In Response to Donald Low
Donald Low responded to my piece from yesterday.
In his response, he now concedes that the concept of market failures is given coverage in introductory econ classes. But I’m afraid this was not the impression given to his readers from his original co-authored article, which in my opinion gave more the impression that Econ 101 was suffering from an overwhelming pro-market ‘neoliberal’ bias, hence prompting my response.
In fact, if we look at arguably the most popular contemporary economics textbook today, Gregory Mankiw’s Principles of Microeconomics, whole chapters are dedicated to so-called market failures such as monopolies and externalities, or how to design the tax system. Not to mention, there is scarce mention of key market institutions such as property rights or the Rule of Law. Hardly a pro-market bias.
The fix to simplistic Econ 101 is not Government 101
Yet there is good reason to be sceptical of government interventions despite the fact that markets are imperfect.
The case for successful government action does not merely depend on competent and benevolent politicians – electing the ‘right people’, so to speak – as many commonly believe. It also depends the types of rules that characterise the political process, how interest groups mobilise, and how informed voters are. In other words, how liberal democracies function. All of these determine the efficacy of when we claim the government should do something. These are the central lessons of Public Choice economics, of which James Buchanan won a Nobel Prize for.
Yet only a mere four pages for Public Choice are dedicated to Mankiw’s signature textbook. Eamonn Butler’s free primer to this research area is instructive for why free-market intellectuals are distrustful of state action. And no, it’s not a mantra of ‘government bad, markets good’ as some would have you believe.
This is why I found his claims that there is a pro-market bias in Econ 101, or that market failure is ‘underemphasised’ severely puzzling.
The case for free markets
Yet all these does not get at the heart of the issue, which is that both the type of Chicago school pro-market neoclassical economics that Donald Low criticises and many anti-market economists are both guilty of the same error.
And that error is that they are both wedded to the neoclassical core where the normative benchmark for informing policy is the famous economic fiction of a perfectly competitive economy in full equilibrium, populated with fully rational utility-maximising actors, judged against the standard of Pareto-efficiency. Because we are inevitably never in such a state, the market is perpetually in failure and the focus of the policymaker is invariably always on correcting this ‘imperfection’.
This commits the grave mistake of misunderstanding the role of competition. Market competition is a coordinative process through time. This process takes place within a free market system of three primary components:
- Private property
- A stable price system
- The profit and loss calculus
Private property (complemented by the Rule of Law) gives entrepreneurs the confidence and security to invest, knowing they can reap tomorrow’s profits. The price system allows them to forecast their plans by using freely fluctuating prices to guide their investment decisions. Finally the profit & loss mechanism, plays the essential role of revealing error (when entrepreneurs incorrectly meet consumer demand) and rewarding correct decisions (when they provide consumer value).
It is only under this institutional framework that market competition can function to the benefit of the public interest: Adam Smith’s invisible hand postulate.
Where economics really went wrong
What Econ 101 teaches students instead, is that markets are portrayed as working perfectly fine based on all these questionable assumptions, yet does not explain how is it that it actually comes to work.
For instance, the assumption of ‘perfect competition’ is taught as one aspect of the ideal benchmark which we should judge the efficiency of an economy against. But this is wrong and misleading because such an assumption merely assumes away the economist’s task of explaining how is it that demand and supply in an economy converge under conditions of bounded rationality and ever-changing human desires and values.
Two Nobel Laureates recognised this folly early on. F. A. Hayek captured this insight as early as 1946. James Buchanan similarly exposed this fallacy in his seminal 1964 essay What Should Economists Do?:
A market is not competitive by assumption or by construction. A market becomes competitive, and competitive rules come to be established as institutions emerge to place limits on individual behavior patterns. It is this becoming process, brought about by the continuous pressure of human behavior in exchange, that is the central part of our discipline, if we have one, not the dry-rot of postulated perfection. A solution to a general equilibrium set of equations is not predetermined by exogenously-determined rules. A general solution, if there is one, emerges as a result of a whole network of evolving exchanges, bargains, trades, side payments, agreements, contracts which, finally at some point, ceases to renew itself. At each stage in this evolution towards solution, there are gains to be made, there are exchanges possible, and this being true, the direction of movement is modified.
For more on this, see Don Boudreaux’s brilliant discussion here.
Market institutions cope better with complexity
In sum, yes, I fully agree with Donald Low that the inadequate neoclassical economics framework has been used to justify pro-market arguments that have come up lacking. But many of these erroneous analytical tools have similarly been marshalled by market failure and Keynesian economists who are arguing for government interventionism. (The most authoritative piece on this subject is Peter Boettke’s Where did economics go wrong? Modern economics as a flight from reality).
Behavioural economics, of which he claims to be a supporter of, is not exempt from some of these neoclassical errors. I have written about this elsewhere.
It is heartening to know that Donald Low goes beyond simplistic economics and recognises the role of institutions and complexity. But on this note, he should also acknowledge that some of the best works done on this is precisely done by some of the biggest champions of markets.
Economic giants such as F. A. Hayek and James Buchanan made a strong case for free markets without depending on the neoclassical toolkit of homo economicus and perfect competition taking place within an institutional vacuum that Low and his co-author rightfully condemned.
And they are not alone. The economist Israel Kirzner opened the black box of the entrepreneur and taught us how economic actors constantly readjust and adapt within their institutional environment from an evolutionary perspective.
Other scholars such as Armen Alchian and Herbert Spencer have also drawn on evolutionary biology and dedicated their career’s work to showing how free market institutions deal with complexity. Paul Zak has also used the insights of biology and neuroscience to show how the rules of markets evolve overtime to promote virtuous and moral behaviour.
Elinor Ostrom, winner of the 2009 Nobel Prize winner in Economics, showed us how decentralised polycentric systems where alternative institutions can compete have more robust adaptability mechanisms than any government planner can imagine.
All these thinkers and more, showed us how market institutions are superior without a naive reliance on simplifying Econ 101 assumptions. We should all pay more attention to their lessons.
Featured image credit from Enlinea.