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Sandy and Bob on the Efficiency of ‘Inefficient’ Free Markets

Posted By Don Boudreaux On December 12, 2012 @ 3:39 pm In Complexity & Emergence,Economics,Hubris and humility,Man of System,Prices,Property Rights,Reality Is Not Optional,Religion,Science,Scientism | Comments Disabled

In the November 2012 issue of The Freeman my old buddy Sandy Ikeda explains the virtue of market inefficiency [1].  Sandy’s is a straightforward but important point, and he expresses it in a way that gives to it a dimension that at least I had never before encountered.  Here are Sandy’s closing five paragraphs:

One implication of this insight is that government policies that undermine the (admittedly imperfect) reliability of money prices also make the discovery of inefficiencies profoundly problematic: undermining prices casts doubt on the very meaning of inefficiency.

Strictly speaking, an inefficiency exists when, for a given person at a given time and place, the cost of an action outweighs the benefit.  We’ve seen that to rationally calculate costs and benefits you need money prices of inputs and outputs, of steel and bridges.  So when government erodes private property rights, interferes with trade, distorts prices, and manipulates money, it doesn’t just make it harder to be efficient; it also pulls the rug from under the very ability to spot inefficiencies at all.

Using the rules of arithmetic, for example, it’s easy to see that the statement 1 + 2 = 4 is wrong, but what about  _ + _ = _ ?  What’s the solution to this “problem”?  Is there even a problem here?  Money prices fill in the blanks; they “create errors”—i.e., reveal mistakes that no one could see without them—that alert entrepreneurs might then perceive and correct. If mistakes and inefficiencies remain invisible, the search for better ways of doing things could never get off the ground.

An economy without inefficiencies is either one where knowledge is so perfect that no one ever makes a mistake, or it’s one in which government policy has effectively foreclosed the very possibility of inefficiency.  In a world of surprise and discovery, of experiment and innovation, the former is impossible; the latter sort of economy, as Mises showed almost 100 years ago, is impossible as well as intolerable.

So a living economy needs to “create” inefficiencies, and lots of them, to set the stage for greater efficiency and ongoing innovation.  And that’s just what the market process does all the time—thank goodness!

Sandy’s essay is complemented nicely by another essay that I read today, one by Bob Higgs in the hot-off-the-press Winter 2013 issue of The Independent Review [2] (which Bob edits).  Bob’s essay (yet to be put on-line, although here’s an earlier version of it [3] [HT Austill Stuart [4]]) is entitled “Truth and Freedom in Economic Analysis and Economic Policy Making.”  Here’s a central passage (original emphasis):

Those who have studied a little economics in a university may object that according to the theory of “market failure,” various deviations from hypothetical “perfectly competitive” conditions may cause market-determined prices to be distorted and outputs to be “inefficient,” and in this even the government can intervene with taxes, subsidies, and regulations to bring the market into an efficient configuration.  What these students probably were not taught, however, is that this theory assumes a great deal that cannot be known by anyone except as it is determined in actual markets.  Further, because the actual parameters of demand, cost, and supply functions are unknown (and constantly subject to change) in the real world, the government does not, indeed, cannot know how much to intervene – what amount of tax to collect or how much to pay as a subsidy, for example.  Further still, this theory implicitly assumes that the interventionist actions the government takes are themselves without costs.  [DB: Or simply assumes that those costs are outweighed by the benefits of the government intervention.]  One wonders: how are the tax-and-subsidy agencies and the regulatory bureaucracies supported?  Even further still, because in reality  such interventions are the creations not of genuine economic experts (themselves helpless enough), but of politicians and their lackeys, the interventions are normally intended to, and do, serve not the purpose of establishing an efficient allocation of resources, but the purpose of promoting the politicians’ personal, ideological, and political ends.  The entire apparatus of the theory of market failure is a sheer blackboard fantasy, an economic theorist’s plaything that has been accepted far too often as a helpful guide to, or justification of, government intervention in the market economy by putatively public-spirited legislators and regulators.

I would add only (in addition to the bracketed remark that I’ve already added) that the fantasy of government officials possessing sufficient knowledge, and having appropriate incentives, to intervene in markets in ways that improve markets’ operation becomes only stronger and more believable the more the typical student studies economics at the typical university.  Mastering beautiful mathematical techniques and conquering the latest advances in econometric analyses and testing too easily deludes students – especially those unfortunate enough to be cursed with the combination of a high I.Q. and weak wisdom – into fancying that they thereby possess keys to unlock secrets of reality that will enable them, or those whom they advise, to poke and prod and push and pull and yank and nudge and tax and subsidize private market actors in ways that yield outcomes that would bring a smile of approval to the face of God.  But as I suggested earlier today [5], this social-engineering mindset reflects a profound failure to understand the importance of the lessons that have emerged from the Scottish Enlightenment tradition.

Scientism is not made scientific by wearing a science costume.

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URLs in this post:

[1] Sandy Ikeda explains the virtue of market inefficiency: http://www.fee.org/the_freeman/detail/the-virtue-of-market-inefficiency#axzz2ErzKhFGz

[2] The Independent Review: http://www.independent.org/publications/tir/promo.asp

[3] here’s an earlier version of it: http://blog.independent.org/2011/04/19/truth-and-freedom-in-economic-analysis-and-economic-policy-making/

[4] Austill Stuart: http://www.facebook.com/austill.stuart

[5] as I suggested earlier today: http://cafehayek.com/2012/12/quotation-of-the-day-488.html

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