TOTM, Now with Extra Nuance!

Josh Wright —  16 June 2006

In response to Thom’s post on the merits of federal subsidies for private efforts to develop alternative fuels, frequent and thoughtful commentor William Goodwin issues a critique of Thom’s post, and of TOTM more generally. I will leave the merits of Mr. Goodwin’s specific criticisms (do read them) to Thom, but this particular portion caught my eye:

As for Hayek, public choice, etc., these critiques apply to all government action, and say nothing interesting or specific about how to solve the collective-action problem raised by positive externalities. And while I realize that every post at Truth on the Market effectively ends: “Let the market figure it out,� at some point it’d be nice to hear a more nuanced, and less ideological, position.

Do TOTM bloggers advocate market-based solutions for public policy problems more frequently than our friends at the other blawgs? Probably. But I’m puzzled by the notion that the prescription to “let the market figure it out” is an inherently simplistic and ideology-driven position. This sort of criticism is often leveled at those who advocate market-based solutions to public policy problems, so I do not mean to single out Mr. Goodwin, but this view, in my mind, suggests a fundamental misunderstanding of how markets work. Why?

One of the fundamental Hayekian insights is that the information required to make efficient resource allocation decisions is scattered throughout the population in a manner such that no central planner could successfully obtain all of it. It is the price mechanism that allows aggregation of these diffuse parcels of information. Public policy problems, I’m sure we can all agree, can be incredibly complex. To “let the market figure it out” is not to assume that any pre-determined set of individuals (say, those in a government agency) will have the information necessary to solve these problems correctly (much less the appropriate incentives to solve them). Rather, a preference for the market is to concede that the complexity of the problem requires a solution which depends on the creativity of market participants. While “let the market figure it out” sounds simple enough, and no mantra is an appropriate substitute for rigorous analytics, the mechanism by which resources are allocated by prices is wonderfully nuanced, and necessarily more so than the alternative central planning mechanism.

Don Boudreaux at Cafe Hayek articulates this point wonderfully in this post, which I recommend in its entirety, and from which I cannot resist excerpting:

To recommend the market, in fact, is to recommend letting millions of creative people, each with different perspectives and different bits of knowledge and insights, each voluntarily contribute his own ideas and efforts toward dealing with the problem. It is to recommend not a single solution but, instead, a decentralized process that calls forth many competing experiments and, then, discovers the solutions that work best under the circumstances… .

While declaring “Let the government handle it” comes across as a solution, it’s no such thing. Instead, it is merely a sign of a simple and baseless faith — a simple and baseless faith that people invested with power will not abuse it; that political appointees possess or will find better answers than will millions of people pursuing solutions in their own ways, and staking their own resources and reputations on their efforts; that only those ‘solutions’ that are spelled out in statutes and regulations and that have officials paid to implement them are true solutions.

I’m not sure I know what it means to label as ideological the view that it is generally superior to rely on decentralized allocation of resources and individual incentives rather than central planning. So I plead no contest to the charge that the prescription to “let the market figure it out” is ideological. But I am quite sure there is nothing inherently “less nuanced” about this solution than the alternative. To the contrary, market solutions are inherently complex and nuanced.

10 responses to TOTM, Now with Extra Nuance!

  1. 

    Gentlemen–

    Sorry for the belated response. I’ve been (somewhat blissfully) Internet-deprived for the last couple of days. This is an excellent discussion. Thank you all for your thoughtful comments.

    Markets fail. So do governments. In a dispute over which institution(s) are best able to direct resources so as to maximize social welfare, the key question will be whether the welfare loss from market failure (e.g., positive externalities leading to suboptimal amount of some behavior, or negative externalities leading to an excessive amount) is greater than the inefficiencies that would result from government intervention (e.g., resource misallocation, deadweight loss from rent-seeking). I had speculated that we are at a point in the development of alternative fuels at which there will be less welfare loss if the government stays out of the picture (or, to be more specific, refrains from providing targeted incentives for alternative fuels research). Perhaps I’m wrong — William has suggested some compelling reasons why externality-based welfare losses will exceed the welfare losses resulting from government intervention. This is ultimately an empirical question which I, at this point, am unable to answer.

    I don’t believe, though, that my position is “un-nuanced.” Indeed, my post on the Austrians and Public Choice was intended to provide some nuance: I conceded that there may be positive externalities that lead to “too little” alternative fuels research, but I pointed out that the alternative to laissez-faire entailed its own losses which I thought, in this case, would exceed the losses occasioned by externalities.

    In any event, this has been a constructive conversation. Thanks to all for your comments.

  2. 
    William Goodwin 17 June 2006 at 10:21 am

    Just a couple of (belated) thoughts:

    On 1 and 2: Incentives obviously matter, but even a cursory look at corporate history will tell us that the profit motive is no guarantee that good decisions will be made. Let’s take a simple example: something like 70% of all new products fail (are withdrawn from the market) within a year. Let government fund hundreds of experimental programs, and I wouldn’t be shocked if 30% of them were effective (and we could establish the metric in advance to know what “success” would mean).

    In any case, it’s not true that government officials do not bear the costs of their mistakes. Government officials are fired for their failures, denied promotion, etc. The incentives may not be as powerful as in the corporate sector, but it’s wrong to deny they’re there. A raft of research over the past two decades in behavioral economics shows that financial incentives are not always or necessarily the most powerful motivators for behavior: reputational and social incentives also matter enormously. And these play a key role in any organization, governmental or otherwise.

    In any case, I don’t believe that government is superior to the market as a decision-making/problem-solving body. I’m arguing, effectively, that the government is better than nothing when it comes to solving problems that entail large social costs and benefits. So, with regard to point 3:

    You write that it’s “private actors who have the incentives to (for example) innovate new methods of appropriating external social benefits.” But they don’t have those incentives. The social benefits of investment in alternative fuels include (at least): reduction of pollution, softening the impact of global warming, a reduction in military spending to protect supply of oil, and (arguably) a dramatic reduction in geopolitical tensions. Private actors will be able to capture none of those benefits, because any single individual is not going to be willing to pay for them (with the exception of a small number of altruists). That’s not because the problems are unimportant — it’s because the dent any one individual’s decision would make in those problems is so small that it’s not economically rational for an individual consumer to take them into account.

    This doesn’t mean there won’t be any investment in alternative fuels: depending on the business, or the individual’s consumption patterns, $70-a-barrel oil will justify some people buying a Prius or using solar power, and therefore will justify investment in those technologies. But that investment will be much smaller than it would be if the total calculus of social costs and benefits were taken into account.

    Now, it’s true that any governmental attempt to calculate social costs and benefits will be decidedly imperfect, skewed by political considerations, etc. That’s one reason why I think using prediction markets to make that calculus would be so beneficial. But saying that the attempt would be imperfect does not mean that it would be worthless. Take the Clean Air Act and the Clean Water Act. It is absolutely true that if those laws had not been passed, American air and water would be much dirtier, and America itself would be much less livable, than if they hadn’t been, because again, individual companies and consumers had no personal incentive to reduce pollution. Are those laws perfect? By no stretch of the imagination. Were they worth passing? Absolutely.

    In any case, I absolutely agree with your final paragraph, and as much as possible, I think governments should try to harness the power of markets (tradable emissions-permits being a classic example of this) rather than simply ignore them. And the default assumption should not be that market failures require government intervention — or that the simple presence of externalities means that government will do better. But when the externalities are as massive as they are in the case of oil/alternative fuels, and when the social costs/benefits are so immense, I think there’s a strong case that some government action is warranted.

  3. 

    Thanks for the thoughtful response William. A few quick thoughts:

    1. Large corporations are driven by the profit incentive and bear the costs of their mistakes. Government decision-makers do not. This is the reason why government decision-making, in addition to corruption, etc., is less likely to result in efficient allocations. In fact, this is the argument you make for why externalities render market allocations inefficient, i.e. economic agents do not take into account all social costs/ benefits.

    2. We both apparently agree (I think) that one ought to consider all the plausible resource allocation mechanisms, their costs, benefits, and consequences. I take the position that, as an empirical matter, decentralized allocations have done far more for producing social wealth than the alternatives. The position of “assuming” that government allocations will prove to be failures is not one of blind faith. Unfortunately, history is full of examples of such failures.

    3. As for the presence of externalities, maybe I am missing your point, but it is private actors who have the incentives to (for example) innovate new methods of appropriating external social benefits. If your point is that the government will necessarily do a better job in the presence of externalities, I disagree. Externalities, in some form or another, exist in a huge number of markets! Do you think government allocation is justified in each of them? I’m guessing not, though perhaps for different reasons than me.

    Granting the allocation rights to the government does not mean that the government is “asking the right question” or attempting to aggregate the right information.

    In any event, at a minimum it seems that we can agree that such the party advocating such proposals ought to consider the incentives created for participants in the market, the costs of the regulation, and what the allocation will look like relative to the “unregulated” one.

  4. 
    William Goodwin 16 June 2006 at 5:34 pm

    I didn’t see Josh’s last post, so let me clarify one other thing:

    When I say that “let the market figure it out” is un-nuanced or simplistic, it’s not because I think the market mechanism is uncomplicated or simple. I am as dazzled as anyone by the way in which markets allow millions of individuals to coordinate their behavior and produce elegant solutions to complex problems, solutions that no central planner could ever discover. But markets don’t work in all circumstances. That’s just their nature. And any sophisticated analysis of the economy and society has to be willing to admit that, and to recognize that when markets aren’t dealing with a problem, it doesn’t mean the problem doesn’t exist, or that no real solution is possible.

    Assuming that government is bound to do badly when it reaches outside the realm of property rights enforcement is just as much a statement of blind faith as was the Marxist assumption that the state is bound to do well.

  5. 
    William Goodwin 16 June 2006 at 5:27 pm

    A couple of points:

    Re: the question of “efficient resource allocations,” there are a number of problems with simply relying on Hayek to make the case against government. First, the price system does not work well when all of the factors that are relevant to the efficient allocation of resources are not captured in the price. If you’re offering me oil at a significant discount to its true cost (which is what happens because the costs of pollution, congestion, military spending, etc. are not included in the price of a gallon of gasoline), I’m going to buy a lot more gasoline than I otherwise would, which means investors are going to invest more in oil than they otherwise would, and invest less in other alternatives. The same is obviously true, on the flip side, with products that have massive positive externalities — like alternative fuels, which could significantly reduce pollution, global warming, and military spending. These will be underinvested in.

    Now, you can say, “We still don’t know enough to make an intelligent governmental decision about how much to help/hinder these,” but your reason for saying that can’t be that the market will be better, because the market is simply ignoring the factors that matter in this debate (the positive/negative externalities). In other words, there are “no diffuse parcels of information” about the real cost/value of the positive/negative externalities that are being aggregated in the price mechanism, because no individual has to pay the costs or gets to reap the benefits, and in the Hayekian model, only information that is germane to an individual ever gets aggregated. In other words, even though tremendous amounts of valuable information about the real cost of oil and the real benefits of alternative fuel exist in the world, they does not exist in a Hayekian sense. So saying, “Let the market figure it out” really means, “Let the market ignore all of this information about social costs and benefits” — because for Hayek, there are only individual costs and benefits. (I’m not saying this invalidates Hayek’s work tout court, just that price is not informative in a Haykeian sense where major positive or negative externalities exist.)

    Under these conditions, government has a good chance of being an improvement on the market, because government is at the very least asking the right question, and trying to aggregate the information that will help answer it. The market, by contrast, is ignoring it (because that’s what markets do with costs and benefits that are not captured in a price).

    Now, governments obviously screw up a lot of the time (and here the public-choice critique is obviously germane). But they obviously also do a passable job a lot of the time as well — it’s impossible, for instance, to conceive of how impoverished our medical and scientific knowledge would be without government funding. Thom and Josh are setting up the all-seeing market against the blinkered government. But in the case we’re talking about here, the government is the only one of the two even trying to look at the problem. And given the importance of that problem (that is, moving away from an oil-based economy), it’s not clear we shouldn’t prefer the possibility of a passably good answer (acknowledging the risk of a bad one) to no answer at all.

    “Let the market figure it out” is un-nuanced, then, because it simply fails to acknowledge the times and places where the market can’t figure it out (if only because the market isn’t interested in figuring it out). And the invocation of regulations and property rights does not solve the problem. Social costs and benefits are real, and it is not always possible for millions of people acting on their own to come up with the best way to deal them. The reality of living in a society is that sometimes collective action is required. “Let the market figure it out” denies this, and that’s why it’s un-nuanced.

    It’s also un-nuanced because its view of government is so impoverished, because, like Boudreaux, it assumes that government will always be corrupt or inefficient or unable to aggregate enough information to make a good decision. But if we assume that large corporations (many of which are bigger than most government agencies) can make good decisions, there is no reason in principle why government should be incapable of doing so. More important, there is no reason why the government can’t use Hayekian tools to inform its decision. To take only the most obvious example, prediction markets represent an attempt to use a market mechanism to aggregate the collective wisdom of large groups of people to inform decisions. Corporations that have experimetned with these markets have enjoyed excellent results, and there is no reason why governments could not do the same. That would allow the aggregation of “diffuse parcels of information” — and this case the market would function to aggregate that information, because the price in these markets can be pegged explicitly to social outcomes — and give government access to knowledge it would otherwise miss.

  6. 

    Perhaps I was unclear. What I am saying is that the rule of law can be instrumental to well-functioning markets, while other forms of regulation can be socially wasteful because they interfere with the decentralized allocation.

    Enforcement of property rights is “regulation,” but most economists who believe that we should “let the market figure it out” believe that we should have strong third party enforcement of such rights, and that such regulation is socially productive and possibly even necessary for well functioning markets. The question is whether the proposed regulation is going to interfere with or facilitate the efficient allocation. Many times, the answer is the former (i.e. rent control, price gouging legislation, among many others). Sometimes, i.e. enforcement of property rights, the answer is no.

    Whether or not the statement is useful, I suppose, depends on the audience. I hope we can all agree that a full blown attempt to completely address any public policy problem requires more than a 6 word mantra. But many charged with proposing such regulations would be well served by a better understanding of the market mechanism they seek to replace and the potential costs and consequences of the proposed regulation. This, I think, is a simple point. The second is that no matter how “useful” the mantra, the mechanism behind decentralized allocation is not a “simple” solution. This is the point I was attempting to make in the post.

  7. 
    Steven Donegal 16 June 2006 at 4:37 pm

    If what you are saying is that part of “let the market figure it out” is how the market should be regulated or incented, I suppose we don’t have a disagreement. In that instance, I would also have to agree with your commenter that the statement isn’t very useful.

  8. 

    Thanks for the comment Steven. Let me respond with a few thoughts.

    In this post I responded to the frequently heard complaint (maybe you hear it less frequently than I?) that “let the market figure it out” is overly simplistic lacks nuance. Here, you raise a separate complaint that boils down to the basic point that the rule of law is an important part of markets outperforming their centrally planned counterparts.

    I agree! Who said anything about “unregulated”? The rule of law is an important underlying condition to the proper workings of markets, i.e. property rights must be enforced, etc. Let’s take your own example of unregulated markets evolving into monopolies. Enforcement of the antitrust prohibitions against price-fixing are an important component of ensuring that unregulated markets to not fall victim to collusion. Though let me note here that I object to your suggestion that deregulation is as likely to result in monopoly as government intervention. But holding that aside to address what I take to be your larger point …

    In other words, a preference for allowing the market to make resource allocation decisions is not the same thing as desiring the government to disappear into the ether. Governments have important roles to play in markets in enforcing rights. And while I agree with you that defining that role with precision is an important question, this point does not render a preference for decentralized allocation of resources “simplistic.” Rather, it is typically a useful starting point for thinking about what types of regulation will be socially productive.

  9. 

    Why do you assume that free-markets result in monopoly? There are, historically, virtually zero monopolies without government intervention.

  10. 
    Steven Donegal 16 June 2006 at 12:46 pm

    The problem is that you pose a duality (unregulated markets v. central planning) that in practice lead to largely the same result–inefficient resource allocation either through monopoly or bureaucratic corruption. The complaint about “let markets figure it out” is that it does not address what level or type of regulation is appropriate (which is usually the question that matters).