The Myth of the Universal Market

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Communication among economists, other social scientists, natural scientists, and lawyers is far from perfect. When the topic is the environment, discourse across disciplines is both important and difficult. Economists themselves have likely contributed to some misunderstandings about how they think about the environment, perhaps through enthusiasm for market solutions, perhaps by neglecting to make explicit all of the necessary qualifications, and perhaps simply by the use of technical jargon.

So it shouldn’t come as a surprise that there are several prevalent and very striking myths about how economists think about the environment. Because of this, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I posed the following question in an article in Nature:  how do economists really think about the environment? In this and several succeeding postings, I’m going to answer this question, by examining — in turn — several of the most prevalent myths.

One myth is that economists believe that the market solves all problems. Indeed, the “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met. This theorem, easily proven, is exceptionally powerful, because it means that no one needs to tell producers of goods and services what to sell to which consumers. Instead, self-interested producers and self-interested consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number, as if “guided by an invisible hand,” as Adam Smith wrote in 1776 in The Wealth of Nations. This notion of maximum general welfare is what economists mean by the “efficiency” of competitive markets.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Those conditions are obviously very restrictive, and they are usually not all satisfied simultaneously. When a market thus “fails,” this same theorem offers us guidance on how to “round up the usual suspects.” For any particular market, the interesting questions are whether the number of sellers is sufficiently small to warrant antitrust action, whether the returns to scale are great enough to justify tolerating a single producer in a regulated market, or whether the benefits from the good are “public” in a way that might justify outright government provision of it. A public good, like the light from a light house, is one that can benefit additional users at no cost to society, or that benefits those who “free ride” without paying for it.

Environmental economists, of course, are interested in pollution and other externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers. With a negative externality, such as environmental pollution, the total social cost of production may thus exceed the value to consumers. If the market is left to itself, too many pollution-generating products get produced. There’s too much pollution, and not enough clean air, for example, to provide maximum general welfare. In this case, laissez-faire markets — because of the market failure, the externalities — are not efficient.

Similarly, natural resource economists are particularly interested in common property, or open-access resources, where anyone can extract or harvest the resource freely. In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity (called “user cost” or “scarcity rent” by economists). The result, of course, is that the resource is depleted too quickly. These markets are also inefficient.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency. I will turn to such interventions in a subsequent posting.

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10 Responses to The Myth of the Universal Market

  1. Torben says:

    Well Summarized Rob!

    To add more,
    1. In most cases extreme environmentalists vision of zero pollution is socially inefficient.
    2. Lack of perfect information makes market fail. For example, so as to fix O-zone problem, we aggravated Green house gas concentrations, I believe, due to lack of information at the time the decision was made. Which also gets me to point 3
    3. Markets in most cases do not function perfectly [ at least due to perfect information]
    4. However, governments may not perform better than market in the areas where markets fail. But, the our tendency to do something when we see problems pushes us for government intervention.
    5. Neither the product market nor the political markets are efficient enough to supply optimal long-term public goods.

  2. Torben, thanks for your comment. On your first point, as you know, it’s conceivable that zero emissions (banning a specific product, for example) can be justified on economic grounds — it depends on the shape and position of marginal benefits (damages) relative to marginal costs. But, in most cases, the complete elimination of emissions will lead to marginal costs greater than avoid marginal damages. On your second point, public policies can certainly have unintended consequences. On the one hand, the poster child for negative unintended consequences of an environmental policy is probably acid rain due to tall utility stacks, which were put in place to reduce ambient pollutant concentrations under the Clean Air Act. On the other hand, although the SO2 allowance trading program in the Clean Air Act amendments of 1990 was intended to reduce acid rain (and its ecological consequences), the program has had vastly greater benefits in terms of human health impacts via reductions in particulates. Thanks again,
    RS

  3. MattYoung says:

    The environmentalist gives the economist an incalculable problem when he restricts “public good” to an exogenous constraint, when it is the thing being estimated. We want CO2 usage specified as a constraint on the problem, then we want CO2 usage estimated for the future.

    The better approach would be Krugman and agglomeration; or Hayek and minimization of transactions, both of which can treat public goodness as a differential property of monopolies. But they also lead to quantum solutions.

    But take the calculable, but more difficult road. Ask how the economy would reorganize if best practices were applied to energy efficiency across the board. That is, find the expected agglomerations, if they exist.

  4. anonymous says:

    It’s also important to point out that there is nothing inherently “just” about the allocative efficiency of even perfectly functioning free markets. Basic resources are still acquired, originally, by simply claiming the piece of land they are on for oneself, or else stealing it from the previous owner. Human effort of course adds to the value of such resources but the origin of wealth, land ownership, is still an arbitrary and amoral phenomenon. What you mean by markets being “efficient” or “clearing” is that everyone can get as much as they wish to without stealing. But why should stealing be ruled out? It is no more arbitrary a transfer of wealth than was the original acquisition of it.

    The takeaway is that even efficient markets aren’t necessarily “fair”. There is no moral argument to be made that someone “deserves” the wealth they receive from discovering gold, while someone else who seeks it but doesn’t find it deserves to be poor.

    If you don’t feel the need to concern yourself with fairness then this is of course a moot argument, until the hoards of have-nots come knocking on your door.

  5. Anonymous, economists do not claim that “efficient” allocations are necessarily fair, or in the language of economics, “distributionally equitable.” Indeed, distributional equity is another important topic in economics, and provides another potential criterion for assessing public policies. More about this in future postings, particularly in the context of concerns about global climate change, where distributional issues rise to the center of the stage. On one other point, your suggestion that the origin of wealth is land ownership had more salience prior to the twentieth century, and even less in the twenty-first.
    RS

  6. Tim Ridgers says:

    Free market conditions with an economic “level playing field” never exists in reality. Always there are conditions that privilege some players against others. So instead of striving to create such inattainable conditions economists, should work to understand the implications. I would like to make a parallel between economics and engineering (I am an engineer not an economist). The physical laws that describe the behaviour of matter are well understood and universally accepted. At the highest level this is Newtonian mechanics. When we go to a lower level we have Maxwells equations, Shrodingers, and Einstein’s relativity to describe electrical behaviour. But the “unique” solution to any problem only comes from factoring a detailed description of the boundary conditions. For me many economists are trying to evolve the Maxwell /Shrodinger equations, not endeavoring to properly take into account boundary conditions – like : oil has a limited supply; when huge populations are out of work they have no means to prurchase goods; pollution incurs significant health costs; but also pollution causes soil /water resources to be removed as means for production, and so on. These economic boundary conditions should include both the environment and human populations.

  7. Tim, thanks for your comment. Because I am traveling at the moment, I will be very brief. I agree that economics is more analogous to engineering than to physics, in fact I made this point in a recent essay. Your description of what economists should do is, in fact, precisely what environmental economics does. You may have missed a central point of this posting (my fault, not yours), namely that environmental economics focuses on market imperfections, including externalities, NOT on trying to prove that markets are perfect. Stay tuned for future postings. Thanks again.
    RS

  8. The Lawyer says:

    Nice Site.I will be visiting more often as you have done a good job.

  9. Manish Srivastava says:

    Dear Robert,

    Your short essay has effectively highlighted the challenge of current times. I liked its simplicity and straightforwardness. I am not an economist. Thus I am reading it from a different perspective of a social change & systems thinking perspective. I have come across this paradigm war and it always reminds me of the 6 blindmen and elephant fable, eachone having a perspective on the big complex issue in the room. The challenge lies in how do we help experts sitting on either side of socio-economic-ecological spectrum to see and act with multiple perspectives. With reference to recent financial crisis and debate between free-market vs govt-regulation paradigms, I see a continuous historical conflict between greed & fear or free desire & control. I wonder is there a possible middle-way?

  10. Systems thinking remains an underutilized management tool even fifty years after it was developed. If we are going to address the environmental and economic challenges ahead of us, it would be well to stop thinking linearly, and start thinking systemically! Not just for the sake of profit, but for the sake of humanity.

    “Limits to Growth” remains a sadly misunderstood concept in mainstream economics, and econometric models simply aren’t well equipped to deal with non-linearities and feedback effects.

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