Posts Tagged ‘Economics’

Older Entries »
h1

Alex Tabarrok on innovation, barriers to it, and the warfare-welfare state

February 13, 2012

Lynne Kiesling

I was glad Mike mentioned Alex Tabarrok’s recent Launching the Innovation Renaissance in his recent post on the Honeywell-Next patent lawsuit, because reading Alex’s new TED book was on my to-do list for this past weekend. Alex’s focus in this book is U.S. innovation policy and ways that we could improve the institutional environment to better enable innovation to create opportunities for people to thrive, and consequently to create growth. He analyzes the patent system, education, and how the federal warfare-welfare state has a high opportunity cost in terms of resources that could be dedicated to R&D (through both public and private funding) but aren’t because of the heavy burden of defense and entitlement spending.

An important variable on which Alex focuses is the ratio of development costs to imitation costs, and he argues that laws such as patents are more likely to be positive-sum and pro-growth in industries with high development costs and low imitation costs. He discusses pharmaceuticals as the canonical industry in this category, where the absence of patents would be likely to reduce the amount of new drug development. But patents in other industries with lower development costs and lower imitation costs can hinder innovation, because they discourage the use of ideas in novel, unexpected ways by people other than the patent-holder. Moreover, notice the dynamic incentives that the current patent system presents to engage mostly in defensive patenting, which is wasteful and reduces the extent to which patents are positive-sum. The high-profile activities of patent trolls in technology-related industries in the past decade indicates just how wasteful this perverse incentive is.

One of Alex’s recommendations to reform the patent systems is variable patent duration in accordance with these differences in development costs and imitation costs. For example, from the book, one-click shopping and a pharmaceutical that cost millions of dollars to develop both receive 20-year patents. Uniform patent length means that the patent system ignores the importance of both development costs and imitation costs in determining whether the monopoly granted by the patent will be positive-sum or not. Granting different monopoly lengths depending on the interplay of development costs and imitation costs in that industry when the invention is created would enable developers to recoup costs while reducing the lost beneficial applications of imitation. Note in particular that a lot of these beneficial applications are not direct imitation, but are rather creative uses of the idea as an input into some other idea. Patents that are either too long or too broad (or both) deter such beneficial activity.

For brevity I’ll skip over his thought-provoking discussion of education (but I do recommend it to your attention), and connect the patent discussion to the implications of federal warfare-welfare spending for whether or not we have an institutional environment that is conducive to unleashing innovation. Alex presents some sobering data on federal government spending on research, entitlements, and defense, data that he elaborates on in a post at Marginal Revolution today in which he puts a NY Times article on the welfare state in the context of his argument.

And that doesn’t even take into account the important, but trickier to estimate, effect of government spending on private R&D funding (the crowding out question). Crowding out can take two forms — government spending on R&D reducing private R&D spending, or government spending on other goods and services reducing the resources available for private R&D spending.

Alex boldly makes what I think is the crucial material point:

The point is not simply that the U.S. should spend more money but that a state with these kinds of budget priorities does not have innovation at the center of its vision. If innovation is not central to the vision, then it is inevitably given short shrift.

Given the incontrovertible evidence that low barriers to innovation are the biggest ultimate institutional cause of the unprecedented growth in well-being and living standards over the past 250 years, the absence of this innovation vision is backward-looking and short-sighted.

Alex also highlights the extent to which regulatory thickets generate wasteful spending, particularly in health care and energy. Money we could spend on medical research and basic energy research gets spent instead on regulation-induced bureaucracy and wasteful projects like Solyndra and others that have failed. Reducing these regulatory thickets and focusing more vision on innovation and basic research than on bureaucratically-weighted and centrally planned projects would be an important incremental move in the right direction. To the extent we’re going to have a state, we should move from a warfare-welfare state to an innovation state.

Sadly, I think Alex is right about the political economy of innovation when he notes that “… few people lobby for innovation because almost by definition, innovation creates present losers and future winners and the present losers are by far the more politically powerful. Innovation has few champions.”

The book closes with seven institutional/policy recommendations touching on patent reform, education, regulation, and open trade in goods, services, and ideas. These recommendations also have implications for issues like immigration and health care.

One of the most valuable features of this book is how well written it is. While being a short, easy, compelling read, it’s a book dense with good and thought-provoking ideas presented clearly for non-specialists (and backed up by extensive references at the end for further analysis). I don’t remember where I saw it, but I think someone commented that we should send a copy of Alex’s book to every member of Congress and their staffers. That would be a valuable education process.

See also a short essay drawn from the book, and listen to Alex’s EconTalk podcast with Russ Roberts discussing the book.

Posted in Economics, Regulation, Technology | Tagged , , | 1 Comment »

h1

Dynamic pricing and technology in different markets

February 10, 2012

Lynne Kiesling

Dynamic pricing has long been a topic of great interest here, in large part because digital technology is increasingly making it feasible to implement dynamic pricing in retail electricity markets in ways that can be acceptable to consumers. But dynamic pricing is fraught with challenges, and not just in retail electricity markets. Dynamic pricing is a form of price discrimination, and as such can improve efficiency; prices also are knowledge surrogates, communicating diffuse private knowledge about the relative scarcity of that good in that place at that time. Dynamic pricing is also most applicable in markets in which demand varies over time, and if you are going to implement dynamic pricing without annoying and aggravating consumers, consumers have to have access to the prices in advance.

These general principles showed up recently in a kerfuffle over dynamic pricing of taxi services by a new firm called Uber:

On New Year’s Eve, Uber, a start-up in the city, adopted a feature it called “surge pricing,” which increases the price of rides as more people request them.

Although New Year’s Eve was very profitable for Uber, customers were not happy. Many felt the pricing was exorbitant and they took to Twitter and the Web to complain. Some people said that at certain times in the evening, rides had spiked to as high as seven times the usual price, and they called it highway robbery. Uber’s goal is to make the experience as simple as possible, so customers are not shown their fare until the end of the ride, when it is automatically charged to their credit card. While the app does not show the total fare in dollars when customers book a ride, Uber did show a “surge pricing” multiple to customers booking rides for New Year’s Eve.

So what’s the underlying economics here? Jodi Beggs comments on the kerfuffle starting from first principles, pointing out that when demand increases, consumers are not likely to be able to get the quantity they want at the price to which they may have gotten habituated as “the price”. She also points out that the dynamic pricing is what keeps shortages from occurring — think about it: would you rather pay 7 times the base fare to have an immediate ride home after your New Year’s Eve party, or would you rather wait in line for the next available car? Either way, you pay; opportunity cost matters. In other words, as my colleague Jeff Ely observes, variable pricing means that prices go up and down, and generally will be higher when more people want the good (due both to higher and more inelastic demand at that time and to higher relative scarcity). Note that these observations also apply to retail electricity pricing — market demand varies over time, and prices can signal relative scarcity, if regulators allow them to.

The relative scarcity is another aspect of the economics here, because in the immediate run the firm can’t go out and scare up more cars and drivers; in other words, supply is not going to increase. Here we see the analogue to other industries that use dynamic pricing, such as airlines and hotels and car rentals — they have a pretty fixed supply, so as demand rises and falls the price to the consumer will rise and fall accordingly, because the supply response at the time is so limited. Over time profit signals will indicate to them whether or not to invest in more cars, planes, hotels, but if you’re trying to get home on that New Year’s Eve that’s not going to kick in that quickly. Thus prices adjust to communicate relative scarcity.

But notice another aspect of the story of Uber’s pricing: although they told the customer what the “surge multiple” was when they called the car, the customer doesn’t know the fare until after the transaction has occurred. Here I concur entirely with the NY Times blog post, Jodi, and Jeff, that not informing customers ex ante about at least an estimate of the fare is a bad way to implement dynamic pricing! Especially for flesh-and-blood humans who are more than calculating machines, and are likely to be royally ticked off when they are charged 7 times base fare for such a short ride. The NY Times blog post quotes Yale economist Dirk Bergemann, saying that consumers prefer price predictability, which is true as a very broad claim … but if I draw an analogy from regulated retail pricing in electricity (and using a rhetorical trope of Jeff’s), consider the equilibrium. If instead they kept their fares constant, it’s entirely possible that the average fare could be higher in the single fare market design than in the dynamic pricing market design. That’s one of the anxious concerns that regulated electricity firms have about dynamic pricing — what if our revenue falls because a large enough share of demand ends up happening in low price periods (i.e., more demand is more elastic)? In any case, not giving customers at least an estimated fare before they commit to the order is bad business, and it should be easy to communicate that estimate, because customers are all using smart phones to order the cars.

I’d like to suggest a couple of alternatives that my colleagues did not. The first alternative is inspired by time-of-use pricing as used in electricity, or by the types of dynamic pricing contracts used in car rentals. If I know well enough in advance that I want a car at 2AM on New Year’s Eve, why not offer me a contract in which I can make a reservation at a firm price, albeit one that is higher than the base price? Then Uber could, say, take reservations for 50% of their fleet, and leave the other 50% open for spot-market transactions. With that model, those customers who are risk averse and want to make sure to have a car at a particular time at a reasonable price will have an option. But if they can’t commit to a time for a pickup, then they suck it up and deal with the spot market.

The second alternative is less relevant to the Uber example, but in lots of markets that could have dynamic pricing, we can use technology to automate our responses to the price. I’ve gone on ad nauseam about the potential for transactive technology in retail electricity markets, and it’s applicable in other markets too — automated reservation bots for making a flight reservation if the price on your preferred itinerary on your dates goes below a trigger price that you set, or a device in your car or an app on your phone that receives the current toll level and tells you whether or not to take the toll road, wait to go home, etc. Transactive technolgies reduce the cognitive barriers associated with price uncertainty, as well as reducing the transaction costs of using dynamic pricing in the first place.

Posted in Economics | Tagged , | 1 Comment »

h1

New paper: Knowledge Problem

February 9, 2012

Lynne Kiesling

I have a new paper that may be of interest to KP readers, since the subject of the paper is the same as the name of this site: Knowledge Problem. I am honored to have been invited to contribute this paper to the forthcoming Oxford Encyclopedia of Austrian Economics (Peter Boettke and Chris Coyne, eds.). Here’s the abstract:

Hayek’s (1945) elaboration of the difficulty of aggregating diffuse private knowledge is the best-known articulation of the knowledge problem, and is an example of the difficulty of coordinating individual plans and choices in the ubiquitous and unavoidable presence of dispersed, private, subjective knowledge; prices communicate some of this private knowledge and thus serve as knowledge surrogates. The knowledge problem has a deep provenance in economics and epistemology. Subsequent scholars have also developed the knowledge problem in various directions, and have applied it to areas such as robust political economy. In fact, the knowledge problem is a deep epistemological challenge, one with which several scholars in the Austrian tradition have grappled. This essay analyzes the development of the knowledge problem in its two main categories: the complexity knowledge problem (coordination in the face of diffuse private knowledge) and the contextual knowledge problem (some knowledge relevant to such coordination does not exist outside of the market context). It also provides an overview of the development of the knowledge problem as a concept that has both complexity and epistemic dimensions, the knowledge problemʼs relation to and differences from modern game theory and mechanism design, and its implications for institutional design and robust political economy.

In this paper I analyze the development of the two categories of the knowledge problem — the complexity knowledge problem and the contextual knowledge problem — and explore both the history of the development of these concepts and their application in robust political economy and new institutional economics. As is the hallmark of a good research project, I think on balance I learned more than I created in the process of writing this paper.

One other thing I made sure to include was a discussion of how the knowledge problem and its development relates to game theory and mechanism design, through the work of Oskar Morgenstern (and then through some of the work of Herb Simon and Vernon Smith, among others).

Tying together economics, institutional design, history of thought, and epistemology, I hope you find this paper informative and useful! I’ll also make sure to update when the full volume is available.


Posted in Complexity, Economics | Tagged , , , , | 3 Comments »

h1

SOPA/PIPA protests and the economics of content market power

January 19, 2012

Lynne Kiesling

I found some things striking in yesterday’s SOPA/PIPA protests. One was Jim Harper’s clear and cogent statement that the Internet is not a thing, it’s a set of protocols stipulating how computers communicate with each other. That set of protocols is a platform, and those protocols are not the government’s to regulate.

Jim’s Cato colleague, the ever-reliable Julian Sanchez, points out that if you estimate the profits/surplus at stake from piracy relative to the lost value all of the other Internet activities that would be stifled under SOPA/PIPA, the cost of piracy is just not that large. Sure, it’s concentrated in the hands of politically-powerful entertainment content companies, but relative to the rest of the vibrant, dynamic value creation that would “be disappeared” it’s small. Moreover, domestic and international legal institutions already exist to deal with piracy; like any other human institution they are imperfect, but as a consequence of them the losses from piracy are small relative to what would be lost if Congress imposed SOPA/PIPA. Here’s a good, short video from Julian covering some of the basics:

At Digitopoly, Joshua Gans makes an analogy near and dear to my heart: consider how SOPA/PIPA would make the Internet more like the arbitrary, intrusive, Constitution-free zone that is our airports:

But the notion that enforcement and prevention matters will be put in place that create massive harm to the lives of innocent individuals while being unlikely to really actually led to less of the activity targeted is not unprecedented. You can think about this every time you go through a US airport and think about who is winning there. …

So the scenario that US people should be concerned about is if publishing on the Internet becomes like airport security. That is, if copyright enforcers are able to automate enforcement without due process. That will raise the costs of publishing and will deter many. As is often the case with over-reaching laws, the problem is that it creates too few incentives for enforcers to enforce discriminately rather than indiscriminately.

These contributions to the discussion have all been outstanding, but the most useful one in my estimation is this TED video posted yesterday from Clay Shirky on the issues at stake in the SOPA/PIPA debate:

It really is a must-watch video, well worth 10 minutes of your time. Shirky describes the technological issues clearly for non-techies and delves helpfully into the legal history of copyright in media, but then makes the crucial economic point when he says “Time Warner wants us all back on the couch and not creating our own content”. In all of the justifiable furor about censorship, this is the economic point that gets a bit lost. For the past 70 years the entertainment companies have had a lot of market power, because entertainment was essentially an oligopoly. They profited handsomely from their market power over content. But with the decentralization and edge content generation now possible due to technology, and with the way that their content provides an input into that edge creation, we now have many more substitutes for their content. They are using the piracy red herring (which is not as large as they claim it is, as Julian points out above) to try to retain the viability of their decades-old business model and market power over content. That’s the real economic issue here — they want us back on the couch and in the movie theater.

This is a fight that is not new with SOPA/PIPA and the Internet, nor will it end with the Congressional retreat from these ill-designed pieces of proposed legislation. Yesterday raised a lot of awareness of the issues, but it’s going to have to happen over and over and over …

I’m going to give the last word to my friend Sarah, who makes a useful analysis of language and its use in the context of both SOPA/PIPA and the recently signed into law National Defense Authorization Act, complete with its provisions that allow extralegal detention of American citizens without due process on suspicion of terrorist activity. Sarah offers an analysis of Orwellian Newspeak language, and identifies disturbing parallels with our current environment:

It struck me today that the combination of SOPA/PIPA and the NDAA move us terrifyingly close to an Orwellian world where people, language, history, and information can disappear at any time. Forever. As if they never were. And worse than that, our primary way to discuss/protest/remedy that disappearance–the Web–will be taken from us as well. …

Newspeak as a language, then, mirrors the political system that creates it, and serves to support it and perpetuate it by creating an agreed upon reality where meanings are strictly limited, the possibility for unorthodox thought is all but eliminated, and an agreed upon “reality” allows Ingsoc to have been always in control. Winston’s friend Syme is correct that “Newspeak is Ingsoc and Ingsoc is Newspeak.”

I leave further connections to the contemporary political situation as an exercise for the reader.

Posted in Economics, Liberty, Politics, Regulation | Tagged , , , , | 2 Comments »

h1

Music, harmony, and social cooperation

December 23, 2011

Lynne Kiesling

I am a big fan of English renaissance choral music, particularly sacred polyphony from Tallis and Byrd (and stretching back to Taverner, but he’s not as distinctively polyphonic). One of the best ensembles performing such music is Stile Antico, a group of 13 British singers who do an outstanding job with this music, and whose recordings I have recommended here before. Especially at this time of year, their music really resonates and adds joy and beauty to life.

A couple of weeks ago we got to hear Stile Antico perform live in Milwaukee: Thomas Tallis’ Puer Natus Est mass interspersed with pieces from Byrd, White, and Taverner. The music was gorgeous, the voices delightful, and the artists charming and gracious.

But what really struck me was their method of decentralized coordination. Typically when we think of musical performance beyond, say, a chamber quintet, coordination involves hierarchy in the form of a conductor, to “keep everyone on the same page”. The larger the number of performers doing different things, the harder to coordinate, and therefore the greater need for a conductor … right?

Not so in this case. 13 singers, each with a particular part, bringing a distinctive element to the work. But in some ways the music is simultaneously so lush and yet so spare that if their timing is off, the beauty of the result is diminished. 13 singers with no conductor, and they coordinate by taking their visual and verbal cues from each other in a dynamic and evolutionary manner. This is a vivid example of decentralized coordination.

Of course the goal is harmony (in the general sense). If each individual acts and reacts to the actions of the other individuals in a way that produces a harmonious outcome, that’s beauty. And it’s an emergent outcome; each has his or her own score and acts accordingly, adapting to the actions of the others in a way that creates emergent harmony.

The music metaphor illustrates achieving emergent order through decentralized coordination, and it’s a metaphor for social cooperation too. Adam Smith employs the harmony metaphor for social cooperation in The Theory of Moral Sentiments, in which he invokes harmony as a desirable outcome of social interaction repeatedly (and refers to the music metaphor directly in the last reference). Note the emphasis on harmony as distinct from uniformity — each individual brings personal, private, heterogeneous features to social interaction (whether musical or economic), and they are not the same, not uniform. Each has an incentive, a desire to coordinate, to harmonize; in music it’s finding the complementary notes, in social systems it’s grounded in our innate desire for sympathy and mutual sympathy, according to Smith. Each individual brings something different to the party/performance/market.  The most beautiful and sublime outcomes emerge when each acts on its individual traits with a view toward creating harmony and sympathy. And it does not necessarily require the top-down imposition of control or system-wide hierarchy, but can be achieved through decentralized coordination.

Of course there are limits to applying the music metaphor to institutional design and social cooperation, such as the scale/number of actors. But it reminds us of the possibility of cooperation and harmony through decentralized coordination, without the need for imposed system-level control.

 

Posted in Complexity, Economics | Tagged , , , | 7 Comments »

h1

Breaking news: State regulatory procedures do not favor consumers

December 22, 2011

Lynne Kiesling

As is the vernacular these days, your response to the title of this post is probably “I know, right?” Or, if you prefer sarcasm, you may say “no, really?” This is the conclusion of an all-too-rare piece of investigative journalism from Dan Garino at the Columbus Dispatch:

Ohio’s unique system for setting electricity rates has created a quagmire of regulations that have benefited industry over consumers. …

The rate increases stem from a complex regulatory approach unlike any other in the country, one that combines elements of both regulated and free-market systems.

Beyond that, The Dispatch found during a yearlong investigation that the state’s regulatory structure misses what many observers see as the underlying problem: Utility companies have tremendous political power that tends to overshadow consumers’ needs in the process.

This lengthy article goes into detail on the legislative history of electricity restructuring in Ohio and the political economy of utility lobbying of legislators, as well as the role of the Public Utility Commission as regulator in this hybrid restructured state. If you are interested in electricity or the political economy of regulation, it’s a worthwhile read — a case study in public choice theory.

In its early years of restructuring, Ohio was held out as a leader with strong potential for consumer-oriented retail competition, but over time that competition has not emerged. One of Ohio’s institutional innovations was “aggregation”, or allowing municipalities to act as a retail aggregator on behalf of a set of customers, in that case its residents. But Ohio’s legislators and regulators did not pay adequate attention to the unintended consequences of the political compromises they made that would continue to serve as entry barriers to potential retail competitors, including aggregation.

In terms of the PUCO regulatory procedures and the processes through which debate and discussion are supposed to happen, the article makes a lot out of the unanimity of the Commission’s decisions, but does not dig into the very formal (and formulaic, I think) procedures for filing comments on cases. That process, and its positive and negative consequences, is in and of itself worthy of a lengthy analysis; because of that process, most issues that the commissioners have are likely to be resolved before the ultimate vote, so unanimity is not that surprising. It’s not unique to Ohio, though.

I don’t want to comment on the particulars of Ohio, but I think that most of the states that have implemented regulatory restructuring have a similarly tortured legislative and regulatory story to tell. This Franken-restructured status arises out of a politically-motivated desire to “ring-fence” competition, to capture the benefits of utilities being able to purchase power in competitive wholesale markets, but to control and manage the retail market in ways that create the (realistic, IMO) impression that retail customers are still subject to the regulated monopoly. Ohio’s record on that front is not good, but Ohio is not alone in that camp.

Posted in Economics, Electricity, Regulation | Tagged , , | 1 Comment »

h1

Waterless fracking?

December 21, 2011

Lynne Kiesling

Pale Rider is one of my favorite Clint Eastwood movies. One of its central themes revolves around classic property rights concepts in a community of miners that includes a number of small pan miners and a family that has built a larger, hydraulic mining operation that essentially uses pressurized water to blast rock hillsides apart and release the valuable gold therein. This hydraulic mining harms the mining potential of the downstream pan miners, reducing the value of their property. It’s a vivid example of property rights and Coase’s point about the reciprocal nature of costs when the actions of community members are interdependent. Of course, as director Eastwood heightened the dramatic conflict by making the hydraulic mining family greedy and mendacious, but that’s not necessary for there to be an underlying property rights conflict.

Pale Rider came to my mind yesterday afternoon, when I happened on an interview with Daniel Yergin on Fox Business. The interviewer asked him about fracking as a “new” technology and the US prospects for energy independence (oh, how I wish people would just get over that), and he pointed out that fracking is being used both for natural gas and for “tight oil” (which all KP readers know thanks to Mike, but I think a lot of people don’t). But Yergin also corrected her assertion that fracking is a new technology, mentioning very briefly that this technique in one form or another has existed for a long time. Fracking as we know it has been around for decades, but almost as soon as Evangelista Torricelli discovered atmospheric pressure and the vacuum in 1643, people started exploring using pressurized fluids to do work that they and their animals could not. In the 19th century that included hydraulic mining to get at subsurface mineral deposits.

Yergin’s remark triggered my Pale Rider memory, and the economic parallels between the issues in using hydraulic mining in Pale Rider and hydraulic fracturing today are strong — conflicts over the use of resources with ill-defined property rights, environmental impact, changes in potential profitability of using resources in different ways, etc. In particular, conflicts arise about the quantity of water used and water quality post-fracking. Again, thanks to Mike I think we understand those issues well.

I’ve been wondering about the next step in the chain of Coasian logic: if property rights and legal liability are defined so that energy companies are liable for harms they create (water scarcity or contamination), does that induce harm-reducing innovation? In the abstract, theory suggests that such innovations would fall into the two categories, waterless fracking and water remediation and purification.

And it is happening, although in its infancy and still more expensive than using water. Consider this Forbes article from Erica Gies about innovations in waterless fracking. The relative value of such innovations is going to be highest in places like Texas, as she observes:

Water shortages and conflicts are on the rise due to increasing population and climate change–caused fluctuations in precipitation that are making drought more frequent and severe in some places.

One of those places is Texas, where this summer’s mega-drought invoked comparisons with the 1930s Dust Bowl, as ranchers sold their emaciated animals for a song and agricultural losses soared to more than $5 billion.

As a result, gas industry projects in Texas had to scale back, as energy producers scrambled to find sufficient water.

She then points to a couple of different approaches being developed — liquified (again note the role of atmospheric pressure!) propane gel injected instead of water and which may be reusable, and a vapor “foam” that may reduce water use by 95 percent. I think her conclusion accurately captures the tradeoffs involved, and the role that innovation can play in reducing harms from fracking:

These technologies are in their infancy, and many questions about efficacy, impacts, and cost remain to be answered before they could move into widespread use. And of course, reducing water consumption does not mitigate concerns about prolonging our reliance on fossil fuels or the inherently ugly nature of extractive industry, especially for local neighbors.

But for the gas companies, although such technologies are currently more expensive than water, they offer the promise of reducing myriad headaches and expenses, including costs for hauling water and sand, repairing roads damaged by heavy truck use, and managing water pollution, including “produced” water disposal.

Gies wrote earlier in the year about innovations in water cleaning and business opportunities for wastewater treatment companies, providing concise background on the use of water in fracking. I also read an article last week (that I can’t locate now) about the potential to use technologies developed for oil spill cleanup to clean fracking water. Innovation changes some of the tradeoffs involved in fracking.

Posted in Economics, Energy markets | Tagged , , | 1 Comment »

h1

David Henderson on crony capitalism

December 17, 2011

The KP Chicago contingent is still on vacation, barely recovered from the end-of-term rush and grading, and the KP Texas contingent is still head-down-pen-moving over the aforementioned grading; thus the relative calm here.

In the interim, I cannot recommend highly enough David Henderson’s recounting of his talk at Occupy Monterey. David’s notes contain substantive and rhetorically valuable arguments defining crony capitalism, differentiating it from true market exchange, and debunking the history of the “robber barons”. He sets a great example for teaching, for persuasion, and for open-minded conversation to discover where people who disagree may find common ground. Thank you, David; I am looking forward to part 2.

Posted in Economics, Politics | Tagged , | Comments Off

h1

“Market failure”: you keep using that term. I do not think it means what you think it means.

December 8, 2011

Lynne Kiesling

Steve Horwitz’s column in The Freeman today is a great explication of why the phrase “market failure” is so problematic, and so often misused and abused in public policy analysis when employed to criticize market outcomes. Steve does a good job of explaining the origins of the phrase in the standard textbook case of “perfect competition”: in equilibrium that simple benchmark model, resources are allocated to their highest-valued use, all Pareto-improving trades have occurred, and while firms have earned inframarginal profit, the marginal profit at the equilibrium level of output is zero. More simply, all gains from trade have been exploited and no one has left any money on the table. Thus, the argument goes, in applying that model to reality when we see outcomes that deviate from that and do have misallocation or some unrealized gains from trade, the logical conclusion is that the market has failed to enable agents to achieve that optimal outcome.

Steve highlights two reasons why this interpretation is incorrect; the first reason is a misunderstanding of the nature of competition and the market process as it operates in real conditions of the knowledge problem, imperfect foresight, differentiated products, small numbers of agents, etc. People making the above critique of markets expect a threshold of unrealistic perfection, and consequently make an unfair comparison of a simplified benchmark model with the complications and nuances of a real-world application. I encounter this argument all the time in electricity regulation, which is predicated precisely on this type of false, over-simplified argument, and has a century’s worth of regulatory institutions built upon the false presumption that achieving such a static outcome in reality is possible.

One thing I particularly like about Steve’s argument is how he points out that these cognitive-epistemological characteristics of the real world are features, not bugs, with respect to how market processes create value and gains from trade:

… these sorts of imperfections (a better term than “failure”) are not only part and parcel of real markets; they also are what drive entrepreneurship and competition to find ways to improve outcomes.  In other words, what markets do best is enable people to spot imperfections and attempt to improve on them, even as those attempts at improvement (whether successful or not) lead to new imperfections.  Once we realize that people aren’t fully informed, that we don’t know what the ideal product should look like, and that we don’t know what the optimal firm size is, we understand that these deviations from the ideal are not failures but opportunities.  The effort to improve market outcomes is the entrepreneurship that lies at the heart of the competitive market.

Thus the value of markets is not that they will achieve perfection, but that they have endogenous processes of discovery that enable people to correct the market’s imperfections.  Just as it’s the very friction of the soles of our shoes on the floor that enable us to walk, it is the imperfections of the market that encourage us to find the new and better ways to do things.

He then counters a second aspect of the “market failure” argument: this argument is typically coupled with a recommendation for some form of government intervention or regulation to “correct” the perceived failure. But if market processes in realistic contexts have imperfections, don’t government intervention and regulation have imperfections too? The relevant comparison is between the results of market institutions and government institutions in realistic contexts, not in simplified blackboard theory.

I would add a third point to this analysis. Often when I encounter the “market failure” argument I make a quick riposte of “markets don’t fail, they fail to exist”, which is the Coase/transactions cost response. Transactions costs interfere with the ability of parties to find mutually beneficial trades, thus impeding optimal resource allocation and the creation of maximum gains from trade. Transactions costs lead to missing markets, as in the case of environmental pollution and other common-pool resource situations. This driver of so-called “market failure” complements Steve’s process-oriented argument and reinforces his points … and it implies that one high-priority objective of public policy should be to reduce transactions costs, not to impose regulations that are intended to “correct” market failures but have little realistic hope of doing so effectively.

[Thanks to Aeon Skoble for the Princess Bride hook I used in the title.]

Posted in Economics | Tagged , , | 7 Comments »

h1

An example of what not to do in persuasion

December 6, 2011

Lynne Kiesling

Alex Tabarrok has an excellent post this morning at Marginal Revolution:

David Warsh and Paul Krugman try to write Hayek out of the history of macroeconomics. …

It is true that many of Hayek’s specific ideas about business cycles vanished from the mainstream discussion under the Keynesian juggernaut but what Krugman and Warsh miss is that Hayek’s vision of how to think about macroeconomics came back with a vengeance in the 1970s. …

… Hayek was an important inspiration in the modern program to build macroeconomics on microfoundations. The major connecting figure here is Lucas who cites Hayek in some of his key pieces and who long considered himself a kind of Austrian.

I offer this as a cautionary “what not to do” note to students in particular, but also to all of us. In the piece to which Alex is responding Krugman chooses his definition of “modern macroeconomics” in a way that clearly maps into his preconceptions and reflects his confirmation bias. Such a rhetorical stratagem is unscientific and anti-intellectual. It’s also easy to critique (no disrespect intended for Alex’s good, pointed critique) by simply looking at the literature and seeing that modern macro encompasses a breadth of ideas and approaches, many of which are substantially informed by models and methodological approaches that Krugman chooses to reject.

Thus both on intellectual grounds and with a view toward crafting an argument that is persuasive to those who don’t already agree with you and share your worldview, don’t do this. Being more ecumenical and treating the contributions of your intellectual opponents with respect will make your arguments more thorough, effective, and persuasive.

On a substantive note, I’d like to echo the recommendation that Jacob Levy made in the comments on Alex’s post; the conclusion of Warsh’s essay is a good one, and suggests that incorporating more of a complexity approach into macro would enable us to build better models:

That said, it is pleasing to think that Hayek himself may yet turn out to have been a very great economist after all, far more significant than Myrdal or Robinson, when seen against the background of a broader canvas. The proposition that markets are fundamentally evolutionary mechanisms runs through Hayek’s work. Caldwell, of Duke University, notes that, starting with the Constitution of Liberty, “the twin ideas of evolution and spontaneous order” become prominent, especially the idea of cultural evolution, with its emphasis on rules, norms, and decentralization.

These are today lively concepts in laboratories and universities around the world. “It could have been that Hayek was running a different race, and the fact that he didn’t do well in the Walrasian race was that he wasn’t running in it—he was running in the complexity race,” says David Colander, of Middlebury College. Hayek may yet enter history as a prophet of evolutionary economics, a discipline dreamt of since the days of Thorstein Veblen and Alfred Marshall in the late nineteenth century but not yet forged, whose great days lie ahead.

UPDATE: See also Pete Boettke on this same theme, motivated by Alex’s post.

Posted in Complexity, Economics | Tagged , | 1 Comment »

Older Entries »
Follow

Get every new post delivered to your Inbox.

Join 47 other followers