Chapter 16. From the Perfect to the Imperfect:
General Equilibrium, Property Rights, and Imperfect Information.

No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were.
John Donne, "Devotions Upon Emergent Occasions," 1623, XVII


  • French theorists with jazzy goatees
  • Intellectual revolutions from above
  • Why steel factories have the right to pollute
  • Those loud stereo speakers facing toward the Quad

In an ideal economy, prices adjust until all markets are in equilibrium. When there is general equilibrium every market in the economy is at its optimum. Reality, however, is always a step behind the ideal of general equilibrium. (Maybe a giant's step.) Four interfering factors are: ill defined property rights, high transaction costs, costly or distorted information, and sheer uncertainty. One can name other factors that interfere: power, time, and war, for example. Economists are thinking more and more creatively about these interfering factors and their consequences for the economy.

Maria: So far we have talked a great deal about markets but I can't believe that they work that well! People are not as rational as you economists make them out to be, and most markets are controlled by a few big firms.

Paul: Wait a minute! We did cover oligopolies and monopolies. What's your point?

Rodney: I agree with Maria. Markets are not as neat as the previous chapters make them out to be. It's all too perfect.

Bayla: I actually think that markets are great. If only the government would keep its big hands out, they would finally be given a chance to show their greatness.

Ziliak: Sounds like a juicy chapter!

Klamer: Indeed. Let's see how Maria and Rodney could substantiate their doubts about markets.

Ziliak: Fine, but let's first display the beauty of a well-functioning market economy in general. Recall the circular flow: all flows come around mediated by markets. What if all markets were to work well?

The diagram of the circular flow conveys an important insight in economics: everything depends on everything else, however remotely, as John Donne said in the motto. Like the flap of a butterfly's wing in nature's economy, any small event or change will have a ripple effect throughout the market economy. When, for example, consumers pay attention to food labels and start preferring foods with less than 5 percent total fat per serving, food processing firms will search harder for fat substitutes, or will add more spices. Chemical factories making fat substitutes will boom; the spice islands will flourish; antacid pills will rise; all sorts of changes will happen, big and small.

Figure 16-1: The circular flow diagram

The markets for factors of production complete the circular flow. They mediate the supply of and demand for inputs. The markets in the upper part of the circular flow mediate the supply of and demand for goods and services.