Perfect markets are a beautiful fairy tale, but they do not correspond to reality. And few straw men have been put to death as repeatedly as the idea that the case for markets depends on market perfection, and that the inevitable inability of real world markets to match this textbook abstraction undermines the argument for the use of markets. Some of the strongest defenders of the market system, such as FA Hayek and Israel Kirzner, reject ideas such as perfect markets, perfect information, perfect competition, and so on. Their argument for the use of markets does not rest on some abstract perfection of markets, but on the real dynamics inherent in the ongoing and evolving market process. Markets are not useful because in a market-driven world there are no $20 bills on the sidewalk. Markets are useful because they create the right environment find those $20 bills.
One real friction in real markets is price stability. In the fairytale version of perfect markets, prices adjust immediately. In the real world, prices can be sticky; they may not change, or change slowly. One reason for this is transaction costs. Sometimes changing a price is not free. The textbook example of these so-called ‘menu costs’. Even as the costs of different foods and ingredients change, restaurant prices can remain fixed and unchanged. In order to change their prices, restaurants would have to print a whole new set of menus with the updated price for each dish. This costs money and time. If the price of potatoes increases slightly, it is often not worthwhile for a restaurant to print a new set of menus with updated prices for each dish that contains potatoes.
But like asymmetric information, transaction costs have a half-life. There is an incentive in the markets to find ways to reduce transaction costs and thus reduce price stability – because finding ways to reduce transaction costs is itself a money-making opportunity. Menu costs are also an example of this. One way I’ve seen restaurants get around menu fees is by simply not listing a price for certain menu items. If a beach town restaurant regularly serves fresh and locally caught fish or lobster, the cost for those products can fluctuate significantly. To accommodate this, they often list such dishes on the menu as ‘market price’ rather than as a fixed dollar amount.
More recently, I’ve seen many other restaurants put their menus on digital displays instead of having them printed, and some have ditched physical menus altogether and replaced them with a QR code at each table. You scan the QR code with your smartphone and a website will open with the most recent menu. This dramatically reduces the transaction costs associated with menu pricing and makes pricing more flexible. Price stability is a real problem – but at the same time, the very existence of that problem creates an incentive for the market to find solutions. Hence Arnold Kling’s statement: “Markets fail. Use markets.”
On the other hand, there is also a problem with the tenacity of the policy. When governments develop policies to solve a social problem, those policies themselves become sticky. It is surprisingly easy for people to overlook this problem. The fantastic book by James C. Scott See as a state provides a comprehensive look at how policy interventions go wrong. Towards the end of the book he gives some tips that can help improve the situation, such as:
Favor reversibility. Favor interventions that can be easily undone if they turn out to be mistakes. Irreversible interventions have irreversible consequences. Interventions in ecosystems require special care in this regard, given our great ignorance of how they interact. Aldo Leopold summarized the caution required: “The first rule of intelligent tinkering is to save all the parts.”
It’s not that this is bad advice in the abstract. But the idea that interventions can be “easily undone if they turn out to be mistakes” is less convincing when you consider that policies are also sticky. In practice, it is often extremely difficult to undo interventions, no matter how wrong they turn out to be. Policies become sticky because, as Pierre Lemieux often notes, all public policies necessarily benefit some at the expense of others. This quickly turns into a public choice problem. Once the government implements some intervention, it creates a new interest group that will invest in keeping that intervention alive, while the benefits of ending that intervention are so dispersed that no one in particular has a strong incentive to to try to do that. put an end to it. It’s not without reason that Milton Friedman quipped, “Nothing is as permanent as a temporary government program.”
This joke overstates things: not all policies are so sticky that they become immovable. But it’s a real problem. A classic example is the mohair subsidy. This program was initially implemented to ensure that the US military would always have enough wool for their uniforms. But eventually the military stopped using this wool in their uniforms and started using synthetic materials instead. Nevertheless, the federal government continued to spend tens of millions of dollars per year subsidizing mohair production long after the original reason for doing so had disappeared. The program was eventually (largely) eliminated – more than four decades after the switch to synthetic materials.
This The 1993 report detailing ongoing efforts to eliminate these subsidies includes a commentary from Senator Charles Schumer, who notes that he spent years trying to reverse this policy. If there was ever a policy that was supposed to be “easily undone,” you would think it should be as simple as possible. But policy persistence can be such a powerful force that even something as seemingly simple as “stop spending tens of millions of dollars a year subsidizing something you didn’t need decades ago” takes years of intense effort to achieve. to ultimately achieve it. Pace James C. Scott: “interventions that can be easily undone if they turn out to be mistakes” are only found in fairy tales, and not in reality.
While markets provide an incentive to find ways to offset and reduce price rigidity, politics provides incentives for the beneficiaries of policies to make those policies as sticky as possible. In markets you can make money by finding ways to reduce transaction costs. In politics you protect your generosity by ensuring that transaction costs are as high as possible. In the real world, price stability is the most decisive factor proverbial stain and policy consistency is the proverbial logbook.