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There Are No Market Failures, Only Human Failures

The Mises Institute has started a video series, in which one of the professors at the Institute gives the “Mises View” on a current event. The great thing about this series is that these are short videos (~5 min), in contrast with the hour-long lectures usually posted on misesmedia. In the clip below, Peter Klein discusses Blackberry’s recent downfall in the broader context of Austrian theory.

First thing I should say is that I’m glad they’re doing this. Shorter videos have more appeal to a larger audience, and while this is still great for the base of supporters they already have, I think their main goal in doing this series should be to expand that base.

So that’s where a slight criticism of mine comes in. The downside of shorter videos is that you can’t properly develop the arguments you do have. That said, I don’t think the first of Klein’s arguments will reach very many people who don’t understand the fundamentals of Austrian economics, especially those with a mainstream economics background.

To summarize, Klein is arguing against those economists who propose government intervention as a solution for the market failure of network effects.

In the video, Klein responds “just a few moments of reflection can show that this is not at all a good idea: the government is in no position to make these decisions ex ante. The government doesn’t know what technologies will end up being the most popular, which technologies will end up satisfying consumers in the greatest way.”

It’s true that the concept Klein is discussing is almost unbearably simple, but to individuals without any knowledge of Austrian basics, it might seem like the folowing:

Mainstream economist: Market failures exist where the best product may not actually be chosen by the market due to things such as network effects. In such industries, it’s best if government steps in and tries to fix it.

Klein: Nop.

Just for emphasis: I am NOT saying Klein does say this, I’m saying to an individual without knowledge of the fundamentals of Austrian economics might see it like this.

So let me elaborate on Klein’s argument so it is clear what he’s saying and so that a supporter of intervention to fix this apparent market failure does realize it’s a strong one. In addition, I want to expand on this argument to my own conclusion, which is in fact the title of this post.

Individuals act to satisfy preferences. Markets are created by individuals voluntarily trading one good for another. If I spend $100 on a phone, it’s because I value the phone over the $100. In contrast, the seller of the phone values the $100 over the phone. If one of these two conditions did not hold, the trade would not take place.

The phone was produced by a producer in anticipation of the trade. He believed creating this product now would satisfy an individual’s preference for it in the future. If he’s right, he makes a profit, but if he’s wrong, he’ll make a loss. As such, a correct anticipation of preferences that rewards a businessman with profit will allow him to stay in business, but incorrect anticipations that result in losses will tend to drive him out of business.

Before we move on, let’s differentiate between ex ante and ex post.

ex ante: this means right before and at the moment of the exchange. An individual ex ante values what he is receiving over what he is giving up in a voluntary trade. Otherwise he would not do it.

ex post: this means after the exchange. An individual ex post, after an exchange, may realize the trade was a mistake and no longer value what he received over what he gave up. Alternatively, ex post he may still think he made the right decision.

As we can see, in the marketplace, there is a connection between sellers and buyers in that sellers always satisfy their buyers ex ante preferences. This is because it is a voluntary trade: the seller is funded by voluntary means and must make profits to stay in business.

What about ex post? There is no necessary connection between any particular trade and the satisfaction of ex post preferences for that trade. Even if the trade is voluntary, mistakes can be made on the part of consumers. However, there is a tendency for the satisfaction of ex ante preferences, which as we have seen, always result from voluntary trade, to result in the satisfaction of ex post preferences in the long run. Let’s go back to the individual in the previous example to see why. If he thought he made a mistake by buying the phone for $100, now he can choose to buy another phone instead. The realization of his mistake allows him to make correct decisions in future exchanges.

Now, a person might admit this, but then bring up the supposed “market failure” of network effects in the free market. Essentially, this argument states that certain products have value not only for the obvious reasons they satisfy a person’s preferences, e.g. a phone allows a person to communicate, but also because the more people that use that particular product, the more value it has, e.g. you wouldn’t want to switch from Facebook to some other social network because your friends wouldn’t be there. Because of this, it’s possible a product that wasn’t objectively the best of its kind could be chosen just because it has a particular network associated with it that people can’t break off of to switch to the better product.

Because of this, the person might continue to say, government needs to step in and regulate the sector so that the best products are chosen.

Let’s accept the existence of network effects. This is certainly a legitimate phenomenon as the example of Facebook above shows. However, the government clearly cannot be a solution. We have seen that businessmen who engage in voluntary trades do satisfy the ex ante preferences of individuals, and this process tends to result in the satisfaction of ex post preferences. Businessmen are ultimately funded in this voluntary manner, and must earn profits to stay in business. However, government, which is ultimately funded by taxpayers has no connection to the satisfaction of preferences, not ex ante and certainly not ex post. This is because taxation is not a voluntary exchange. In addition, there is no direct connection between this method of funding and the decisions the members of government make. Government doesn’t have to be “profitable” to stay in the “business” of regulation; in fact these very terms are inapplicable here.

Because there is no test to see if government regulators are making the right decisions, there is no reason to expect they will in fact make correct decisions. Instead, we should expect government regulators to make horribly wrong decisions: without profit and loss, government is like a blind and deaf man who also has happened to drink a bit too much alcohol in the past few hours. We can only hope he manages to get home safely tonight, but if he walks in front of a moving bus and gets hit, we should not be surprised.

If the government can’t fix this problem, what are we going to do? The important thing to realize, as with all arguments revolving around market failures, is that network effects are only one incentive working amongst many incentives involved in human action. For example, if a product is bad enough, no amount of network effects are going to keep individuals from switching to another product. What we shouldn’t do, in attempting to make the situation better, is ditch the ex ante preference satisfaction the market provides and throw a bunch of random fix-its instead. Ex ante preference satisfaction is far too fundamental to disregard; if we do this, it is likely we are making the situation even worse.

Finally: when I say there’s really no such thing as market failures, I say that because all market failures are merely instances of a broader concept of human failure, which cannot be “scientifically” solved by individuals outside the market (and this belief that individuals outside the market can solve this issue is precisely why they call it a market failure: putting the blame on the market means there could be a solution outside). Humans are at fault for being bandwagoners and choosing a product that has a large network but is clearly deficient in other respects to other products. But when the blind, deaf, and drunk guy comes along and tells you he can fix everything for you, reacting with skepticism is the proper response.

Photo Credit: Nukamari via Compfight cc

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Does the Free Market Presuppose the State?

Finally finished Man, Economy, and State after only 2 years! (Yes, I read other stuff and took huge breaks in between haha)

Now I’m going to start reading a bit of Power and Market in my free time, but mainly I’ll be reading a book called The Last Superstition by Edward Feser.

Regardless, here’s a short passage I just read from Power and Market:

The laissez-faireists offer several objections to the idea of free-market defense. One objection holds that, since a free market of exchanges presupposes a system of property rights, therefore the State is needed to define and allocate the structure of such rights.

This is an important argument to deal with. Here’s an analogy: if someone said the natural sciences presuppose free will, then the natural sciences cannot tell us anything about free will. Likewise, if the free market presupposes a system of property rights, someone could argue the latter must be built outside of the free market.

But there is nothing obviously wrong about saying defense can be provided by the free market even if the free market presupposes property rights. All that’s needed is a slight semantical change. Let’s say 10% of the free market is defense and 90% of the free market is the other stuff. I can say that 90% of the free market presupposes the other 10% of defense services. There is nothing illogical about this.

By acknowledging defense services can be provided by the free market, we can have a consistent libertarian theory unimpinged by a State that so clearly contradicts it.

Tampering with a Price Signal

One of the prime features of the free market is that you only have to know that the price does change, but not necessarily the reasons for it.

Money prices are the medium through which the communication of necessary information is made to coordinate effectively the actions of individual planners. As Hayek has pointed out, each particular decision maker does not need to know all the facts pertaining to the changes in resource usage. What is relevant to each is “how much more or less urgently wanted are the alternative things he produces or uses.” [15] The economic question is always a question of the relative importance of specific things available for the satisfaction of human wants. Each planner does not usually need to know why the relative importance of the things that he uses or produces has changed. What he does need is some indication of the extent to which its relative importance has been altered.

The coordinating function performed by the price system can be illustrated by assuming a sudden shortage of some resource. Those people who will eventually solve the problem of the shortage do not need to understand its cause. The price of a unit of the resource will be driven upward as those who employ it in the most important usages, i.e., use it for the generation of products promising the highest return, outbid those producers who plan to use it in less remunerative products. The shortage has meant that the marginal uses of the resources that could be supplied before the advent of the shortage cannot be provided for as long as the shortage persists. The higher price successfully causes the curtailment of the employment of the resource in its marginal uses. (Thomas C. Taylor, An Introduction to Austrian Economics, 35-36)

Hayek states:

…the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction….I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. (F.A. Hayek, “The Use of Knowledge in Society,” p. 87)

When that occurs with credit expansion (the reason) changing the interest rate (the price change), knowledge of the reason would allow an entrepreneur to make proper investments. The fact that he does not know how much of the lowering in the interest rate is due to credit expansion and how much is due to real increased savings is the reason the business cycle must take place. An invaluable market signal tampered with by government intervention loses its prime quality as a signal.

We have just seen that there are two factors that tend to hold down the rate of interest below the level sufficient to allow for the related elements emerging on the market: (1) The implementation of the price premium lags behind the changes in purchasing power stemming from the inflation; and (2) the additional supply of money thrown onto the market has a dampening effect on the interest rate. Concerning the latter point, it must be realized that entrepreneur-producers are unable to differentiate between additional funds that have been artificially created and additional funds emanating from real savings. (Taylor, 93) [my emphasis]

To blame the entrepeneur for not being able to understand the signal misses the point and misunderstands the esteem Austrians hold entrepreneurs with.

Tom Woods sums up this type of thinking very eloquently:

“If the free market is so great, why can’t it operate without the free market?”

Are Traffic Lights Necessary?

It’s pretty amazing how many unquestioned premises actually turn out to be false upon examination of them. I saw these videos a few months back, so day before yesterday when I was reading Buchholz’s New Ideas from Dead Economists and bumped into this passage about Adam Smith’s invisible hand, I had a good laugh:

But if everyone charges ahead in his own direction, why does society not resemble anarchy, something like a complex highway intersection with broken traffic lights? Shouldn’t we hear a frightening crash when self-interests clash? If roads cannot be safe without a traffic authority designating who shall move, can a community survive without a central planning authority to decide who produces and what is produced?

Yes. Not only will it survive, but the community will thrive far more than any community with central planning. More surprising, it will surpass both in output and social harmony any economic system based on altruism.

Just to clarify, the argument is not that we should get rid of all our traffic lights (as may seem implied by the libertarian’s stance of getting rid of all central planning or even my title). But what is apparent from the two cases above is that traffic lights aren’t required everywhere, and certainly in some situations it would be better to have no traffic lights at all. But a central planning agency is going to have a much harder time figuring out where is where, and as usual there will be a tendency to create uniform rules rather than going through the pain of distinguishing. Only a free market in roads can determine where traffic lights are efficient and where they are not and continue to innovate new ways to encourage the smooth flow of traffic while maintaining safety.