Friday 12 August 2011

The omniscience constraint

Man, a bit of market failure theory can really screw you up.

Recall that the First Welfare Theorem shows that, under an idealized set of sufficient conditions, market outcomes cannot be improved upon.

Normal economists recognize that the conditions fail and that, when they do, there may be room for ameliorative government policy. Policy would still need to be assessed to see whether it's welfare improving; we need comparative institutional analysis.

Abnormal economists say that whenever one of the conditions fails, we can throw all of economics out the window. That's what Collins & Lapsley did when asserting that alcohol consumption involves only social cost with no offsetting benefit: because consumers don't have perfect information, they can't have enjoyed consumption benefits.

Here's Single, Collins et al:
Thus, if the costs of substance use are to be classified as private costs, the following three conditions must be simultaneously satisfied:
  1. The users are fully informed as to the costs which the substance use imposes upon themselves;
  2. The users are required to bear the full (internal and external) costs of the consumption; and
  3. The users make rational consumption decisions in the light of all the information available to them.
These requirements are extremely stringent, so stringent in fact that the conventional approach of treating all abuse costs as social costs is fully justified.
Collins & Lapsley wrote as reason for counting private costs as social:
Being fully informed about the private costs of abuse requires the abuser to have access to, and have the ability to process and evaluate, epidemiological information on the effects of drug use. It also requires the drug user to be able to evaluate the probable future health and other costs resulting from the drug use. It is difficult to believe that drug users, by their nature, are fully-informed, or even well-informed, about the costs of their abuse.
Both of these are clearly nonsense. Sure, full information would require that. But that's insufficient basis for assuming zero private benefit. And, it's insufficient basis for saying that alcohol needs more regulation than anything else: no form of consumption would meet the Single et al requirements.

Don Boudreaux finds another example today from the New York Times' letters section:
In a perfectly functioning economic world, all consumers would receive perfect education about good nutrition and then simultaneously demand that fast-food companies and grocery stores start offering healthy options, thus forcing Big Food to supply what the people demand.
Until that happens, we need regulation of NestlĂ©, Monsanto, McDonald’s and the rest of the moguls that dictate our diets.
I suppose that's not as bad as the Collins & Lapsley assertion that imperfect information transforms all private costs into social ones. But it's worrying how often folks run the following syllogism:
  1. People make choices I dislike;
  2. Those people do not have perfect information; therefore:
  3. Regulation must be used to make people choose the things I would have chosen for them.
No recognition of imperfect information problems in government; no notion that preference heterogeneity could underlie different choices; no attempt at comparative institutional analysis.

I think we as a profession are doing harm in our principles level teaching when we cover market failure. Far too many people seem to come away from Principles of Micro with the impression that any market imperfection is sufficient basis for throwing away the rest of price theory and revealed preference.


  1. I get emails along these lines all the time. People just don't realise that the burden of proof for intervention, and for interfering with individual choice, is ON THEM - it isn't up to economic theory to prove to them why they shouldn't arbitrarily intervene.

  2. @Matt: True story. Shortly after my edited volume on market failure came out, I got an email from somebody in UK Trade and Industry saying he was pushing policy X and needed a market failure theory to justify it; he was asking what failure he should cite.


  3. And from the paper this morning... Antony Gough criticises height restrictions as being "an arbitarary line in the sand". His solution? 10 stories (clearly not an arbitrary figure).

    But according to Parker, the height restrictions are to stop poeple being overshadowed by buildings. Is 'people scale' market failure in your book? If not, can we expect a new edition?


  4. The worst thing is how many economists get asked to do this, then talk themselves into believing the market failure.

    The sooner we recognise the institutional incentives associated with government, the sooner we can do better economics.

  5. @AJ: Shade can be an externality. But Coase does come in. David Friedman's written usefully on the topic.

    @Matt: Totally.

  6. If you don't like the work of DJ Collins, perhaps you would prefer the work of MA Collins. Both research alcohol, one usefully.

    addresses sick quiters issue as well.