The perfect market fallacy

Suppose you want to compete in the 100 meter dash. Your odds of breaking Usain Bolt’s world record are pretty slim. So should you bother training? If you did train but ended up losing in the Olympic quarterfinals, would you take that as proof that training was a waste of time?

Now consider that you are a legislator trying to reduce CO2 emissions as quickly and as cheaply as possible. Should you bother putting a price on pollution to discourage its release? Noting the extreme rarity of “perfect markets” and the recent spate of financial scandals, should you not instead conclude that using markets as a policy tool is a waste of time?

The two questions are logically equivalent. Like training, markets do not guarantee perfection. But just as you can’t win unless you train, you cannot identify the lowest cost solutions to any given challenge without markets.

This point is too often lost in our public debate, which is framed as an argument between two equally illogical positions. One side argues for small-government policies on the tenuous basis that anything done by government can be better done by market forces in the guise of profit-seeking companies. The other side argues for big government on the grounds that only an enlightened regulator can ensure the public welfare. The one point of agreement between these extremes is that economic theory stipulates the existence of perfect markets (their dispute is over whether or not the purported theory is correct.) But that’s not what the theory says. It is like arguing whether the best way to run faster is to do nothing but push-ups or consume nothing but steroids.

The problem comes from a confusion of terms. Profit-seeking behavior, markets and efficient capital allocation are not synonymous, and the presence of one does not guarantee the presence of the others.

A “market,” after all, is nothing more than a description of our collective allocation of resources. Economists refer to markets as being efficient only when they meet a specific set of conditions, at which point the benefits that accrue from Adam Smith’s invisible hand are realized through the independent actions of profit-seeking actors. But most markets are inefficient–often woefully so. Effective regulatory processes can make markets more efficient–but regulatory processes that seek to bypass market forces will serve only to increase the inefficiency of the markets that remain.

What Economic Theory Actually Says About Markets

Basic economic theory says that price is a function only of supply and demand, and therefore is a perfect reflection of all of the information affecting both sides of that equation: production costs, consumer preferences, future availability of raw materials, competing options, possible changes in regulation, and so on. To the extent that this price-omnipotence is obtained, markets for the good/service in question are completely free to optimally allocate their scarce resources: money flows to its best use, labor is perfectly matched to the talents and demands of the community and natural resources are precisely consumed in careful consideration of both their present and future values.

Assuming perfection makes for easy choices. Adonis didn’t have to worry about changes to his diet, exercise routine, fashion sense or hairstyle since knew that any change to his perfect form would, by definition, render him imperfect. Many regulators and journalists fall into this same Adonis-trap when discussing markets. Any policy change intended to encourage different behaviors is dismissed as a step towards imperfection–and any unsuccessful business/technology is not worthy of regulatory support since “if it’s such a good idea, our perfect markets would have already done it.”

But here’s the rub: economic theory does not claim that markets are perfect. It simply explains how capital would be allocated if they were. As proof, look no further than the Nobel committee:

• Robert Solow won the Nobel in 1987 in part for making the observation that economic theory implies that prices will always be driven down to the marginal cost of production. If this occurred, corporate profits, the reinvestment of those profits and ultimately economic growth would be mathematically impossible. Solow’s insight was that this persistent “impossibility” exists in part due to technological progress. But note the implication: the presence of economic growth implies the absence of perfect markets.
• Daniel Kahneman and Vernon Smith shared the 2002 Nobel for their work in behavioral economics. They showed (among other things) that prices depend significantly on context rather than fundamentals of supply and demand, and thus the “signal” that price sends to the market is often incompatible with that required for efficient capital allocation.* Again, note the implication: perfect markets may incompatible with the way the human brain works.

* (An example: would you go 10 minutes out of your way to save $20 on a $100 piece of furniture? Would you also go 10 minutes out of your way to save $20 on a $20,000 car? If you answered yes to the first but no to the second, you have demonstrated economic irrationality by “charging” for your time based on variables other than supply, demand and your marginal cost. Shame on you!)

So why does the perfect market theory persist? Two reasons:

1. It’s a useful approximation tool. Knowing how to calculate the area of a circle is helpful, even if there are very few naturally-occurring perfect circles. Similarly, there are many markets (commodities being an obvious example) where actual behavior can be very nearly approximated and understood with perfect market theory.
2. It’s a useful policy tool. If we understand the conditions that allow a perfect market to exist, we are better able to craft policies that will reap its rewards.

For policy purposes, this latter point is critically important. Recall Solow’s insight that perfect markets are incompatible with profits. That is understood at a gut-level by every business owner who has seen competition drive down their margins–which is why businesses seek to make their markets as imperfect as possible. In turn, we have created regulatory agencies (like the SEC) to counter-balance. That is a healthy tension, and a good model for well-informed policy: don’t simplify markets as pure good or pure bad, but rather seek to create conditions that facilitate efficient markets.

So what are the conditions under which “perfect” markets exist?

1. There are no barriers to entry and exit.
2. No single entity can independently act to control price.
3. Markets consist of many buyers and many sellers.
4. There is perfect information; all prices up and down the value chain are fully known to all buyers and sellers.
5. All sellers seek to maximize their profits.
6. The good/service traded in the market is perfectly homogeneous, such that there is no differentiation (other than price) between competing suppliers.

It’s pretty easy to identify imperfect markets with from this list. Want to find a barrier to entry? Try to start a new car company tomorrow. Barrier to exit? Try to sell your house. Imperfect information? Look no further than Bernie Madoff. But it’s also easy to use this list to guide good policy that will steer markets towards perfection.

Policy Consequences for CO2 Regulation

So let’s return to the question posed at the start. If you are a legislator seeking to craft policies to reduce CO2 emissions, how should you approach the problem?

1. Avoid polemicists. Do not assume that price alone is sufficient to drive market behavior, but do not discount the tremendous power of markets to provide least-cost solutions to complex problems.
2. Maximize market participation. Exempting sectors from participation in CO2 markets permanently or temporarily (e.g., through a phase-in) increases the likelihood that individual actors will be able to control price to their advantage.
3. Craft rules to ensure price consistency. The cost of a ton of emissions release ought to be identical to the revenue received for a ton of emissions reduction. The cost a ton of CO2 imposes on our climate is independent of the location or corporate structure of the source; its price shouldn’t either.
4. Maintain robust market oversight. The lesson to take from the California power crisis is not that markets don’t work, but that markets can fail when large players can independently affect the supply/price of a given commodity. Trade watchdogs will be no less critical for emerging CO2 markets.

This post first appeared on REDBlog.