Thursday, November 1, 2007

Economist's Notebook: Markets and Policy

I have already talked a lot about markets using specific policies and events to highlight aspects that I think are relevant. But I thought, thanks to a suggestion, that it might be worth talking briefly about the good and the bad of markets and the way that I, in general, assess a particular market and think about the potential for policy to do some good.

Here are the basics. As a mechanism for distributing scarce resources, complete free markets are exceptional. By exceptional I mean precisely that they extract every available amount of surplus possible and are, therefore, efficient. For example, if there are a number of people out there with tickets to a Kenny G concert and a number of people who wish to see Kenny G, allowing these individuals to interact in a free market will mean that the exchange of these tickets will ensure that the people who want to see Kenny G the most will get the tickets, and that every seller that wishes to sell for a given price (and for whom there exists a buyers willing to by at or above that price) will be able to sell. In other words, all mutually beneficial transactions will occur. To see this another way, a complete free market will prevent instances where there is a buyer of a Kenny G willing to pay up to, say, $100 for a ticket and a seller willing to accept anything above, say, $50 but a transaction between these two does not occur. This is what is meant by efficient: that last transaction should occur, if it did not occur, $50 worth of surplus (the difference between the $100 and the $50) would not have been created. This is the “miracle,” if you will, of the invisible hand: everyone in this market acts in their own self interest, but socially that create maximum surplus and the most efficient distribution of the tickets (only the people who values them the most will end up with them) and it is the price system that makes this all happen. Markets really are remarkable and this result is what fuels almost all free-market based arguments (individual liberty as a political philosophy is another).

NB: It is worth pausing for a moment to give the important disclaimer that efficiency has nothing to do with equity. Equity may be an important social goal, but does not mean we have to sacrifice efficiency. Extra-market redistributions can accomplish the equity goal, but without efficiency, there is less to redistribute to everyone.

Another note: careful reader may object by saying that the people who value the Kenny G tickets the most are almost surely the richest – and that allocating tickets to them is unfair. But consider this thought experiment. What if seeing Kenny G was worth only $25 to me (yes, perhaps because I have such low income). If I were given a chance to buy a ticket for $25, what would I do? I could go to Kenny G and basically come out even, or I could turn around and find the person who would pay $75 for it and sell it. Then I would come out $50 ahead. Remember everything is scarce and we are all trying to do the best we can with what we have. Creating the most surplus is best for everyone. So preventing this last transaction is what is unfair in this point of view.

So I have shown the basics of why complete free markets are so great, have so much traction in political consciousnesses and are often the lesson undergraduates take away from the little exposure they get to economics. This is partly due to how incredible we economists think they are and how important we think it is for people to understand and appreciate them. But the whole thing, it turns out, rests on a set of assumptions that really never hold in the real world. The four biggies are externalities, public goods, information asymmetries and perfect competition. I have talked about these and will continue to do so in my posts, because understanding these (and their implications for markets) is key, in my view, to evaluating policy. Briefly externalities are the costs and benefits of an economic activity that do not accrue to the person engaged in the activity. They can be positive (maintaining a nice garden in front of my house) or negative (the particulate pollution from my wood-burning fireplace). Either way the free market result is inefficient: I do too little than is socially optimal if the externality is positive and too much if the externality is negative. Public goods are goods in which there are aspects of non-excludability (can’t prevent non-payers from consuming) and non-diminishability (use by one person does not leave less for the next). The classic example of both is radio transmissions. It turns out that for these types of goods (roads, parks, fire protection, etc.) the free market will not allocate a socially efficient amount. Asymmetric information is where, for example, sellers know more about the quality of a good than do buyers. Efficient free markets rely on complete information – everyone (buyers and sellers) knows everything (prices, quality, availability) about everything (all products and their complements and substitutes). Finally, too much market power can be inefficient, so there often has to be perfect competition on the part of buyers and sellers for markets to operate efficiently. (We also know that inefficiencies can arise on the supply side from trying to prevent competition, offering too much variety and engaging in investments that are too risky, to give a few examples).

Almost every market you can imagine has some sort of market failure of the types mentioned above. The key to assessing interventions in free markets is in understanding the nature of the market failure, estimating the impact of the failure (is it important?, if so how important is it?), and then thinking of ways the government can correct the failure. Are the remedies going to be effective? Are they going to create new problems? Are they expensive relative to the cost of the inefficiency? These are all questions I ask every time I start to think about a policy and you will see them and references to the market failures ever time I post about policy.

As an economist I appreciate that free markets are great. But I also understand that most free markets are subject to some sort of failure. Sometimes this is small and interventions are bad, sometimes this is big and interventions are necessary. But I am a typical economist in that I view free markets as the first best when we can make them happen. I am also typical in that I understand that market interventions are often necessary, but that I tend to prefer as small an intervention as possible. Where most of the debate happens among economists is in this last bit – assessing the impact of the failure and the worthiness of the intervention. What I cannot tolerate are self-styled 'economists' who think that free markets are the answer to everything and who show no knowledge or appreciation of market failures - and we see these types far to often in public policy debates (hence this blog).

It is really not that hard to be a good economist, but it appears to be far too easy to be a bad one.


Jeff Alworth said...

I will digest this over time and probably refer back to it when I forget the four mitigating factors. But, since I am in a mind of this post on BlueOregon, which shows stagnant wages for the bottom four quintiles in Oregon, here's a thought: could the increasing income disparity begin to affect markets?

In my crude thinking, I imagine a situation in which five people each have $20 and they buy things from one another. Eventually, one of the people is more clever and begins to make smart decisions so his wealth increases. At a certain point (when he has $60, $80, $90?) their exchange is going to be hampered. Dunno where I'm going with that. It just seems like another market factor

Jessica said...

Just wanted to let you know that I enjoy reading your blog and your take on economics. I minored in econ many moons ago but have sinced not used anything I may have learned. Thanks for making me think about these things again!

Patrick Emerson said...

Jeff - inequality will not affect market efficiency in the way you are thinking about it. Remember, efficiency is a technical term that is most easily though of as all mutually beneficial transactions that could take place do (and I could add: given present circumstances). However, you seem to be alluding to the fact that markets may come and go and if, for example, too many people become rich, the market for, I dunno, cheap winter jackets may simply disappear leaving low income individuals - wait for it - out in the cold! (economist humor). This is potentially true if there are, for example, economies of scale in the production of jackets. But this is a slightly different thing - it may no longer be economically feasible to supply winter coats at a low enough price, but then the absence of a market is, once again, efficient.

Jessica - thank you very much, I am glad you found my blog.

Patrick Emerson said...

BTW, the link to the data on rising inequality in Oregon begs a post on inequality.

I will do so soon.