Charles Davi over at The Atlantic recently wrote an article detailing a particular example of “market failure” – the so-called “coordination failure”. Here, I hope to offer a largely Austrian view of this “failure”. In the end, we’ll see that a proper understanding of the problem will eliminate any valid role for government.
Davi presents us with a simple example to demonstrate what he means by a market failure. Imagine a case where I would like to have my house painted, and would be willing to pay you a certain sum to do it. Also, you would happily exert the effort to paint my house for that sum. So, it’s obvious that the best thing that can happen is for me to pay you to paint my house.
However, there’s a small difficulty. Neither of us trust each other, which creates a problem for the timing of payment. For example, if I pay you first, I fully expect you to “take the money and run”. So, I end up losing the money and not having my house painted. Meanwhile, if you work first, then you fully expect me to refuse to pay. So, you end up working and not getting paid. Since each of us distrust the other, the deal doesn’t end up happening. A “suboptimal outcome”.
There are several levels on which the problem breaks down. First, Misesians should be quick to point out that preferences can only ever be objectively known from action. So, a person can say “I would prefer that you pay a certain sum of money and that I paint your house than not”, but if that same person is offered the deal, and doesn’t take it, we reach a very obvious conclusion. They were lying. Or, to be a bit more charitable, they were imprecise. What they actually meant was “I would prefer to paint your house under conditions of 100% certainty that you would pay me a certain sum if I did.” Since 100% certainty is not the condition under which the choice is made, there is no contradiction in declaring this preference and then not actually choosing to paint the house when given the opportunity.
Taking this view, a Misesian can quickly point out the first problem in Davi’s logic: he’s comparing apples and oranges. He defines “optimality” based on an imaginary construct where there is 100% certainty. Then, he mourns the fact that reality is not like his imaginary construct. However, if we take the conditions of reality as given (that is, we take as given the lack of trust), then the decision that is reached is actually optimal. Given the amount of uncertainty involved, both you and I would rather not engage in the trade than engage in it. So, there is nothing “suboptimal” in the outcome at all. Now, we can’t completely blame Davi for this approach. After all, comparing the real world to imaginary constructs and using these constructs to condemn reality is a long-accepted practice in the mainstream of economics. Austrians are often alone in declaring that this is not a valid way of measuring the optimality of market outcomes.
Davi declares that the way that “free market zealots” solve the problem is by appealing to reputation. So, we can achieve some degree of certainty by looking at each other’s past. Davi declares that “That would probably work in a tiny village where everyone knows everyone else, travel is infrequent, and therefore reputations are easy to track. But in the developed world, it’s impractical and creates a fantastic opportunity for those willing to move around a lot pretending to be a painter.” However, it’s obvious that the free market zealot Davi talked to was terribly uncreative. There are, in fact, a number of ways that the mistrust problem can be ameliorated. For example, I can agree to pay you at the end of each hour of work. So, at worst, you will waste 1 hour of your time. Once I refuse to pay you for an hour’s work, you can simply stop working for me. Or, alternatively, I can pay you in advance for each hour of work. Then, if there’s an hour where you take my money and laze about, I can refuse to hire you for the next hour. This diminishes the risk significantly, and allows for reputations to be formed “on the spot”. Now, in reality, the way this kind of thing tends to work is through a multiple payment system. So, I would pay you half of the money in “advance” and half upon completion. This sort of setup can be used to establish reputations very quickly, even in a big world where laborers move frequently.
Davi’s complaints about the reputation system, though, are not limited to its unworkability. He also declares that “if it were practical, any system based on reputation alone would favor incumbents and make it very difficult for new entrants to compete”. However, this is very far from reality. It seems that Davi doesn’t recognize that the level of pay is not a given. So, as a new entrant, I can offer my services at a discount to make up for my lack of reputation. So, employers would have two types of employees to choose from: those that have good reputations, but high wages, and those that have no reputation (or bad reputations!) and low wages. A proper “reputation premium” would allow for both types of workers to find jobs.
Davi’s suggested solution to the problem is one that we find in the real world quite a bit. We write an enforceable contract. This is certainly a sensible solution. Then, the needed trust is transferred from being our trust in each other to being our trust in the government. Since there are relatively few governments in the world, they will have reputations that are easy to track. In offering it Davi makes a very strong assumption. He assumes that only government is capable of enforcing contracts. However, in theory and in reality, more than just governments are capable of enforcing contracts. Ed Stringham is one who documents this quite nicely. So, even if we accept that Davi’s solution of enforceable contracts is the only or best one, he still has to show that government is the only or best way to enforce contracts. I strongly suspect that private arbitration is likely to be significantly better – if only because the costs of enforcement will be paid by the parties that benefit (which guarantees that the benefit from enforcement is greater than the cost) rather than being socialized.
After discussing coordination failures and suggesting that the problem requires a government solution, Davi moves on to suggest another vague case in which regulation is called for: when “sophisticated” parties are dealing with “unsophisticated” parties. Davi suggests that there are “obvious” examples in which regulation is called for so that unsophisticated parties don’t get “screwed or even physically injured … even if [they] are not technically mislead[sic]“. This is an odd statement that obviously cannot mean what I think it means – that is, that the unsophisticated are signing up willingly and knowingly so that the sophisticated can cause them physical injury. Since that obviously cannot be the intended meaning, I’m left wondering exactly what the intended meaning is. But, let us suppose for the moment that the sophisticated are in a position to take advantage of the unsophisticated. The question then arises: will regulation actually help? Here, we have to ask how regulation is likely to be formed. One can easily make the argument for regulatory capture in this case. After all, regulation can only help because one party is significantly more powerful or knowledgeable than the other. So, who is likely to have a greater voice in forming regulation? I’d suggest that the sophisticated party will – and see very little reason to expect the opposite. So, from a purely practical standpoint, the question is: is it better to hand the abusive “sophisticated” parties the weapon of government, or is it better to make them operate without that weapon? I think the answer is obvious.
Davi himself notes that poor regulation is often worse than no regulation at all. As Bob Murphy has noted, it’s likely that the SEC actually encouraged fraud. It’s almost certain that Madoff’s scam would have come to an end had the SEC not given its tacit approval. One can come up with numerous examples of similar situations for other regulatory agencies. (The FDA regularly blocks effective treatments, yet we still end up with drug recalls. What gives? Maybe it’s that the FDA is actually working for the drug companies – who also exploit government protections to create intellectual monopoly – rather than working for the public good. You know, just maybe.)
In sum, Davi’s critique of the free market condemns it based on imaginary constructs, implicitly assumes that moderately creative solutions (solutions that are found all the time in reality) are impossible, acts as if government is the only possible enforcer of contracts (despite numerous real examples to the contrary), and acts as if bureaucracies can avoid regulatory capture (once again, despite experience that suggests that regulatory capture is a powerful force in reality).
Once we properly understand the problem we will reach a conclusion that should be quite familiar to mises.org readers: the market provides better solutions than government does, and getting government involved is likely to make things worse.
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Rather then a market failure, this is the market at its best. It shows both consumer and producer exercising caution. It shows how much reputation and integrity are key financial assets not only for the seller, but also for the buyer.
“…the needed trust is transferred from being our trust in each other to being our trust in the government… In offering it Davi makes a very strong assumption. He assumes that only government is capable of enforcing contracts.”
Not only that, as with all govn sympathizers he makes the further assumption that the govn will be totally impartial when it comes to the arbitration of any contractual disputes, including disputes involving itself and/or its patrons.
As HH Hoppe never tires of asking: how do you think govn will act when its own interest is at stake, given its monopoly of force and its exclusive position as the ultimate judge/arbitrator within its realm of jurisdiction?
Coordination “failure” = new nonsense concocted by economists who have no real argument against markets.
One thing that has to be understood is that those who consider themselves liberals define “market” differently from how we define market. I was talking to a liberal last week and he stated that the government would pass a law and the “market” would then price all transactions involved. Then if the system did not work it was a “market failure” rather than the intervention the law created. There is a serious communication problem concerning issues like this because the language means different things to different people.
Davi’s critique of neoclassical economics is justified. His understanding of free markets is informed by neoclassical definitions. The problem is with neoclassical economics, not with Davi’s critique.
Davi: “In particular, neoclassical economists reject the idea that coordination failures can occur.â€
That’s pretty much the efficient market hypothesis, a neoclassical fallacy.
Davi: “A coordination failure can be roughly described as a scenario where each individual in a group acts in a way that maximizes its own expected outcome, but by doing so fails to maximize the expected outcome of the group.â€
If I understand him correctly, he has described the utilitarianism that rules neoclassical econ. Optimal solutions occur when the group is economically better off. If one person is better off at the expense of another, nothing good has been accomplished. If one person improves his situation without hurting another, then the whole group benefits. That’s why taxing the rich and giving to the poor is the best idea that neoclassicals can imagine. The poor value the money more than the rich so the whole group benefits. Even though the rich are harmed, they are harmed less than the poor are helped.
Davi needs to know that another school of economics exists, the Austrian, that disagrees with neoclassical understanding of coordination and optimality that conforms to a large degree with his complaints against it. Austrian econ disputes the efficient market hypothesis and emphasizes the problems of lack of information, error in judgment and criminal activity. But more importantly, Austrian econ understands optimality differently.
In the first place, Austrian econ rejects the utilitarian model of optimality because it’s impossible to know, let alone measure, the subjective values of millions of individuals. But even if such knowledge were possible, it would be totally impossible to predict the outcomes of individual decisions on the group unless the group was very small, say a family, because of the large number of unknown variables and parameters.
Austrian optimality tends to be a measurable one—wealth. Austrians strive for maximum wealth creation. That requires private property and the institutions necessary to protect it—free markets, the rule of law, and honest courts, police, and legislators.
Here are some excerpts from Wikipedia’s article on Pareto Optimality. This is the kind of neoclassical BS that Davi seems to be attacking and that Austrians constantly fight against.
“Given a set of alternative allocations of, say, goods or income for a set of individuals, a change from one allocation to another that can make at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as Pareto efficient or Pareto optimal when no further Pareto improvements can be made. This is often called a strong Pareto optimum (SPO).
An economic system that is Pareto inefficient implies that a certain change in allocation of goods (for example) may result in some individuals being made “better off” with no individual being made worse off, and therefore can be made more Pareto efficient through a Pareto improvement. Here ‘better off’ is often interpreted as “put in a preferred position.” It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies.”
“Under certain idealized conditions, it can be shown that a system of free markets will lead to a Pareto efficient outcome. This is called the first welfare theorem. It was first demonstrated mathematically by economists Kenneth Arrow and Gerard Debreu. However, the result does not rigorously establish welfare results for real economies because of the restrictive assumptions necessary for the proof (markets exist for all possible goods, all markets are in full equilibrium, markets are perfectly competitive, transaction costs are negligible, there must be no externalities, and market participants must have perfect information). Moreover, it has since been demonstrated mathematically that, in the absence of perfect competition or complete markets, outcomes will generically be Pareto inefficient (the Greenwald-Stiglitz Theorem).[3]”
fundamentalist,
Oh, I agree that Davi’s treatment of “optimality” is very mainstream neoclassical, and that, therefore, the problem is, at least in part, mainstream neoclassicism.
But, it’s not clear that he does actually have in mind a case of utilitarianism rather than Pareto-optimality. His example is analogous to a Prisoner’s Dilemma, in which individual incentives result in the Nash equilibrium being a “bad” one. That is, we could both be made better off by changing our action – as long as we both do it. The failure in the Prisoner’s Dilemma is a coordination failure – based, to some extent, on “mistrust”. Though, I agree that utilitarianism is a dangerous social ethic, and that, for the good of society, we should push for the execution of all utilitarians. [Irony intended.]
Actually, to me, Davi doesn’t really seem to be criticizing neoclassical economics at all. (He does, for example, accept the neoclassical definition of optimality. And the proposal of “coordination failures” is hardly heterodox.) Instead, he seems to be criticizing just free market neoclassical economists. From an Austrian perspective, he’s criticizing the wrong half of the phrase. The problem isn’t the free market. The problem is the neoclassicism.
The problem with most commentary on markets is that almost all of it is based on few facts, bad logical models and the incorrect assumptions that follow from their joining. When you start with a faulty foundation, everything else that comes afterward is going to be corrupted. Charles Davi is no different, unfortunately. He’s horribly ignorant of reality. I laughed at the end of the article, where he says he’s thankful a Fed exists. To me, that’s akin to thanking the arsonist for burning down your house.
J Cortez,
As someone who knows recreational hunters (though I don’t myself), I kind of thought the argument about the Fed was a point AGAINST the Fed’s existence… Though that’s obviously not what was intended. Eh, well.
I am increasingly amazed that the “economic” solution by so many people is the use of political force. Certainly the market isn’t perfect, but resorting to government regulation requires, as already noted, that a “problem” truly exists, and that the government is capable of doing more good than harm in the situation.
As for the sophisticated preying on the unsophisticated, I’m reminded of the time a few years ago when my state wanted to license roofers operating in the state. Besides generating more money for the state, I wondered how this would protect people from shoddy or shady roofers. If someone is unsophisticated enough to not ask for references, why would they bother to ask for a state license? And if they did, all the license would really show is that the roofer paid the state some amount of money for it.
Michael: “…the government is capable of doing more good than harm in the situation.”
Good points! I just finished Hayek’s “Counter-Revolution in Science.” I think it’s a must read to understand the left. The origins of the left are in the worship of scientists as the priesthood of all wisdom and knowledge. The left has long forotten this, but still look to a priesthood of super-intelligent elites to safe us. Of course, they consider the masses to be stupid.
As for the “sophisticate preying upon the unsophisticated” that’s the definition of socialism.
My favorite example of a pointless regulation:
The township my church operates in decided to institute a $25 fee for a permit to burn candles in public buildings. Because it’s a relatively rural township, this would mostly affect the churches in the area.
One of the guys in my church led a media campaign to get the township to drop the fee. It worked.
The most common justification I heard for the fee was “because we’re allowed to by state law”.
It was a truly puzzling regulation, as it would only raise about $200 for the township, and obviously didn’t serve any particular public purpose – or even a private purpose. It’s kind of like the township just said “Well, here’s a way that we can take $200. Let’s see if it flies.” Ends up the answer was “no.”
Of course, they consider the masses to be stupid.
On that point, they’d be correct…but I can’t see how that constitutes an argument for government. Especially democratic government, in which the stupid get a vote.
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