468. Markets and government

It is difficult to find an industry where markets are completely free, without regulation or intervention. The very notion of ‘free’ is problematic. Institutions are required not only to correct but also to enable markets.

In the most general terms, conditions for markets are conditions for the freedom of choice for users and freedom of enterprise for producers. To the extent that these freedoms are constrained, which is always the case to a greater or lesser extent, markets function only to some extent.

A question then is when we reach a point that regulation dominates freedom to such an extent that we can hardly still speak of markets. The question then becomes when regulations to channel and restrict the operation of a market go so far that it might be more efficient to take the alternative approach of public planning, which of course requires its own correction mechanisms. The question is not regulation or not, but how much regulation is needed.

Between ‘pure’ market, if that notion makes sense, and ‘pure’ public administration there is a range of forms with more or less public participation and regulation.

John Groenewegen identified several categories of public-private hybrids. In the first category the state owns and manages the assets, though it can by contract allocate the decision rights to a public agency or corporatized public entity. We may find that in the infrastructure of network industries, such as, for example railways, energy, water supply. Since there are no competing producers one can hardly speak of a market. However, the government can impose benchmarks that show the best performance achieved to challenge producers, or use them to set ceilings to costs. Sometimes the mere threat of privatization may stimulate efficiency. Also, producers may hive off part of their activities to markets, by outsourcing activities other than their core activities to commercial suppliers.

In the second category, Public-Private-Partnerships (PPPs), there are different distributions of ownership and decision rights. Private parties take risks in the supply of capital and responsibility for operating them. In return, they claim rights in the commercial supply of the service, a right to operate, and the right to design, build and operate the asset. Government maintains property and decision rights to the extent needed to guarantee a minimum level and quality of service. In some PPPs ownership is public and ‘peripheral parts’ are privately owned, and in others the building and maintenance of assets is private but the government is responsible for its design. Here, there is the possibility of concessions sold to private operators for a limited period, after which the rights are returned into public hands. Here we can think of the concession of rail and bus services.

The third category is regulated industries, where sector-specific regulators can by law intervene in the structure of the market or directly in the behaviour of the private actors. Here we find the telecom market, for example, where the government can intervene in tariff structures, for example. In case of a natural monopoly, where cost considerations, such as avoidance of any duplication of investments, such as with railway tracks or water or gas ducts, dictate a monopoly, there may be regulation concerning access to the infrastructure, quality, and price caps.  We find this, for example, in energy pipelines.         

467. A different view of markets

In view of all the problems of markets as envisaged by economics, discussed in preceding items in his blog, in summary I propose a view of markets that is different, indeed more or less the opposite to the model of perfect competition. My eight basic assumptions, replacing those of that model, presented in item 458, are the following:

1. Actors are limitedly rational. Though rational reflection does have an effect on choice, the latter is largely dictated by unconscious impulse, as recognised in behavioural economics.
2. Knowledge is biased by forms of thought that have developed during life, on the basis of genetic endowments, and vary between people to the extent that they have developed in different environments (cognitive distance).
3. People have no fixed, prior identity. Ideas are pragmatic and preliminary, and develop on the basis of success and opportunities in practice. As a result, preferences are limitedly stable and shift in the process of choice and action.
4. Especially in innovation there is radical uncertainty that precludes prior intelligent design. The development of novelty has the basic characteristics of evolution, with selection from trial and error and transmission of success.
5. People are not autonomous in their knowledge and preferences, which arise from social interaction. Markets are not only about competition but also about collaboration, to utilize complementarities in competence.
6. In markets there are transaction costs of contact, contract and control.
7. Products are differentiated to a greater or lesser extent. As a result, competition is seldom pure price competition and profits routinely exceed costs.
8. By nature, people are self-interested, but they are also oriented towards social legitimation, by which they also have a natural though limited capability to trust. Next to private motives people are entangled in group interests. Collective and individual interest are obstructed by both individual and collective egotism and deadlock (such as prisoner’s dilemmas).
9. Ethics is more than only a consequentialist ethics of utility, to include virtues of justice, moderation, and solidarity. These values are not all commensurable, cannot always be brought together in calculative trade-off, in an objective function.

Clearly, all this leaves much more complexity than the economists’ view of efficient markets. This is a deliberate methodological choice for finesse rather than geometry in human affairs. Given new technologies of computing and software there are novel ways of analysing complexity (e.g. in agent-based simulation). Evolution provides a theoretical framework for modelling such complexity, with markets interpreted as selection mechanisms, together with institutions, as well as sources of variety and discovery, and transmission devices.

The assumptions entail central importance of institutions, descriptively to understand individual and collective behaviour, and prescriptively to enable markets, to constrain perverse effects, to try and prevent their failure, to enable collaboration next to competition, and to ensure minimal standards of justice. But institutions need to be supported and complemented by ethics, which has the advantage of being voluntary and open to personal variety, interpretation, and circumstance.

 As a result of all this, markets can never ‘be left to themselves’, in ‘laisser faire’. It is misleading to speak of ‘market failures’, which suggests that as a rule they do not fail, while as a rule without proper institutions, interventions and ethics they cannot function. Markets always suffer failures to be redressed.

466. Transaction costs

Transaction costs are the costs of markets: costs of contact, contract and control. Costs of contact lie in searching for buyers/suppliers, evaluation of the quality of their products, their reliability, etc. Costs of contract lie in coming to some form of governance, in reaching an agreement, negotiation, contracting, and costs of organization (division of labour, collaboration, and exchange). Costs of control lie in monitoring performance, adjustment of agreements, haggling, conflict resolution, litigation, if it comes to that, and costs of separation.

Governance needs to deal with relational risks. A central notion here is that of relation-specific investments: investments whose value is partly or wholly limited to the relation, and is largely worthless outside the relationship, and therefore entail switching costs: costs of switching to another buyer or supplier. The possible loss of such specific investment constitutes a risk, in that the partner can threaten to break up the relationship at the cost of that loss. As a result, such investments cause dependence that can be used as leverage in the distribution of jointly produced added value. A condition for making a specific investments is that one can expect that the relationship will last long enough, or will yield a sufficient volume of transactions, to recoup the investment.

Why incur such problems and not avoid specific investments? Often, most value is added, and most profit made, with specialized, differentiated products that distinguish themselves from the competition. That is mostly achieved by combining complementary resources from different firms (knowledge, technology, skills, market access, …) into novel, unique combinations of features. However, that requires relation-specific investments. So, one incurs the problems of dependence to utilize an opportunity for profit. As a result, collaboration is as much part of markets as competition is.  

There is a dominant rhetoric of maximum flexibility to ensure maximum efficiency, in hiring and firing workers, in buying and selling parts of firms, and in beginning and ending relationships of collaboration. The logic of specific investments goes against that. Instead of maximum flexibility one should go for optimal flexibility, with relationships that are durable enough to elicit specific investments but not so fixed that they yield rigidities in the inability to adjust to novel conditions or opportunities.

There are also implications for choosing between on the one hand markets and on the other hand integration within a large organization. When the costs of the market exceed a certain limit, its motivational advantages, in partners being independently responsible for their own survival, becomes less than the costs involved in exchange and governance, and it is more efficient to integrate.

The standard theory proposes that the greater the uncertainty the higher relational risks and hence the greater the preference for integration. However, that is not quite right. It is useful to distinguish between behavioural and technical/commercial uncertainty. The claim applies for behavioural uncertainty, as when motives and capabilities are difficult to judge or when there is a low general level of trust. Under the technological and commercial uncertainty of innovation, on the other hand, outside, independent partners contribute more to the necessary variety of knowledge and the flexibility and scope of a variety of relationships. So there the prediction is the reverse: more uncertainty pleads for less integration.

465. Market failures

There is a range of market failures and here I can only review a few. Perhaps the most perverse failure is when the two core virtues of markets are destroyed: freedom and variety of choice and initiative, and selecting out failures. Destruction of freedom occurs in monopolies and in the command economies of large firms. Persistence of failures occurs, for example, with large banks that are ‘too big to fail’, and in large corporations where top managers are ‘too megalomaniac to fail’, impregnable and intolerant to criticism, keeping failures hidden or propped up with internal cross-subsidies.

A widely known failure lies in so-called externalities, such as environmental degradation and damage to health (negative externalities) and so-called public goods, such as parks and street lighting (positive externalities). One reason why they are difficult to include in markets is that they are non-excludable: it is difficult to exclude users who do not pay. An example is roads, but here, with toll roads one can restrict use to those who pay, at the cost of constructing tollbooths at limited entry and exit points.

There is a range of problems that violate the assumption in market theory of full information and rationality, and independence between autonomous agents and their choices and actions. In preceding items I discussed limits to rationality, as in framing, and problems of herding, which yield financial and other bubbles that burst, and in prisoners’ dilemmas in which economic actors lock each other up in conduct that yields adverse effects (as in too risky investments).

In particular, there are problems of limited or asymmetric information. An important case is the phenomenon of adverse selection. This arises prominently in insurance, when risks are hard to judge by the insurer, such as a risk of skiing, say. The people most at risk have the highest need for insurance. Knowing this, the insurer could raise his premium, but then most seekers of insurance drop out, leaving only the worse risks. The result is that there is no price at which buyers and sellers can agree. Either the risk for a number of cases or the premium is too high.

A requirement for perfect competition is the absence of economies of scale, by which larger firms produce more cheaply than small ones. In fact, such effects are ubiquitous, in various forms, and they give an impulse to concentration of markets in a small number of large firms that can limit competition.

On a global scale, there are exploitation of labour and adverse economic and societal structural effects on developing countries. National policies for justice and human rights lack grip because multinationals are footloose, able to migrate to where conditions are least restrictive. Corporations far outrun the capability of governments to restrain them. Markets unleash forces that can become impossible to control.

Another adverse effect is that expectations on capital markets impose a short term perspective, and a focus on the interests of shareholders, whereby long term interests and public interests such as protecting the environment, are neglected. Investors and managers squeeze too much from the firm, reducing spending on innovation, to increase cash flow, which reduces innovative capability.

In the following item in this blog I will discuss the important problem of transaction costs.

464. Evolutionary economics

Perhaps the most fundamental problem for rational choice arises when uncertainty is radical, i.e. when we do not know in advance what all the options for actions are and what their consequences may be. Often options arise in the light of the outcomes of actions rather than being given in advance. Also, the preferences that are supposed to form the basis for rational choice are often formed in action rather than being given before it. I will argue that an evolutionary perspective of innovation, which avoids ‘intelligent design’, yields a more useful perspective.

The basic principles of evolution are variety generation, selection and transmission (of what survives selection). In item 30 of this blog I discussed evolution in society. Here I focus more on the economy. Variety generation arises from innovation, selection is performed by markets and institutions, and transmission of success occurs in firm growth, imitation, education and training.

However, in item 30 I warned against going too far in adopting a biological analogue of evolution. In society, variety generation, selection and transmission take their own forms, which are quite different from biology. Innovation is not the same as mutation of genes and crossover of chromosomes. The selection environment of markets and institutions can be manipulated by political influence. Transmission entails communication, which entails interpretation, which entails transformation, so that it is at the same time not only transmission but also a source of variety. 

Evolution provides an alternative to market logic including freedom and variety as well as selection. There is freedom in a variety of ideas put up for selection. Struggle for survival includes competition, but also symbiosis. Survival, in adaptiveness to the selection environment, is not necessarily rational or optimal. In innovation it is often not the best product that wins, but the one that manages to conquer the market first. Most important, evolutionary theory recognizes radical uncertainty that limits intelligent design. 

It is often adaptive, good for social survival, to go along with majority opinion, against one’s own views and convictions. This is connected with group think in organizations, herd conduct in markets, and immorality of groups (see item 48). Policies are designed and adopted that are illogical, not optimal or even detrimental, for the sake of political expediency.

Paradoxically, this can lead to policies that satisfy old, erroneous intuitions of rational design, thwarting the dynamics of evolution. An example is innovation policy, as adopted in the Netherlands, in the form of planning innovation in committees for selected industries. It goes against the logic of evolution, and indeed the logic of markets, in reducing variety and selection. It yields an obstacle for the crossing of boundaries between industries and technologies that generates innovation. However, there is an erroneous, adaptive political rationale. Such policy avoids the risks of real innovation that parliament finds hard to stomach for its ‘failures’ to succeed, it gives vested interests in big business an opportunity to lobby for their interests to limit innovation to incremental innovation that does not upset existing investments and markets too much. This yields a powerful political force to adapt and conform to current standards that sweeps along even scientists who know better.

Is there no evolution or market mechanism to penalize this? Yes: it is manifested in new emerging countries less caught in habits and regulation that win out in innovation.   

463. Human nature

 Economists adopt a limited, highly stunted view of human nature, even while not actually believing in it. They are geared to think in terms of rational choice between alternatives, but people are very limited in their rational evaluation, for good cognitive reasons. Recent debates on the limits of free will, or even its absence, indicate how limited the rationality of our choices is. See also the previous item in this blog.

Economists further assume that people are driven only by self-interest. Many economists recognize that in markets there is collaboration next to competition, but here collaboration is still driven by self-interest, though this includes enlightened self-interest in which one makes sacrifices for others as long as in the end it yields net advantage for oneself. There is still no room, most economists think, for altruism, which may be detrimental to material self-interest. The argument is that competition is too harsh, too ‘perfect’, as economists would call it, to allow for any compromise on maximum profit or minimum cost. The firm would not survive if it did not grasp every opportunity for higher profit. I disagree.

As I argued in preceding items in this blog (e.g. 46), the human being has an instinct for both self-interest for the sake of survival, and altruism for the sake of social legitimacy and cohesion, with a corresponding ‘moral’ sense of normativity next to self-interest. Furthermore, competition is seldom so harsh that survival requires maximum possible profit. Product differentiation, segmentation of markets, innovation, and durable competitive advantage due to specialized, difficult to imitate knowledge and other assets, yield some slack to take other objectives into account.

The conduct of people is also determined, to a large degree, by behavioural phenomena of social interaction such as studied in social psychology. Group cohesion can have both beneficial and detrimental effects (see item 48 on immorality of the group). Time and time again economists, except Keynes, also neglect other sociological effects such as herd conduct, which leads to bubbles and their burst and indeed was a major factor in the current financial crisis.

I propose that for a proper understanding of markets we must include insights into the limits of rationality, psychology and sociology, processes that entail radical uncertainty, and the role of institutions. To some extent these can be found in non-standard economics, such as behavioural economics for limits of rationality, evolutionary economics for processes that are not based on rational foresight, and institutional economics. However, for sufficient depth and coherence of insight we must move beyond economics into the areas of cognitive science, social psychology, sociology, and philosophy rather than having heterodox economists re-inventing wheels in primitive ways, in those areas.

The partnering of economics and psychology is not new: it was there in the early economics of Adam Smith, who in his work on morality recognized an inability of people to focus on the long term, a concern for the well-being of others, in what he called sympathy, a tendency to overestimate one’s own abilities, and an inclination to underestimate risks. Let us return to this wider view of human conduct.

462 Philosophy of economic science

A famous defence of the unrealistic mythmarket of perfect competition is that theory requires abstraction and cannot and should not try to reproduce reality. The question is only whether the theory yields accurate predictions when we look at reality ‘as if’ the model applies. This is the famous instrumentalist argument of Milton Friedman. In fact most evidence has contradicted the theory. 

Karl Popper proposed that a theory cannot be proven true but can only be falsified by evidence against it. A problem there is that in economics theory is hard to falsify because one can take shelter in the fact that there are so many other, uncontrollable conditions that can upset predictions, other than limitations of the theory.

Therefore, the argument for validity, or warranted assertibility, if not truth, on the basis of empirical validation may work for physical science, but for economics it does not fly, but flutters like a lame stork.

In fact, economists perform a sleight of hand here. While granting that assumptions are not realistic, and are made only ‘as if’, economists next give excuses why predictions cannot be rigorously tested, and then fall back on the theoretical assumptions anyway, no longer only ‘as if’ they apply, but also in deriving policy implications, claiming that markets should be left alone because they are efficient. But that remains to be demonstrated. The snake bites its tail. At first, markets are taken only ‘as if’ they are efficient, this is never convincingly corroborated, and then for policy implications they are taken to be efficient. It is admitted that the model is a Utopia but since it cannot be falsified it is taken to be real.

Traditionally, science aimed to ‘save the phenomena’: a theory should be able to explain accepted observations or facts. In economics the principle is ‘save the theory’. If things claimed by the theory cannot be observed, occult, unobservable entities are posited by which they exist anyway.

There are several examples but I will discuss only one. In economic theory rational choice rests on the assumption that people have preferences that satisfy certain axioms (such as transitivity: if A is preferred to B and B to C, then A must also be preferred to C). These preferences cannot be observed, indeed in psychology they are found not to exist as postulated. In fact, much choice arises from unconscious impulse. And now comes the economists’ sleight of hand again, the reversal of logic: since people do make choices, preferences must exist; they are revealed in the fact that choices are made. What is wrong with this is that it neglects the possibility that choices are made differently. Intransitive preferences have been shown to occur, when choices have to be made among options with several dimensions of utility that are not commensurable, i.e. cannot be added and subtracted (see item 79 on incommensurability).          

 But then, if people are unable to arrive at a consistent, rational evaluation, how are choices made? If people are unable to consistently add and subtract different dimensions of utility, the choice may be determined by whim and impulse. Producers exploit this in advertising. Not knowing how to trade off different dimensions of utility consumers decide on something often small but salient, with simple, emotional appeal, such as the design of the dashboard As they also do in politics.

Also, preferences often are not given beforehand but develop when things are tried out, arising after rather than prior to choice and action.