Power and “Development”

Raúl Sánchez de la Sierra

University of Chicago
Spring 2024

Lecture 2
Markets: A Great Idea, Many Failures, and a Few Disasters
Quiz?
Taking a step back
In the fourteenth century...
Moroccan scholar Ibn Battuta described Bengal in India as:

“I saw no region of the earth in which provisions so plentiful.”

Moroccan scholar Ibn Battuta described Bengal in India as:

“I saw no region of the earth in which provisions so plentiful.”

Three centuries later, French diamond merchant wrote:

Moroccan scholar Ibn Battuta described Bengal in India as:

“I saw no region of the earth in which provisions so plentiful.”

Three centuries later, French diamond merchant wrote:

“Even in the smallest villages, rice, flour, butter, milk, beans

and other vegetables, sugar and sweetmeats, dry and liquid,
can be procured in abundance.”

Source: Jean Baptiste Tavernier

Fast forward to today...
People in India are better off than seven centuries ago:
People in India are better off than seven centuries ago:
access to food,
medical care, shelter and
the necessities of life
People in India are better off than seven centuries ago:
access to food,
medical care, shelter and
the necessities of life

Yet by world standards today most are poor

People in India are better off than seven centuries ago:
access to food,
medical care, shelter and
the necessities of life

Yet by world standards today most are poor

What happened?
The Great Divergence
The great divergence and the birth of capitalism

Since the 1700s, increases in average living standards

became a feature of economic life in many countries.
The great divergence and the birth of capitalism

Since the 1700s, increases in average living standards

became a feature of economic life in many countries.

This was associated with the emergence of a new economic

system called capitalism, in which private property, markets
and firms play a major role.
What is capitalism?

‘Capitalism’ refers not to a specific economic system, but to a

class of systems sharing certain characteristics.
What is capitalism?

‘Capitalism’ refers not to a specific economic system, but to a

class of systems sharing certain characteristics.

Institutions of capitalism:

private property,
markets,
firms.
The Great Divergence

Source: Pomeranz “The Great Divergence”

“Much of modern social science originated in efforts by late

nineteenth- and twentieth-century Europeans to understand what
made the economic development path of western Europe unique”
The Great Divergence

Source: Pomeranz “The Great Divergence”

“Much of modern social science originated in efforts by late

nineteenth- and twentieth-century Europeans to understand what
made the economic development path of western Europe unique”

Economics
Adam Smith and the invisible hand

Adam Smith (1723–1790): founder of modern economics.

Adam Smith and the invisible hand

Adam Smith (1723–1790): founder of modern economics.

Visited Toulouse, claimed had ‘very little to do’ and thus

began ‘to write a book in order to pass away the time.’
Adam Smith and the invisible hand

Adam Smith (1723–1790): founder of modern economics.

Visited Toulouse, claimed had ‘very little to do’ and thus

began ‘to write a book in order to pass away the time.’

This was to become the most famous book in economics:

The Wealth of Nations (1776)

Wealth of Nations

The question: how can society coordinate the independent

activities of large numbers of economic actors
Wealth of Nations

The question: how can society coordinate the independent

activities of large numbers of economic actors —producers,
transporters, sellers, consumers—
Wealth of Nations

The question: how can society coordinate the independent

activities of large numbers of economic actors —producers,
transporters, sellers, consumers— often unknown to each
other and widely scattered across the world?
Wealth of Nations

The question: how can society coordinate the independent

activities of large numbers of economic actors —producers,
transporters, sellers, consumers— often unknown to each
other and widely scattered across the world?

The proposed answer: coordination among all of these

actors might spontaneously arise,
Wealth of Nations

The question: how can society coordinate the independent

activities of large numbers of economic actors —producers,
transporters, sellers, consumers— often unknown to each
other and widely scattered across the world?

The proposed answer: coordination among all of these

actors might spontaneously arise, without any person or
institution consciously attempting to create or maintain it.
Wealth of Nations

A radical answer: this could take place as a result of

individuals pursuing their self-interest:
Wealth of Nations

A radical answer: this could take place as a result of

individuals pursuing their self-interest:

“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 interest”
Wealth of Nations

A radical answer: this could take place as a result of

individuals pursuing their self-interest:

“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 interest”

One of the most enduring metaphors in the history of

economics, that of the
Wealth of Nations

A radical answer: this could take place as a result of

individuals pursuing their self-interest:

“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 interest”

One of the most enduring metaphors in the history of

economics, that of the invisible hand.
The First Fundamental Theorem of Welfare Economics

“The businessman intends only his own gain,

The First Fundamental Theorem of Welfare Economics

“The businessman intends only his own gain,

and he is in this, as in many other cases, led by an invisible hand

to promote an end which was no part of his intention.
The First Fundamental Theorem of Welfare Economics

“The businessman intends only his own gain,

and he is in this, as in many other cases, led by an invisible hand

to promote an end which was no part of his intention.

Nor is it always the worse for the society that it was no part of it.
The First Fundamental Theorem of Welfare Economics

“The businessman intends only his own gain,

and he is in this, as in many other cases, led by an invisible hand

to promote an end which was no part of his intention.

Nor is it always the worse for the society that it was no part of it.

By pursuing his own interest he frequently promotes that of the

society more effectually than when he really intends to promote it.”
Specialization

Specialization: Division of labor

Why is specialization good?

Specialization

Specialization: Division of labor

Why is specialization good?

Learning by doing
Specialization

Specialization: Division of labor

Why is specialization good?

Learning by doing

Difference in ability
Specialization

Specialization: Division of labor

Why is specialization good?

Learning by doing

Difference in ability

Economies of scale
Specialization

Specialization: Division of labor

Why is specialization good?

Learning by doing

Difference in ability

Economies of scale

Only constrained by the ‘extent of the market.’

Specialization and gains from trade

Comparative advantage and markets

Markets allow people to specialize in the production of goods

for which they have a comparative advantage
Specialization and gains from trade

Comparative advantage and markets

Markets allow people to specialize in the production of goods

for which they have a comparative advantage

In that, they contribute to increasing the productivity of labour

Specialization and gains from trade

Comparative advantage and markets

Markets allow people to specialize in the production of goods

for which they have a comparative advantage

In that, they contribute to increasing the productivity of labour

Rise in extent of markets would explain “Great Divergence”

Freeing Markets:
 Freeing Markets:

A historical experiment
Bringing free markets to Russia in 1990

Economy was organized by the state

Through public ownership and production plans
Bringing free markets to Russia in 1990

Economy was organized by the state

Through public ownership and production plans

US economists and world bank

Pushed free market reforms
Bringing free markets to Russia in 1990

Economy was organized by the state

Through public ownership and production plans

US economists and world bank

Pushed free market reforms

The Result?
One of the late 20th century biggest development tragedies
The “Russia debacle”
Russia went back a decade.

Unemployment, poverty skyrocketed, the Ruble lost its value.

Jobs lacked, little exchange, and society was plunged in a crisis

where people lived on survival, corruption, organized crime
The invisible hand was nowhere to be found
Main debate at the time: Gradualism vs. Shock therapy

Market shock therapy

Privatize as fast as possible public firms, labor markets

Markets would breed demands for institutions, for democracy

There Were no Market Supporting Economic Institutions

Privatization: voucher system 1992-1994

Sale of public firms to the public through voucher system

There Were no Market Supporting Economic Institutions

Privatization: voucher system 1992-1994

Sale of public firms to the public through voucher system

Each voucher corresponded to a share in the national wealth
There Were no Market Supporting Economic Institutions

Privatization: voucher system 1992-1994

Sale of public firms to the public through voucher system

Each voucher corresponded to a share in the national wealth
Distributed equally among the population
There Were no Market Supporting Economic Institutions

Privatization: voucher system 1992-1994

Sale of public firms to the public through voucher system

Each voucher corresponded to a share in the national wealth
Distributed equally among the population
Vouchers could be exchanged for shares in the firms
There Were no Market Supporting Economic Institutions

Privatization: voucher system 1992-1994

Sale of public firms to the public through voucher system

Each voucher corresponded to a share in the national wealth
Distributed equally among the population
Vouchers could be exchanged for shares in the firms

Problem: Most people did not have market skills. Most vouchers
were bought by elite, former managers. Markets failed.
There Were no Market Supporting Economic Institutions

More privatization: 1995 shares for loans program

Yeltsin, needing funds for reelection, offered to give shares of

national companies to commercial banks in exchange for loans
There Were no Market Supporting Economic Institutions

More privatization: 1995 shares for loans program

Yeltsin, needing funds for reelection, offered to give shares of

national companies to commercial banks in exchange for loans

Problem:
Auctions of shares were rigged (low competition, low value)
Government never returned loans
Most firms ended up in the hands of former political elite
Creation of the class of oligarchs 1995
The “Russia debacle”
Freeing Markets:
 Freeing Markets:

Another experiment
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
competitive exchange rate
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
competitive exchange rate
liberalizing trade
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
competitive exchange rate
liberalizing trade
permitting inward foreign investment
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
competitive exchange rate
liberalizing trade
permitting inward foreign investment
privatizing state enterprises
The Washington consensus

Washington Consensus: WB, IMF, US Gov

These policies included

“fiscal discipline” (less government spending)
“reordering public spending” (less health and education)
“reforming” tax policy (lower taxes)
allowing the market to determine interest rates
competitive exchange rate
liberalizing trade
permitting inward foreign investment
privatizing state enterprises
deregulating barriers to entry and exit
Washington Consensus Impact

Washington Consensus Was Accountable for Various

Financial crises
the tequila crisis in 1994–95
the Asian crisis in 1997–98
the Russian crisis of 1998
Washington Consensus Impact: Down to a Science
The invisible hand was again nowhere to be seen

What happened?
What happened is that markets, without appropriate regulation by
the government, almost always fail
First Fundamental Theorem of Welfare Economics

This idea was known since Adam Smith

Adam Smith (1776)

First Fundamental Theorem of Welfare Economics

This idea was known since Adam Smith

Adam Smith (1776)

Leon Walras (1860)

First known mathematical derivation of the theorem
First Fundamental Theorem of Welfare Economics

This idea was known since Adam Smith

Adam Smith (1776)

Leon Walras (1860)

First known mathematical derivation of the theorem

Edgeworth (1881)
Pure exchange economy (no production)
Market equilibrium maximizes the sum of utilities of the parties
First Fundamental Theorem of Welfare Economics

This idea was known since Adam Smith

Adam Smith (1776)

Leon Walras (1860)

First known mathematical derivation of the theorem

Edgeworth (1881)
Pure exchange economy (no production)
Market equilibrium maximizes the sum of utilities of the parties

Pareto (1906)
Pareto Optimum
First Fundamental Theorem of Welfare Economics

This idea was known since Adam Smith

Adam Smith (1776)

Leon Walras (1860)

First known mathematical derivation of the theorem

Edgeworth (1881)
Pure exchange economy (no production)
Market equilibrium maximizes the sum of utilities of the parties

Pareto (1906)
Pareto Optimum

Arrow and Debreu (1951): 1st Welfare Theorem

Generalization: 1st Welfare Theorem

SOCIAL EFFICIENCY

Theorem: If certain conditions are met then private market

equilibrium is Pareto efficient
Generalization: 1st Welfare Theorem

SOCIAL EFFICIENCY

Theorem: If certain conditions are met then private market

equilibrium is Pareto efficient

Pareto efficient: Impossible to find a technologically feasible

allocation that improves everybody’s welfare

Recitation, Part II, will make this point very simply

What are certain conditions are met?
Most Nobel Prizes since 1960’s were about showing that markets
fail when the conditions fail
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
3 Perfect Competition (Jean Tirole)
Monopolies destroy surplus, challenge is how to regulate them
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
3 Perfect Competition (Jean Tirole)
Monopolies destroy surplus, challenge is how to regulate them
4 Humans are rational: behavioral economics (Rich. Thaler)
self-interest isn’t even self-interested
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
3 Perfect Competition (Jean Tirole)
Monopolies destroy surplus, challenge is how to regulate them
4 Humans are rational: behavioral economics (Rich. Thaler)
self-interest isn’t even self-interested
5 No Altruism (Adam Smith, Theory of moral sentiments)
humans care about more than themselves
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
3 Perfect Competition (Jean Tirole)
Monopolies destroy surplus, challenge is how to regulate them
4 Humans are rational: behavioral economics (Rich. Thaler)
self-interest isn’t even self-interested
5 No Altruism (Adam Smith, Theory of moral sentiments)
humans care about more than themselves
6 No repugnant goods (Alvin Roth)
Slavery, organs, babies (Michael Sandel)
“Certain conditions:” If they are not met, markets fail

1 No strategic interactions (prisonners’ dilemma, John Nash)

invisible hand can destroy wealth when we compete
2 No externalities (Ronald Coase) Recitation, Part III
invisible hand can destroy wealth if our actions affect others
3 Perfect Competition (Jean Tirole)
Monopolies destroy surplus, challenge is how to regulate them
4 Humans are rational: behavioral economics (Rich. Thaler)
self-interest isn’t even self-interested
5 No Altruism (Adam Smith, Theory of moral sentiments)
humans care about more than themselves
6 No repugnant goods (Alvin Roth)
Slavery, organs, babies (Michael Sandel)
7 Complete information (Akerlof, Stiglitz)
I know something that you don’t: this can lead markets to fail
All of these economists in the lost decades are very smart:
All of these economists in the lost decades are very smart:

Why did they not see it coming?

Historical context and ideology

Interpretation is influenced by the historical context

Cold war: economic departments was an institution that

allowed to legitimize a certain way to organize society
Historical context and ideology

Interpretation is influenced by the historical context

Cold war: economic departments was an institution that

allowed to legitimize a certain way to organize society

Before the cold war: it tended to be historians, and also,

earlier, religious institutions
Historical context and ideology

Interpretation is influenced by the historical context

Cold war: economic departments was an institution that

allowed to legitimize a certain way to organize society

Before the cold war: it tended to be historians, and also,

earlier, religious institutions

Motivated reasoning
Historical context and ideology

Interpretation is influenced by the historical context

Cold war: economic departments was an institution that

allowed to legitimize a certain way to organize society

Before the cold war: it tended to be historians, and also,

earlier, religious institutions

Motivated reasoning

Emotions → actions → ex-post rationalization (beliefs)

Even scientists have biases

Left vs. right in macroeconomics:

Sticky vs flexible prices
Even scientists have biases

Left vs. right in macroeconomics:

Sticky vs flexible prices

Left vs. right in public economics:

elastic vs. inelastic taxable top income labor supply elasticity
Even scientists have biases

Left vs. right in macroeconomics:

Sticky vs flexible prices

Left vs. right in public economics:

elastic vs. inelastic taxable top income labor supply elasticity
The ideological biases in economics
The ideological biases in economics

Down to a Science: Jelveh et al. (2018)

Jelveh et al. (2018): ideology in economics

Predict political behavior of a subset of economists using

the phrases from their academic articles, then predict
partisanship for all economists.
Main Result

Imputed partisanship is correlated with estimated parameters,

such that the implied policy prescription is consistent with
partisan leaning

Going from the most left-wing authored estimate of the

taxable top income elasticity to the most right-wing authored
estimate:
decreases the optimal tax rate from 84% to 58%.
Why economists?
Why economists?

Democrat to Republican ratio:

Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Political science: 6.5 to 1
Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Political science: 6.5 to 1
Anthropology: 10.5 to 1
Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Political science: 6.5 to 1
Anthropology: 10.5 to 1
Sociology: 44 to 1
Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Political science: 6.5 to 1
Anthropology: 10.5 to 1
Sociology: 44 to 1

Economics is the most conservative social science

Why economists?

Democrat to Republican ratio:

Economics: 2.8 to 1
Political science: 6.5 to 1
Anthropology: 10.5 to 1
Sociology: 44 to 1

Economics is the most conservative social science

Source: Cardiff and Klein (2005)

Economists the most conservative social science

“People drawn to the economics profession do tend to favour the

market mechanism to allocate resources instead of the
government”

Source: The Economist magazine

Beliefs are socialized, even those of economists

“10 percent of first-year students in economics considered

themselves conservative;
Beliefs are socialized, even those of economists

“10 percent of first-year students in economics considered

themselves conservative;

by the fourth and fifth year, this number had risen to 23 percent.
Beliefs are socialized, even those of economists

“10 percent of first-year students in economics considered

themselves conservative;

by the fourth and fifth year, this number had risen to 23 percent.

Source: Colander and Klamer (1990) “the Making of an

Economist”
What I want you to take-away from this:

1. Markets need (smart) government

What I want you to take-away from this:

1. Markets need (smart) government

2. Don’t believe economists

What I want you to take-away from this:

1. Markets need (smart) government

2. Don’t believe economists

We all have biases, cultural influence, unconscious motivations,

and are socialized. It’s not left or right.

Take a step back and recognize the limitations of who is telling you
anything that has normative implications
What I want you to take-away from this:

1. Markets need (smart) government

2. Don’t believe economists

We all have biases, cultural influence, unconscious motivations,

and are socialized. It’s not left or right.

Take a step back and recognize the limitations of who is telling you
anything that has normative implications

Economists claim that we are objective: it is an illusion

Markets with government

The (re)birth of political economy

Key dates in syllabus

Weds. March 27: Congo Calling, 6pm SkySuite

Tuesday, April 11th: Midterm 1 (about lectures), in class

Tuesday, April 18th:

Class Discussion 1: graded reading commentary
Group task is announced

Thursday, May 9th

Class Discussion 2: Reading quiz guaranteed
Midterm 2 (about lectures), in class

Monday, May 13th: Group presentations: , Sky Suite 5-9pm