Economic Collapse
Economic analysis shows the mathematically optimal way to arrange society…assuming all the assumptions are correct. The free market maximizes outcomes in situations with perfect competition. The invisible hand is the idea that consumers and firms will do what is best for society by serving their own interests. Economics often uses this idea as a starting point when considering how best to allocate resources. While not perfect, rational self-interest is helpful since it can be easily studied and modeled.
“All models are wrong, but some are useful.”
— George Box
Models are only useful when the limitations are known. Unfortunately, most people rarely think in economic terms, and many others fail to see the limitations of economic models. An analytical framework provides unwarranted confidence when the underlying assumptions are poor. This leads to stubborn partial penetration.
Again, simple economic models are incredibly valuable in understanding human behavior; however, they are incomplete in situations with imperfect competition. These situations are considered market failures since government intervention is necessary to realize optimal outcomes.
Market Failures
Externalities are unaccounted for costs or benefits borne by others. They can be positive — such as spillover effects from research & development — or negative — such as second-hand smoke. Either way, the socially optimal point won’t be reached due to the misalignment between personal and societal incentives. Corrected this market failure is straightforward as taxes internalize costs and subsidies internalize benefits.
Economists don’t see people; they see perfectly rational consumers. “Perfectly rational” isn’t how I would describe people which is why behavioral economics exists. Behavioral economics considers instances in which actions differ from the rational, selfish behavior suggested by classical economic models. Loss aversion — the idea that losses are felt more strongly than gains — is one such example. People feel worse after gaining and then losing $10 even though they end with the same amount of money as they started. Besides being a market failure, loss aversion often prevents us from taking healthy risks.
The free-rider problem occurs when individuals don’t pay their share for something because it is non-excludable. This can be for a common resource with a finite quantity or a public good with ample supply. Cattle grazing and fireworks are both prone to the free-rider problem since people can’t be excluded. Common resources will be overconsumed without an appropriate mitigation strategy. The government supplies public goods since the market would not provide freely-consumed resources.
Non-competitive Markets
Non-competitive markets are another market failure. These come in various forms. A buyer or seller can exert control over a market when there are few participants. When only one supplier exists, the monopoly has little incentive to compete on price or quality. Similarly, a company can exert market control through product differentiation even if there are many competitors. Branding and lock-in are common forms of differentiation. For example, Teams doesn’t need to be the best messaging app, and Airpods don’t need to be the best headphones. An inferior product is the rational choice for businesses and consumers due to previous purchases.
Markets are also non-competitive when there is incomplete information. Adverse selection occurs when there are information asymmetries between buyers and sellers. For example, a car seller knows much more about the vehicle’s condition than the buyer. The buyer assumes it is sold due to some undisclosed fault which drives prices down for all used vehicles. Moral hazard arises due to the transfer of risk. Insurance protects the agent from risk which causes them to engage in riskier behavior. Motorcycle riders would want to opt for the most comprehensive health insurance. This is inefficient due to both adverse selection and moral hazard since the insurance company is unaware of the risky behavior, and the driver no longer bears the entire cost of an accident.
Barriers to entry limit innovation by limiting new entrants to the market. This is common in industries with high capital requirements, but can also exist due to government interference. Regulations, licenses, and complexity all favor existing, large firms over newer, small entrants.
Enough is Enough
If all these (and many other) market failures were corrected, the market would naturally maximize total surplus, or total benefits. However, this isn’t necessarily the social optimum. People have different needs, and everyone has diminishing marginal utility. A person might spend their first dollar on water, their thousands dollar on transportation to work, and their millionth dollar on a first class flight. Another way to think about diminishing marginal utility is to consider Maslow’s hierarchy of needs. Money can easily help achieve the base requirements, but the higher levels can only be realized through personal work. It follows that more money should be spent where it is effective.
While money spent on water may be more beneficial than money spent on nicer flights, there is an inherent trade-off between equity and efficiency. Administrative costs associated with redistribution are one source of inefficiency. More importantly, transfers disincentivize work both for those taxed and those receiving payments.
The equity-efficiency trade-off can ultimately only be settled by ethics, not economics. Commodity egalitarianism minimizes redistribution while satisfying some minimum living standard for all. Commodity egalitarianism, and equality of opportunity, seem to strike the right balance between equity and efficiency.
Economics is necessary to correctly assess trade-offs as it studies the allocation of scarce resources. Concepts such as the law of supply and demand can be understood by considering perfectly competitive markets. However, this framework cannot fully describe the world since real markets are more complex. Understanding the limitations in this model can highlight common flaws in many people’s thinking.
