Tuesday 7 December 2010


Brad DeLong posts on what Econ 1 students should remember from the course.

First most important: markets are the best way of dealing with scarcity.
This simple institutional arrangement has a huge number of advantages as societal mechanism for planning and coordinating the production and distribution of scarce, rival, excludable commodities.

It solves the problem of production--what commodities we should try to make more of. Individuals look forward into the future and recognize that others will be willing to pay them high prices for commodities they greatly desire. That gives individuals an incentive to figure out how to make more of those scarce, rival, excludable commodities that are scarcest.

It solves the problem of economizing--of how to get people to economize on their own consumption and not hog too great a share of society's total resources for themselves. Because they have to pay the owners the prices the owners ask, their eyes may be bigger than their stomachs but their wallets generally will not be.

It solves the problem of distribution--of determining who is going to get to use newly-produced commodities. The owner has an incentive to choose the person willing to pay the highest price--and the person willing to pay the highest price is, in some sense, the person who values it the most, to whom it is scarcest.

Moreover, it solves the problem of coordination: As long as market prices are free to move to equalize quantities supplied and demanded, there does not need to be any huge centralized computer bureaucracy keeping track of everything and making sure that plans add up. The market will coordinate itself.

And it solves the problem of information: In a market economy with commodities with owners, decision-making is pushed out to the periphery of society where people already know what is going on. You don't need any huge centralized computer bureaucracy collecting and processing information--and where people do discover that there are things that they don't know but need to learn, why knowledge of something and that somebody else would like to learn it is also a commodity and those who know those two facts are its owners.

It is hard to imagine a simpler institutional framework--owners and prices--that could solve those five problems so very well.
All good. I start worrying when we get to DeLong's second most important thing to remember
What is the second most important thing for you come one student remember? It is how stringent the requirements for any form of "market efficiency" are: how many ways a market economy can go wrong and go badly wrong. I count seven ways that market economies can and do go badly wrong:


Whenever the system falls into any one of these seven arenas of psychological, behavioral, or institutional myopia and market failure, the market will go wrong. A good government will put its thumb on the scale in order to offset all of these seven forms of market failure. A great government will have foresight and take care to structure political-economic institutions to make these seven arenas of myopia and market failure as small as possible.
I've a few minor quibbles. I'll leave those for later. Here are the two big problems.

First, DeLong missed the third lesson - the necessary correlate of the second. Governments screw up too. Maybe he wanted us to take it as read for folks who read his blog through the Bush administration.

Second, even if a market "goes wrong", we're still only evaluating things relative to a blackboard ideal of perfect markets. So long as we know that that's what we're doing, fine. But lots of folks will leave Principles level econ with the lesson that any kind of market failure effectively means "anything goes".

Those two together mean that we really have to emphasize comparative institutional analysis. Otherwise we fall too quickly into the Nirvana Fallacy. As Kling put it:
At the University of Chicago, economists lean to the right of the economics profession. They are known for saying, in effect, "Markets work well. Use the market."

At MIT and other bastions of mainstream economics, most economists are to the left of center but to the right of the academic community as a whole. These economists are known for saying, in effect, "Markets fail. Use government."

Masonomics says, "Markets fail. Use markets."

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market.

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets.

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell.

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.
Sure, without market failures, things could work better. But it's not like everything falls apart as soon as one of the conditions for the first welfare theorem breaks. We don't live in a vacuum, but 9.8 meters per second squared remains a useful approximation. And besides, we'd all suffocate in a vacuum.


  1. It's precisely because markets are imperfect that they work. Otherwise nobody could compete properly against each other. A perfect market would, in effect, quickly become a perfect socialist system with one provider for each good or service.

  2. "...we'd all suffocate in a vacuum..."

  3. Well that's not true Blair. Diseconomies of scale would be one reason why not.

  4. @Blair, Sam: If we were in the exact scenario described in the perfectly competitive model, with no changes to preferences or to constraints ever, then we could have things run equally well by socialism or markets barring the very obvious incentive/totalitarian problems of socialism.

    It's that things keep changing and that there are market failures that provide impetus to entrepreneurship and that make life fun!