by Robert Litan
Despite its flaws, this common notion of the market is pretty amazing. Several years ago, the economics writer for the New Yorker, James Surowiecki, wrote a wonderful book, The Wisdom of Crowds, which I found not only highly thought provoking, but a good way of illustrating the virtue of markets. The book’s main thesis was that when people can act independently without knowledge of what others are doing, large groups of them, on average, often are able to make better predictions than experts.10 In much the same way, the uncoordinated actions of billions of people and firms each day (if you count multiple transactions by the same people, just in the United States alone) do a far better job than any central planner could not only to ensure that just about everything that people want they can get, as long as they are willing to pay a market-clearing price.
The great Austrian economist Friedrich Hayek, writing in the middle of the last century, argued that prices are the most important piece of information in any economy. Knowing the price of an item and the prices of the items and labor required to produce it (or deliver it in the case of a service, like health care) tells producers whether they can earn a profit making (or delivering) it, and if so how much to make. Likewise, the first question most buyers ask or want to see about anything they are interested in purchasing is the price. To be sure, information about quality is important, and in the age of the Internet, it is more available than ever before, either for free (ratings are provided on products and sellers on many websites) or for modest costs from for- and nonprofit entities like Angie’s List and Consumer Reports, respectively.
Prices also have two other key relationships. Generally, the higher the price of any item, the more of it producers will be willing to make, but the less of it consumers will be willing to purchase. As standard economics textbooks then show—and this may be the single thing from taking a course in the subject that former students remember—these propositions can be graphed, with an upward sloping supply curve and a downward sloping demand curve. The point at which the two curves cross is the market-clearing price.
There is a third kind of market institution, the auction, which was thought to be reserved for determining the price for unique items, such as art and other collectibles. In Chapters 3 and 11, I discuss how auctions, even though they have a long history, have become much more widely used in recent decades in the physical and virtual worlds for many, many more items or services. In each case, economists helped business discover ways to generalize the auction so it is capable of being used routinely, while they have also persuaded policy makers to use the device for allocating scarce publicly owned goods, such as the electromagnetic spectrum that has enabled the incredibly rapid growth of wireless telecommunications.
More broadly, in many cases what appears to be scarce can be made less so through the signaling function of prices. High prices attract investment that expands capacity and entrepreneurs who invent or discover cheaper ways to provide the scarce resource or commodity. One of the best examples is the combination of horizontal drilling and chemical fracturing techniques that have transformed the energy landscape over the past few years. It took a while, but the high prices of oil and natural gas stimulated the development and widespread use of these innovations. Had oil and natural gas prices still been regulated, as they were in the 1970s, the energy revolution probably never would have happened. Economists played an important role in facilitating this outcome, a story told in Chapter 10.
Market Failures
While markets are superior to central planners in sending the right signals for the production and consumption of most goods and services, this is not always the case. Markets can fail to maximize efficiency under certain conditions, although economists often disagree about the extent to which these failures occur and whether the governmental fixes represent improvements or are appropriate in the first place.
Perhaps the best-known cases in which markets fail involve externalities, both negative and positive, which are not taken into account by private actors. An example of a negative externality is when manufacturers generate pollution and harm third parties; they will tend to produce too much because, in the absence of taxes or regulatory mandates, the producers or consumers do not pay for the costs of pollution. In a famous article published in 1960, Nobel laureate Ronald Coase of the University of Chicago showed that, in theory, government intervention is not required to internalize such externalities since the producers of pollution and those harmed can negotiate a solution.11 In practice, however, there are typically so many who are harmed that it is too costly for them to band together to conduct such a negotiation.
The standard answer to the externality problem therefore that is advocated by many (maybe most) economists is to impose taxes in the amount of the damage caused by the polluters. This idea goes back to Arthur C. Pigou, an economist who outlined such an approach in the early twentieth century.12
A carbon tax is a notable example of a Pigouvian tax. The basic logic is simple: Taxing the emissions from pollution sources forces the emitting parties to internalize the costs imposed on society. A carbon tax could reduce both greenhouse gas emissions and the federal budget deficit, which is why many economists from both sides of the political spectrum have advocated it.14 I have a lot more to say about a carbon tax, or its rough equivalent—cap and trade—in Chapter 14.
Conversely, the benefits of some goods may not be easily captured by a single purchaser, such as the security provided by local police or a system of national defense. Similarly, the benefits of basic research and developments in the physical and health sciences spill over or accrue to the larger public, including many companies or potential companies that are capable of using the fruits of the research, together with their own proprietary knowledge, to develop new goods and cures. Likewise, some of what policy makers now call basic infrastructure—such as roads and sewers—benefits society at large. Even education has positive externalities, since although individuals benefit personally from attending and doing well at school, many of them later use the knowledge they pick up along the way to develop new scientific advances or to launch new companies that benefit the public. For example, one estimate is that inventors reap only about three to four cents of every dollar in benefits they generate for society as a whole.15
These various public goods must be financed by some governmental entity, or otherwise there will be insufficient volunteers to pay for them—that’s why we have taxes. (Another reason is to support various social safety net programs, notably Social Security, Medicare, and Medicaid that transfer income from working members of society to those who no longer can work, such as the aged and disabled, and, most recently in the United States, those with insufficient income to purchase affordable health care.)
You will learn in later chapters of several ways in which public goods have found their way into business applications. In particular, the federal government has funded several important fields of study that have led to breakthroughs in economic science, which in turn have been used in business—the very premise of this book. The National Science Foundation supported Internet search technologies, which eventually sparked the interest of two Stanford computer science graduate students, Sergey Brin and Larry Page, who founded Google, now one of the world’s leading Internet search companies which has benefitted from the application of economic ideas (about which you will read in Chapter 3). In addition, during and after World War II, the fields of linear programming and operations research were funded by the Office of Naval Research, which generated mathematical techniques for minimizing costs (the subject of Chapter 4).
A second way in which the market can fail is if sellers (more typically) have superior information than buyers. Economists call this information asymmetry. Normal people call it unfairness. In some cases, markets can solve the problem; for example, by consumers demanding and willing to pay for warranties against defects. But in some situations, warranties, backed up by arbitration or the availability of the judicial system to resolve disputes,
are not enough. Requiring appropriate disclosures, which sometimes can be excessive with too much fine print, is the standard additional remedy for information asymmetry. Mandatory disclosures are especially important for services, such as insurance, where what consumers are buying are promises by the sellers to make payments, contingent on some event (such as disability, damage to your house or your car, or your death) far into the future. These regulations are supplemented, as in the case of banks as well, with financial soundness requirements and regular supervision of these financial institutions to give customers comfort that the firms that are holding their money will be able to give it back to them when they want it (banks) or deserve it because of losses covered under their policies (insurance).
The third source of market failure occurs in rare cases when the structure of the market itself limits the market to one competitor because the average costs of serving more customers continue to fall even as more goods or services are sold. For example, if the investment to build a network is so large relative to the size of the market, then the average costs of supplying the service may continue to decline even as more customers are added (this is in contrast to most goods after which at some point, both the average cost and the marginal cost, or the cost of serving additional customers, turn up well before all customers in the market are served). Traditional examples of such natural monopolies are the old wire-based telephone network (unlike newer mobile telephone services where competition is not only possible but has proven to be highly desirable) and the distribution of everyday utilities, such as electricity, natural gas, and water.
How does or should society deal with natural monopolies? The textbook answer is with price regulation: capping rates at some level that enables the monopoly provider to earn an appropriate return (given the modest risk) for its investors, but no more. Over time, different approaches to monopoly price regulation have been developed, as will be discussed in Chapter 11. Price regulation of monopolies is the exception to the proposition that markets are always better at setting prices than governments.
Believe it or not, there are cases in which, sometimes given the right governmental rules, private actors can help correct certain market failures and make money at the same time. I devote parts of several chapters in this book to explaining how this is either already being done in some cases, or in others, could be done in the future, either initially or more extensively than has been allowed so far.
For example, in the case of pollution, environmental regulators have shown increasing interest in adopting an idea thought up by economists: allowing polluters to trade allowances to emit a maximum amount of certain pollutants (sulfur dioxide being the first example). Such cap-and-trade systems encourage those that can most efficiently reduce pollution below some level to do so, while requiring those who do not have this capability to pay the social cost of exceeding the limit. This is more cost effective for society as a whole than simply requiring every polluter to meet the same standard, regardless of its costs (although many economists believe pollution taxes, such as a carbon tax, are a more efficient way to get to the same result, the politics of enacting such taxes has proved even more difficult than persuading Congress to extend cap-and-trade to carbon-based air pollution). So-called emissions trading also opens up business opportunities for exchanges to handle these trades, opportunities that could be expanded if cap-and-trade systems were more widely adopted for other pollutants, as I discuss in Chapter 14 in the concluding part of this book.
In the case of information asymmetries, newspapers and magazines have long been a source of information for consumers about specific products, although less so about service providers. Customer ratings of some professionals, such as doctors, are beginning to be available on the Internet. At the same time, as surely all readers of this book know, the Internet has been steadily, and in more recent years rapidly, undermining the economic feasibility of print publications, largely because information can be distributed to additional customers at essentially zero cost without the need for additional paper and trucks to deliver the product into buyers’ hands. So far, those information providers that are making money in the Internet age are using some variation of a free service available to anyone who accesses the Internet coupled with a pay wall for premium content. Time will tell whether this, or another, business model will succeed.16
In the meantime, there is one business that has done much to solve the information asymmetry problem in financial markets, and that is Bloomberg LP. I discuss the success of the particular Bloomberg technology and business model in Chapter 3, which although it cannot be traced to the idea of any particular economist, highlights the importance of the economics of improving transparency.
As for the regulation of monopoly, several chapters in Part II of the book show how the government has inappropriately regulated certain sectors of the economy that never were or no longer display the declining cost characteristics of natural monopolies—transportation and telecommunications. These are instances of what some economists have called government failure and serve as a warning to those who quickly embrace government intervention as the immediate solution to market failures. Most economists will tell you that government should only intervene where the costs of market failures outweigh the costs of government failure, a calculation that admittedly is often difficult to make in the abstract or without sufficient experience to test the outcome; further, by that time, since government intervention has become the status quo it tends to be very difficult to change, let alone eliminate.
My main purpose in the second section of the book, however, is to tell the story of how economists have had a powerful impact in persuading federal officials to establish the right policy platform—deregulating prices and entry in industries where it never was or no longer is appropriate—that quickly facilitated the rise of a whole new range of businesses and business models that have literally remade much of the U.S. economy in the process. This is a story that has benefited many businesses, and yet they, as well as many readers, are probably unaware of it. It is also a story of how economists have had a powerful impact on business indirectly by doing what most economists believe they are best at—convincing policy makers of doing what economists believe is in the best interest of society.
Oh, one more thing: There have been through the years a number of critiques of markets, along the lines that it is immoral or unjust to let markets allocate many inherently nonmarket things or institutions: like organs, or votes, or even who gets tickets to concerts. One of the best works of this genre is a thoughtful book by Harvard political scientist Michael Sandel, What Money Can’t Buy.17 He’s right, of course, to a certain extent, but as an economist, I believe he overstates his case. The alternative to allocation by price is allocation by queue. That may be fair in some eyes, but it’s a method that doesn’t provide an economic incentive for innovation or enhanced supply to eliminate or reduce a shortage of an item that may be in scarce supply. Economist Timothy Besley has provided a thoughtful critique of Sandel’s views on these matters.18 Readers who want more philosophical discussion of what is sure to be an ongoing debate over the role and limits of markets in any society are well advised to consult both these works.
The Macro–Micro Distinction
Another economic concept it would be useful for you to know before exploring the rest of the book is the distinction between what economists call macroeconomics, which covers how entire economies perform, and microeconomics, which concerns itself with how individual households and firms behave. In most college courses, the two subjects are typically taught in different semesters.
Macroeconomists try to understand what drives the performance of the overall economy, and ideally how to mitigate extreme cyclical fluctuations. They monitor various indicators, with which many readers may be familiar, such as the growth of GDP and inflation, the unemployment rate, and the trade balance, but they continue to argue about the fundamental causes of variations in these indicators.
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nbsp; When I was an undergraduate majoring in finance (really a subfield of economics) in the late 1960s and early 1970s, and later in the mid-1970s when I was completing my graduate training in economics, macro was much sexier and more interesting for members of the profession and at least for students like me than micro. In my undergraduate years, the big debate was whether monetary policy or fiscal policy (changes in taxes and government spending) was more effective in mitigating the ups and downs of the overall economy. The main protagonists were two early Nobel Prize winners, Milton Friedman of Chicago, who argued that the money supply affected only the rate of inflation and who was skeptical of the impact of fiscal policy, and Paul Samuelson of MIT (see accompanying box), who had more faith in the effectiveness of both monetary and fiscal policy.
Paul Samuelson: A Twentieth Century Legend
The two other great economists of the twentieth century, at least in my view, were John Maynard Keynes, the British economist whose writings really established what we now routinely call macroeconomics, and Paul Samuelson, who among his amazingly diverse contributions put Keynesian theories into mathematical language. He was awarded the second Nobel Prize in Economics for just a small portion of his research, notably, his Foundations of Economic Analysis, written when he was a graduate student and which sufficed for his PhD thesis. It also earned him the first John Bates Clark award ever awarded by the American Economic Association. Numerous other awards graced him during his long career.
