is a normal good, increasingly unequal distributions of income and wealth will contribute to it. For the last several
decades it has been evident that the annual quantity of FX transactions swamps any plausible demand that can be attributed to trade,
travel, hedging, or other real business activities (Ghosh, 1995;
Frankel, 1996).
A consequence of the institutional changes that have so profoundly
reduced both transaction and carrying costs has been, as was hoped,
the generation of an enormous volume of activity in these markets.
Another probable consequence has been an enhanced degree of price
movement in these markets. Specically, we now routinely observe
price movements that no longer maintain a consistent, or in the shortterm even discernible, connection to economic fundamentals (De
Grauwe, 1989, Ch. 9; Frankel, 1996).
Volatile FX markets contribute to an increased degree of uncertainty. This generates a number of associated problems. One of these
Asset markets
75
is the increased cost of overseas trade. Those engaged in foreign trade

must either accept the additional risks associated with uctuating
exchange rates or purchase hedges in futures markets to guard against
them. Other costs that can be attributed to enhanced price uctuations include the decimation of jobs and industries that occurs
when the exchange rate undergoes an extreme appreciation such as
occurred during the early-to-mid-1980s. During that period exports
were diminished, import competition rose, and rms were obliged to
cut their costs and prot margins to defend their market share.
Likewise, if the value of ones own currency greatly depreciates, ones
trading partners experience a substantial price disadvantage. Taris,
competitive depreciations, and other trade disruptions are predictable consequences (De Grauwe, 1989, Ch. 12).
To avoid these dilemmas, countries have made periodic eorts to
manage or even control the exchange value of their respective currencies. A prominent historical instance was the xed exchange rate
system of the nineteenth century we remember as the gold standard.
The gold standard was considered, at that time and today, to be an
essential component of the nineteenth centurys commitment to
laissez faire (Clarke, 1988, pt. II; Eichengreen, 1992). The Bretton
Woods system of the mid-twentieth century was a deliberate eort to
preserve the virtues of xed exchange rates, while simultaneously
attempting to account for the deationary bias that characterized the
gold standard. Given the eort that has been expended over most of
the last two centuries to manage or control FX uctuations, it is
almost remarkable to ponder the now-conventional assessment that
freely uctuating exchange rates are best.5
TOWARD ORDERLY FOREIGN EXCHANGE

MARKETS
A more predictable and orderly market could emerge if we reduced
speculation in FX markets (Eichengreen and Wyplosz, 1996; Frankel,
1996; Davidson, 1997). This could be achieved in a number of ways.
First, a valuable short-term policy would involve a joint and credible
announcement on the part of the worlds major central banks that
speculative exchange rate movements between and among the most
prominent world currencies are a concern. At a minimum such a
statement, if forcefully presented, could inuence the formation and
76
stability of expectations in FX markets. Indeed, the historical record

suggests that credible commitments induce supporting speculative
movements (Eichengreen, 1992, Ch. 2).
A second policy would aim for a direct reduction in speculative
trading by reducing its protability. A turnover tax on foreign
exchange transactions has been suggested as one way to achieve this
end. Interestingly, a sales tax on foreign exchange would not have
to be large to be eective. Based on the long experience of stamp
taxes and other charges on various stock exchanges, a tax of around
0.5 percent would discourage traders, especially those that like to
change their positions frequently, from making whimsical trades. The
idea is that an increased cost of trading would induce rms to make
a greater eort to nd the correct position earlier (Tobin, 1978;
Erturk, 2006).
Simultaneously, 0.5 percent is not so high as to discourage traders
from conducting normal business transactions such as hedging
against risks incurred in the normal course of international trade in
goods and services. If it works as predicted, this small tax will at least
partially pay for itself. The reason is that with lower FX volatility, the
cost of purchasing a hedging instrument in the markets will also
decline, thereby osetting a portion of the initial tax.
Such a tax can also be expected to enhance the autonomy of central
banks. Today, commercial banks, speculators, and other FX traders
and brokers know that the overwhelming majority of central banks
are working at a disadvantage relative to the size and breadth of the
worlds FX markets. For most nations, it is prohibitively expensive to
engage in meaningful foreign exchange operations. One reason is that
under current arrangements virtually all of the risk and potential
expense associated with managing currencies is placed on central
banks. When speculators are selling the currency, and the central bank
purchases in order to prevent a devaluation, speculators trade at virtually no cost. If the central bank cannot continue to purchase and is
forced to devalue, speculators reap a signicant prot. By contrast, the
central bank can only break even if they succeed in preventing a
devaluation. Alternatively, they can take a substantial loss if they
cannot continue to purchase and are forced to devalue. It follows that
speculators are better o, on average, under current arrangements. A
turnover tax on FX transactions would partially even the odds.
As with any market in which we wish to reduce the quantity of
activity, higher prices should decrease demand. If speculators faced a
Asset markets
77
sales tax on foreign exchange transactions this would, ceteris paribus,

lower the expected returns and diminish their enthusiasm. Moreover,
should it turn out that the central bank succeeds in maintaining a
specic exchange rate despite the selling pressures of speculators, the
latter would face a loss equal to 1 percent of their total purchases. The
reason is that it would cost speculators 0.5 percent to sell or short
the currency in question, and 0.5 percent again as they returned to the
portfolio they held prior to their eort to prot from a forced or anticipated devaluation. On the other hand, the threat of a broadly-based
ight from a currency will continue to exert formidable market discipline on central banks since a 0.5 percent tax is inadequate to
prevent the selling of a genuinely weak or overvalued currency. Such
pressures, even without the assistance of excessive speculation, will
remain eective checks on the discretion of central banks.6
To summarize, with a modest transactions tax, one not at all out of
line with the taxes and fees that were long a xture of a number of
prominent asset markets, FX markets will feature an improved
balance of power between central banks and private speculators, less
speculation, and more stable currencies. The world, meanwhile, could
look forward to a more stable foundation for international trade, and
perhaps partially restore a basis for a revival of the growth rates that
existed during capitalisms golden age from the end of WWII to the
demise of the Bretton Woods system (Weisbrot et al., 2001). Granted,
some will be disappointed. That list would include the big commercial and investment banks, hedge funds, and other substantial currency speculators. We should expect them, their paid consultants, and
their kept intellectuals and lobbyists to resist such prospects.
NOTES
1. In the polite language so emblematic of the Internet Bubble of the 1990s, such
traders were called momentum investors, as opposed to followers of the
herd. Remarkably, rms with names such as Momentum Securities emerged at
this time. Apparently this choice of name reinforces the message that investors
may be assured that the rms managers would studiously follow the herd. Suce
it to say that the nomenclature of American nancial markets, dominated as they
are by the rhetoric of salesmanship, is a subject unto itself (Frank, 2000; Cassidy,
2002).
2. This, in essence, was the problem with portfolio insurance, that became so widespread in the mid-1980s. Since so many rms had computers programmed to sell
under similar conditions, a minor downturn had the potential to become strongly
self-reinforcing. On October 19, 1987, it was.
78
3. The politics of our era discourages persons of good reputation from admitting this
reality in public forums (unless a crisis is undeniably underway). For this reason
signicant asset-price adjustments must always be attributed to some external
cause no matter how implausible. Hence the October 1987 crash was blamed
on a modest rise in the interest rate that took place a week or so earlier. What is at
stake, of course, is the publics faith in the rationality of the stock and other asset
markets, and thereby the suitability of these markets for the ecient allocation of
scarce investment capital. If the social value of these otherwise remarkably expensive set of institutions were to be widely questioned, or the whole process came to
be thought of as the by-product of a casino (Keynes, 1936 [1964], ch. 12), some
political pressure aimed at regulating or circumscribing their activities might
emerge. Even worse, people might begin to question the legitimacy of the large
incomes routinely commanded by the stars of Wall Street investment houses,
and the wisdom of having the agendas of the nations major corporations set
almost exclusively with an eye to next quarters stock market price (Lazonick and
OSullivan, 2000). Since such eventualities are too terrible to contemplate, they
remain beyond the pale of accepted and acceptable political discourse. Hence
ascribing rationality to the stock market remains an important, albeit intensely
ideological and political, act.
4. Of the maxims of orthodox nance none, surely, is more anti-social than the
fetish of liquidity, the doctrine that it is a positive virtue on the part of investment
institutions to concentrate their resources upon the holding of liquid securities.
It forgets that there is no such thing as liquidity of investment for the community
as a whole (Keynes, 1936 [1964], p. 155).
5. While this chapter cannot accommodate an explanation, I would argue that this
change in the conventional wisdom reects the recent hegemony of the nancial
sector over the real goods sector of the world economy. While these two sectors are
not necessarily in conict, they do not have identical interests either.
6. Other scholars have argued that the problem of adverse speculation is so powerful
that a good case can be made for more extensive controls over foreign exchange to
even more substantially reduce speculation and further enhance central bank
independence, but the issues involved are beyond an introductory book (Crotty
and Epstein, 1996; Davidson, 1997).
PART III
Labor markets
LECTURE V
Labor market dynamics when needs

are a consideration
Labor, that is to say the purchase and sale of a persons capacity to
work for someone else, is another exceptional case that motivates at
least two ideal types of markets. The reason is that labor markets
trade a highly unique item the time and eort of living, thinking,
persons. Persons, unlike inanimate objects, have rights, obligations,
and needs.
For a moment, let us contrast the exchange of labor with that of a
clove of garlic. In the case of a clove of garlic, the transaction can be
characterized by the legal condition of being free and clear in the
sense that after settling with the previous owner I can use the clove of
garlic in any manner that I see t. I might use it to avor an Italian
dish, scare o vampires, or give it to a friend. My use of this clove of
garlic is a matter of indierence to the individual or grocery store that
sold it to me once its purchase has been negotiated and settled. The
reason is that the seller is neither at risk, nor emotionally vulnerable,
nor suers any compromise of their rights, dignity, or any other type
of loss no matter how I eventually dispose of this garlic.
The above characterizations do not apply to labor. If I agree to work
for a wage, I almost always have to deliver the contracted labor in
person. For that reason I remain highly interested in how I am treated
at my place of employment. I have every reason to be concerned if my
employer decides to put my person at risk, abuse me, or otherwise injure
me in the course of completing my job-related tasks. Moreover, certain
state agencies and the courts may take an interest in my situation.
But the issue raised in the previous paragraph, important as it is, is
just one element of the distinction. As a person I have the ability to
reect upon my situation, my actions, and the situations and actions
of those around me. From these and other sources, I can derive
81
82
Labor markets
attitudes and ideas about how I have been treated, or what I have been
asked to do. These attitudes and ideas may or may not correspond to
those of my boss. Clearly such reections are beyond the capacity of
a clove of garlic. If left by a sunny window garlic will spoil, but it is
unlikely to develop a sense of outrage at such negligent treatment.
Additionally, while it is the case that we can purchase the labor
power of an individual or individuals, it is another matter entirely to
motivate and inspire them to work at a high level, and perhaps even
be open to learning new approaches to doing things new approaches
that may, or may not, be usefully deployed elsewhere. In the event that
these learned skills can be deployed elsewhere, I may nd that I have
inadvertently contributed to the capabilities of one of my competitors employees if my employee is then hired away.
It should now be evident that labor is dierent from a simple consumer good, such as a clove of garlic, in several meaningful ways.
These are qualities that can, or should, matter for economic analysis.
This lecture will address only one of these meaningful dierences
the role that needs play for the theory of labor supply. The next
lecture will address the importance of reection or self-consciousness
in the supply of labor. While other issues exist, they are addressed in
more specialized writings (Fine, 1998; Prasch, 2004b).
We begin with a fairly banal observation. This is that labor is necessarily contributed by human beings, and that all human beings can be
presumed to have needs. While this analysis is not dependent on any
particular list of needs, one might reasonably surmise that such a list
would include food, shelter, basic medicine, potable water, etc. But, as
will be seen, much follows from this seemingly innocuous assumption. At a minimum, it will become evident that the market for labor
must be its own ideal type.
The crucial distinction is as follows. When the price of a consumer
good or commodity falls, the theory of supply maintains that suppliers will substitute out of the business of providing that particular
item, and devote more of their productive capacity to the provision
of some other item. Broadly speaking such an assumption is both reasonable and plausible, although we can quibble over the size of the
adjustment costs. For example, a low price for minivans relative to
other large vehicles will induce automobile manufacturers to apply
more of their productive capacity to the manufacturing of substitutes, perhaps light trucks or sedans. But can such a line of reasoning
be applied to the aggregate labor market without modication?
When needs are a consideration
83
The stylized fact upon which the following analysis turns is that
most of us depend upon the sale of our labor for the bulk, if not all,
of our income. Stated simply, our livelihoods depend on our labor
market earnings. In light of this fact, can we plausibly conclude that
lower wages will induce people to substitute into leisure and
thereby reduce their eort to earn a living? After all, how many
people can live o the bounty of the land, depend upon their savings,
or count on the benecence of family, friends, or the welfare state to
meet their day-to-day needs? Yet, such a choice is implicit in conventional depiction of the labor supply curve.1 For the above reason, I
would argue that presenting the supply of labor schedule as if it were
the supply of any other commodity is an implausible representation
of the decision faced by the overwhelming majority of people in the
American labor market. It even more completely misrepresents conditions in the Third World. Happily, a more substantive and defensible specication of the relationship between income and labor supply
can be constructed without losing the foremost merit of the conventional model its analytic and pedagogical simplicity.
THE CONVENTIONAL LABOR SUPPLY

SCHEDULE
The upward sloping supply curve for what are termed factors of production holds a prominent place in textbook discussions of the labor
market and, as a consequence, the distribution of income. As one
among several productive factors the conventional, or textbook,
labor supply schedule depicts the quantity of labor supplied as a
direct function of the ination-adjusted wage rate, often called the
real wage. The aggregate labor supply schedule is typically presented as a summation across all of the laborleisure choices made
by every actual and potential worker in a given labor market (cf. Katz
and Rosen, 1991, pp. 13350; Taylor, 1998, pp. 3269).2
Despite the apparent consensus at the textbook level, there is some
dissatisfaction with the conclusions typically drawn. One is suggested
by our actual experience with labor markets. Over the years, numerous empirical studies have indicated that the labor supply schedule is
nearly vertical or even sloping downward to the right (Lester, 1941, pp.
10408; Kaufman, 1994, pp. 602; Gordon, 1996, ch. 4; Bluestone and
Rose, 1998, 2830; Dessing, 1999; Mishel et al., 1999, pp. 30714). If
84
Labor markets
this is the case, then textbook representations of the labor market,

specically the shape of the labor supply curve, have to be revised.
To partially address these empirical concerns, the labor supply
curve is sometimes presented as backward-bending at higher levels
of wages. For over 50 years economic theorists have acknowledged
that at high wages, and consequently high income levels, the representative worker will wish to purchase more of all normal goods.
Since leisure (dened in the broadest sense as doing anything but
working for wages) is a normal good, high wages can induce a
reduced quantity of labor being supplied to the market. Such a
modied labor supply curve appears in Figure V.1.
Underlying this result is the plausible notion that leisure has
properties that mimic those of normal goods. With the increased levels
of income that follow from higher wages, people will wish to purchase additional units of leisure. This tendency is known as the
income eect. But, we also have to consider another consequence of
higher wages we can purchase more of all things. It would not be sur-
W (Real wage)
S
Q (Labor)
0
Figure V.1
Backward-bending labor supply curve
85
prising if some of these items are desirable enough to induce us to

work a bit longer at our high wages. It follows that high wages also
induce a second tendency that is in opposition to the income eect just
described. This is a tendency for higher-compensated workers to substitute out of leisure time into additional labor time. This substitution eect, like the income eect, is a plausible response to higher
wages.
The substitution and income eects, although pressing in opposite
directions, are each consequences of a single cause higher wages per
unit of time. In technical language, economists have agreed on the
stylized fact that there exists some relatively high wage that enables
the income eect to dominate the substitution eect (ceteris
paribus, of course).
Despite these theoretical propositions, an additional problem
remains. The labor supply schedule depicted in Figure V.1 suggests
that, as wages decline below some point, the quantity of labor supplied will steadily decrease. Yet empirical studies consistently fail to
support this formulation. The American experience from the 1970s to
the mid-1990s, which featured a conjunction of falling or stagnating
wages and increased work hours for the bulk of the population, fails
to support such a depiction of the labor supply schedule (Schor, 1992,
chs. 13; Gordon, 1996, ch. 4; Mishel et al., 1999, pp. 30714). These
tendencies are even more pronounced outside the developed world.
In separate studies Maryke Dessing and Mohammed Sharif have
each identied similar tendencies across a broad range of Third
World labor markets, thereby undermining the idea that the quantity
of labor supplied declines as wages decline (Dessing, 1999; Sharif,
2003). This substantial array of facts, considered in conjunction with
implausible foundations, suggests a pressing need to reassess and
recongure the shape of the labor supply schedule.
INCOME AND THE VALUE OF LEISURE

Conventional depictions of labor supply posit a positive relationship
between income and the value of leisure. This is plausible as it is consistent with the experiences of the bulk of the, relatively well-o,
people who read economics books. It draws its strength from the
notion that, as incomes rise, people will place an ever-higher value on
an additional hour of time away from paid labor, and that they may
86
Labor markets
even be willing to purchase it with a portion of their rising incomes.

Implicitly, this theory suggests that while a person with a substantial
quantity of leisure may place a low value on additional quantities
of it, additional leisure is always and everywhere a good thing.
Consistent with its posture toward goods in general, the received
theory assumes that additional free time is always better.
Yet in light of what empirical studies suggest concerning low wage
labor markets, perhaps this latter assumption needs to be reevaluated.
Here it will be proposed that under certain conditions, increased
leisure is not only undesirable, but might even be perceived as disagreeable. This, perhaps striking claim, is grounded upon several
stylized facts that readers may nd plausible once they reect upon
the relationship between leisure and income:
1
2.
3.
Leisure worthy of the name is generally a joint product of free

time and purchasing power. For example, if I enjoy the perfect
margarita on my spacious deck overlooking the ocean in front of
my Laguna Beach home, my leisure is more fullling than if I
spend the same quantity of time drinking a cheap beer in a dark,
dingy, and cold apartment.
In the economics literature, leisure is an omnibus term for time
not spent working for wages. Often it includes time spent on
duties and chores that can more accurately be termed personal
work (Mincer, 1963; Prasch, 1997). Cleaning the house, paying
taxes, and washing dishes all fall into this category. One way to
arm this is to observe that the wealthy and even much of the
middle class are willing to pay for someone else to attend to a substantial portion of their personal work. As a consequence, they
can devote a larger percentage of their non-work hours to the
pleasures that non-economists usually associate with the word
leisure. Indeed, as a partial response to this problem, and as a
reection of the changing distribution of income, we now see the
emergence of rms that, for a fee, will attend to the personal work
of others (Levine, 1997, pp. 114-18). To the extent that the
wealthy can substitute money for personal work, they can derive
more utility from their non-work hours.
It is a agrant misuse of language to assert that the destitute individuals living upon the sidewalks of our major cities are enjoying
leisure. For many of the persons who nd themselves in such a
predicament, additional free time is a burden rather than a boon.
87
The theme running through the three propositions above is that, at

suciently low levels of income, the value of additional leisure time
can be negative. They collectively suggest that a destitute person
spending his or her leisure looking for work, negotiating with the
bureaucracy of an increasingly intrusive and judgmental welfare
state, or listening to their children plead for food, may perceive additional leisure hours to be both long and painful.
Of course our conventional understanding, and the received view
of labor economists, is that additional leisure must be a benet.
Therefore it needs to be repeated, and emphasized, that the generalization made in the previous paragraph is closely grounded upon the
three propositions presented above. Consequently it is evident that
the conclusion was derived without invoking some concept of
rened taste or any other aspect of snobbery. On the contrary, the
generalization or stylized fact being advanced here is that, as a consequence of low purchasing power, the poor face a diminished quality
of life during the hours that they are not working for wages. Unable
to meet their basic needs, they face such diminished prospects that
additional leisure hours may be unwelcome.
REVISING THE LABOR SUPPLY CURVE

If the value of free time is partially a function of income, and low
levels of income are incompatible with a decent standard of living,
then it is possible that if wage levels decline far enough, economic
agents (a person or a family) will be willing to work additional hours.
The reason is that the additional income will enable the person (or
family) contributing the additional work eort to more fully appreciate the hours of leisure that remain. Graphically, the result is a second
bend in the labor supply schedule as depicted in Figure V.2. The
level of wages at which this lower bend in the labor supply curve
takes place may be termed, in honor of the classical economists, the
subsistence wage (Ws).
Despite the above respecication of the relation between wage
levels and the quantity of labor supplied, it remains the case that over
an extensive range, lower wages will continue to reduce the quantity
of labor supplied as the received theory predicts. This portion of the
labor supply curve can be thought of as consistent with the experience and behavior of middle- and upper-middle class Americans.
88
Labor markets
W (Wage)
S
Ws
Wu
S
0
Figure V.2
Q (Labor)
Revised labor supply schedule
However, Figure V.2 supplements this tendency with the additional

proposition that once the real wage (W) falls below the subsistence
wage (Ws), the quantity of labor supplied will begin to rise, even as
the real wage continues to fall. This trend will continue until the total
hours of work required to maintain a socially acceptable standard of
living are too long to be sustainable. As a consequence, when the real
wage falls so far (to Wu) that the hours that a family must work to
maintain its subsistence are simply unsustainable, the hours worked
will once again decline, and rather precipitously. The reason is that
the primary worker and his or her family will be forced by exhaustion,
disease, despair, and disrepair to abandon their eort to maintain a
standard of living consistent with eective membership in the labor
force and, consequently, civil society. They become homeless, petty
thieves, or beggars, with strong prospects for a relatively short and
miserable life.
W (Wage)
Wa
89
D
A (Unstable)
Wh
B (Stable)
Ws
C(Unstable)
Wc
Wu
Wp
D(Stable)
D
Q (Labor)
Figure V.3
Revised labor market
MULTIPLE EQUILIBRIA IN THE LABOR

MARKET
If Figure V.2 is an accurate reformulation of the labor supply schedule, the labor market may be characterized by multiple equilibria. To
illustrate this, let us stay with the conventional representation of
factor demand functions and assume that the labor demand schedule
slopes downward to the right as depicted in Figure V.3.3
If we consider the revised presentation of the labor supply schedule in conjunction with a conventional downward-sloping labor
demand schedule, we could nd ourselves with a revised graph of the
labor market featuring four points of intersection. Two of these equilibria are stable and two are unstable. All four are of interest.
It will be supposed, in keeping with conventional presentations of
labor market dynamics, that when the quantity supplied of labor is
90
Labor markets
greater than the quantity demanded, the real wage will fall. Likewise,
when the quantity demanded is greater than the quantity supplied,
the real wage will rise. With this in mind, and turning once again to
Figure V.3, it can be seen that when the market wage is higher than
Wa, competitive pressures will induce it to rise. When the real wage is
just below Wa, competitive pressures will force it to decline until a new
equilibrium is established at point B. It follows that point A is an
unstable equilibrium.
Between points B and C, the wage will tend to rise until it is consistent with the equilibrium at point B. It follows that point B is a locally
stable equilibrium. Given the stability of the equilibrium at point B,
the range of wages between Ws and Wa is consistent with the selfregulating labor market of the textbooks and the laissez-faire policy
recommendations that typically follow from those presentations. This
explains why the range of wages between Ws and Wa is emphasized in
conventional presentations of the labor supply schedule.
Wages below Ws are interesting since they capture some of the novel
aspects of the revised labor supply curve. As wages fall below a level
consistent with subsistence, continued declines induce a higher quantity of labor supplied as people struggle to maintain a standard of
living consistent with the norms and values of their society. However,
so long as we remain above the unstable equilibria at point C, the
quantity demanded of labor is continually greater than the quantity
supplied and there are pressures in the system to return it to the higher
wage equilibria at point B. However, at wage levels below Wc, these
countervailing tendencies are defeated. The quantity supplied of labor
is now greater than the quantity demanded and for this reason market
forces will now press wages even lower as people strive to supply everincreasing labor hours in an eort to sustain a minimally acceptable
standard of living. The graph suggests that these eorts will result in
a tragically perverse outcome. The willingness of downwardly mobile
people to work additional hours places additional pressures on the
market wage which continues to fall thereby inducing even greater
work eort. This process continues until the market achieves another
locally stable equilibrium at point D.
Just above the stable equilibria of point D, the market registers its
greatest quantity of labor supplied at a wage of Wu. Here the total
number of labor hours supplied in the eort to maintain subsistence
reaches a level that is unsustainable. Fatigue, disease, despair, and disrepair place an inescapable upper boundary on hours of work. With
91
only 24 hours in a day, the human body can only sustain so much eort.
At wages below Wu, people are defeated by their physical and mental
limitations. It follows that they are forced to surrender their eort to
maintain a subsistence standard of living. The family in question then
cuts back on its labor supply. This conception is consistent, to put it
dramatically, with dropping out of the workforce. In a country with a
welfare state it may be supposed that they turn to its programs for
support. Absent formal or informal support, they become indigent and
live outside of the structure of society. As mentioned above, they
become homeless, petty criminals, beggars, or simply die o.
The larger lesson is that in a free market setting, where people must
depend upon their labor to meet their needs, inordinately low wages
can continue to decline as a consequence of their previously low level.
In such a market, featuring as it does a system of cumulative causation, low incomes lead to even lower incomes. Stated simply, in a
free labor market poverty can induce even greater poverty.
Such a theory of labor market dynamics, by contrast with the
received view, provides a dierent perspective on some long-standing
labor market interventions, including laws over child-labor, maximum
hours, and minimum wages. The concern is to avoid the low-level equilibria, what was once termed a poverty trap. Prior to our own era,
such concerns were better understood. Consider the following observation made almost one hundred years ago by Henry Rogers Seager,
a founder of the American Association of Labor Legislation and an
economics professor at Columbia University. Under these circumstances, as our experience abundantly proves, the free play of economic forces results in starvation wages for thousands and hundreds
of thousands of workers, and these starvation wages persist year after
year, with little or no sign of improvement (Seager, 1913, pp. 823).
In the terms introduced earlier in these lectures, these low-wage
dynamics are an example of a positive feedback system, or vicious
circle, at work in the economy (Prasch, 1998a). According to the
revised labor supply schedule, market processes can push a perversely
low wage rate ever further from the range consistent with a selfregulating market. Wages are relentlessly pressed into a range featuring destructive competition among those who must earn their
living exclusively from supplying their labor. (Destructive competition was the early twentieth century term for those varieties of competition based on shifting the legitimate costs of production onto
others through degradation of the environment, the labor force, etc.
92
Labor markets
This concept was to be contrasted with competition driven by

improvements in organization, products, or processes.) These dynamics enable us to more sensibly interpret the following statement by
labor market reformers John Commons and John Andrews: Another
reason for the low wage scale . . . is the cutthroat competition of the
workers for work (Commons and Andrews, 1916, p. 170).
The novelty of the revised labor supply schedule presented in Figure
V.3 is that it features two locally stable equilibrium points points B
and D. These reect high wages/low hours and low wages/high hours
respectively (I will ignore all initial wage levels higher than Wa). Under
free market conditions the system has a built-in tendency to gravitate to one of these two points and remain there. The particular equilibrium that is eventually achieved is entirely dependent upon initial
conditions in the market. This is a critical nding. If this theory is a
plausible representation of the low wage labor market it follows that
no amount of education, training, exhortation, or lectures on moral
uplift directed at the poor will force the labor market equilibrium to
move from point D to point B. Once achieving a poverty trap, the
system remains there. End of story.
Point D, which is consistent with a wage level below the subsistence
wage, is a locally stable equilibrium point as is point B. Given the
existence of two locally stable equilibrium points, there is no a priori
reason to believe that the equilibrium at point D is more natural,
ecient, or likely to occur than that at point B. Moreover, the wage
level at point D can no longer be presumed to uniquely represent the
true market value or marginal product of labor. The reason is
that the lower wage/higher hours equilibrium at point D is every bit
as consistent with the operations of a free market as the higher
wage/lower hours equilibrium featured at point B. Again, let us recall
that both equilibria are locally stable which means that once they are
achieved, the market embodies no internal mechanism or competitive
force that will induce a change in the result.
IMPLICATIONS FOR ECONOMIC THEORY AND

POLICY
The revised theory of the labor market presented above, if accepted,
has important implications for economic policy. To begin, let us
observe that, at wage levels above Wa, the market is dynamically
93
unstable in an upward direction. The quantity of labor demanded will

continue to exceed the quantity supplied at every wage level. Since the
quantity of labor supplied will continue to fall as the wage continues
to rise, no equilibrium will ever be achieved. The theory posits that
these high wages will move continuously upward.
At rst brush, this story appears to be consistent with the pay of
American CEOs since 1980.4 In such a state of aairs, there is a prima
facie case for a progressive income tax on all wages over Wa.
Moreover, and despite the touching concern of those associated
with the supply-side school of economists, it is evident that such a
tax will not reduce the quantity of labor supplied by these wellcompensated workers. Indeed the above analysis suggests that a progressive income tax would actually increase the quantity of labor
available to the market.
Now one might plausibly argue that this model of the labor market
is inapplicable to the labor supply decisions of the very wealthy. For
one thing, extreme wealth is rarely a consequence of wages. Rather its
typical source is as a reward for ownership of stock shares, a form of
return that in an era less attuned to the sensitivities of the wealthy was
called unearned income. Another reason, as Thorstein Veblen and
others have long observed, is that economic reward plays a diminished role in the economic calculations of the extremely wealthy.
Rather, relative income, social status, and rivalry are issues and motivators of substantially greater consequence (Veblen, 1899). In short,
Donald Trump did not star in his own reality television show
because he was worried about making his rent, or because his wealth
was inadequate to meet his needs.
A more interesting and signicant lesson follows from the coexistence of two equilibria. These have direct implications for the
ecacyof minimumwageormaximumhourslaws.Consider,oncemore,
Figure V.3. Suppose a maximum hours law were to be imposed that was
just below the hours that would otherwise be contributed at point C.
In light of the market dynamics illustrated by the arrows on the gure,
it is evident that such a restriction would set processes in motion
that would continue until the equilibrium at point B is achieved.
Interestingly, the initial hours limitation would not be binding in the
sense that the equilibrium hours worked once all adjustments had
occurred would be less than the mandated maximum a nice illustration of how market forces can interact with legislation to bring about
results that are not immediately evident or expected.
94
Labor markets
Let us also observe that with such legislation a lower quantity of

labor will be supplied than would be the case if the system were
allowed to remain at the low wage/high hours equilibrium. This consequence, of course, is the traditional worry of opponents of hours
legislation. These opponents have repeatedly argued that in free
markets everyone is free to choose the hours they wish to
supply. Figure V.3 arms everything they have said concerning the
voluntary nature of labor supply decisions. But, when the situation
changes, people revise their decisions in light of the new facts. When
market dynamics track them into the high wage/low hours equilibrium, people just as freely choose to cut back their hours, enjoy
more leisure, keep their children in school longer, etc. Figure V.3
reects these revised decisions. It follows that even though the
observed quantity of labor supplied is lower at point B than at
point D, it would be incorrect to infer that the market features an
excess supply of labor. Rather, what is being observed is the common
sense truism that when people earn higher wages, they often make
dierent labor supply decisions for themselves and their families. One
result may be a lower quantity of labor supplied, ceteris paribus.
The revised labor supply schedule implies a similar analysis in the
event that a minimum wage is enacted. Consider, again in Figure V.3,
a minimum wage set just above Wc. With such a mandated minimum
wage, the quantity of labor demanded will be greater than the quantity supplied. The competitive process will then exert pressure on
wages to rise until the market achieves the high wage/low hours equilibrium at point B. As with the above analysis of hours laws, the nal
result is contrary to much of the received literature. This should not
surprise us as these results were a consequence of analysing the
problem while holding the false belief that labor was a just another
commodity which is not the perspective taken in these lectures.
In Figure V.3, a minimum wage set just above Wc supports a market
equilibrium with a wage rate substantially higher than the legislated
minimum. Consistent with more conventional analyses, the quantity
of labor supplied does decline as a consequence of this legislation.
But, and this is important, this decline is NOT a consequence of an
excess supply of labor at the new market level of wages. Rather the
observed decline in the quantity of labor supplied can be attributed
to freely-made, but dierent, decisions as to how much wage labor the
individual (or family) should provide. Again, the legislative details
might vary depending upon the particularities of individual nations,
95
institutions, proposed wage levels, etc. What can be concluded from

the above is that revising the labor supply schedule along the lines
suggested is consistent with the extensive theoretical and empirical
research into the behavior of people who depend upon low wage
labor markets to earn a subsistence for themselves and their families.
For this reason it is a part of our revised understanding of the economics of minimum wage legislation (Brosnan and Wilkinson, 1988;
Card and Krueger, 1995; Prasch, 1996, 2000a, 2000b; Glickman,
1997; Carter, 1998; Prasch and Sheth, 1999; Levin-Waldman, 2000;
Waltman, 2000).
In conclusion, this lecture presents an implicit critique of the positivist tradition within contemporary economics a tradition that
long eschewed economic theories or models featuring multiple equilibria. In opposition to that tradition, it argues that a theory of the
labor market featuring multiple equilibria sheds some important
insights on a subject that has long been downplayed. This is the existence of dual labor markets, and the ameliorating properties of
minimum wage or maximum hours legislation. In this sense the
model of the revised labor supply schedule is not identical to, but is
broadly consistent with, the literature on what has been termed the
theory of segmented labor markets (Edwards et al., 1975; Harrison
and Sum, 1979; Gordon et al., 1982). In addition, a labor supply
schedule that is downward-sloping at lower wage levels is consistent
with the empirical generalization that, in the face of a declining or
stagnating median wage, many families, in both the developed and
underdeveloped worlds, will work longer hours in an eort to maintain their standard of living (Gordon, 1996, ch. 4; Bluestone and
Rose, 1998, pp. 2830; Mishel et al., 1999, pp. 30714).
NOTES
1. During the years I was in college in Boulder, Colorado, an individual gained some
local notoriety by claiming to be a breath-airian. As such, he claimed that he
could survive and be nourished by air alone. To prove his claim, he oered to sit
upon a local mountain top in a position of deep meditation for an extended
period. Whatever the physiological merits of his claim, it did have the potential to
overturn one of the particularities of labor that is critical to this lecture he had
no needs. On the other hand, it might be pointed out that to eliminate needs he
had to rst achieve a trance-like level of meditation. This implies that he would
not have been a particularly useful employee, so maybe even his example does not
rescue the conventional approach to labor markets with its presumption that
96
Labor markets
labor has the ability to fully constitute itself prior to, and independently of,
market relations.
2. Presenting the aggregate supply curve of labor as a simple summary of individual choices is problematic for a number of reasons. In keeping with the introductory nature of this book, these will be ignored.
3. The Reswitching Controversy of the 1950s and 1960s demonstrated that there is
no a priori reason to believe that the labor demand schedule has this shape. Readers
interested in an in-depth discussion of the issues associated with this debate
should consult, among others, articles by Georey Harcourt (1972), Pierangelo
Garegnani (1990), and Heinz Kurz (1990).
4. I note that it is merely consistent, since this market is institutionally complex. A
partial development of the authors views on this subject have been presented elsewhere (Prasch, 1998c).
LECTURE VI
Labor market dynamics when

motivation is a consideration
The previous lecture argued that labor features several essential and
distinguishing characteristics. These collectively imply that the labor
market does not function in a manner that allows for simple analogies to other kinds of markets. By taking such characteristics seriously it was demonstrated that the dynamics of low-wage labor
markets are dierent from those for simple commodities. Moreover,
the theoretical modications that follow are suciently important to
change our understanding of what constitutes plausible or defensible
labor market policies.
One of the new assumptions introduced above was the proposition
that most people, lacking the advantages of inheritance or accumulated wealth, must work to maintain themselves and their dependents.
As such, most people must enter the labor market to access the
income required to obtain those items that are necessary to function
in society. As was discussed, in those cases where, for any of a host of
reasons, a person or family nds themselves on the margins of the
workforce, without savings or substantial employment opportunities,
the market can operate in perverse and detrimental ways.
Yet, from the perspective of business accounting, it is equally undeniable that the wages of labor represent a cost. Such a perspective is
in clear contrast to that of employees for whom wages represent a
clear benet their income. It follows that changes in wages have
dierent implications for those on either side of the negotiation.
It is well-known, and no longer denied, that there has been a dramatic increase in social and economic stratication since the early
days of the Reagan Administration. A consequence of this is that
signicantly fewer upper middle class and wealthier Americans have
had any direct experience with the low-wage labor market. This lack
97
98
Labor markets
of knowledge, when considered in light of most peoples inclination

to assume that their own experiences can be readily generalized, has
created a situation in which many Americans have diculty understanding the choices faced or the decisions made by those living and
working in low-wage markets. Neither do they understand its eects
on the morale, lifestyle, and outlooks of those consigned to it for any
extended period of time. As a consequence the dynamics of the lowwage labor market, and the decision-making of those individuals
caught up in it, appear to be idiosyncratic or even perverse to those
who have spent their lives in more comfortable circumstances. Over
the years these misapprehensions have provided political support
for a variety of awed labor market policies, and not a few poorlyformulated ideas for the uplift of those caught up in low-wage
employment.1
This lecture will, however, set aside these considerations to examine
an altogether dierent aspect of labor markets, one that is more
applicable to the non-poor. But, as will be seen, these considerations
will further arm the broader lesson of these lectures that simple
analogies from commodity markets to labor markets should be
treated with some skepticism. To begin, let us reect on yet another
unique characteristic of people, and consider how this quality might
manifest itself in the labor market (Prasch, 2004b).
LABOR EMBODIES THE QUALITY OF

SELF-CONSCIOUSNESS
The characteristic that will be emphasized in this lecture is our
capacity for reection or self-consciousness (Frankfurt, 1971). This
capacity is, unfortunately, too rarely considered by economists. But
neglect does not diminish the fact, armed by both experience and
introspection, that perceived fairness and quality of treatment on the
job can rival monetary compensation in eliciting employee loyalty
and eort.
Our capacity for reection enables each of us to consider, and form
judgments, concerning the qualities of our place of employment. Such
judgments have implications for how, and even if, we will continue to
work at a particular job or location. By contrast, a capacity for
reection is not commonly associated with broccoli, bags of cement,
or other marketable commodities. While it would be incorrect to
When motivation is a consideration
99
suppose that our capacity for reection is always or even routinely

exercised, ignoring it altogether has left some economic theorists, and
even the management of some important companies, subject to some
important errors. This becomes most evident in the event that an
employer violates one or more widely-held norms of fair play.
Arguably, reection or self-consciousness is unique to the productive input we conventionally call labor.2 Certainly broccoli or bags of
cement do not develop an aesthetic, moral, or any other attitude or
response to how it is treated or believes that it is being treated. A bag
of cement will not think it is unfair if it is emptied before another is
opened. Broccoli will not feel violated or cheapened if it is given away
to someone else. As Alfred Eichner so wonderfully stated, It is a
matter of indierence to the barrel of oil that is sold whether it is used
to heat a house of God or a house of prostitution (Eichner, 1985,
p. 79; see also Marshall, 1920, p. 471).
People, on the other hand, generally arrive at work with a more or
less developed perspective on what is right or wrong. They also bring
experiences, beliefs, and expectations to their places of employment.
As a consequence, management must either work with, modify, or
confront these norms and expectations. Ignoring them altogether is
rarely an option. The reason is that these attitudes will often be
reected in the quality and even the quantity of work contributed by
any given labor force. Such considerations explain why management
is, or should be, thought of as a art that is substantially more subtle
than supply chain management or operations research.
Now, it is well-known that horses, mules, and camels also exhibit
the quality of consciousness. They can learn from previous experience and have emotions as wide-ranging as fear, irritation, and
aection. But it would be a stretch to argue that they reect on their
surroundings or draw larger meanings from what they are asked to
do. While I freely admit to being underqualied to hold forth on the
origin and exact meaning of reection in juxtaposition to consciousness, I am condent that most understandings of these terms accept
that reection, drawing as it does on the ideas of learning, context,
and time to make judgments, is largely unique to adult human beings
(Frankfurt, 1971).3
In labor markets, and labor relations within a rm, the fact of
reection makes an enormous dierence. For example, in the contemporary United States the broadly accepted cultural understandings that we (too-freely) label common sense support the norm of
100
Labor markets
equal pay for equal work for all employees of any given establishment. By contrast, a machine or a mule would not object to receiving
less compensation for its services than another, identical, machine or
mule. People, experience shows, are typically oended by such treatment unless a compelling reason can be presented to satisfy their
sense of fair play. For example seniority, additional education, or
superior skill are widely considered valid reasons to pay one person
more than another even if they work in similar jobs.4
Drawing upon such considerations, prominent economists from
John Maynard Keynes to Clark Kerr, Frank Pierson, and John
Dunlop have emphasized the importance that employees place on
their wage relative to others at the same workplace or in the same
industry (Taylor, 1957, pp. 3-31; Keynes, 1936 [1964], pp. 4-22;
Kaufman 1993, pp. 75-102). These economists built upon the observation that whether or not a persons compensation is deemed
satisfactory or unsatisfactory often depends upon the perceived legitimacy of the bargaining process and how much comparable workers
are paid. As professional arbitrators and other labor relations experts
know, within every rm and even industry there is not simply a wage
or an average wage, but a wage hierarchy. This hierarchy, be it formal
or informal, simultaneously draws upon, reinforces, and legitimates
employee wage expectations. John Dunlop developed his famous
ideas concerning job clusters and wage contours to illuminate
these issues (Dunlop 1957). Smart managers know they should avoid
disturbing or upending these hierarchies and their associated expectations without presenting their employees with a clear and compelling reason. Arbitrary wage adjustments that ignore the social
and rm-level values implicit in an established wage structure can
signicantly decrease morale. Such a decline, if widely shared, can
disrupt the smooth operation of a business. Taken to the extreme, it
can lead to work disruptions or stoppages due to deliberate slowdowns, strikes, or other job actions.
The idea that people are beings with a capacity for reection, and
consequently are concerned with their treatment and status at their
place of work, suggests a critical role for eective organization and
management in economic production. This insight, combined with
frustration with then-conventional labor economics as a eld of
research, contributed to the development of industrial relations as an
independent area of scholarship (Kaufman, 1993, pp. 75102). These
insights have also been the basis for pathbreaking studies into the role
101
of organizations in the success of modern economies (Chandler,

1977; Lazonick, 1991).
THE MARKET FOR LABOR AND THE MARKET

FOR COMMODITIES
With the above considerations in mind, let us now return to the elementary theory of the market for a simple commodity. However, we
will modify it so that it might be seen to apply to labor. To this end,
the vertical axis will feature the ination-adjusted wage, here simply
called the wage, instead of the commoditys price. The horizontal
axis will feature the quantity of labor. These modications are
depicted in Figure VI.1.
Once again, let us recall that in these markets the quantity supplied
is adjusted through changes in prices (in the case of labor, wages).
With a homogeneous commodity, perfect information, and no transactions costs, people will never pay more than the market price for
Wage
S
Quantity of labor
Figure VI.1 Supply and demand of labor (if labor considered as a

commodity)
102
Labor markets
any given commodity. Neither will anyone accept less. Collectively,

these assumptions amount to an assumption of perfect arbitrage
across the entire market, thereby ensuring all identical items will sell
at the same price. In this lecture we will demonstrate that in the case
of labor, substantial grounds remain for contesting this proposition,
otherwise known as The Law of One Price.
Now, let us suppose that a rm needs employees to accomplish
two distinct tasks. We will further suppose that these employees are
identical in every attribute that could be relevant to these tasks.
Additionally, we will suppose that neither task has qualities that
render it more challenging or dicult than the other, but it will be
supposed that the cost of monitoring performance at each one diers
signicantly.
Let us suppose that the rst job can be described as a sta task
in which monitoring is costly so that the worker has substantial discretion over the speed and intensity of their eort. The second will be
supposed to be an assembly task that can be monitored at low cost.
Should an employees eort wane while performing this latter task,
their boss can readily identify this reduced level of eort. Again,
recall that we are supposing that all employees are homogeneous.
Being of the same innate capacity and ability these employees are
paid the same wage. This is, after all, consistent with the principle of
perfect arbitrage described above. Here is the problem. If, as is conventionally supposed, there is disutility in working, what keeps
employees from shirking in their eorts?
Given the structure of the above scenario, it is evident that the
employees engaged in the easily monitored task have a direct incentive to maintain their contracted degree of eort. After all, their
failure to do so can be readily identied so they risk being disciplined
or red. The reason is evident from the assumptions it is not particularly dicult for management to ascertain whether or not a given
individual is shirking. By contrast, the situation in the sta job is
neither as simple nor as straightforward. Again, the job task is such
that, even in the event of failure, it remains dicult to evaluate the
level of eort that was contributed. A wedding planner might be a
case in point. The job is not intrinsically dicult, in that it does not
require an advanced degree or higher mathematics. But it is hard for
a soon-to-be-married couple to monitor the eorts of their wedding
planner. Can they be certain that the planner has failed to make a
good-faith eort to locate the best and most reliable orist at the
103
lowest prices, found the best caterer at the most competitive price, the
most tasty cake, a sober and suitably profound minister or priest, etc.?
To an important extent, the couple must place a degree of trust in the
proposition that their wedding planner is working as hard as can reasonably be expected.
This leads us to the following interesting possibility. For some types
of labor there is an incentive to pay more than necessary, in this case
the equilibrium or market wage, in an eort to induce employees to
value or appreciate their job and, as a consequence, contribute
a more substantial eort. This tendency, which was once wellunderstood by economists, was rediscovered a couple of decades ago.
Today it is known as eciency-wage theory and has received some
degree of recognition (Akerlof, 1982; Shapiro and Stiglitz, 1984;
Bowles, 1985). This nomenclature is explicitly designed to evoke the
idea that some rms may deliberately overpay some or all of its
employees in order to enhance eciency, and thereby lower labor
costs per unit of output. In general those who are most likely to
receive such a wage premium are employed at tasks where performance or eort is inherently dicult to measure or otherwise ascertain.
It follows that paying such a wage premium is not an intrinsically generous act, but rather part of a broader plan to induce greater eort
from dicult-to-monitor employees. Again, the presumption is that
paying above the existing market wage will induce greater workplace
eort and thereby support the rms most consistent goal the lowest
cost of labor per unit of work accomplished.
While the professional literature advances a host of reasons as to
why such a compensation strategy might be successful, only two will
be explored here.5 First, someone paid more than a market wage is
earning more and therefore has an interest in keeping such a desirable
job. Their self-interest will incline them to more diligently pursue
their assigned tasks so as to avoid being caught shirking (while these
jobs are dicult to monitor, the probability of being caught is still
greater than zero). Second, anthropologists have argued for the existence of a trans-cultural tendency to repay kindness with kindness.
For this reason employees who feel trusted and well-compensated are
inclined to reciprocate with greater loyalty and eort. The rm
wins by gaining the benet of greater eort with lower turnover
and training costs. Additional benets might include a willingness to
stay late or come in at weekends to assist in meeting big deadlines
(Akerlof, 1982).
104
Labor markets
Wage
S
We
Wm
D
0
Figure VI.2
Qe
Qm
Quantity of labor
The eciency wage (We)
Such considerations, commonplace though they may appear, have

enormous implications for our understanding of the labor market.
This is illustrated in Figure VI.2. If the above considerations are
meaningful, prot-seeking employers would willingly pay an abovemarket wage to employees engaged in dicult-to-monitor tasks. In
Figure VI.2 this is labeled an eciency-wage (We). Again, employers willingly pay this premium wage even though they fully understand that other workers of identical ability would be willing to sta
these same jobs for the lower, or market, wage (Wm). This tendency,
and its eects, are illustrated in Figure VI.2.
In Figure VI.2, and in the absence of the above considerations, the
labor market would feature a wage of Wm and a quantity of labor
hired of Qm. But there are other considerations. We are supposing a
situation in which it is dicult to monitor the eort expended on
some essential job tasks. To enhance eciency the employer is willing
to pay a wage of We to at least a subset of his or her employees so that
they will value their jobs and contribute a more diligent eort. As can
be readily observed from an examination of Figure VI.2, when an
eciency wage is paid, We Wm and Qm Qe. It is also evident that
at wage We more employees are willing to take this job than will be
105
hired. The rms decision not to hire more people at a lower wage
arms that they believe that they have a compelling reason for not
doing so. This is, according to the eciency-wage theory discussed
above, that this task may be more eectively and cheaply accomplished by taking account of employee motivation.
With many otherwise qualied workers now shut out of the
primary labor market, additional numbers of persons will be
seeking, and accepting, positions in the secondary labor market.
(In keeping with a long-standing convention in the economics literature, we will hereafter term the high wage market the primary
labor market and the low wage market the secondary labor
market.) Keep in mind that this secondary labor market is exclusively
distinguished from the primary market by the existence of a low cost
to monitoring employee performance. It follows that paying a wage
premium is unnecessary in this secondary market. Given the facts of
competitive prot-seeking and rivalry between rms, we can deduce
that the market wage will be paid for labor applied to this latter task.
This being the case, and in the presence of a now-increased supply of
workers seeking work in this secondary labor market, we expect a
decline in that markets equilibrium wage. This is illustrated in
Figure VI.3.
The increased quantity of labor supplied to the secondary labor
market is represented by an outward shift in the supply of labor
schedule from S to S1. Again, let me reemphasize that in Figures VI.2
and VI.3 we are assuming homogeneous labor that is to say we
are assuming that every current and potential employee has equal
skills and ability. Nevertheless, in the presence of unequal monitoring costs, the decisions of prot-seeking rms will create a situation
of unequal wages and hence a dual labor market. To reiterate, the
labor market described above is divided not according to the inherent
ability, capabilities, education, or a superior work ethic of one subgroup of employees contrasted with another. On the contrary, the
specic qualities of the task assigned are driving the divergence of
wages.
The above exposition can assist us in at least partially resolving an
apparent conundrum. Why is it that those jobs featuring the best
work conditions tend to pay more? In the simple example presented
in this lecture, these are the jobs with less direct monitoring. Given
that most people do not like to be closely monitored, why is it that
in the real world additional or even overbearing monitoring is
106
Labor markets
Wage
S
W
W1
S1
0
Figure VI.3
Quantity of labor
The secondary labor market
generally associated with reduced compensation? The reason is that,

from managements perspective, paying a wage premium and hiring
additional monitors represent alternative strategies (Shapiro and
Stiglitz, 1984; Bowles, 1985; Gordon, 1996). From a management
perspective, the task at hand is to choose the least-cost approach to
maximizing employee eort. In some instances paying more turns out
to be the least-cost approach.
Before moving on to the next lecture, it should be observed that the
surplus of applicants to the primary labor market is consistent with
some important sociological processes that are familiar to all of us.
When supply exceeds demand for any given position, employers must
establish some criteria with which to choose among otherwise eligible workers. If we consider this fact in a social and political vacuum,
it will be evident that employers can set all kinds of criteria for such
a selection including criteria that have no relation to performance.
Consequently, a persistent surplus of potential employees hoping for
a job paying a premium wage represents an opportunity for an
employer to indulge a variety of whims and preferences even prejudices in the course of deciding whom to hire and retain. History and
107
experience demonstrate that nepotism, racism, sexism, age discrimination, political aliation, even a willingness to have sex with the
boss, have each and severally been criteria used to select from among
a surplus of equally-capable job applicants. Again, with a substantial
surplus of eligible applicants, there is no economic cost or
penalty for bosses or their managers to indulge such whims or
prejudices.
Workers, who are all too aware that the better-compensated jobs
are scarce, know that rewards come from investing in any sort of
signal that might appeal to the moods, whims, or vanities of those
employers paying eciency wages. Sometimes this is close to impossible. Few of us can change our race or gender to suit a prejudiced
boss. But other signals, some of which enjoy wide social approval,
do exist. We could, for example, pursue a college education. Selection
by such a criteria is acceptable to employers, and upheld by the norms
and laws of our society. Given the assumptions of the above model,
a college education will have no eect on workplace productivity, but
it does provide employers with a non-trivial, but socially and judicially approved, means to select among the surplus of job applicants.
Not too long ago, most of the country accepted race and gender as
reasonable criteria for selecting from among potential employees
for positions in the primary labor market. When such criteria are
widely adopted, dual labor markets serve to reinforce and validate,
rather than undermine, pre-existing social prejudices. Today we term
such prejudices, when applied to markets, discrimination. This the
subject of the next two lectures.
NOTES
1. This is the origin of the legendary story that had Marie Antoinette exclaiming Let
them eat cake when she was initially informed that French peasants were without
bread. Such a solution would, of course, be plausible for her and everyone in her
social circle.
2. Given my seemingly chronic mishaps, I periodically imagine that computers also
have a capacity for independent reection and decision-making.
3. Indeed, it is precisely because children are thought to be lacking a sense of context
and a developed capacity for reection that we do not grant them the legal rights
and responsibilities that we conventionally extend to adults.
4. As is well known, for much of American labor history gender or race were widely
taken to be valid reasons for discrepancies in opportunity or pay within the same
workplace. Happily, these awed conventions have become less legitimate over the
past century (Figart et al., 2002, pp. 1633).
108
Labor markets
5. Labor economists will note that in this text I am presenting only two stories to
motivate this theory. As they undoubtedly know, the literature on eciency wage
embodies several variants, such as the lowering of turnover and retraining costs,
the health and stamina of employees, etc. Since this book is presenting the elements of economics, and in no way presumes to present a more complete account
of eciency wage theory, these two arguments will have to suce.
PART IV
Social, ethical and political considerations
LECTURE VII

Chicago School approach
Economists have long invoked analogies to the economic theory of
commodity markets when examining the consequences of labor
market discrimination. This theory of the market, as has been shown
above, is constructed upon several important assumptions. Of
specic interest to the issue of discrimination, the theory of the perfectly competitive market explicitly rejects the notion that distinctions of theoretical or practical consequence can be made between
dierent commodities. Arguing from this premise, the Neoclassical
or Chicago School approach to the study of discrimination has
long been drawn upon to demonstrate that the free market can be
relied upon to resolve the eects and thereby the legacies of discrimination (cf. Friedman, 1962, ch. 7; Becker, 1968, 1971; Sowell, 1981a,
1981b).
Crucial to this vision are several assumptions concerning adjustment processes. Less clearly defended is the idea that these several
assumptions are plausible characteristics of markets as they exist in
the real world. If we are to understand the strengths and the weaknesses of the Chicago School approach to the economics of discrimination, readers must remain cognizant of these underlying
assumptions. The reason is that they are essential to the construction
of the theory, its conclusions, and the policy proposals that follow
from it. In short, it is these assumptions that ultimately determine
what, from the Chicago School perspective, may be taken to be
plausible or implausible policies for undermining the consequences
and possible persistence of labor market discrimination. As these
assumptions are listed, it should become evident that they are similar
to the assumptions that characterize commodity markets as
described earlier in this book:
111
112
1.
2.
3.
4.
5.
The markets for labor and products feature many small rms,
none of which have the capacity to modify wages, prices, or the
structure of these markets.
An assumption of standardized literally homogeneous inputs
and nal products. For this reason, all current and potential
employees are presumed to be identical in every aspect of their
ability and motivation. For the purposes of this lecture they can
only, and exclusively, be distinguished by their race. (To examine
other forms of discrimination, gender, religion, caste, etc., are
substituted for race.) It will be assumed that a workers race can
be immediately and costlessly ascertained by everyone in the
market.
Free and costless entry and exit from each and every market on
the part of all rms and employees.
Free and costless movement of all other productive resources,
including technologies and capital, across all rms currently or
potentially in the economy. This implies a perfectly knowledgeable and uid market in credit. (A critical implication is that
everyone, of all races, can borrow money on the same terms at
the same rate of interest.)
All actual and potential market participants have perfectly and
costlessly acquired information concerning all prices and production processes, including the location and quality of all competing opportunities.
Let us now assume the existence of a labor market operating in an

economy characterized by the above assumptions. We will further
suppose that race discrimination exists in this hypothetical society.
Discrimination, in this case, means that at the going rate of wages
many businesses will exclude workers of a particular race (or gender,
religion, caste, sexual preference, etc., again, the model has been
generalized to a wide variety of types of discrimination).1
In the event that some employers practice discrimination in hiring,
its most immediate eect is that those rms are denying themselves
access to a portion of the available labor pool. In the language of this
analysis the reason for this discrimination is that, in the eyes of prejudiced employers, minority workers are simultaneously producing
two items. The rst is the work-eort that all (otherwise identical)
workers are paid to contribute. The second is the race quality that
discriminating employers nd objectionable. (This is the source of the
The Chicago School approach
113
controversial phrase taste for discrimination initially advanced by

University of Chicago economist Gary Becker.)
Now, suppose that there are enough persons of the privileged race
to ll all positions in discriminating rms. If we further assume that
all workers exclusively care about their own individual wage, then in
the event of perfect competition discriminating rms will nd enough
workers to satisfy their perceived need for a workplace entirely
constituted of the racial characteristics they prefer. Following
the assumptions of perfect competition posited above, minority
workers will be able to costlessly locate and secure jobs at the market
rate of wages at other, non-discriminating, rms. The nal outcome
will feature no eect on anyones wages, but there will be an eect on
the distribution of employees. Some rms will have exclusively white
employees, whereas non-discriminating rms will have, relative to the
entire population, a disproportionate number of minority employees.
But, one might reasonably ask, what if a substantial percentage of
all rms were owned by prejudiced persons? In fact, let us suppose
that so many rms are owned by prejudiced persons that it is impossible for them to hire exclusively from the privileged race. Conversely,
there may be too few unprejudiced employers to hire all of the
discriminated-against workers. Under these conditions, some minority employees are forced to seek out positions at discriminating rms.
If these workers are to induce discriminating rms to accept their
applications for employment, they must oer to perform the same
work as their privileged peers for a reduced wage. In short, they must
accept a reduced wage if they are to oset the distaste of discriminating employers in hiring them.2 Depending upon the intensity of
discrimination felt by any given employer, they will face a larger or
smaller reduction in wages. Of course it is conceivable, as a matter of
logic, that this discount could be 100 percent. However, it is an
implicit preconception of this theory that rational discriminators
will be willing to hire minority workers for some non-zero wage. For
that reason we will maintain that assumption here.
If we further assume that employer prejudice varies in intensity
along a continuous scale, discriminated-against employees have an
incentive to seek out the least prejudiced employer rst. Drawing
upon the assumption of perfect information, such a search is costless. Consequently, discriminated-against workers will initially ll
positions at non-discriminating rms, then search for positions at the
lesser discriminating rms, turn next to moderately discriminating
114
rms, and so forth, until all minority workers have secured

employment.
Now and this is critical we have assumed that all workers are
perfect substitutes for one another with regard to ability, eciency, and
productivity. Since, under the assumptions of perfect competition,
similar goods must sell at the same price, it follows that workers with
identical qualities must all be paid the same wage. (This is an extension
of the law of one price discussed in previous lectures.) Since discriminated-against workers are all identical to each other in every aspect, it
follows that they will all, independently of the variety of rm that actually employs them (i.e. discriminatory or non-discriminatory), be paid
the same wage. Consequently a dual wage structure will emerge. It
will feature a privileged wage and a minority wage with the latter
set at a level that enables all minority job seekers to nd employment.
This conclusion is consistent with the race premium that was long a
distinguishing characteristic of labor market discrimination (Lester
1941, 20206, see also his several references).
Notice that for a dual wage structure to emerge, it is unnecessary
that each and every employer be prejudiced. All that is required is that
there be more minority employees than positions at non-prejudiced
employers. The second condition is that all employers are rational
in the sense that even non-discriminatory employers exclusively seek
to maximize prots. It follows that if non-discriminating rms can
hire minority employees at a discount, they can be expected to seize
the opportunity.
Considered from the perspective of rms, a most interesting and
protable opportunity is presented by the existence of prejudice elsewhere in the labor market. This is because unprejudiced rms will
experience an economic windfall. After all, these rms were previously
willing to pay the full market wage for labor without regard to race.
As prot-making non-discriminating rms, their exclusive interest
is to fully sta their workplaces. However, these non-discriminating
rms have found, to their undoubted delight, that they can now save
on labor costs by hiring discriminated-against workers at the discounted minority wage. This provides unprejudiced rms with more
prot than they otherwise would have reason to expect. These are
prots that they can use to invest and expand their market share at the
expense of their competitors discriminating rms.
Discriminating rms, on the other hand, must operate in the same
product and labor markets but they also confront a unique obstacle.
115
To the owners or managers of these rms the discounted minority

wage represents compensation for the psychic cost they experience from hiring and working with persons against whom they are
prejudiced. The savings on wages they accrue from underpaying
minority workers represents, in their view, a necessary bonus,
undoubtedly taken in some form of consumption, that compensates them for the discomfort they have experienced. In their minds
the compensating discount is just adequate to induce them to hire
minority employees. It follows that, on average, these rms will
employ a disproportionately greater number of the higher-paid privileged workers than their unprejudiced competitors. The latter, seeing
only an easy opportunity for enhanced prots, will actually seek out
minority workers so as to acquire as much of the labor they need at
a reduced cost.
As a direct consequence of the prejudices of their owners or managers, discriminating rms must contend with higher wage costs.
Moreover, the prots they will be able to accumulate for further
investment will be less than that of their non-discriminating competitors. With lower rates of investment discriminating rms will be
unable to expand as rapidly as their unprejudiced competitors,
so their market share can be expected to decline over time. Nondiscriminating rms, with higher rates of investment and growth,
will come to command a larger percentage of the markets for
output and labor. As the share of discriminating rms declines, and
that of non-discriminating rms expands, the wage discount that
minority workers must accept will also decline. Over time, the wages
of all equally qualied workers will converge on a single market
wage. The only remaining residue of discrimination will be that the
remaining, and increasingly inconsequential, prejudiced rms will
still employ labor forces made up exclusively of the privileged
group.
The larger lesson of the Chicago School theory of discrimination is that in the presence of free market forces, the material eects
of labor market discrimination can be expected to wither away.
Although a few die-hard rms will continue to practice discrimination, and hire exclusively privileged workers, these rms will be
increasingly at the margins of the larger labor market and society as
a whole. Over time, their employees will be privileged exclusively in
the historical sense the wage premiums they once had will be long
gone.
116
Another and important conclusion drawn is that the most eective

way to erode the material eects of discriminatory practices is
through market competition. The weapon of choice to a despised
group is the acceptance of wage discounts. From such an argument it
is inferred that government eorts to legislate equal wages for equal
work will, perversely, maintain discriminatory practices. The argument is that such laws undermine the ability of unprejudiced rms to
garner exceptional prots and thereby expand their market share.
Such laws, these authors contend, enable prejudiced rms to continue
their labor market practices without fear of competition from unprejudiced rivals. This is one of the reasons that Chicago School economists have long argued against minimum wage laws, maximum
hours laws, equal opportunity laws, and other well-intentioned
labor market interventions. They believe that they each and severally
undermine the capacity of a free market to create, over time, a
society of more genuinely equal opportunity (Friedman, 1962, ch. 7;
Becker, 1968, 1971; Sowell, 1981a).
The processes described above will be accelerated in the event that
discriminated-against workers are able to turn to prot-oriented and
competitive technology and nancial markets to start rms of their
own. Given the conventional assumptions of perfect competition, no
obstacles should obstruct the founding or expansion of rms owned
by non-discriminating employers. This urry of entrepreneurial activity will even more rapidly expand opportunities for discriminatedagainst employees. With more opportunities for employment, the
privileged wage and the minority wage can be expected to even
more quickly converge.
In the end, rms owned or managed by prejudiced persons will be
confronted with a choice that is as hard as it is inescapable. They can
continue to operate with the services of well-paid privileged workers
while indulging their sense of prejudice. Or, they can stie their inclination to discriminate and employ minority workers at a discount.
This latter strategy enables the rm to grow and prosper. The former
strategy will inevitably lead to their rms marginalization or even
elimination in a competitive market.
It is consistent with the ethos of the free market Chicago School
that it is not the government that penalizes discriminating rms.
On the contrary, penalties are imposed by impersonal market
forces exclusively motivated by private self-interest. In a competitive
market, rms refusing to hire the most qualied workers available at
117
the lowest wage will have less prots with which to expand their enterprises. By indulging their prejudices rather than attending to the
bottom line these rms are penalized by market forces. The Chicago
School of economists is condent that the penalty to indulging
ones taste for discrimination is as substantial as it is inevitable.
An extension of the above analysis is the proposition that, in the
event that the discriminating rm is owned by prot-seeking shareholders, that is to say that it is a private corporation, minorities
will be in an even more favorable position. The reason is that selfinterested shareholders have every incentive to replace discriminating executives and managers. After all, shareholders stand to earn
higher levels of prot per share if they operate their company with
non-discriminating executives and managers. Even if the shareholders are themselves prejudiced, they will not be themselves obliged to
work with the outcast group, and their self-interest will constrain
managers who might otherwise exhibit a taste for discrimination.
Extending the Chicago School perspective, Thomas Sowell has
argued that for-prot corporations are less likely to discriminate
than non-prot entities such as museums or universities. For similar
reasons he claims that monopolies, since they are protected from
competition, also retain the ability to indulge a taste for discrimination over time (Sowell, 1981a, ch. 3).
Sowells argument is along the following lines. Imagine an isolated
community whose economy is dominated by a large employer. Let us
further suppose that this prominent employer is organized by an
equally prominent union that has negotiated for a wage higher than
the prevailing market wage. All workers not employed by this dominant rm must work for another of the towns employers. These
latter rms are smaller and pay the prevailing market wage. In such a
case, the owners or managers of the dominant rm may freely indulge
their proclivity toward discrimination because they have the luxury of
selecting from among a surplus of applicants for whatever qualities
they, for whatever reasons, may prefer. This may be employees who
are white, male, or straight. They may select all of the above, none of
the above, or even their inverse. If enough applicants of the favored
group are available to ll all the jobs at this dominant rm, the workplace will be completely segregated. Moreover, this condition may be
sustainable for an extended period.3
The larger lesson of the above analysis is that the solution to discrimination is to eliminate any and all limitations on the scope and
118
functioning of competitive markets (Friedman, 1962, ch. 7; Becker,

1968; Sowell, 1981a). Such a policy will operate on a fatal weakness
of discrimination it is poor business practice. The principle is that
market forces are Darwinian processes that ruthlessly undermine
inecient enterprises, without care or concern for the origin of a
given rms ineciencies. It follows that competition will weed out
discriminating rms as relentlessly as it weeds out incompetent management, outdated technology, or unfashionable products.
The Chicago School economists all agree that owners and managers who require compensation, in the form of a wage discount,
to hire minority workers are certainly harming their employees. But
their attention is generally focused on the longer term wherein discriminatory owners and managers succeed only in bringing harm to
themselves. As they see it, the situation is analogous to those people
who refuse to shop in minority-owned or staed shops or restaurants.
They will only reduce the range of choices and prices from which they
can select. In their view, prejudiced shoppers should have every right
to indulge their biases, but they will also, on average, pay more for
less. Before too long, they maintain, the invisible hand will draw
patronage to the cheaper shops.4
THE MARKET ECONOMY AND

DISCRIMINATION
Can Dierentials in Economic Opportunity and Remuneration
Continue to Exist?
Let us now reiterate several points. First, the Chicago School theory
does not prove that the market mechanism will eliminate previouslyexisting discriminatory practices. Rather it deduces such a conclusion
by considering the implications of a particular economic theory, one
that features a specic set of assumptions concerning the structure
and dynamics of output and labor markets. Specically, the theory
assumes that the economic system can be plausibly represented as
having highly competitive markets. From this beginning it follows
that the market will eliminate the economic consequences of discrimination. All of the above leads to the following conclusion, one
that is of critical importance for contemporary policy discussions. If
we have a reasonably free-market economy and accept the Chicago
119
School theory of the economics of discrimination to be broadly accurate, then we must conclude that the remaining dierentials in economic attainment must be attributed to some existing and persisting
extra-market condition or constraint.
Hypothetically, suppose we were to accept the above theory.
Suppose that we also accepted the proposition that labor markets
have been reasonably competitive for a substantial period of time.
Jointly, these require us to consider an important question. How is it
that substantial dierentials in employment and compensation continue to exist and even persist between any two populations (or
genders, or castes, etc.)? Again, if we accept the arguments summarized in this lecture, logic dictates that the lower remuneration of any
particular minority group must occur because our assumption of
equally capable workers is inaccurate.
This last conclusion bears repeating since the implications are substantial. If one believes that: (1) The Chicago School theory of discrimination is accurate and (2) That dierential levels of employment
compensation and opportunity remain and persist across two distinct
social groups, then it follows that there must be substantive and
lasting dierences between the average ability or disposition of
employees between the populations one is studying.
This conclusion follows directly from the structure of the theory,
as there is no other explanation for the sustained dierences in compensation. If a social scientist, citizen, or politician remains concerned about this persistent inequality, and wishes to address it, the
set of workable solutions is both revealed and constrained by the
structure of the analysis. It must be to identify and reduce any premarket or extra-market characteristics responsible for dierences in
productivity between groups. With such an end in mind, several
explanations have been advanced to reconcile the existence of continuing economic inequality with the presumptive competitiveness of
the American economy and the presumed veracity of the Chicago
School theory of discrimination.
First, is the proposition that an anti-market culture or some
otherwise dysfunctional prevailing attitude allegedly adopted by
some social groups is limiting their assimilation and thereby economic achievement (Steele, 1990; DSouza, 1995). In one of the more
thoughtful books of this genre, Thomas Sowell argues that immigrant
groups emerging from peasant backgrounds take longer to adjust to
the norms and values of capitalist markets relative to immigrant
120
populations more experienced with urban and marketized settings.

He identies the Irish refugees of the Great Famine and AfricanAmerican refugees from the early twentieth century Jim Crow South
as examples of peasant societies that have been relatively slow assimilators (Sowell, 1981b). In American political circles, this explanation
has been labeled conservative.
A second explanation ascribes gaps in earnings and economic
opportunity to dierentials in education. The problem, according to
this explanation, is neither discrimination nor the functioning of the
labor market. Rather low productivity and economic remuneration
are thought to be a consequence of failed schools. The poor quality
of the school, or the low expectations of the nations teachers and
school administrators, are to blame not employers or the structure
of markets. It follows that the solution is to leave the markets alone
while improving the schools which, it is supposed from the way the
problem is structured, must be failing minority students (Welch,
1973). In American policy circles, this explanation has been labeled
liberal.
A third explanation is one that those of us who came of age in the
1970s had thought, or perhaps more accurately had hoped, was pass.
But one should never underestimate the power of poor ideas backed
by substantial sums of money. Thanks to the generosity of the
Bradley Foundation, economist Charles Murray and his co-author,
the late Harvard psychologist Richard Herrnstein, famously argued
that the explanation for the sustained gap in compensation occurs
because African-Americans are inherently, that is to say biologically,
less capable persons. For this reason they are less productive employees and therefore paid less than the broader population (Herrnstein
and Murray, 1994). Since this book received substantial criticism
when it was published, I will refrain from rehashing these arguments
here. However, I will recommend a detailed and critical review of its
empirical claims by the University of Wisconsin econometricians
Arthur Goldberger and Charles Manski (Goldberger and Manski,
1995).5
Each of the above arguments has a common origin. They have been
advanced to explain sustained inequality in wages, opportunity, and
achievement in light of the long-standing existence of competitive
markets in American society. The common theme running through
these perspectives is that they all implicitly or explicitly accept the
Neoclassical or Chicago School position that the labor market
121
cannot be an independent cause or contributor to the social pathology of racism (or sexism, or discrimination by caste, religion, sexual
preference, etc.).
The Chicago School theory, it should be clear by now, is distinctive
for its position that the market mechanism, if given full reign, will
quickly and eectively undermine unprotable prejudices and institutions. This includes discrimination. Chicago School economists
such as Milton Friedman, Gary Becker, and Thomas Sowell have persistently maintained that the more competitive the market, the
stronger these ameliorative forces will be. The reason, as we have seen,
is not the altruism or superior moral conduct of private employers.
On the contrary, with rms seeking only their own self-interest in
competitive markets, we can expect to see a relatively rapid convergence of economic opportunities across all social divisions: racial,
ethnic, religious, gender, etc. As mentioned, this conclusion follows
so long as the underlying productivity of minority groups is identical
to that of the privileged group or groups. This theory does allow
for exceptions. As discussed above all organizations insulated from
market forces, including non-prot institutions and for-prot monopolies, can stave o pressures to integrate. Finally, these authors
contend that government regulation of the labor market, no matter
how well intentioned, will diminish the markets ability to erode discriminatory practices.
NOTES
1. I am aware that there have been analytically important dierences in the form and
meaning of discrimination over the course of history. For this reason I will remind
the reader that this and the next lecture are not to be taken as a comprehensive
treatment of discrimination. They are designed to be part of an introduction to
economics, and specically to illustrate that when conditions change in a market,
the assumptions and analysis may also change. Those looking for more detailed,
but readable treatments of the economics of race and discrimination should
consult Andrews (1999) or Loury (1998, 2002). For a more historical treatment,
see Colander et al. (2004).
2. Alternatively, they could accept harsher or more onerous workplace conditions.
For example, minority workers might be crowded into undesirable shifts or asked
to perform more demanding tasks. Thomas Maloney and Warren C. Whatley have
found that this was the case at the Ford Motor Company (Maloney and Whatley,
1995). In the case of gender discrimination, the issues are familiar. Leaving more
overt sexual demands to one side, less frightening, but nevertheless unpleasant
forms of what we would now term sexual harassment have long typied the
American workplace. For example, in the 1970s one prominent Georgia law rm
122
expected, all in good fun of course, its young women interns and associates to
entertain their colleagues at the rms annual summer retreat with a wet-T-shirt
performance. More mundanely and conventionally, the oce culture of a rm
might pressure women workers to perform minor, but gender-reinforcing, tasks for
the boss and the men of the workplace. Examples have long included making the
coee before sta or client meetings, cleaning up after such meetings, watering the
plants in the oce, etc. In short, jobs that no one would expect male employees to
perform.
3. Historically, things rarely work this way. What appears to be desired is not segregation per se, but the recognition and armation of a certain hierarchy at the
workplace. For example, management may be all college-educated Protestant
white males. The factory oor may be dominated by white men of a dierent ethnic
or religious background (say, Irish Catholic immigrants). The cleaning sta may
be all black men, and the kitchen staed exclusively by women, perhaps with white
women in managerial positions. Gays and lesbians will conceal their identities. The
point is that mixed ethnicity and gender workplaces have been common in
American history, even under conditions of extreme and unabashed prejudice. The
issue is more frequently over the comparative status of their jobs and how much
dierent groups are paid.
4. Readers may have already discerned that an unargued subtext of this theory of discrimination is that short period harms have few lasting eects. As with the theory
itself, this can and has been challenged.
5. For an accessible discussion and criticism of the revival of biological theories of
race in our era, see Graves, 2001.
LECTURE VIII

structural approach
The Chicago School theory of discrimination has been the dominant
view of the economics profession since the late 1970s. As can be discerned from the previous chapter, it has also been at the foundation
of virtually all discussions of how the United States should address
its legacy of labor market discrimination. This is not too surprising
as market-oriented approaches to social and economic problems have
been in ascendance since the late 1970s.
There has, nevertheless, been some dissent from this consensus.
One point is related to the very meaning of discrimination. To review,
the term means that an identiable group of persons are, by virtue of
their race, gender, religion, caste, sexual preference, or some other criteria unrelated to skill or job performance, systematically disadvantaged in some market or markets. The site of discrimination may be
in the realm of production or consumption. For examples of discrimination in the sphere of consumption, consider whites only
restaurants, real estate developments, schools, or country clubs.
Discrimination, interpreted this way, denies the validity of an
important assumption underlying the model presented in the previous
lecture. There, free entry and exit was assumed to be operative in all
output markets. Initially, it might appear to be obvious that expanding
the size of the market would be in the interest of all producers. But, historically, the right to enjoy the services of every hotel, restaurant, or
other public accommodation was not a spontaneous consequence of
market pressures. On the contrary, equal access to such public accommodations would not be rmly established until the Supreme Court
upheld the 1964 Civil Rights Act in December of that same year. In
short, the conventional assumption of free entry and exit was not
simply false it required a Supreme Court ruling to come into eect.
123
124
The previous paragraph suggests that free entry and exit may be
neither an inherent quality nor spontaneous consequence of market
processes. On the contrary, American economic, legal, and social
history collectively arms that classication and exclusion along the
lines of race, gender, national origin, religion or sexual orientation
can readily co-exist with free markets. History suggests that formal
equality and inclusiveness typically have to be mandated and
enforced by law.1 To consider what a theory of discrimination would
look like if it embodied such contrary premises, this lecture will
present what I will call a structural theory of labor market discrimination. But it must be noted that what follows is far from the
only structural theory of discrimination in markets. Its advantage
is that it is historically important and relatively straightforward to
learn. For these reasons it is most suited to a book on elementary
economics.2
The essential stylized fact of the structural theory of discrimination is the proposition that for some reason a reason that can and
does vary the labor market is segmented. This division can occur
along the lines of race, gender, religion, caste, or sexual orientation.
The origin of this division could follow from a variety of causes.
Formal legal restrictions, widely accepted social norms, or conventional social practices and biases could each or severally be responsible. An example would be the expectations, real or perceived, of a
rms current labor force. In a racist or sexist society a person might
be, or believe they might be, stigmatized or dishonored if they work
with a person of the wrong race or gender. Customer expectations
constitute another, distinct, and historically important constraint on
a rms hiring practices.
To the above considerations, let us also add the observation, one
that holds across a substantial swath of the economy, that qualications are important for entry-level positions only to the extent that
rms need their new hires to meet a competence threshold. Stated
simply, most employers do not expect their new hires to know the job.
What they do require are employees who show signs of being willing
and able to learn and t in.
To illustrate the importance of these generalizations, consider
Barbara Bergmanns (1974) discussion of how the sta of dierent
qualities of restaurants come to be entirely of one or another gender.
It is evident that this gendering of restaurants is not a matter of
innate skill or ability, as table service is almost always learned on the
The structural approach
125
job. Yet for a long time it was conventionally understood that only
men should serve customers at upscale restaurants. Equally widelyheld was the convention that only women should serve customers at
diners or downscale restaurants. Yet the skills drawn upon to
perform each of these jobs are similar and it is not inherently harder
to learn the particular practices of one venue over the other. No qualities mark one or the other kind of restaurant as clearly and exclusively the domain of a particular gender.3
Despite the clear absence of an underlying logic, when gendered
hiring practices exist over a substantial period of time they became
naturalized. That is to say that they become the norm in the public
mind. Once this naturalization has occurred, customers will come, at
least in part, to associate the quality of their dining experience with
the meeting of their expectations as to what now constitutes a
normal or reasonable practice. Being more concerned for prots
than social justice or equality of opportunity, rms will be loath to
challenge or violate these expectations. On the contrary, it is likely
that they share these norms in addition to feeling an obligation, dictated by their customers, to follow them. Of course, when rms
choose to conform to these expectations, their decision further reinforces them in the public mind. Consequently the naturalization of
the gendered hiring practice is even further advanced. Even those
employers who privately disapprove of this now-widely established
social norm will feel compelled, socially and economically, to respect
these entrenched expectations.4 A failure to respect widely-held social
conventions means that the innovative employer will be jeopardizing
their all-important bottom line (Bergmann, 1996, ch. 3). They also
risk losing their credit-worthiness, as they are also putting their
banker at risk. If the bank responds by not renewing their line of
credit, the viability of the rm will certainly be threatened. To sum
up, any widely-held attitude, norm, social convention, or practice can
constitute the foundation of a structural theory of discrimination.5
Historians, sociologists, and psychologists tell us that discrimination
is usually the consequence of a multitude of preconceptions, fears,
anticipations and experiences interacting in a given situation. Issues of
identity, good repute in the community, perceptions of decency or
modesty each and severally interact in the formation of some activity or practice that constitutes prejudice or discrimination in hiring.
But peoples response to discrimination is not simply passive. It is
well known that members of discriminated-against groups can, upon
126
occasion, act in a manner that may even appear to validate conventional expectations or biases. An important reason for the latter
response is, of course, prudence. Another is that a socially-accepted
convention or norm, even those that are generally oppressive, can be
permissible in some, albeit highly circumscribed, ways. To more fully
grasp these points let us illustrate the theory of structural discrimination with an example from American history.
At the beginning of the twentieth century it was considered indecent for a young woman to work at a bar or a saloon owned by
anyone other than her father or husband. The reason was that any
unattached women in a bar was presumed to be a prostitute.
Consequently those men who were concerned with their standing in
the community would avoid drinking establishments where prostitution might be taking place, and where disreputable individuals, men
or women, might be found. This interaction of variables created, in
eect, a self-fullling prophesy in which taverns that employed
women would nd themselves catering to down-scale clienteles.
That is to say its patrons would be disproportionately made up of
men whose reputations were not at risk if they were thought to be
associating with prostitutes. The preponderance of such patrons
usually discouraged women from seeking employment in such establishments, unless they were in fact prostitutes or otherwise indierent
to their social reputations. In eect, the dynamics of the marketplace
reinforced a widely-held social belief. As a consequence of the interaction of strongly-held expectations and market forces, respectable
women would avoid taverns as employees or patrons.
The considerations described above were not the only obstacle to
the employment of women in taverns. Owners of taverns that
employed women were at risk of having town or city ocials revoke
their liquor licenses or take a disproportionate interest in penalizing
relatively minor infractions, etc. Safety and the inconsistent protection of the law were also barriers to womens employment in this
industry. Reecting the widespread expectations described above, if
a woman employed in a tavern were to be mistreated, she would be
less likely to receive a sympathetic hearing from the police, the courts,
or public opinion. The reason, of course, was that most people would
be inclined to share the conventional perspective on her presumed
lack of virtue and for that reason tend to blame her for the incident. Should they come to believe that she actually was a legitimate
bartender or waitress who was the victim of an assault, they might
127
still play down her grievance, proclaiming Well, what did she
expect?6
Of course, social scientists have long understood that economic
interest plays an important role in the shaping of norms and conventions. At a minimum, individuals and rms come to have a vested
interest in the continuation of those norms and conventions of
which they are the direct beneciaries. Of interest here is the proposition that labor market discrimination can persist when an important group obtains, and is able to sustain, an economic advantage
from it. It follows that a privileged group, one with political
inuence, may have a direct interest in sustaining a social practice
that results in labor market segmentation if this is to their collective benet.
To move to a more analytical plane, consider an economy, let us call
it a city, featuring two broad classications of jobs. The rst we will
call the industrial or primary sector. The second will be called the
services or secondary sector. Let us further assume that the skills
required for an entry-level position in either sector are identical.
However, once hired, on-the-job-training (OJT) provides the
employees of each sector with unique job-specic skills that are not
readily transferable. As a consequence, anyone wishing to change
sectors in mid-career has to begin anew. This arms that it is costly
for workers to switch sectors after acquiring some seniority.
Now, let us suppose that those who work in the industrial sector
have successfully restricted their numbers by excluding workers of
some readily ascertainable quality (such as race or gender). It follows
that the quantity of labor supplied to the industrial sector would
be reduced and wages would be higher than if the citys labor market
were characterized by free entry and exit.
In Figure VIII.1 the restricted supply of labor to the industrial
sector is illustrated by the leftward shift in the labor supply schedule
(from Sw1 to Sw2). Recall, once more, that these graphs are read from
left to right, so that a shift to the left signals a reduced supply, that is
to say a reduced quantity of labor supplied at each and every wage
level, ceteris paribus.
The horizontal axis, which tracks the quantity of labor, arms that
after adjusting to the restriction, the industrial sector will employ
fewer workers. The vertical axis on Figure VIII.1, which displays
wage levels, arms that the workers remaining will earn higher wages.
(This should be interpreted as an average wage paid in this sector
128
Wage
Sw2
Sw1
0
Figure VIII.1
Quantity of Labor
Employment in the Primary Sector
since employees earn more with seniority.) These workers clearly

win from this arrangement. Moreover, we can expect that these
privileged workers will be interested in maintaining or even strengthening the conventions, norms, or social practices that restricted
competition in this industrial or primary sector.
In the real world, especially one that values norms such as equality and meritocracy, it is necessary to explain the exclusion of some
otherwise eligible workers from a given sector of the economy.
Institutional economists have labeled such explanations enabling
myths (Dugger, 1989). Enabling myths can take an almost innite
variety of forms, varying as widely as the human imagination. But
some of them have become familiar through their frequent appearance across many cultures and societies. These include the following
claims: African-Americans are not smart enough for industrial
work, or Women are too delicate for factory jobs, or The Chinese
are culturally predisposed to work for inhumanely low wages.
Historically, when people have an economic interest in a belief
that dees logic or widely-available experience, enabling myths are
recast and defended as ethical imperatives. To see the power of
such rhetoric, consider the three statements that closed the previous
129
paragraph after they are rephrased as moral imperatives: God did

not intend for blacks and whites to work side-by-side. The morality of the nations children will be compromised if women work in a
factory. God intended California to be settled and civilized by
white men. I am condent that every reader can readily conjure up
a number of past (and current) enabling myths, and reformulate them
as ethical imperatives.
The value of labor market segregation to a privileged group depends
on their numbers relative to the excluded group. Additionally, it
depends on how much it would cost employers to deploy labor-saving
devices and/or raise the price of the goods being produced. Bergmann
points out that the value of the white employment premium was, as
a consequence of the above considerations, much higher in apartheid
South Africa than in the United States of the post-war era. The reason
was that in South Africa the excluded group was substantially larger
than the included group. In the United States, white labor has been in
the majority. However, this generalization has not been true for all eras
and all regions. For example, the wage premium for white employees
was higher in the post Civil War southern states before the Great
Migration of black labor to the north in the early twentieth century.
Wage premiums existed in the northern states too, as Irish and Eastern
European immigrants were initially viewed as races that were altogether dierent from persons of English and German heritage, and for
that reason subject to discrimination.
In the structural theory of occupational segregation, some
identiable subset of workers are, through one pretext or another,
excluded from jobs in the primary labor market. From this it follows
that the supply of labor to the secondary labor market what is
here termed the services sector is increased. Graphically, the
supply of labor function in the services sector shifts to the right.
This reects a greater supply of labor available to this sector at each
and every wage rate. An additional consequence is that the average
wage in the secondary sector is reduced.
These considerations are illustrated in Figure VIII.2, which depicts
the secondary labor market. Reecting the existence of what economists have termed occupational crowding, the labor supply
schedule has been shifted from Sw3 to Sw4. This is solely a consequence
of labor market discrimination, and workers in this market earn a
reduced wage despite our assumption that workers of all races
(or genders, etc.) are equally capable and motivated. Likewise, the
130
Real wage
Sw3
Sw4
Demand
0
Figure VIII.2
Quantity of labor
Employment in the secondary sector
average wage in the industrial or primary sector is, and will remain,
higher than average wages in the secondary or services sector. This
wage gap is, to reiterate, unrelated to the abilities, skills, education, or
motivation of the workers employed in each sector.
From the above, it is evident that the labor force of the services
sector is made up of two groups: (1) Members of the privileged group
not fortunate enough to obtain employment in the primary sector,
and (2) All discriminated-against workers.7 It is evident that the
supply of labor to this sector is larger, and wages are lower, than if
discriminatory hiring practices did not occur. We will return to this
crucial point.
An important inference we can draw from a societal point of
view, that is to say from the perspective of maximum output, is that
labor is being allocated ineciently. In the presence of discrimination it is evident that there is underproduction in the industrial sector
while there is overproduction in the services sector. The size of
this imbalance of productive eort depends upon a variety of conditions beyond the scope of an introductory book. But, independently of the size and value of this misdirection of productive eort,
131
the conclusion remains that occupational segregation is socially

dysfunctional.8
Although, considered as a whole, society is worse o in the presence of labor market discrimination, it would be incorrect to infer
that everyone loses. On the contrary, two subgroups are clear
beneciaries. The rst beneciaries are primary sector employees.
They receive a higher average wage as a direct result of reduced competition in their segment of the labor market. Secondary sector
employers also benet since they have access to a greater quantity of
workers. Having a greater supply of labor while paying a reduced
average wage enables them to produce for a larger market.9 As
beneciaries of discriminatory hiring practices, we should expect
primary sector employees and secondary market employers to be supporters of the norms, social practices, and enabling myths that underlie and validate what is to them a most satisfactory outcome.
Of most interest, from the perspective of things potentially changing, are the attitudes and outlooks of primary market employers and
secondary market employees. Discrimination in the primary labor
market clearly disadvantages these two subgroups. If they could or
would nd a way to negotiate and contract they could each benet.
Access to a greater quantity of labor would allow primary sector rms
to reduce the rate of wages they must pay while increasing their output.
Secondary market employees would also benet from higher wages.
Notice also that even those secondary market employees who do not
change jobs would experience wage gains with the end of discrimination in hiring. The reason is that wages would rise across the entire secondary sector as the overall supply of labor in that sector is reduced.
By contracting with each other each of these two groups will be
able to undercut the privileged positions and articially high remuneration of their rivals: primary sector employees and secondary
market employers. The economic benets to each aggrieved group are
clear. In a world of perfect competition and no social, political, or
economic obstacles, such contracting can be expected to occur. If we
do not see such contracting taking place, it is plausible that some
structure or structures must be preventing it (hence the Structural
Theory of Discrimination).
If the discrimination represented in Figures VIII.1 and VIII.2 is to
be sustained, some reason, necessarily social and historical in nature,
is required to explain why people are not making otherwise mutuallyadvantageous exchanges. This reason may not be simple or obvious
132
and the reader should know that many economists, especially those
inuenced by the Chicago School, do not believe that such conditions
can exist for long if mutually-advantageous trades can be made. That
said, let us enumerate a few possibilities, even as we acknowledge that
every situation of discrimination is unique and has its own particularities in addition to enabling myths to support it.
One possibility is that primary market employers might forgo
hiring workers out of the secondary labor market if they believed that
the losses they incurred by paying premium wages were small relative
to the direct and indirect costs of challenging a widespread norm of
discrimination. This would be plausible if they were confronted with
a well-organized primary-sector craft union with a proven ability to
strike. Another obstacle could be strongly entrenched prejudices on
the part of the rms customers or suppliers. In such cases the cost of
challenging entrenched labor market practices could be high relative
to the savings that would accrue from lower wage costs.
Under such conditions, even unprejudiced but prot-maximizing
employers might be reluctant to hire secondary market workers.
Finding no employers to contract with, secondary market workers
would have to remain in their current positions. This would be true
independently of any desire on their part to improve their individual
or collective situation. It takes two parties to achieve a contract and
primary sector employers have decided that the costs of challenging
the status quo are not worth it.
We can complete our story by taking a closer look at the situation
of secondary market workers. Are they rational economic agents
freely seeking the highest wage, or can we suppose that they also face
barriers to independent action? Drawing upon history, we nd a multitude of instances wherein the losses experienced by workers crowded
into secondary labor markets fail to be registered as legitimate economic or political grievances. This occurs when such workers are
politically disenfranchised and thereby subject to random acts of violence. In such cases, it could be personally hazardous to seek to
improve ones economic condition as one might nd that both the
larger community and its system of justice are unwilling to validate
or protect such an action. Another contributing factor is learned passivity. Economists tend to eschew social psychological arguments, but
we know of many historical situations in which oppressed people
come to accept their situation as natural, normal, or consistent
with Gods Will.10 Even if a discriminated-against population is
133
willing to resist, there is generally a coordination problem in that those

who make the rst move, or make the initial eort to organize the
others, will be treated harshly. Keeping people divided to facilitate
control over them is one of the most ancient arts deployed by the few
to rule the many.
As mentioned above, historically we have found that discrimination
is usually enforced and sustained by a combination of the above
causes. Primary market employers who are unwilling or unable to
undertake the costs of challenging entrenched norms co-exist with
secondary market workers subdued by a combination of legal restrictions and widespread social practices and enabling myths acting in
conjunction with learned passivity. It is important to note that the
law, in almost every instance, tends to side with societys most powerful economic interests, which in this example includes privileged
workers and secondary sector employers.
Under the conditions summarized in the previous paragraph, it is
evident that secondary market employees challenging discriminatory
practices are taking substantial risks for highly uncertain rewards.
Not surprisingly, we nd that their eorts to disrupt the existing
labor market structure are often thwarted by the political and economic strength of those interested in maintaining the status quo.
Consequently we frequently see an equilibrium of sorts, in which
discriminatory practices persist over an extended period.
A prominent example was the long-standing gentlemans agreement that, for six decades, prohibited African-Americans from
playing in baseballs major leagues. It was not always this way. This
prohibition, beginning in the 1880s, lasted until Jackie Robinson took
the eld for the Brooklyn Dodgers in 1947.11 Such a long-standing
prohibition, maintained without the assistance of the law or even a
formal contract, represents a challenge to the Chicago School theory
of discrimination. Here was an instance where a clear incentive
existed for low payroll teams to purchase rst-rate talent for secondrate wages. Moreover, information was not a problem here, as the
talent of the excluded players was well understood. Because of the
informal between-season barnstorming games in which blacks and
whites played against one another, it was long understood that many
of the excluded African-American baseball players would have
excelled in the major leagues.
If we assume that playing talent is equally distributed across each
race, then it is evident that the most highly talented white players had
134
little if anything to lose from integration (economically speaking, that

is). More at risk were the average and below-average white players.
The latter would almost certainly lose their jobs to superior AfricanAmerican players. Even those average white players able to keep their
positions would have less bargaining power over wages. If, for the
sake of the argument, we assume that one-third of players are of
superior talent, one-third are average and one-third of inferior talent,
then 2/3 of white players had a clear economic incentive to resist integrating the major leagues.
In keeping with the contours of the structural model posited above,
owners of the Negro League teams had, along with the average and
below-average white players, an economic interest in maintaining segregation. African-American players, especially those of superior
ability, had an interest in moving to the better paying, to say nothing
of more visible, positions in Major League Baseball. In keeping with
the above theory there were clear reasons why a less-wealthy major
league team would wish to contract with a highly-talented AfricanAmerican baseball player. Yet the owners of the major league teams
were able to maintain their gentlemans agreement. From what historians have been able to learn about this restriction and its longevity,
its persistence can be attributed to three causes: rst was a concern
for the prejudices of fans; second was the latent racism of most
owners and managers; third was the pressure exerted on lower-payroll
owners by the league and their fellow owners.
Eventually one team, the Brooklyn Dodgers, broke the agreement.
Its decision was motivated by the frustration of competing with its
more well-heeled rivals, the then-New York Giants and New York
Yankees, to sign young talent. A second cause was the thaw in social
norms concerning racism that emerged after World War II. Third,
was the singular presence of a highly motivated and unprejudiced
evangelical-Christian manager (Branch Rickey) who had long wished
to repeal the gentlemans agreement. Fourth, was Rickeys ability
to nd a highly-talented baseball player willing to enter into and live
by a secret agreement not to retaliate against any and all taunts or
aggression no matter how egregious for a period of several years.
Even with such a concurrence of singular circumstances, several more
decades would pass before the major leagues were fully integrated.12
Now, on its own, the structural theory of discrimination does not
and cannot fully explain the source of the initial discrimination or the
reasons for its persistence. But this aw is not as fatal as some
135
economists believe. In the case of race and discrimination the initial

cause may not be sucient on its own, and for this reason it is reasonable to invoke extra-market and extra-theoretical factors for a
complete explanation. It follows that the structural model of discrimination, or what in the professional economics literature is sometimes called the occupational crowding model, can be useful when
we examine instances in which labor markets have been restricted by
either a widespread social practice, as in the nineteenth and early
twentieth century South, through explicit bargaining agreements as
periodically happened with some northern craft unions and in major
league baseball, or through some government edict, as with the
passage of explicit Jim Crow laws across much of the South (Litwack,
1998).
NOTES
1.
2.
3.
4.
5.
6.
7.
Heart of Atlanta Motel v. United States 379 U.S. 241 (hotel accommodations);
Katzenbach v. McClung 379 U.S. 294 (patronage of restaurants); Diaz v. Pan
American World Airways, Inc. 442, F. 2nd 385 (5th Cir. 1971) (male cabin
attendants).
Structural theories are a large and heterogeneous category. Early contributions
include Anne Krueger (1963), Lester Thurow (1969), and Barbara Bergmann
(1974). A similar theory can be deployed to illustrate structural discrimination in
consumption markets.
While he did not write on this specic subject, Veblen did observe that being served
by men, especially in the performance of largely servile and deferential tasks, is
particularly gratifying to those who wish to enhance the experience (and cost) of
personal service with conspicuous leisure. Clearly (low wage) women working
eciently to provide the best dinner at the lowest price eliminates the conspicuous
leisure component of the meal and thereby the subjective value of the experience
to those for whom such performances are vital (Veblen, 1899, ch. 3).
Such a generalization would seem to apply to some of the employees of Ollies
Barbecue, who were themselves African-American.
Of course, an important dierence remains between a distinction and a discrimination. The former represents an instance where one kind of person is
dierentiated from another for a reason germane to the process or activity at
hand. For example, selecting the best performers to sta an orchestra is, or should
be, a procedure designed to make a distinction. Discrimination occurs when an
dierence that is arbitrary with regard to the task at hand is the basis of selection.
I trust that it is clear that none of the attitudes being described here are those of
the author, but that this paragraph is simply a summary of attitudes that were
widely-held from the nations founding until rather recently.
It would be relatively easy to extend this theory in a manner that would reect
even more realism. Suppose that to merit a position in the primary labor
market one had to undergo some expensive and/or onerous activity such as
additional schooling, the purchase of a suit, etc. Assuming, again, homogeneous
136
8.
9.
10.
11.
12.

workers, it is plausible that all eligible workers would be willing to undertake this
expense in the hope of being selected for the primary labor market. Those discriminated against, understanding that they are highly unlikely to be granted
access to this market, will rationally decide to not make these investments. Ex
post, primary sector employees, their employers, and the politicians who represent them, will attribute the reduced circumstances of discriminated-against
workers on their unwillingness to make appropriate investments in schooling,
attire, or other forms of public deportment. The end result is, in either case, occupational segregation. What has changed is that all workers, who were initially of
homogeneous quality, would now appear to be heterogeneous. The political and
social importance of this outcome cannot be overemphasized.
The growth rate of the post-bellum South, with its extreme racism and segregation, was signicantly less than that of the northern states. Southern growth rates
rose as the lawlessness of Jim Crow broke down. The relationship between these
events is too complex for a footnote, but it is evident that there was an important
relationship (Ransom and Sutch, 1977).
To be perfectly accurate, under the standard assumptions of perfect competition,
economic prots for rms in the secondary sector will still be zero even if they
operate on a larger scale than rms in the primary sector. Nevertheless, these
rms still retain a stake in the status quo because eliminating the barriers preventing the movement of labor into the primary sector will force them to pay
higher wages. They will then experience negative rates of economic prot until
enough rms exit the market and the equilibrium condition of zero economic
prot is restored. In short, rms in the secondary market have a collective interest in avoiding the costs associated with the transition to a free and fair labor
market.
Consider the experience of women workers over the centuries. It was long
thought to be normal or natural for women to not have waged positions in
the workforce, especially after marriage. It was also thought to be unfeminine
for a woman, especially a young women, to drive a hard bargain with her boss,
or forcefully demand change. For women to progress in economic status and
opportunity, such deeply entrenched ideologies had to be challenged at the same
time that employment barriers were being challenged. While on this subject I wish
to note that while the acceptance or rationalization of ones situation might be a
poor long-term political strategy, it should be recognized that it has the clear
merit of presenting the oppressed with short-term psychological comfort. The
value of such comfort is often underestimated by economic and political theorists who have a tendency, as a result of their chosen occupation, to overemphasize the place of economic interest in explaining the behavior of individuals
and groups. As a professional economist, I include myself as one who is prone to
this error.
Actually, his rst major league season was with Brooklyns AAA team, the
Montreal Royals in the 1946, where management thought, correctly, that he
would be more readily accepted by fans. But, in keeping with the long-standing
American convention that all things Canadian should be ignored, I will overlook
this fact.
In one of the better books on the subject of baseball, David Halberstam credits
the rise of the completely integrated St. Louis Cardinals team of the 1960s, led
by their legendary pitcher, Bill Gibson, with establishing for once and all the idea
that to win in the modern era a team had to recruit and integrate AfricanAmerican players (Halberstam, 1994).
LECTURE IX
Values and prices: reintroducing

ethical considerations into economics
INTRODUCTION
Non-economists often perceive economists to be immoral or, at a
minimum, amoral. Periodically, this view receives strong armation.
An example that captured the publics attention occurred in the
early 1990s when Lawrence Summers, then the World Banks Chief
Economist, set o a controversy with his famous memorandum that
concluded that the economic logic behind dumping a load of toxic
waste in the lowest-wage country is impeccable and we should face up
to that (New York Times, Feb. 7, 1992, p. D2; Washington Post,
February 10, 1992, p. A9). Non-economists, not surprisingly, took
this statement to be another sign of the professions moral bankruptcy. Characteristically, Summers attributed the resulting controversy to political correctness. While I will not review the specics of
this controversy, I do believe that substantial insight may be gained if
we understand that Summers was simply drawing out an inference
from mainstream economic theory.
Underlying the clash of cultures between many economists and
the rest of the citizenry is a way of thinking about choices and policy
that periodically reveals that the former are often prone to confuse
values with prices. For example one can simply, and correctly, refute
Summers memo by observing that in our post-aristocratic era most
thinking people believe that each life should be accorded an innite
value. Since this idea is unworkable in practice, ethical reasoning
ascribes a high and equal value to each life. It follows that systematically imposing the disease and early demise associated with certain
production processes on a select group of persons, specically chosen
because they are poor, is thought to be immoral.
137
138
Indeed, when one examines the structure of economic theory

especially in its policy-making guise wherein statements concerning
eciency, welfare-maximization, and cost-benet calculation
are reied as neutral and transcendent standards of judgment some
disturbing value judgments and premises are, in fact, unveiled. This is
the case because every policy decision taken, or not taken, impacts some
third party. Often this fundamental quality of decision-making is
dodged or repressed by positing the existence of a depoliticized and
thereby unproblematic social welfare function. Once such a social
welfare function is posited, the distribution of the several costs and
benets from a course of action, if addressed at all, are hidden behind
criteria such as the market outcomeor, worse-yet, a hypothetical standard of non-reimbursement called HicksKaldor Compensation.1
In sum, too many of the economists of our era are prone to reproduce Summers error even if they, or the institutions they work for,
have become more sensitive to the consequences of letting memos
such as his leak into the public realm. In short, the public pronouncements of economists, and too many applications and examples from our textbooks, suggest that a confusion between values and
prices runs deep, even to the core of the economics discipline. This is
important to all of us as the economics profession has been engaged
in a century-long quest to establish itself as the eld that presents
unbiased advice on matters of public policy (Bernstein, 2001).
ON PRICES
Reduced to its simplest form, a price is the ratio at which things
exchange for one another. Consider the theory of price now dominant in American economics (the theory of commodity prices
described earlier). Its assumptions of perfect competition full and
free information, many competing buyers and sellers, free entry and
exit, and homogeneous products collectively imply costless arbitrage across the market. Drawing upon this theory, it is often inferred
that the market price prevailing at any given time represents the summation of individual choices made by the numerous independent
individual decision-makers that collectively make up the marketplace.2
If we assume that we are dealing with a moment in time and
thereby ignore discounting the future (nothing important changes in
Reintroducing ethical considerations
139
the analysis if we do this), many economists will condently state that

the demand curve that exists in the market is derived from the prior
endowments and the (stable) preferences (drawn as utility functions) that describe the collection of individuals trading in a particular market during a particular trading period (Becker and Stigler,
1977).3 The market, then, is presented to readers as the realm of
choice, since the nal pattern of demand can be said to reect a
summation of the choices being exercised by the multitude of persons
currently trading in the market.4 Under the conditions specied
above, the market is said to be an ecient allocator of goods and services as it is thought to accurately reect the willingness of people,
given their prior preferences and endowments, to pay for a particular
distribution.
When we review the above depiction of the market process, what
stands out is that what is described is less a choice than a calculation. This follows directly from the assumptions deployed to construct the idea of a rational economic agent. They are, to review,
highly knowledgeable; have a clear and independent understanding
of their own preferences; and can draw upon sophisticated mathematics to solve for an optimal decision.
To explore the ethical aspects of this understanding of choice, consider the following thought experiment. Suppose we have a rational
person whose characteristics ts standard criteria including the
Walrasian principle of gross substitution. (This principle guarantees
that there is a price, above zero but below innity, at which all goods
can be priced in terms of one another, thereby ensuring that the
system is coherent with an equilibrium solution.) Now, let us assume
a simple world of two commodities. The rst is a medicine that I must
have in a certain discrete, ie. non-innitesimal, quantity to keep my
sister alive. I will call this sisters medicine. The second commodity
is beer. In light of my income and the market price of each good, I
can aord certain bundles of each of these two goods.
Now, let us suppose an optimizing agent who really loves his or her
sister. This person would have a relatively at but, being rational,
downwardly sloped utility function between sisters medicine and
beer. Yet the principle of gross substitution implies that there must
exist a price for beer at which our rational consumer will not purchase
an adequate quantity of medicine to keep his sister alive.
According to mainstream economics, the above outcome must be
both rational and ecient. However, virtually everyone else would
140
say that such a choice is irrational even criminal. The absurdity built
into the example is that it places on a single scale two goods that,
for most people, exist on dierent planes or spheres of importance or
priority. Philosophers say that such goods or choices are an instance
of incommensurability (Chang, 1997). One of the goods, beer, is for
most of us a moderate intoxicant used exclusively for recreational
purposes. The second, sisters medicine, is about the life and death of
a loved one. Most sane people consider the life of their sister to be a
priority over the momentary pleasure of drinking beer, and for this
reason would take the above to represent a false choice. This is
exactly my point it is a false choice.
The above example suggests that if the conventional theory of
choice is to make sense, it must be restricted to considering the more
banal decisions of life. In other words, a choice between corn or peas
for dinner, or buying a navy blue or tweed jacket to wear to an economics conference, are the sort of choices best suited to consideration within this framework. The reason is that nothing fundamental
is at stake so a model of choice suggesting parameters such as preferences, relative prices, and budget constraints is plausible. If
peas and a navy blue jacket are relatively expensive, I will purchase
corn and a tweed jacket.
No one is surprised, or should be surprised, to nd that a model
designed to explain the banal choices of life is lacking when something more fundamental is at stake. The limitations of this approach
will become evident in two broad classes of choice discussed below.
The rst I will label moral choices, the second I will label identity
choices.
MORAL CHOICES VALUES

Moral choices, what the philosopher Martha Nussbaum calls tragic
choices, are qualitatively dierent from the calculations that are the
ideal subject of the Neoclassical theory of choice (Nussbaum, 2001).
In the latter a signicant tension is present that forces the person
choosing to assess or reassess their values. The reason is that the decision they are making may be laden with ethical implications.
Nussbaum believes that literature is a realm well suited to exploring tragic choices. I will follow her lead. Consider the novel Sophies
Choice, which poignantly captures the idea of a moral choice (Styron,
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1979). In William Styrons novel, a Nazi prison camp doctor forces a

young mother to choose which of her two children is to be led away
to die. It trivializes the situation to describe her choice as a calculation in the sense that one decides to have peas or corn for dinner.
Rather, she was confronted with an irresolvable moral dilemma.
Sophie, the heroine of the book, after being forced to make such a
choice, is tormented for the rest of her sad and shortened life.
Recently, McDonalds Corporation learned that a failure to appreciate the ethical implications that others ascribe to certain choices can
result in actionable consequences. McDonalds had to admit that for
years, and without informing their customers, they had used animal
products to avor their French fries. Evidently, McDonalds management believed that those who wished to be vegetarian were free to
exercise such a choice, but that such a choice was trivial. That is to say
that in McDonalds view it was based upon a calculation that management could undermine without repercussions of importance for
anyone concerned. What they did not, or would not, understand is
that for some persons, such as practicing Hindus, vegetarianism is a
moral choice and not a preference or lifestyle. For that reason
McDonalds knowing misrepresentation of the qualities of one of its
leading products was deeply oensive to many customers.
Without considering their ultimate foundation, the importance of
moral choices for economics can be readily understood. The distinguishing feature of a moral choice is that it should not depend on
price considerations. For example, the Biblical injunction Thou
shalt not kill is not modied by the qualication that one should feel
free to kill if it pays enough. While each of us may continue to disagree over the motivations and conditions under which one might
nevertheless kill another person judicially-mandated punishment,
self-defense, defense of ones family or nation, under no circumstances, etc. I am condent that all religious and philosophical
frameworks concur that killing for money is wrong. It is illustrative
that the level of remuneration does not constitute an extenuating
consideration.
Hollywood tapped into such issues with the movie An Indecent
Proposal (1993). Here a young wife (Demi Moore), with the consent
of her husband (Woody Harrelson), agrees to spend a night with a
wealthy stranger (Robert Redford), in exchange for a million dollars.
The young couple initially perceives the transaction to be a pragmatic
exchange that could never undermine their strong relationship. But
142
they were wrong. For the audience, the interest and dramatic tension
of the movie turned on the fact that incommensurable goods were
being exchanged.
IDENTITY CHOICES
Somewhere between the set of neoclassical choices (calculations) and
moral choices (duties, obligations) exists a third set of choices that are
neither moral choices nor simple calculations. I will term this category identity choices. To motivate this set of choices, consider the
fact that anthropologists, sociologists, and marketing professionals
do not think of consumption choices as taking place in a series of discrete settings by individuals who are existentially alone (ie. according
to the rules of what is called methodological individualism).
Rather, most of the non-economic literature understands that consumption plays a role in shaping a persons sense of themselves and
their place in those complex spaces that we call society. In short,
consumption serves to simultaneously identify and distinguish a particular person with and from their fellows (Goman, 1959; Lutz and
Lux, 1979, chs. 13; Levine, 1988, ch. 1; Douglas, 1992).
These identity choices, which often appear to be arbitrary when
viewed from a distance, eectively circumscribe the everyday consumption decisions of most people. That is to say their choices are not
based upon an accidental conguration of preferences, relative prices,
and budget constraints. Yet it would be equally incorrect to think of
identity choices as moral choices, although this generalization has
exceptions or at least a gray area. Depending on the specics of a
given culture or situation, a persons choice of food and clothing can
come close to representing a moral choice. For example, during the
German occupation of France in the 1940s, patriotic women wore
long and owing skirts to signal their non-compliance with the
German and Vichy governments request to spare cloth in support of
the war eort.
In general, a persons choice of clothing or food is a decision that
they, and their peers, feel strongly about even in the absence of a clear
moral basis. In short, there is a reason, beyond a calculation based on
preferences and relative prices, that I did not present this lecture to
my classes while wearing a swimsuit and sunglasses. While it would
not have been illegal or immoral to have done so, my choice was
143
nevertheless constrained by the social meanings that would be

implicit in such a mode of deportment. The point is that identity
choices are fraught with meaning when considered in light of the
interest that people have, consciously or unconsciously, in a particular self-image or sense of themselves. Within our own society certain
clothing choices are identied with certain professions and contexts.
What I would wish to wear to the beach is dierent from what I would
wear in my classroom or to a job interview, and vice versa, all other
things being equal.
The larger lesson is that in a complex social structure, the ability to
act or, more importantly, to interact with our fellows, to eciently
complete transactions or work-related tasks, and to have satisfactory
interpersonal relationships, requires a more nuanced pattern of consumption than what might be deemed necessary or convenient for
biological subsistence (Prasch, 2003). When our sense of identity and
social standing are involved, consumption is less about wants, or even
needs, than our ability to act as members of society. As Amartya Sen
put it, The focus has to be, in this analysis, on the freedoms generated by commodities, rather than on the commodities seen on their
own (Sen, 1999, p. 74). With this more complete understanding of
the dynamics of choice, we are ready to return to the previouslyposited distinction between values and prices.
VALUES AND PRICES

Prices, as previously noted, are an economic category. They are the
ratios at which objects trade for one another. Values, on the other
hand, are grounded in considerations of ethics, religion or identity.
The reason that we do not kill each other for money, or spend money
on beer rather then on our sisters medicine, is not because the price
signals from the market fail to consistently support these choices. On
the contrary, we all know that for some people, todays prices are
already sucient to support perverse, dangerous, or even pathological choices. To discourage such choices we do not rely upon the price
system, but impose sanctions, sometimes criminal and at other times
social, to reinforce our collective disapproval. Tellingly, we often act
as though at least some of our choices are larger than ourselves and
our own gratication. And they are. To this end we pursue consumption patterns or agendas that identity, taboos, religion, morality or
144
reason dictate to be ends in themselves and are, for that reason, not
to be surrendered for nancial considerations.
Now, as a matter of experience, we know that some people can be
bought (how cheaply can be a disturbing surprise). In the case of an
identity choice, buying someone is often, and ought to be, easier
than in the case of a moral choice. For example, we have reality television shows that reward people for violating certain norms associated with identity, such as our resistance to eating exotic bugs. So far
we seem to be spared shows in which moral choices are violated for
money prizes, although Temptation Island comes close.5
Keeping the above distinctions in mind can be of assistance when
we examine the arguments of economists who wish to expand the
logic of markets into every investigation of social life. What they fail
to understand or appreciate are the distinctions at the core of the
moral systems that philosophers, theologians, and most thinking
people uphold. This explains why it is that when economists argue
that Christmas gifts are inecient, or that the adoption of children
could be more eciently conducted through the market, they are
thought to be missing the point, if not being amoral or even immoral.
A failure to distinguish values from prices can become distressing
when economists participate in debates over social policy. When
assessing the value of a clean environment or the proper level of a legislated minimum wage, most people place signicant weight on moral
considerations. When economists insist that these questions should
be exclusively decided upon the criteria of costbenet analysis they
are, not too surprisingly, discouraged to see that they have lost their
audience.
It is now evident that George Stigler was in error when he observed
that the publics support of the minimum wage demonstrated that the
mass of people are ignorant of the insights that economists can contribute (Stigler, 1982, p. 57). It is unnecessary to share Stiglers perspective on the economics of the minimum wage to grasp the reason
why his perspective has been rejected to most Americans he simply
failed to address the point. When considering a legislated minimum
wage, most people wish to uphold a long-standing social and even
religious norm that maintains that a person of able mind and body
who plays by the rules should be able to live by their labor. As with
many strongly-held values, this norm has come to be embodied in law.
In other words, most Americans take the minimum wage to be an
ethical, rather than an economic, issue. When the issue is examined
145
from the perspective of values, the econometricians analysis of that

policys eect on the employment prospects of teenagers is, independently of the results, besides the point (Waltman, 2000).
CONCLUSION
Most of us have heard the quip that An economist is someone who
knows the price of everything and the value of nothing. This joke is
amusing because it embodies an element of truth. Having a developed theory of price, and a method for estimating and contrasting
probable outcomes, economists have come to invest the results that
follow from such analyses with more importance than they merit.
Recently, Amartya Sen summed up the essential problem, Since
the preference for market-price-based evaluation is quite strong
among many economists, it is also important to point out that all
variables other than commodity holdings (important matters such as
mortality, morbidity, education, liberties and recognized rights) get
implicitly a zero direct weight in evaluations based exclusively on
the real-income approach (Sen, 1999, p. 80). At times this bias has
left economists on the periphery of public discussions of social, and
sometimes even economic, policy. It will continue to do so until economists come to appreciate the meaning of incommensurability and
what it implies for their theory of choice.
NOTES
1. When policy researchers ask themselves if, hypothetically, those who gain from a
proposed policy would be able, in principle, to compensate the losers from such a
policy, then the policy is said to have passed the HicksKaldor Compensation
test. Notice that this test includes no plan or proposal to actually make such compensation occur; it only demands that the gains be adequate to do so in principle.
2. Of course several other coherent, viable, and applicable theories of price exist, but
since they are no longer part of the training or knowledge base of American economists their implications for the subject of this lecture will not be considered. For
a survey of some of these other theories see Arestis (1992, ch. 6) or Lavoie (1992,
ch. 3).
3. The reception accorded this paper by Becker and Stigler will someday be the basis
of a fascinating history. Essentially, it announced a set of rules for theoretical
work rules that were neither plausible nor adequately defended that in turn
became a parameter of research and hallmark of professional conduct for a generation of economists. For a critique, along with the sketch of a viable alternative,
see a recent paper by Georey Hodgson (Hodgson, 2003).
146
4. Again, by staying within the spirit of mainstream analysis, I am brushing over a

host of serious, and inadequately resolved, conceptual and technical problems in
the actual theory itself. Those that most stand out are the aggregation problems
involved in summing across a collection of individual demand curves of several
individually rational actors to arrive at an aggregate demand curve. John Hicks
(1939, note to ch. 9), Oscar Morgenstern (1940) and Harvey Leibenstein (1950)
each present interesting analyses of the pitfalls that await the careful theorist in the
process of aggregation, although they drew dierent conclusions as to how fatal
these problems were for the theory. Finally, it must be acknowledged that theorists
working within the Austrian tradition also reject this mainstream approach. To
Ludwig Lachmann or Friedrich von Hayek and, depending on the text in question,
Ludwig von Mises or Israel Kirzner, the economy is about change and adjustment
to change from continually evolving states of the world, including changes in information and preferences. Taking the market to be a process, they generally reject
attempts to aggregate the demand of several individuals and are suspicious of conclusions drawn from such exercises.
5. Of course, the reason may be that moral choices are often codied into law. Either
way, we do not see cannibalism or incest encouraged on reality shows. Or did I
speak too soon?
CONCLUSION

Collectively these lectures suggest that the theory of Supply and
Demand is not as generalizable as many economists have come to
suppose. A parallel concern is how eectively a market system may
serve our social and individual need to reliably and reasonably allocate commodities, jobs, and assets. To a degree, this is a larger question, connected to the theory of macroeconomics, and for that reason
a full answer is beyond the scope of a set of introductory lectures. But
enough has been written to advance a few ideas. Here I will briey
summarize four instances where regulation, if appropriately drawn,
can enhance the performance of markets.
First, well-crafted regulations can enhance the quality and quantity of information available to the customer. By this means, many
experience goods can be transformed into inspection goods. (To
review, experience goods are those about which one learns of their
underlying qualities with the passage of time. By contrast, most of
the germane qualities of inspection goods can be assessed at the time
of purchase.) While such regulations may be unimportant when considering the purchase of a trinket, the situation is more serious if
fraud or public health are potential considerations.
The implications of this idea are more sweeping than one might at
rst suppose. As James K. Galbraith argues in a recent and important paper, when people purchase a good they are actually purchasing both the item and some assurance that the product is safe and
eective. For this reason an industrial market system requires that a
ow of detailed and credible information be provided about the products on oer (Galbraith, 2007, p. 17). For a modern economy, with
its inherently complex products and processes to work:
the necessary and sucient condition is a credible guarantee of product
authenticity and quality. The customer must have reason to believe that
147
148
the product is what it claims to be, and that it will function as it is supposed to do. This is what a strong system of regulation provides.
(Galbraith, 2007, p. 13)
Consider the following, fairly important, decision one confronted

by millions of Americans each year. What do we really know about
the maintenance practices of the airline whose airplane we are about
to board? To be properly informed each of us would have to acquire
substantial expertise in modern aircraft and the qualities that make
them operate safely. Additionally, we would have to study the business practices, procedures, and trade secrets of the several competing
airlines are they cutting back too far on their repair budgets? Is
management careful with weight limits on takeos? Does the maintenance supervisor or the pilot have a drinking problem? The fact is
that most of us know next to nothing about these questions. With no
substantial basis upon which to make informed decisions concerning
safety, ying on an airplane is a classic experience good. Left to a
perfectly free market, fewer of us would choose to y.
The solution to this problem, devised long ago, is to develop a credible program of government inspection combined with the penalizing
of rms with inadequate safety records. Broadly speaking, the safety
record of airlines within the United States suggests that this system
has been eective. (Such regulations could, of course, be extended to
prohibit the imprisonment of passengers on runways for extended
periods of time but I digress.) Believing that all airlines are reasonably well-regulated I, as the buyer of a ticket, am able to focus on
variables that I understand. These include relative prices and the
convenience of schedules. In such an instance, then, regulation can
transform an experience good with speculative attributes into something more akin to an inspection good. Being so empowered, consumers are more likely to enter the market, which enhances demand
for the product in question. Consumers and producers both emerge
as winners.
The logic sketched above nds conrmation in the historical
record. In a fascinating and detailed series of essays on the early
history of regulation, Marc Law shows how regulation has been
deployed by business rms and professions, particularly those
using new processes or technologies, as an instrument to expand
markets through the creation of credible commitments to quality and
safety (Law, 2003; Law and Kim, 2005). To sum up, when regulation
149
transforms an experience good into something approaching an

inspection good, it modies the structure of the market, with the
eect of increasing both its size and eciency. Consumers and the
more ecient and innovative businesses are both winners (Galbraith,
2007).
A second concern is that social costs must be accounted for and
allocated. Regrettably, too many economists implicitly assume that
everyone has the ability to exist or at least subsist outside of the
market. Whatever the merits of such a presumption when a large percentage of our population had access to a family farm, it is clearly
refuted by modern conditions of ubiquitous private property, commodication, urbanization, and marketization. In todays urbanbased market societies, the overwhelming majority of people must
meet their own and their familys needs out of what they earn in the
labor market. In the event that their earnings are low or uncertain,
these needs must be met by some other means. If they or their relatives have savings, the problem may be postponed. If they cannot
draw upon such savings, the social costs associated with their survival
may be shouldered by private or public charity. Another possibility is
that these costs may not be met. In either of the last two cases, a
persons inability to cover the basic needs of themselves and their
family generates a social cost with important, lasting, and undesirable
consequences (Prasch, 2005).
Underlying the received theory of free exchange and the workings of the market is the proposition that everyone is participating
because they believe they will improve their situation. It is trivial, but
seems to be routinely overlooked, that for this assumption to be
meaningful, people must have substantial and viable options (Prasch,
2006). However, it is immediately evident that options of this sort are
not always present. Moreover, most of us have neither a trust fund
nor a family farm to fall back on in the event that our wages are
inadequate to support ourselves and our dependents. Lecture V proposes that when a substantial portion of the labor market is in such
a position, their collective eort to cover the cost of their subsistence
may set in motion forces that lead into a poverty trap.
Labor, as was argued, is qualitatively dierent from other commodities. Most people cannot substitute out of the world of paid
work. If their wages are below what is required to sustain themselves
and their families as functioning economic and social entities, then
our market economy has failed them. The morale and ability of the
150
workforce will inevitably be reduced. Sooner or later, this will have

implications for the quality of life in our society, and even the viability of our democracy. Moreover, we will have failed in the ethical
sense when we allow some of our fellow citizens to become immisserated despite their willingness and capacity to earn a living by their
own labor (Prasch and Sheth, 1999).
Third, when market prices depend heavily upon expectations, the
stability of the market system is, and must be, an important consideration. Expectations, when they converge on the idea that an asset is
overvalued and should be sold, can become self-fullling and selfreinforcing as more and more people rush to sell before everyone else.
Under the correct conditions, especially in instances where the asset
in question is being used as security for loans, widely and rapidly
revised expectations can induce a catastrophic decline in asset prices.
Hard experience has repeatedly demonstrated that such problems are
most cheaply and eciently addressed before they begin. Enforceable
rules and checks on lending, greater transparency, the control of
fraud, and a credible lender of last resort are each important, if only
partial, solutions that have emerged to address the issues summarized
above. Moreover, sound regulation has the potential to overcome
another disturbing trend that has emerged with the deregulation of
the market economy an increasing divorce of risk from reward
(Prasch, 2004a). None of these are problems that will disappear
through denial or further deregulation.
All regulations, whatever their merits when enacted, must be constantly reevaluated and updated because nancial market innovations and new technologies often undermine them, rendering them
less eective. But whatever instruments of management and control
are selected, clear thinking on the subject of nancial regulation can
only begin by forthrightly and unapologetically rejecting the nowwidespread assumption that what is good for Wall Street is ipso facto
good for Main Street. This presumption has caused tremendous
harm to the American economy, and must be discarded if clear thinking and workable policies are to reemerge.
Fourth, there are instances in which the market works smoothly
and eciently, but we nevertheless experience what my Middlebury
colleague David Colander calls a failure of the market (Colander,
2003). These are instances where some service or product is being
eciently produced and sold yet, for any of a number of reasons,
a reasonable and decent society would wish that they were not.
151
Examples include slavery, certain varieties of military-grade weapons,

child pornography, and sundry dangerous or vicious products that
have few if any safe or legitimate uses.
In each case these products are known to create substantial harm
in the event that they become commodities. Despite the often-heard
claim that the market is best positioned to decide issues of inclusion
and exclusion, ethics and prudence still have a role to play. Of course,
while the broader concerns are clear, the question of where and how
to draw the line is neither a simple nor xed issue. Moreover, such
decisions will never be permanently resolved in a democratic polity
with a range of views and changing technical capabilities. The
banning of marijuana is an instance of such an ongoing dispute, as
is the ownership of some varieties of guns, and the distribution and
availability of several other items or services.
The point is that everyone who participates in a more-or-less democratic polity likely knows of some item or items that our society
would be better o without. But it is equally likely that good and
decent people will disagree on the list of items to be controlled or
banned. (Might I suggest car alarms?) Nevertheless, a more forthright
discussion of the limits of commodication, and the appropriate
realm of the market, would provide us with the space to discuss the
meaning of a good society, in addition to the proper role and place of
ethical considerations in economic policy.
The several grounds for regulation surveyed here are merely suggestive. It should be obvious that an exhaustive and full argument has
not been presented. By contrast, a proper analysis of a proposed
regulation would require an understanding of the qualities and likely
uses of the commodity in question, in addition to an understanding
of the ideal type of market within which it is sold. Inevitably, such
studies will uncover idiosyncratic issues, obstacles, and even objections including the costs of monitoring and administration that
may work for or against any particular prohibition or regulation.
But enough has been said to support our primary result which is
that markets are more varied than might be inferred if we exclusively
studied them through the lens of what I have termed commodity
markets. By drawing upon the wrong ideal type of market to study
a given sector of the economy, grievous and avoidable policy errors
have occurred and even reoccurred. Policies enacted on such inaccurate premises have been awed in ways that could have been anticipated with a more considered analytical framework, one that was
152
open to the proposition that our economy features several varieties

of markets. An additional concern is, of course, that some of
these errors and false generalizations have come to be mainstays of
economics textbooks and classroom instruction in economics.
Hopefully, by starting with a more complete exposition of the theoretical foundations of economics, readers will develop a more sophisticated insight into the markets of the real world.
The current political trend, one that insists that all values are or
should be market values, and for this reason everything is or should
be commodied, is both unenlightened and vicious. It sties serious
discussion and too often facilitates the adoption of policies that harm
the economy, the nation, and international economic relations. The
worlds poor, the environment, and increasingly the worlds middle
classes, have each borne the burden of the policies that ow from
these ideas. Most thinking people now understand that such policies
are unsustainable, and that our conceptions and outlook must be
modied in some fundamental ways. Important vested interests will
tell us, as they ever have, that nothing can be done and that there is
no alternative to the status quo. Ideally these lectures will prepare
readers for the debates to come by leaving them with a greater degree
of condence in their understanding of how a market economy operates, and by arming their belief that Another world is possible.
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Index
ability to pay 32
abstraction 7
adverse selection 59
advertising 36
African-Americans
and baseball 133
productivity of 120
refugees 120
age discrimination 107
aggression from racists 134
airline companies, maintenance
practice 148
airspace over a building, New York
17
allocation of labor, inecient 130
altruism of employers 121
amorality of economists 137, 144
animal products, secret use of, in
food 141
An Indecent Proposal (lm) 1412
anti-market culture 119
arbitrage 73
arson 58
assembly tasks 102
assets
markets 6578
valuation 150
avalanche analogy 47
Bakers Case, The 234
bank borrowing 613
bank loans
and banks 59
to rms 63
to individuals 61, 62, 63
banning items 151
baseball, prohibition of
playing 1334
bonds 65, 66
Bradley Foundation 120

Bretton Woods system 75
Brooklyn Dodgers 133, 134
budget constraints, and choice 142
businesses, illegal 26
calculations 142
capitalist markets, norms and
values 119
carrying costs 745
caste 124
cell phones taking photographs 18
changes in technology 39, 40
charities 149
Chartists 67
Chicago School
acceptance of school position 120
approach 11122
economists 118, 121
theory of discrimination 11521
child-labor laws 91
child pornography 151
China 4
choice 140
in budget constraints 140
or calculation 139
in relative prices 140
Civil Rights Act, 1964 123
clash of cultures 137
classication of people 124
clothing choice decision 142
Codes of Honor, Italian Maa 26
college education 107
commodication 48, 149
of everything 152
limits of 151
commodities
and spot markets 425
supply 3742
167
168
Index
commodities market 9, 2951,1017

economic theory 111
Commons, John 13
compensation 103, 118
competence threshold 124
competition
for work 92
reduced 131
competitive markets 118
conservative explanation 120
consideration, law of, denition
25
consumer demand 30
consumer income 33
consumption
discrimination in 123
role of 142
context in matters of law 22
contract 1328, 131
contract law 8, 9, 2022
legally binding 227
contracts and gifts 25
conventional practices 124
corner cutting 58
cost-benet
analysis 144
calculation 138
counterparty 57, 58
credit
for businesses 634
from suppliers 412
credit crunch 63
credit markets 43, 5564
credit risks 612
credit transactions 55
criteria for employee selection 106
currency markets 72
customer expectations 124
debt contracts 57
debt, ongoing relationship 43
decency 125
demand elasticity 347
demand for commodities 3034
demand shift 33
and quantity changes 31, 32
deregulation 48
of market economy 150
dierential
in compensation 119
in economic opportunity 118, 119
in employment 119
in remuneration 118
discrimination 131, 132
economic consequences 107,
11136
of Eastern Europeans 129
in hiring 11215
of Irish 129
and market mechanism 121
divorce of risk from reward 150
down-scale clienteles 126
dual labor markets 95, 105
dual wage structure 114
duties 142
earnings gaps 120
economic coercion 23
economic interest and normshaping 126
economic opportunities 121
gaps in 120
economic policy and wage levels
925
economic remuneration, low 120
economic stratication 97
educational level 107
education dierentials 120
education, failure of, in schools
120
eciency-wage theory 103, 104, 105
elasticity of demand 347
employee distribution eect 113
employee loyalty 98
employees
African-American 120
employment in the primary
sector 127, 128
enabling myths 128, 129
environment 152
clean 144
degradation of 91
environmental laws 18
equal opportunity laws 116, 124,
125
equal pay for equal work 100
Index
equilibria in labor market 89
equilibrium hours 93, 94
equilibrium wage 105
ethics
consideration in economics
13752
implications in choice 140
reasoning 137
values 143
ethnic divisions 121
euros, market for 713
exchange and prices 138
exchange of property 20
exchange rate 77
exchange theory 1328
exclusion 124
exclusive disposal 16
experience goods 30, 147
fairness of treatment 98
fair play 98
falling markets 67
false choice 140
Federal Reserve System 69
nancial assets 65
re starting, deliberate 58
rms
discriminating 114, 115
non-discriminating 114, 115
penalization of 148
prejudiced and unprejudiced
116
rst mover advantage 49
xed exchange rates 75
food, choice of 142
foreign exchange 6970
holdings 65, 66
markets, characteristics 7073
for-prot corporations 117
for-prot monopolies 121
Fourteenth Amendment 24
fraud 58
freedom to be 20
free entry and exit, 123, 124
free exchange 149
free market 3, 4,11, 27, 115
free time, value of 87
Friedman, Milton 8
169
Galbraith, James K., on goods

purchasing 147
Gandhi, Mahatma, resistance on
salt 36
gender divisions 121, 124
gendering of restaurant sta
1245
gentlemans agreement, on
baseball 133, 134
German occupation of France,
1940 142
gold standard 75
good repute in community 125
government expenditure 70
government inspection 148
governments role in marketplace 44
hedging 76
Hicks-Kaldor Compensation 138
high volatility 41
high wage market see primary labor
market
high wage/low hours equilibrium 94
home renting 56
identication of individual by
consumption 142
identity 125, 140, 1423
immigrant groups 119
in 19th century 75
income
and labor supply 83
and leisure 857
income eect 85
income tax 93
industrial market system 147
industrial or primary sector
127
industrial relations 100
inequality 119
in achievement 120
in opportunity120
in wages 120
inferior goods 33
inheritance 20
inspection goods 30, 47, 55, 147
insurance 21, 43
and moral hazard 58
170
intellectual property 18
interest rate rises 59, 60, 62
International Monetary Fund 70
investments, xed 48
Irish refugees of Great Famine
120
Italian Maa 26
labor law 214
labor market 21, 8196, 120
discrimination 111, 112, 123
dynamics 91, 97108
earnings from 149
segmentation 124
segregation 129
labor supply
on credit 41, 42
high 131
rising of 88
labor supply curve 83, 84
labor supply schedule 835, 94, 95
labourers wage, case 23
laissez faire policy 4 24, 90
land, restrictions on use 17
Law of One Price 102, 114
law of property rights 16
Law, Marc 148
law, protection by 126
learned passivity of workers 1323
least-cost approach 106
legal restrictions 124, 133
leisure and income 867
leisure purchasing 84, 86
leverage of holdings 679
liberal explanation 120
libertarian philosophers 19
Liberty of Contract, The
Bakers Case 234
liquidity, high 66, 67
liquor license, revocation of 126
literature, choice in 140
loan contract 55
losses, small 132
low-wage dynamics 91
low wage labor markets 95, 978
low wage market see secondary
labor market
loyalty to rm 103
Index
macroeconomics, theory of 147
management as art 99
marginal cost 389
marijuana, banning of 151
market
deregulation of 3
privatization of 3
as realm of choice 139
market-clearing price 43
market competition 116
market economy and discrimination
11821
market equilibrium 438, 94
market uctuations 68, 69
market fundamentalism 312, 69
marketization 149
market mechanism, and prejudices
121
market price 11, 39, 1012
and market stability 69, 150
prevailing 138
market-price-based evaluation
145
markets, illegal 26
market theory 1315
market trading 74
market values, political trend
152
maximum hours laws 91, 116
maximum wage legislation 95
McDonalds Corporation,
admission of guilt 141
military-graded weapons 151
minimum wage 91, 94, 95, 116
ethical issue 144
minorities 117
minority employees 113
minority wage 114
modesty 125
monitoring at work 1056
moral choices 14042, 144
and price considerations 1412
morale decreasing 100
moral hazard 58, 59
morality 143
mortgage contracts 43
motivation and labor market
dynamics 97108
Index
natural monopoly 489
Nazi victim with choice 141
needs and wants 35, 36
negative feedback eects 458
Negro League teams, baseball 134
Neoclassical theory of choice 140,
142
nepotism 107
New York Giants 134
New York Yankees 134
no coercion 225
non-commodity markets 9
non-prot institutions 117, 121
Nozick, Robert 19, 20
obligations 142
on-the-job-training (OJT) 127
orderly foreign exchange markets
757
overpaying 103
overproduction 130
overseas trade, increased costs 75
ownership of own body 19
paternalism 24
peasant backgrounds 119
penalties for discriminating rms
116, 117
perfect competition 4, 113, 138
performance monitoring 102
photographs on internet 18
place in society 142
points of stability 47
political aliation 107
political inuence 126
poor of world 152
positive feedback in nature 46, 47
positivist tradition 95
poverty in free labor market 91
poverty trap 92, 149
preference choice 140
prejudice
of baseball fans 134
of rms customers 132
in hiring 106
premium wages 132
price and demand, relationship 34
price changes 41, 735
171
price considerations, and moral

choice 141
price of credit, changes in 412
prices 13840
primary labor market 105
primary market employers 131
primary sector employees 131
priority of goods 139, 140
privacy for individuals 18
private contractual relationships 26
private property 149
privatization 48
privileged groups 128, 129
privileged wage, 114
production, factors of 83
productivity
dierences in 119
low 120
products
authenticity 147
dangerous 151
quality 147
professional clothing 143
prots 125
prot-seeking, competitive 105
property 8, 9, 1328
denitions of 15
law 1520
rights 13, 15, 16, 44
prostitutes 126
protection of life and property 20
quality, commitment to 1489
quantity, demand and supply 44
quantity of labor
demanded 93
supplied 39, 93
race 124
discrimination 112
racial divisions 121
racism 107
of baseball managers 134
rational economic agent 139
reason 144
recessions 63
reduced wages for minority
employees 113
172
Index
reection, capacity for 98, 99

regulation
history of, in business 148
of new processes 1489
of new technologies 1489
related markets, price changes 41
relational contracts 568
religion 124, 143
religious divisions 121
religious values 142
rent 21
renting of labor-power 21
repairs, postponing 58
reputation and illegal markets 26
Rickey, Branch 134
rights of property, intensive and
extensive 17
rights, inalienable 1920
rising markets 67
risk prole of assets 65
Robinson, Jackie 133
Ryan, Monsignor John A. 23
safety 148
commitment to 1489
of women 126
safety records of airlines 147
sales tax on foreign exchange 76
salt as commodity 356
salt tax 36
sanctions 143
savings 149
secondary labor market 105
secondary market employees 131
segregation, in baseball 34
self-consciousness
labor supply 82
quality of 98101
self-image 143
self-interest 56
of rms 121
in good pay 103
self-selling into slavery 1920
Sen, Amartya 143, 145
seniority in employment 100
services or secondary sector 127
services sector or secondary
labor market 129, 130
sexism 107
sexual orientation 124
shareholders 117
shoppers, prejudiced 118
short-term prot maximization 64
slave emancipation 1819
slavery 151
small rms 112
Smith, Adam 59
social costs 149
social divisions 97, 121, 143
social meanings of clothing choice
143
social norms 124, 125
on racism, thaw in 134
social pathology 121
social practices 133
social scientist 119
social welfare function 138
societys economic interests 133
software 17
Sophies Choice 14041
Southern slaveholders, loss 18
speculation
in foreign exchange market 73
reduction 75
role of 73
speculative exchange rate
movements 757
spot market 425, 55
spot transactions 55
stability of market equilibrium 44,
47
stable equilibrium in labor market
8990
starvation wages 91
Stigler, George, on minimum wage
144
Stiglitz, Joseph 3
stocks 65, 66
striking unions 132
structural theory of discrimination
12336
Styron, William 14041
subsistence wage 87, 90, 91
substitution eect 32, 85
suburban yard sale example 55
Summers, Lawrence 137, 138
Index
superior skill 100
supply and demand of labor 101,
106
supply of credit 60
supply schedule 38
supply, limitation of 37
taboos 143
talent of baseball players 134
tax on foreign exchange 76, 77
technology and legal vacuum 27
The Bakers Case 234
theory of supply 82
third party impact 138
threat 22
toxic waste dumping controversy
137
trade disruptions 75
trading 143
tragic choices 140
transaction costs 745
turnover tax 76
uncertainty in volatile markets 74
underproduction 130
unions 132
uniqueness of market equilibrium
44, 45
unit costs 48
of production inputs, changes
41
unstable equilibrium in labor
market 8991
173
urbanization 149
utility functions 139
value of each life 137
values and prices 13752
confusion 137, 138
values of ethics 143
values, reassessment of 140
vegetarianism, moral choice 141
vested interests 152
violence 26
volunteer army 19
wage adjustments 100
wage discounts 116, 118
wage hierarchy 100
wage premium 105, 106
for white employees 129
wage, real and subsistence 88, 90, 91
wages
higher 84, 85
minimum 23
Walrasian principle of gross
substitution 138
Washington Consensus 4, 5
wealth, extreme 93
welfare-maximization 138
welfare-state legislation 23
whites only restaurants 123
willingness to pay 32
women working in bars 126
work status 100
World Bank 137

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How Markets Work

Dedicated with Love to:

How Markets Work

Robert E. Prasch 2008

A catalogue record for this book

THE THEORY OF MARKETS

Economics today: is market fundamentalism in

MARKET PROCESSES WHEN

Credit markets: the economics of a relational

Labor market dynamics when needs are a

SOCIAL, ETHICAL AND POLITICAL

The economics of discrimination: the Chicago

Values and prices: reintroducing ethical

encouraging, and publishing this work (Prasch 2000a, 2000b, 2004b).

times than I care to remember. These include Uncommon Grounds

The theory of markets

Economics today: is market

The theory of markets

Is market fundamentalism in decline?

unconvinced. Indeed, when non-economists make the sustained

The theory of markets

to that of the textbooks and the policies of the Washington

A THEORY OF MARKETS, NOT OF THE

Is market fundamentalism in decline?

closely conform to one or more of them, or have dierent properties

The theory of markets

OVERVIEW OF THE BOOK

Is market fundamentalism in decline?

The theory of markets

Is market fundamentalism in decline?

protect the public accountants, senior executives of corporations,

The theory of markets

on the elements of economic theory. But the several suggestions or

Property, contract, and the theory of

ECONOMICS AND THE THEORY OF THE

The theory of markets

price. It concludes once the student has been successfully drilled in

Property, contract, and the theory of exchange

If a persons right to exclusive control over his or her property is to

The theory of markets

An implication of Richard Elys statement is that those who enjoy

The scope of this recognition, and the duties that it implicitly

Property, contract, and the theory of exchange

because, in most cases, it is dicult to isolate one persons land from

The theory of markets

Property, contract, and the theory of exchange

The theory of markets

Property, contract, and the theory of exchange

important contracts are explicit (rent, insurance, car payments, etc.).

The theory of markets

Important and lasting changes in the distribution of wealth, income,

THE CONDITIONS FOR A LEGALLY BINDING

Property, contract, and the theory of exchange

Throughout American economic history the courts have had to

The concern to check the coercive nature of economic need motivated

The theory of markets

Property, contract, and the theory of exchange

rational agents, economists have been critical of much of the labor

The theory of markets

(C) Consistent with the Laws of the Land