460. Market ideology: variety

 A second strong argument for markets, next to freedom but related to it, is that in contrast with central planning they give room for variety and variability of local, idiosyncratic tastes and ideas of consumers and producers, and tap into them. That is important especially for innovation. This idea goes back to the economist Friedrich Hayek, one of the godfathers of neo-liberalism, and on this point he was right. Centrally planned economies are unable to plan and innovate production and allocate resources in a manner that fully mobilizes variety and variability of choice and enterprise. Hayek went overboard, however, in assuming that markets incorporate all relevant information efficiently in prices, to automatically produce an optimal allocation of resources. 

In item 57 of this blog I discussed variety of cognition, in cognitive distance, as both a problem for mutual understanding and an opportunity for innovation by novel combinations. To profit from the opportunity of innovation one must learn to cross cognitive distance. A central challenge for entrepreneurs and firms is to develop the ability to collaborate with others who think and perceive differently.

There are now three paradoxes of variety. The first is tension between variety and the efficiency that is claimed for markets. With variety in the form of product differentiation not all information relevant to the individual is included in the price. It increases transaction costs in the form of search costs. Consumers are not always able to fully perceive and assess differences in products. At the same time, product variety reduces the pressure of price competition that is supposed to yield allocative efficiency. Also, differences in composition and quality of goods and services entail that when one chooses one product as the most preferred one, then to switch to another, different product one incurs switching costs in making a compromise on what is most desired. That switching cost for consumers allows producers to raise price above production cost. 

The second paradox is as follows. While perhaps the strongest argument for markets is that they tap into the variety of individual, local knowledge, ideas and preferences, in industrialization increase of scale and concentration of activities into fewer, bigger organizations have led to a reduction of variety, in mass production. The mythmarket is one of homogeneous products, and optimal production technology accessible to all. In facilitating markets there is talk of creating a level playing field.  In fact, competition is mostly about being different, in differentiating products and technology, and creating new playing fields.

The third paradox is as follows. Without institutions markets cannot work. Institutions are not just laws and their enforcement. They are, much more widely, durable social (humanly devised) habits and rules that both enable and constrain behaviour. This includes ethics and morality. They form the basis for predictions and agreements about future actions. Institutions vary among countries. Now, the claim for efficient markets is that they are universal, to be applied everywhere, regardless of varieties of institutions, resulting from differences of culture, history, political conditions, stage of economic development, and available resources.   

In sum, to profit from the variety of markets one must accept that competition is imperfect, operates not only on price but also on quality, and that markets vary with institutions.