Wednesday, October 12, 2011

Re: Darwinism and Libertarianism (Matt Welch & Robert Frank)

Reason Magazine's Matt Welch and Economist Robert Frankdiscuss Frank's new book and various aspects of libertarian thought in a diavlog at What follows is some of my reactions to some of the critique Frank brings.

Since I think it's useful to situate Frank's critique within the intellectual project he is address, I'll start with an (imperfect) sketch of libertarianism itself:

How can we can we create the best possible society for ourselves? Libertarians note that what different people judge to be best for themselves depends on differing values and they judge that what is best for all individuals is the aggregate of what is best for each individual, valued (presumptively) as that individual would value it. By that judgment, what is best is the greatest possible value of "goods" (tangible and intangible) as measured by the revealed preferences of those who consume them — i.e. maximization of total wealth as measured by market value. Or better, as measured by the preferences of hypothetical individuals in a state of stochastic ignorance, such that values are informed by some reasonable amount of aversion to the risk of distributional inequalities. Hypothetical valuations can't be measured, however, so practically speaking, this means maximizing total wealth, then making adjustments and transfers.

The great intellectual project of libertarianism, then, is to grapple with the question: what are the set of institutions that will produce the greatest amount of value, so defined? The key contribution of the tradition is to identify and conceptualize three fundamental challenges to this task.

  • The first challenge is that producing the greatest value requires knowledge to which no one person has (or ever will have) access, most importantly the composition of people's preferences, but also local knowledge about the relative scarcity of particular resources, and the effectiveness of forms of production. The corresponding insight, however, is that order that cannot be designed can instead emerge — the knowledge we require can be collected, weighed and transmitted by the price mechanism of voluntary exchange in a market. If we can assume that frictionless exchange takes place between entirely rational individuals, then the only institution we need in order to attain wealth maximization is a free market with contract and property rights; the price mechanism will emerge and create private incentives that efficiently allocate productive resources.

  • The second challenge is that transaction costs exist. We cannot assume frictionless exchange, because the time and energy required to negotiate exchange can be substantial and is unevenly distributed. And we cannot assume entirely rational individuals because rationality is a context-specific human faculty that must be acquired through experience. This leads to what are classically identified as "market failures," where a market alone, narrowly conceived, will not efficiently allocate productive resources. More on that in a bit.

  • The third challenge is that no system of contract and property rights, indeed no stable set of rules, can merely be posited. Rules and enforcement are themselves the product of institutions in which individuals respond to private incentives. In other words, governance is merely another type of social institution like any other.
It is the second challenge, that of market failures, that Frank's critique relates to, so let's expand on that. The four classic failures are: market power, asymmetric information, public goods, and externalities. Each is presented in binary terms — failure or no failure — but in fact they all exist on a spectrum. Every single good in every single market has some each of these qualities to some degree.
  • Market Power/Monopoly/Monopsony: where production is not allocated efficiently because one firm has the power to restrict the exchange of goods, so that the price will not settle where the value to the marginal seller is equal to the marginal buyers, but will settle where the firm with market power can make the most profit.

  • Asymmetric Information/Bounded Rationality: where one set of parties to a transaction — buyers or sellers — has greater capacity to assess the merits of an individual non-uniform transaction than the other, so that informed parties will systematically withdraw from transactions that will be more beneficial to the uninformed party, leading the expected benefit to the uninformed party to go down. The classic example is the market for "lemon" used cars: quality used cars are worth more than the average price, so people keep them while continuing to dump their bad ones, which further lowers the average quality of cars and thus the average price buyers will pay, rinse, repeat.

  • Public Goods: where a good is non-excludable and non-rivalrous, which means that everyone can use it and no one has to pay for using it, then no one has an incentive to try to put it up for sale. The classic example is a lighthouse: one ship using it doesn't stop others from using it, but you also can't selectively shut it off for the ships that don't pay. Of course, as it turns out, the market, in a larger sense, does create lighthouses without any government intervention, so this gives a preview of the limited sense of "market" we are using when we say that market failures require an additional institution to fix them.

  • (Property Rights) Externalities: where the practical ability of a person to use property is mismatched with the practical ability of the person to exclude others from use of the property. For example: the tragedy of the commons, where a good is rivalrous, but non-excludable — like a pasture everyone is allowed to graze on or air everyone is allowed to pollute — so it gets overused. There is also tragedy of the anti-commons, where a good is non-rivalrous, but excludable — so it gets underused.

The key thing that makes each of these things market failures is that they cause the private price of the good to be mismatched with the true cost of the good, so that they incentivize private behavior different from the behavior that will produce the most social good.

But there is another way that the market failures have been conceptualized. That is, as instance of externalized costs more generally — i.e. whenever the consequence of a transaction between two parties makes a third party better or worse off, but that effect isn't captured by the price because there isn't a recognized right in the effect on the third party. This captures a certain independent moral intuition about externalities — do no harm — but it also broadens the category far beyond market failures. Indeed, it includes the very thing that makes a market healthy, the fact that new producers drive prices down because they do not capture the harm done to their competitors by their entry into the market.

It is this latter conception that Frank appears to have in mind, in part because it is the analogy that can directly be made from biological theory. If I recall my history of biology correctly, Frank's analogy about the peacock is drawn from the group-selection debate, and it reflects the insight that competition for mates can select for adaptations that aren't really beneficial to individual peacocks. But indeed, this reflects the fact that no adaptation is ever selected to benefit the individual organisms. The evolution of the genepool isn't a mechanism for generating peacock welfare; peacocks are just a way that peacock genes use to make more of themselves. The emergent order of evolution is directed neither at the interests of peacocks in general nor at the interests of individual peacocks, it is directed at the interests of genes. Peacocks are the objects of the emergent order of evolution. You can't really say the same thing for the emergent order of the market. It is concern for the welfare of individual market participants that is the basic "selection" mechanism in a market. The objects of the emergent order of the market are productive resources, not humans per se.

But with that in mind, let's examine the collective action problems that Frank is pointing to and analogizing to a classical market failure. The peacock story represents competition for a positional good. A classical good will see increased production when its price goes up, but a positional good will not see increased production as the result of increased price. Competition to attain these goods is thus a zero-sum game and will only drive up their price. Thus someone who bids for a positional good will, in some sense, impose a cost on other bidders. If all the bidders got together and internalized these costs, they would instead collude to purchase the positional good for a much lower price. In the peacock story the supply of mates is basically fixed, and therefore positional, and tail size is the cost of bidding — in an all-pay auction, no less.

The story about the finance job seekers and their custom suits is another example analogous to an all-pay auction for a positional good. In this case the "good" is actually the finance job (conceptually a bit contorted, I know) and the pricy suit is the cost of bidding. Now, actually, the finance job isn't positional, because there would be more of them if the price changed, but we can say that it is positional with respect to the pricy suit. If all the job seekers agreed to buy the same cheap suit, the same number of jobs would get filled. The fact that the group of bidders could get the same collective result while spending less money means that in some sense there is a "rent" — payment beyond that necessary for the good to be caused to come into being — being collected.

But why is this strange suit nonsense happening at all? It's not even like the finance employer is getting the money from all these suit purchases! Well, let's go back to one of our classical market failures: asymmetric information. The potential employee has a pretty good idea how much work he is willing to do and what his talents have been, whereas the potential employee does not, and it is costly to make a hiring mistake. In order to prevent a "lemons market" failure, the potential employees need to effectively signal their worth. One way is to convey actual useful information. But another is to use one of Anthony Kronman's primitive contracting devices: hostage-taking, collateral, union or hands-tying. Buying a really fancy suit that is very affordable if the applicant can hold down a finance job, but very imprudent if he cannot, is a form of hands-tying. The applicant is saying, in effect, "you can trust that I'm telling the truth when I vouch for my quality, because if I am not, I stand to take a big loss."

So, in fact, the suit example isn't a failure of the market, it is an institution that is helping to correct a market failure. That means we need to re-examine the question of whether, if the applicants all decided to buy the same cheap suit, things would still be the same. The suit competition is actually conveying information that is useful to the market, and therefore increases societal wealth. Our collective action problem is only a collective action problem if we define the relevant group in a particular and limited way. There's nothing that needs to be done by the government to stop the applicants from purchasing pricy suits, because until some better alternative comes along, they need to signal a costly pre-commitment regardless of what the government's suit policy is.

Of course, there is a distinction to be made between a government intervention done to correct a market failure and an intervention intended to benefit government. It's not bad that there is a rent being collected somewhere, but if someone is going to collect it, why not the government? There is nothing special about the intrinsic qualities of the $2k suit that the finance applicant is buying. All it needs to do is effectively convey that he spent $2k on it. If the government slapped a 100% tax on suits, he would buy the suit that otherwise costs $1k, and it would still effectively convey that he spent $2k on it.

There is a long intellectual history of trying to figure out how to finance government through taxes on economic rents, both inside and outside of the libertarian tradition. The most famous example being Henry George, who advocated a single tax on the unimproved value of land, a pretty simple scheme. Frank's "progressive consumption tax" is potentially another simple scheme — like the FairTax it is basically a flat tax plus an income-based transfer payment. The problem with any more complicated scheme is that you start needing to know a lot about the microeconomic structure of the market you are meddling in, which goes back to the problem of decentralized knowledge.