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.