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Intersecting supply and demand curves are perhaps the most iconic image in economics. In a simple picture they convey fundamental truths about how free markets find a price that aligns the interests of buyers and sellers, and how the price adjusts to basic shocks to either supply or demand.
But elegance aside, the standard economics textbook that begins with those graphs and the framework of “perfect competition” has held hostage our debates about markets, government, and society. In fact, the very concept that markets can be perfected sells real-world markets far too short.
The Problem With Perfection
Virtually all introductory economics textbooks begin with perfect competition. In addition to those intersecting lines, we learn that free markets create the most possible wealth for society when buyers and sellers are atomistically small, have perfect information, and trade in identical products. The optimality of markets under these conditions has been incorrectly emphasized by advocates of laissez-faire policies. But more frequently this idea has been incorrectly used by advocates of greater government intervention.
Much of the rest of the standard textbook deals with market failures — deviations from those benchmark assumptions that make real-world markets fall short of the idealized outcome. Externalities, monopolists, and imperfect information lurk around every corner.
These phenomena are real and important, but they raise a question that while obvious also misses the point: how can we intervene to make markets more like they were in chapter one? If we break up monopolists, remedy externalities with taxes, and mandate services like insurance in markets that are rife with imperfect information, we’re told, we’ll move ever closer to the ideal system.
Misguided Policy
The assumptions embedded in the standard textbook are so deeply ingrained in our debate that we rarely realize we are making them. Even the current Far Left in the United States can’t escape the pull of perfect competition. Carbon taxes,individual insurance mandates, and regulation of monopolies all strive to move us closer to chapter one.
Entire subfields have arisen to challenge individual assumptions found in the perfect-competition model. Behavioral economics rightfully questions the assumed hyper-rationality of homo economicus but focuses on how we can “nudge” real people to behave more like this idealized construct.
Why shouldn’t perfect competition be the benchmark toward which policy makers strive? First, designing appropriate top-down policies in the real world often amounts to flying blind.
If a factory pollutes more than a “socially optimal” amount, standard theory says that factory should be taxed. Solving for the size of the ideal tax is easy enough in an undergraduate problem set but riddled with uncertainty when we need to predict the decisions of corporations and consumers.
How about market power? Thousands of court opinions and expert reports in antitrust cases attest to the fact that even deciding how much market power a firm has is so subjective as to render any policy response inescapably uncertain in its impact.
Second, even if an optimal policy could be written on a piece of paper, implementation by human beings creates another complicating factor. Writing about a proposed carbon tax, my colleague Phil Magness catalogued the numerous political pitfalls that plague the execution of even the best-designed policy.
Finally, perfect competition is not a useful policy benchmark, because it is fatally flawed as a representation of virtually any market for a real product or service. AIER Senior Fellow Donald Boudreaux described the strange logic of the model, where competition along dimensions such as quality and innovation creates distortionary market power rather than delivering a better product to consumers.
Removing the Rose-Colored Glasses
I first mentioned this confused debate in an article titled “Markets Are Not Perfect, They Are Essential.” This mantra forms the basis for a better conversation about the role of markets in modern society.
Great theorists such as Adam Smith and F.A. Hayek, along with cold hard empirical fact, tell us that a system based around free exchange is the only means by which a complex society can survive. That doesn’t mean we have to like everything that happens in markets, but we usually can’t fix what we don’t like by pushing markets toward an ideal that is both unattainable and unrealistic.
Nobody likes the human suffering that ensues when a company closes a factory in a town that depends on its employment. Both the protectionist and the socialist say we need to somehow control these firms so that they continue to provide jobs in their original locations. Both are wrong. Even the centrist, advocating incentives or penalties to make the market do what we want, treads on shaky ground.
The chapter-one fundamentalist says the factory closing isn’t a problem at all, just the natural process of finding a new equilibrium in the market for labor. They may be correct in the long run, but this position glosses over a degree of suffering nobody should accept.
The theoretical perfection of markets is not a valid argument against government intervention, nor is it a valid reason for governments to intervene in service of that ideal.
Let Markets Be Markets
Does this mean we must accept the bad with the good in a market-driven economy? Absolutely not. Imagine if we took the energy and resources currently spent on debating and implementing policies that strive in vain to push markets to perfection and instead simply helped those around us who struggle. Safety nets and investments in human and social capital are best provided locally by those on the ground who know their neighbors.
In his recent book The Third Pillar, economist Raghuram Rajan discusses the importance of supportive communities alongside markets and government in a well-functioning society. Many well-intentioned government interventions have crowded out roles historically played by the community.
This bottom-up community support is not the pure altruism that is sometimes simplistically dismissed by free market advocates. It is an emergent phenomenon in healthy economies and societies. The idea that we can rig markets to solve all of our problems is the greatest impediment to this type of decentralized micro-philanthropy becoming the norm. It’s time to close the book on chapter one.
Max Gulker
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Why Is the System Rigged?
It’s crazy season, that special time on the American calendar when aspiring candidates for the nation’s highest office try to outdo each other in an effort to attract more voters to their platforms. This time around, background support is provided by a virtual anvil chorus of anti-capitalism clatter. Senator Elizabeth Warren, for example, frequently unleashes criticism of American capitalism by asserting that the “system is rigged,” a complaint that seems to resonate with meaningful populist appeal. It’s an old refrain that has echoed across the years from Karl Marx onward.
Nobel Laureate Robert J. Shiller explains why this may be the case in his new book, “Narrative Economics.” As Shiller points out, when a story is repeated enough, the viral message may be accepted as conventional wisdom, more like an article of belief than a matter of reason.
I’ll also emphasize that for a message to prevail, it helps if its content rests on a preexisting and inherently moral foundation that reflects our tribal instincts as an evolved human species. And what works for a small tribe doesn’t necessarily work so well for a huge industrialized nation.
Consider this: Some may inquire, “Do you believe in capitalism?” almost as if the position one takes is a matter of religion. When answering, we reflect on our tribal preferences, and cooperating and sharing with our family and neighbors is often a key to success. Thus, many people will almost instinctively answer “no,” or at least “yes, but …” followed by some serious caveats and exceptions.
Yes, the beneficial-but-invisible hand of commerce driven by self-interest has never been an instinctually lovable idea. Gains from trade, while well-documented since the days of Adam Smith, can be more elusive than we may first realize. Given the widespread negative views on the subject, politicians’ calls for greater accountability and government intervention may not be welcomed by all, but they’re understandable.
Shiller adds another dimension to his narrative economics story by using data from Google’s Ngram Viewer. The viewer produces charts based on the frequency of particular words and phrases in Google Books, which include some 8 million downloaded volumes in various languages.
Consider an Ngram we might apply to Senator Warren’s comments. The nearby figure contains one for “system is rigged” that shows the frequency of the phrase’s occurrence from 1940 through 2008, the final year in the database. I have smoothed the data by using a three-year running average:
The data show four viral periods: 1940-1950, 1960-1985, 1990-1998, and 2000-2008. The first period encompasses World War II, a time of draft, rationing, price controls, defense contracting, and related cronyism that may in some cases have been highly profitable for hand-picked firms.
The second viral period is much longer and encompasses a period including the Vietnam War and related draft, Watergate and significant social unrest.
The third period includes the first Iraq war, and the fourth contains anti-capitalism protests and budding expressions of concern about income inequality as a version of the economy closer to what we know today took shape.
The Ngram suggests that in seeking to communicate to her base, Senator Warren artfully chose a phrase that had gone viral before—which is to suggest that there may be an embedded tribal norm that reacts during periods when a relatively small number of people are able to build large fortunes or avoid burdens, such as the draft, as a result of government actions and favors.
Oddly enough, Senator Warren and other capitalism critics seldom ask how the system got rigged and what might be done to undo the rigging. But of course, the rigging is done in Washington, sometimes when special interest groups—including corporations—lobby congress for favorable treatment.
And how might that be undone? By trimming away uneven regulation and adopting policies that expose all business firms to the refreshing winds of competition. Put another way, by forcing capitalists to act like capitalists and not lobbyists.
Bruce Yandle
Bruce Yandle is a distinguished adjunct fellow with the Mercatus Center at George Mason University and dean emeritus of the Clemson University College of Business and Behavioral Science.
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Holiday Spending Off to a Modest Start
Retail sales and food-services spending increased 0.2 percent in November following a 0.4 percent gain in October. Excluding gasoline station sales, retail sales and food services were up 0.1 percent in November after a gain of 0.7 percent in October. Over the past year, total retail sales and food services were up 3.3 percent through November, while retail sales and food services excluding gas have increased 3.6 percent (see chart).
The November performance was mixed, with gains in 7 retail-spending categories, two posting declines and one essentially unchanged. Gains were led by a 0.8 percent increase for nonstore retailers (primarily online shopping), and a 0.7 percent rise for electronics and appliance stores – two traditional holiday spending categories. Gasoline stations also posted a 0.7 percent gain which is a surprise since average retail gasoline prices (which often drive monthly changes in retail sales spending) were actually down 2.0 percent. Also posting gains for the month were motor vehicles and parts (autos), up 0.5 percent, food and beverage stores, up 0.3 percent, home furnishings stores and general merchandise stores, each up 0.1 percent.
On the negative side, health and personal care stores saw sales fall 1.1 percent, clothing and accessories stores had a 0.6 percent fall, sporting-goods, hobby, musical-instruments, and book stores posted a 0.5 percent decline, miscellaneous retailers had a 0.4 percent setback, and food services (restaurants) saw a 0.3 percent fall. Building materials, and gardening supply store sales were essentially unchanged for the month.
The mediocre retail sales data for November suggest that the early predictions of a booming holiday spending season may have been premature. Certainly, consumer fundamentals are generally solid with a low unemployment rate, decent income growth, and positive consumer sentiment. Government data are subject to revisions and there is plenty of time for consumers to spend, but today’s data suggest slow growth remains the most likely path.
Robert Hughes
