About three weeks ago, Gulzar Natarajan wrote a blogpost titled “25 economic orthodoxies that should be discarded“. The list is fascinating and worth thinking about. Doubly so if you are learning or teaching economics, and each of his twenty-five picks is worthy of discussion.
So worthy, in fact, that a blogpost probably won’t be enough – but it will be a good enough start, perhaps? Let’s find out, beginning with his first point: there are no free markets in the world.
Have you heard of Gall’s Law? Here’s the quick definition:
A complex system that works is invariably found to have evolved from a simple system that worked. A complex system designed from scratch never works and cannot be patched up to make it work. You have to start over with a working simple system.
Economists look at the world, and try and make sense of it, by building the simplest possible system “that works”. To this system, they add increasing levels of complexity. At some point, they stop and say “Ah, this is now a working model of the world”. They then “run” this model, “see” what happens, and therefore predict what will happen in the real world. Sometimes the model “works”, in the sense that the model predicts, more or less, what actually took place in the real world. Sometimes the model fails, in the sense that the world goes and does something else altogether. The world is quite irritating that way.
In either case, we “update” the model, and we try again. And on and on we go.
But it all begins by building the simplest possible system.
How does this work, exactly?
Let’s say I want to stop writing this post, and I want to go have a cup of chai. Let’s model this simple statement.
I want to have chai.
But I’m a hopelessly lazy person, I don’t want to make chai. I simply want to go outside to a tapri, ask for a cup of chai, and sip on it.
We now have demand. There is a “rational agent”, who desires a particular commodity called chai. Do we have supply?
Sure we have supply! In fact, there is a lot of it – why, there are at least ten chai tapris a short stroll away from my house. Each of them will happily sell me a cup of chai for ten rupees. And, if I so desire, a packet of biscuits, or a cigarette to go with it. I desire neither, but that will not matter to the seller – they will happily sell me just the chai.
So now we have supply. And we have, therefore, a market for chai.
Gall’s Law, y’see. A simple, working model of a market. It’s easy, this economics-y stuff.
Just as there are no frictionless surfaces, there are no free markets in this world, ones that have perfect competition. Nor can there ever be any such markets. All markets, embedded as they are in the real world with people having widely varying and idiosyncratic preferences, suffer from imperfections and failures. The markets cannot self-correct these. Policy interventions are essential in those markets where failures impose significant social costs.
https://gulzar05.blogspot.com/2023/11/25-economic-orthodoxies-that-should-be.html
Is the market for a cup of chai close to where I stay perfectly competitive? That is, is the market that I just described “without friction”?
- Am I indifferent to where I will have my chai? Will any one of the ten tapris do, or do I have a favorite? Of course I have a favorite, which self-respecting Indian doesn’t?! In the language of economics, the good in question (a glass of cutting chai) ain’t homogenous. I have preferences.
- It’s weird, and it is a story worth the telling – I actually am indifferent to the chai in all of the ten tapris, but my favorite tapri sells vada pav as well, and ooh, there’s this one tapri has fantastic vada pavs. And I’ve made friends with the lady who runs that tapri, and whenever possible, she fries up a fresh batch of vadas whenever I turn up. And so I end up having chai there.
Why do I bring this up? Because friction, because imperfection, because idiosyncrasy. This is already not a perfectly competitive market. - Are all ten chai tapris run equally efficiently? Are all run by folks equally proficient in running a chai tapri? What does being equally proficient mean, exactly?
- Equally good at making a cup of chai? Maybe one of them puts green cardamom in their chai, maybe one of them puts ginger, and maybe a third puts a bit of both?
- Equally good at dealing with the local politician or local cops? Maybe one of them speaks Marathi but another does not? Maybe one of them is from a particular religion, but the other is not? Maybe one of them speaks a particular language, but the other does not? Maybe one of them is from a particular gender, but the other is not? Maybe one of them is from a particular caste, but the other is not? Don’t these things matter? Of course they do.
- One of these chai tapris is located next to a sports facility. Another is located right next to a building that has a lot of offices and shops. Another also sells vada pav. A fourth is closest to a mandir. Do preferences build differently over time within the same locality as a consequence? Of course they do.
- Do all of them have access to the same quality and quantity of water, tea leaves, vessels and cups?
- And so, for all of these reasons and so, so many more, the market for chai tapris right outside where I stay isn’t competitive.
I do not bring all of this up to show you that India in particular is imperfect, or that economic theory is hopeless. All societies the world over will have different preferences and constraints. And so both demand and supply, in any market, will have frictions and imperfections. And this is just the market for chai! What about the market for nuclear reactors? Covid-19 vaccines? Helicopters for the military? Software engineers? Milk? Votes? Kidneys?
These frictions and imperfections will mean that markets will not work as efficiently as they would have otherwise. And because they are not able to work as efficiently as they could have, the good in question is either not produced as much as it could have been, or is sold at a slightly higher price than it could have been, or both. And so either producers suffer, or consumers do, or both.
And all this before we talk about externalities, but that’s a whole other story.
Gulzar Natarajan’s first point in his list of things that don’t work in economics theory is that markets are not self-correcting. They don’t work perfectly.
And so, he says, “policy interventions are essential in those markets where failures impose significant social costs.”
Now, here’s where things get interesting, tricky and contentious, so make sure you follow along carefully:
- Almost every economist I know will agree that markets are not entirely self-correcting. We can and do quibble about the extent and ability of self-correction in different markets, but that’s a debate about degrees. It is not a debate about the existence of perfectly competitive markets.
- Almost every economist I know will agree that market failure, in some cases and for some markets, will impose significant social costs. That just is a fact. Again, the debate is about degrees, not about the fact that these social costs exist.
- But those four simple words… “policy interventions are essential”… that is where the debate rages. If economic theory is Jupiter, this is our Great Red Spot.
- Folks who support policy interventions will say “There is market failure! There are significant social costs!”
- Folks who don’t support policy interventions will say “Nah, it’s not as bad as you think it is! See this study, and that one, and that one, and this RCT, and that one, and this RDD and that one!”
- And folks who support policy interventions will publish 547 well-researched, impeccably cited and co-authored papers refuting the 389 well-researched, impeccably cited and co-authored papers saying it wasn’t as bad as you thought, and well, this never stops. Avoid getting sucked into these battles, unless you like doing this sort of thing, or need to publish in order to get a degree or a promotion.
- Bu even if both the pro-interventionists and the anti-interventionists agree about the presence of significant social costs, the story is very far from over. Because all that we have managed to do is agree upon the diagnosis. Not the cure!
- “Market failure leads to social costs leads to policy intervention and so QED”, say the pro-interventionists.
“Not so fast!”, say the anti-interventionists. “Who, exactly, is going to guarantee that the intervention will not make things worse? You and what army?” - “So which is it?”, you may well ask. “Do interventions make things worse, or better?”
- I’m positively delighted to inform you that the answer to this question is dependent on time, place and scale. So a policy intervention that worked in the 1970’s for a village in India will work very differently for a city in China in the 2020’s. So we just don’t know for sure.
Bottomline: yes, of course there is market failure. Measuring the extent of it, and its impacts, is tricky. Yes, thinking about interventions is necessary. Coming up with the best possible design and the best possible implementation for these interventions is tricky. Measuring (let alone predicting) their first and second order effects is impossible.
Bottom-er line: Folks who say markets always work are wrong. Folks who say interventions always make things better are wrong.
EconForEverybody 