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Charles Wheelan, Ph.D. The Naked Economist

Markets Make Sense, Except When They Don't

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Very Good (471 Ratings): 3.766454/5

Posted on Tuesday, February 13, 2007, 12:00AM

Do you believe in markets? Of course you do -- unless you're a communist.

Even the communists managed some pretty impressive black markets. I traveled for several weeks in the U.S.S.R. in 1988, and spent much of the time behind my hotel trading things out of my suitcase to Soviet teens for rabbit fur hats and Lenin pins.

Cornering the Market

Presumably, the 20th century proved that the market solution is usually the right solution. The theory is simple and elegant: Individuals and firms make themselves better off by entering into voluntary transactions, which collectively make up markets. By definition, all involved parties expect a transaction to make them better off, or else they wouldn't do it.

True, things may turn out badly, such as the hot stock you bought last year that fell 78 percent when the CEO revealed that all earnings since 1983 would have to be restated. But that's not what you expected. Nobody intentionally tries to lose money or to make their life worse. Instead, all parties to a transaction expect good things, or at least better than the alternatives.

That turns out to be pretty powerful stuff when you add it all up. If we leave people and firms alone, they naturally do things that make all of us richer -- they innovate, they work hard, they put resources to their most efficient use. Who can be against that?

Trapped by Progress

Just about everyone, it turns out, depending on the market in question. I would venture that economists like markets a lot more than the rest of the population, regardless of their political views.

Left-wingers aren't fond of sweatshops, for example. Why do we pay Vietnamese workers 75 cents an hour to sew shoes? Because we can. That's a pathetic reality; on the other hand, how exactly would closing the sweatshop make those workers better off? In all likelihood, if they had better options than sewing shoes for 75 cents an hour they wouldn't be working in a sweatshop in the first place.

Some liberal opposition to market outcomes is much more justifiable. We too often forget that every time someone builds a better (or cheaper) mousetrap, it's bad news for whoever made the old mousetrap. I don't advocate banning new mousetraps (or curtailing cheap imports from China), but there's nothing wrong with showing some empathy when markets create losers, as they always do.

Free and Easy Trade

What about conservatives? They talk the market talk, but don't always walk the walk. Try this experiment: Find a large Republican rally and take a turn at the microphone. Get the crowd warmed up with some general remarks about the elegance of markets and the evils of government. Then, when the applause lines are coming fast and furious, ask where you can buy some really good sex.

During the stunned silence, admonish these conservative market enthusiasts to fight against the oppressive zoning regulations that make it impossible for you to buy private property and build apartment buildings in most ritzy suburbs.

Why shouldn't you be able to do a tear down a single-family home on a five-acre lot in Greenwich if you can make a profit by replacing it with lots of cheap apartments? After all, don't they call it the housing "market"?

A Free-Market Self-Test

The reality is that most people -- from one end of the political spectrum to the other -- find some market outcomes objectionable.

Markets don't elicit any kind of consensus. The most interesting public policy questions often involve market outcomes that people decide they don't like -- whether it's sweatshops, prostitution, cheap imports from China, or something else.

So how do you feel about markets? Take this quick quiz. I've included my own (short) answers.

Should we legalize the sale and possession of drugs like marijuana, cocaine, and heroin?
My answer: I don't know. Certainly there's a market for these drugs -- lots of eager buyers and sellers. Society spends a lot of money trying to disrupt that market, seemingly to no avail.
Yes, drug use harms innocent third parties, but so do alcohol and tobacco. In those cases, we use taxes to raise the cost of smoking and drinking, and we regulate the specific behaviors that affect third parties, such as smoking at the office or driving drunk.
So why not do the same with drugs? Our current approach is both ineffective and expensive. Nonviolent drug offenders are clogging the courts and prisons. All the while, demand seems unabated and the illegal drug trade is empowering and enriching gangs and violent criminals, just as Prohibition did for organized crime.
Milton Friedman famously noted that everything wrong with drugs stems from the fact that they're illegal. I don't know about "everything" -- these are addictive substances that harm people and their families -- but I take his point.
And yet I'm not prepared to turn the sale of crack over to a Fortune 500 company that can maximize profits by finding new ways to get 18 year olds to sample their product. Nor do I want the government in the business of selling and distributing heroin. I don't have a moral objection to legalizing drug use and punishing only the behavior that affects the rest of us -- the drug equivalent of drunk driving. I just can't figure out how to do it.
Should we liberalize labor markets, so that workers can more freely cross international boundaries?
My answer: Yes. I find it hard to justify criminalizing anything that I would do myself. If I were poor and trying to raise a family in Mexico, I would do anything to get to the U.S. -- legally or otherwise. Capitalism is all about rewarding those who are willing to work harder or cheaper. Why is labor that crosses an international border any different?
When we buy a cheap stereo from China, that's globalization. When we give the kitchen remodeling job to the lowest bidder, that's competition. When some guy from El Salvador offers to cut the lawn cheaply, that's illegal. To an economist, it's just another voluntary transaction that makes both parties better off.
Yes, we need to police the borders -- for terrorists, not cheap poultry workers. You can reasonably disagree with me, but you must concede that I'm the one advocating the "free market" outcome in this case and you're not.
Should we implement a federal carbon tax and/or significantly raise the gas tax?
My answer: Absolutely. If you believe in markets when they work well, then you have to understand how they need to be tweaked when they don't. If page 10 of any introductory economics text explains the wonders of supply and demand, page 12 usually explains that markets don't deliver an efficient outcome when eager buyers and sellers impose some harm, or negative externality, on a third party.
If I can change the oil in your car more cheaply than the competition by dumping the old oil in Lake Michigan, that's not the kind of market transaction that got Milton Friedman so excited. Yes, I make profits and you save money -- a mutually beneficial, voluntary exchange -- but anybody who cares about Lake Michigan is not happy at all, and they aren't represented in our little transaction.
When the price of some activity is artificially cheap because society is picking up part of the tab, people do too much of it. That's not the economically efficient outcome that markets usually deliver. One standard economic fix is to impose a tax on whatever private activity imposes the social cost; when the price of the activity goes up, people do less of it.
That's exactly what a carbon tax or a higher gas tax would do. There's nothing voluntary about me breathing your tailpipe emissions. If we raise the private cost of driving, people will be less likely to commute 60 miles alone in a Chevy Tahoe.
The optimal market outcome isn't always synonymous with doing nothing; in this case, the market works best when the government does something. That something happens to be a tax, or anything else that raises the cost of the polluting behavior.

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97 Comments

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Steve * - Wednesday, May 23, 2007, 1:30PM ET Report Abuse
- Overall: 1/5
I'm rating this poor because it assumes an extremely naive and incomplete view of the "markets." (How many markets are there, by the way?) The question is not whether one "believes in" the marketplace, but in how and where to regulate market transactions, if at all. Most importantly is the question of WHO decides? Problem is, too many Americans have demonized the governments, esp. the federal gov., and have abandoned the very democracy that they claim to cherish. Power of market regulation has fallen into the hands of corporations. This means welfare for the rich on the backs of the poor. Don't hate your government -- in this country the government is you, so you're hating and distrusting yourself. Duh. Hate the corporations who are basically institutional machines that we have lost control over. Using one of the author's examples, we could legalize some recreational drugs if it weren't for having to fear that the sellers would put profits over the health/safety of our kids. But we do because sellers are heartless corporations whose only reason to exist is to expand profitability.
busy - Tuesday, May 15, 2007, 4:54PM ET Report Abuse
- Overall: 5/5
The production and distribution of certain drugs happens. Demand runs this machine through a positive feedback mechanism. The U.S. govt tries to interfere with this machine both by sabotaging production and distribution but demand then increases which causes production and distribution to continue at a similar(?)rate. The U.S. govt suppresses demand by locking up "criminals" who have more free market to these drugs in the prison system(?) then out on the streets, and more ineffectively through propaganda. This appears to be a true dialectical condition with the govt wanting this action to cease while the market pushes it on.
CoolFin69 - Tuesday, May 1, 2007, 5:42PM ET Report Abuse
- Overall: 4/5
I rate the article Very Good because, if nothing else, it sparks a debate on these issues surrounding Economics and Politics. As a proponent of both "free markets" and "free society" that values liberty enough to accept the label "Libertarian" I would expect to answer "Yes" to any question of liberty and freedom. However, my answers to these questions are as follows: 1) Not really 2) Maybe, depending on what "liberalize" means, exactly 3) Absolutely not I see 2 key issues with the 1st and 3rd suggestion that I did not see pointed out in any of the other comments so far. First, you need to replace the word "legalize" with the word "de-criminalize" in order to get my support. Legalization implies a *forced* acceptance of the sale and possession of drugs no matter the preferences of the people involved. I could never sum up my views on this issue as well as David Boaz did in his book. However, I would say that while some people (in any group) should be allowed to choose to accept the sale and possession of drugs in their surroundings, others should be free to choose to avoid such activity in their surroundings. This could take place through de-criminalization as a Federal law. Smaller municipalities would then be free to express their preferences on the subject. Those who wish to continue avoiding such activity are free to do so through de-criminalization in a way that forced "legalization" would not equally allow. The distinction is not as minor as it may seem. Second, on the issue of a carbon tax I have to strongly disagree. There are *many* other factors involved that I feel need to be addressed first prior to any potentially more burdensome government taxation. If people are willing to agree that the price of gas is "too cheap" to curtail usage, especially compared to world market prices, the government should agree to no longer pass *any* subsidies or other hidden "taxes" that benefit oil production and effectively lower prices. Also, people may feel that there are too many automotive drivers on the roads causing too much congestion and slower travel times. To better alleviate this, greater diligence should be paid to monitoring existing rules, regulations, laws, etc. concerning proper motorist transportation. In other words, if municipal police forces or anyone else were to closely monitor anything *other than* just the speed of travel, much fewer motorists would be legally on the roads. In Illinois, for example, your license would/should be suspended if you were to simply achieve 3 moving violations within one year's time. During any given commute, one could witness any number of other drivers who commit 3 or more moving violations. In less than an hour or so, that person has warranted a full year license suspension. They may have even potentially caused an accident during the most densely populated travel times. However, they will most likely not even be reprimanded, let alone have the license revoked as the law already dictates. This would have a greater chance of happening if they were to violate posted speed limits during less congested travel times (and therefore able to achieve those speeds) when they are a danger to less people. Suspending licenses and monitoring for suspended licenses and driving without insurance with resulting criminal punishment would be a better solution to travel concerns than a carbon tax. The worst case scenario might be only marginally less drivers who happen to drive in a considerably safer fashion. Not exactly a horrible outcome. Sure, this doesn't get to the original *point* of the carbon tax, which was to reduce this definition of "pollution"... But the problem with this is that this perceived "danger" to society is still a subjective one. Even if everyone agreed that it was a problem, the end user is not the best agent of change as they would not bear the lowest cost to do so of all parties involved.
clayton - Sunday, April 22, 2007, 10:39AM ET Report Abuse
- Overall: 2/5
two words... false choices We regulate drugs *because* they have externalities. Markets don't work because they don't internalize the other costs to society. The tax on hard drugs would have to be so high due to the crime and brain damage they cause that the small benefit left would likely be smaller than the costs to implement the tax. Plus a large enough tax restores the black market a voila... this "market" solution is even worse. I'm not even sure what to say about equating open borders to free markets. By allowing goods to pass across the border unhindered, we manage competition in product markets. If we allowed guest workers into the country without the entitlements (or cost of a road to entitlements), then we'd get free competition in service markets too. But our entitlement system make the cost to society very high for every person who crosses the border and gains citizenship. In that case, we wouldn't "sell" citizenship for free (as free borders would presume) since we would only sell it to those who contribute more than they cost. On the other hand, the only concern/potential issue I have with carbon tax (as we repeatedly rehash on Mankiw's blog) is that there are costs and benefits to it vis a vis a cap and trade system (or certain hybrid systems), particularly in the bureaurcracy to implement and potential inefficiency of the level of tax selected.
nobody - Tuesday, April 17, 2007, 5:47PM ET Report Abuse
- Overall: 3/5
whenever someone is so insightful on a lot of things and turns to "i dont know" on drugs, in my experience, it means they have tried, used, and/or know someone who uses drugs and they don't see the damage caused by the act of doing drugs. Uhm....they are illegal for a reason. I have not met any wealthy people who attributed their success to the use of drugs. Let's just keep that illegal and move on. Working for 75 cents is an option for people? Hardly! Thats like saying I chose to pay 250k for my lamborghini. The fact is, its there and if you want it..you have to suffer. Problem is, eating and living is not a choice is it? You need to live. Working for 75 cents / hr. is hardly what I would call a choice. Its called survival. Free market for the borders will mean that some of our industries will literally shut down. Its not bad if you are not affected. But when towns disappear in Texas because Mexico residents come over and do it cheaper. We have a problem. I don't know what "markets when they work well" means to you. But, to me that sounds like a disclaimer to your whole idea. When it fails, "I guess that market didn't work well" is surely your excuse for people in the U.S. being screwed. Gas tax? gasoline is a luxury that Americans have enjoyed far too long. Myself included. When I am bored, I hop in the car and drive along the beach cause it makes me feel good. I should ride my bicycle. Or walk. Other countries have not enjoyed the gasoline lifestyle Americans are used to. So, Tax? How about we make better cars and limit gasoline allowances. Reducing the demand reduces the price. Chavez is trying to stick it to the U.S. So, why don't we get smart instead of work some magic. Just use less gas. This would of course include doing away with those trucks that drive around carrying only a banner of advertisement that seem to always get in front of me on the road.

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