Markets Make Mistakes. That’s A Good Thing

Free markets are not perfect.  In fact, they are anything but (a topic I have spilled lots of digital ink in discussing, for example here).  Markets may end up in inefficient allocation of resources, may give rise to monopolies, or any number of other non-perfect competition outcomes.  However, the fact markets aren’t perfect, that people make mistakes, is a feature, not a bug, of markets.

When a market imperfection (or “market failure”) arises, it indicates that there is some “surplus” (that is, welfare) not being captured.  It’s being lost.  This signals a profit can be made for anyone willing to exploit this failure and correct it.  If, for example, the price of Good X is “too high” because of monopoly power, it encourages people to look for ways to enter the market to capture some of that profit.  This, in turn, brings more of Good X to the market which helps lower the price of Good X.*  The market mechanism helps fix the misallocation.

Of course, enticing others into production is not the only way the market can “heal” itself.  Relatively high prices also cause people to search or create substitutes.  A good example of this is what Mark Perry highlights at Carpe Diem: synthetic diamonds created to combat the cartel power of diamond miners. In fact, the failure or missteps of markets is a major driver of innovation!

However, the profit motive is itself not perfect.  When dealing with public goods or poorly defined property rights, the profit motive may break down.  There is a lot of discussion to be had on that topic, and thus I will avoid it for now.  Rather, I want to focus on the larger message: markets stumble, but they also have mechanisms built in to correct those stumbles.**

The market has failed.  Long live the market.

*This example assumes no government barriers protecting the monopoly.  Other barriers, such as geographical or technological, that help create a monopoly can be broken down eventually.  Government barriers, not so much.

**I’m hesitant to use this language as it may cause the reader to conclude, incorrectly, that markets are machines that can be designed.  I hope readers know markets are organic and not mechanical.

Can a Trade War Create Free Markets?

Craig Walenta’s comment on this blog post at Cafe Hayek got me thinking.  Craig says:

“Well they’re [tariffs] also a way to maybe compel a foreign country to cease its protectionist activities they’re engaging in.”

Craig makes a common (at least among some free market supporters) argument for tariffs on the grounds of promoting free markets, but I’m not quite sure it’s a likely outcome.  The reason is incentives.

Governments tend to like tariffs for multiple reasons, and among those are: 1) they’re vote-getters, 2) they generate tax revenues.  If we assume governments, like all organizations and people, are self-interested and rational, then the case for tariffs becomes obvious: it’s a relatively cheap (in terms of political effort) method of promoting one’s political power.  It is not in the interest of the government to reduce tariffs.  Reduction in tariffs would either mean an increase in other, perhaps less politically safe, taxes or cutback in spending (assuming this to be revenue neutral) and the politician himself would need to look elsewhere for votes.  When a foreign nation enacts protectionist measures against a country, it is unlikely they would respond to removing their tariffs because they face the same incentives as the host nation.  Further, the host nation has no incentive to reduce tariffs even if it “wins” the trade war.

In short, I strongly suspect an “arms race” will develop among the competing nations, one which will only lead to higher tariffs and lower standards of living.  Just as war cannot promote peace, a protectionist trade war cannot promote free markets.

Some Data on International Trade

Warning: A bit wonky

Mercantilism and protectionism have come back into vogue lately, not just in the US but across the world.  Although there is all kinds of literature out there on trade, I thought I’d add just a little of my own.  However, a disclaimer is necessary: the results I will be discussing should be taken with a grain of salt.  This analysis has not passed though any other form of review other than myself (which is why this is a blog post as opposed to academic paper).  I’ll leave you, the reader, to judge their value for yourself.

With that said, let’s get started.

Continue reading

The Shortcomings of Cost-Benefit Analysis

In the comments section of a previous post, Ron H and Steven make good points on Cost-Benefit Analysis (CBA).  I regret not addressing them sooner, but I have been sick with a nasty cold.  Allow me to address them now:

Steven writes:

Well, this is the problem, you can’t force anyone to accept a Kaldor-Hicks criteria. They use a measure which substantially discounts those costs, and there is not a sense in which they’re wrong in terms of economic logic.

Steven is 100% correct.  Kaldor-Hicks (the technical name for cost-benefit analysis) is a bit subjective in how these costs and benefits are measured; the assigned values of the like.  He and I, both trained economists, could both use CBA on the same problem and come out to different answers.

Steven continues:

Also,can’t this same distributional argument you make against instating the minimum wage can be used against removing it? There are losers in both situations. Pareto improvements are elusive.

This is also a good point.  Pareto improvements (that is, improvements that occur so that no one is made worse off) are elusive (or, one might say, damn-near impossible).  A CBA argument can just as easily be made to keeping minimum wage as eliminating it.

Ron H writes:

There is also a moral question here. Is it OK for third parties to decide that one person’s well being should be advanced if it means another person will lose their job?

There is a moral question, one which CBA cannot, or does attempt to, answer.  And thus why we must rely on our own facilities to answer them.  In describing one of the shortcomings of CBA, one of my professors likes to point out that, given certain conditions, the Holocaust could be a net benefit if there were more Nazis (this professor is not advocating the Holocaust but pointing out that, under a strict Kaldor-Hicks analysis, if the benefits to the Nazis were higher than the costs to the Jews, then it would be seen as a Kaldor-Hicks improvement).

These points raised by the commentators I would have brought up in this post by myself, but they beat me to it.  These shortcomings are not to be ignored, and why I stress CBA is a starting point in the conversation.  It is what we economists can contribute; it should not be the whole conversation.  We would need our ethical considerations to play into it, too.  Sometimes CBA can help inform this process (“the current FDA procedure kills 2 people for every 1 saved” for example) or may not.  But regardless, it is a good starting point.

Better Living Through Trade

Allow me to take a brief digression from my previous posts on cost-benefit analysis.

I have spent the past few days battling a rather nasty cold.  Fortunately, a number of products are available to me at a moment’s notice and at low prices to help combat this cold.  They are (in no particular order):

  1. Orange juice (Florida)
  2. Cold medicine (Israel)
  3. Lemons (Mexico)
  4. Tea (England/India)
  5. Oatmeal (Canada)
  6. Warm sweater (Made in Singapore with US materials)

Each of these items have helped combat the cold, either physically or mentally.  Each is available to me thanks to trade.  Absent the ability to trade for these items, my cold’s duration would be longer and more miserable.  But the cornucopia of trade provides all kinds of goods, including those which help us when we are sick.

Knowledge is Half the Battle

In my previous post, I talked about what I see as Economics’ contribution to the larger body of sciences.  But that is not the full story.  Formulating the cost-benefit analysis (henceforth in this post called “CBA”) is one thing.  Properly applying it is another.  By way of example, let’s look at some comments at a recent EconLog post:

Commentator Thaomas [sic] says (emphasis added):

But I’ve noticed that when it comes to policies people DO expect free lunches, or at least will not eat unless lunch is free. Take minimum wages. Folks point out that transferring income to low paid workers will cost some jobs (most folks think not very many, but some). Lunch is not free, but some people are willing to accept the cost.

Thaomas correctly notes that minimum wages cost jobs.  However, his mistake is his last line.  As Don Boudreaux explains (emphasis added):

You write, about minimum-wage policy, that you notice that “some people are willing to accept the cost” of lost jobs. Do you mean the people who actually lose, or who never get, jobs because of the minimum wage are among those who are “willing to accept the cost”?

But even for those relatively few minimum-wage proponents who admit that the minimum wage reduces job prospects for the very group of workers that it is ostensibly designed to enrich, it is not the minimum-wage proponents themselves who are “willing to accept the cost.” Instead, these proponents are willing to have others accept the cost.

Don’s last sentence is key.  Despite acknowledging CBA, Thaomas incorrectly applies it.  Those making the decision are not the ones facing the costs of their decision (if they face any at all).  Indeed, they may stand to benefit substantially (though political praise or power, for example).  This means that their own CBA is skewed positive since they face no costs but all benefits!  To them, this is a good move given the incentives they face.

But there is another group who actually faces the costs of a policy.  To them, the CBA is different and more personal.  And, dare I say, more accurate since they are the ones who bare the full responsibility for their actions.  The CBA of the policymakers leaves out a key factor: the subjective judgments of those involved.  This is key and something no policymaker can truly know (and even if they did not be able to act upon since they do not face the trade-off).

This is one of the more subtle aspects of CBA.  CBA is a powerful tool, but it can be misued or misunderstood as we see above.

No Dicipline Is An Island

Where does economics fit in within the great body of human knowledge?  What can we contribute to the other sciences, like environmental science, medicine, politics, law, philosophy, biology, chemistry, etc, that have given so much to us?  In short, why study economics at all?

Economics doesn’t exist unto itself.  While it has become a synonym for “business”, “money,” or “finance,” economics is much more than that.  Economics is a philosophy, a way of thinking.  It is a specialized lens for viewing the world.  One which can (hopefully) help other sciences in their thinking.

What can we contribute?  Cost-benefit analysis.  This may sound like we are mere accountants, but it is so much more than that.  Economists, as Don Boudreaux likes to say, make the invisible visible.  We are taught right from the get-go to look, not just at the visible and immediate benefits and costs of human actions, but at the invisible and long-term benefits and costs.  We look not just at those who have immediate consequences, but on all groups of people.  Further, this is not merely number-crunching dollars and cents.  We need to look at all consequences: emotional, psychological, financial, personal, etc.  All this helps us provide insight that other sciences can use.

The cost-benefit analysis as I described can also help answer difficult questions in other sciences.  Questions like “is there such a thing as too much safety?”  “Will this new policy be the most effective means of accomplishing a goal? (or, inversely, “will this policy accomplish said goal?”)”, “Is this outcome as bad as it appears on its face?”  and, perhaps the single biggest question, “as compared to what?

I wish to stress that these questions are nothing more than starting points.  They are our contribution to the conversation.  Economics cannot speak to moral judgments, or even what is “preferable.”  These are often personal questions.  Economics cannot hope to answer those and it is irresponsible for an economist to pretend he can.

The economic way of thinking has already been applied to several sciences, with great results in helping us more deeply understand them.  Two of these areas are specialties here at George Mason: Law and Economics and Public Choice Theory (politics and economics).  The economic way of thinking has helped us better understand juries, drug trials, politics, property rights and the environment, etc etc.

I am biased, but economics has a lot to offer the world.