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The Mises Review

Edited and written by David Gordon, senior fellow of the Mises Institute and author of four books and thousands of essays.

Markets Don't Fail!

Brian Simpson

3 2006
Volume 12, Number 3

Volume 12, Number 3
Fall 2006

The Myth of Market Failure

Markets Don't Fail! By Brian Simpson. Lexington Books, 2005. Xi + 221 pgs.

Few opponents of the free market today support the replacement of capitalism by socialism. Even anti-capitalists have learned something from the collapse of the Soviet bloc. Instead, it is alleged that capitalism, though a good system, is imperfect. The state must act to "improve" the situation.

This at once raises the question, by what standard is the free market found wanting? Mainstream economics argues against the unconstrained market on the basis of certain efficiency criteria, and it is these that Brian Simpson subjects to penetrating critical examination in this excellent book. He considers a number of alleged market failures, e.g., externalities, predatory pricing, public goods, and asymmetries of information. In each case, he endeavors to show that the case against the market fails. (He discusses only microeconomic challenges to the market.)

Simpson does more. He not only counters the various challenges on their own ground: he rejects the terms of the indictment. The attacks on the market, he maintains, rest on flawed philosophical concepts and a false, altruistic morality. (As readers will already suspect, Simpson is an Objectivist.)

His defense of the market thus differs from that of Milton Friedman, the foremost neoclassical advocate of a relatively free economy. Friedman says, in effect, "The market comes close to meeting the standard efficiency criteria; little government  intervention is needed to 'correct' it." Simpson reacts with horror: Friedman "supports government welfare programs. Further, he believes the government. . .should intervene in the case of 'externalities' when there is a 'very clear balance of benefits over costs.'. .Now, Milton Friedman is not an advocate of dictatorship, but by supporting the principle that the government should initiate physical force in the economy at all, he opens the door for potential dictators. . .he merely disagrees with the dictators over how much force the government should initiate." (pp.203-204)

An example will show Simpson's procedure in action. A currently popular criticism of the market alleges that it cannot handle "network effects. " These "occur with goods whose value to the consumer increases as the number of units of the good sold increases. They occur with respect to goods whose uses are dependent on others possessing the goods or many people having specialized knowledge about how to use the goods." (p.49) Computer systems are an excellent case in point: 'The more people that use a particular operating system (such as Windows), the more valuable it is to users of the operating system  because. . .it is easier to share files with people, it is easier to find producers of software for the system, and it is easier to find technical support for the system."(p.49)

Why is this a problem? Critics claim that the market can be "locked in" to an inferior good. Suppose, e.g., that a new operating system is better than Windows. It will be difficult for it to take over the market, despite its superiority. The network effects of Windows outweigh the advantages of the new product. Even if consumers would have been "better off" had the other system been introduced first instead of Windows, they cannot easily switch to it.

In my example, the network effects operate as the critics of the market allege, but this is only because I have invented the case. In the real world, Simpson notes, cases of "lock-in effects" and "path dependency" are few and far between. Normally, "the superior products have prevailed because as long as competition is not legally restricted, such competition is always intense in competition for so-called network goods."(p.49) And even if a new good cannot fully overcome the barriers of network effects, it can often secure a niche for itself.

Simpson now deepens his criticism. If the government attempted to correct the supposed malign results of network effects, what reason is there to think that it would improve matters? Why should one expect the government to be able to discern the superior products?

So far, the criticisms that Simpson has advanced, though excellent, do not differ from those that Milton Friedman might have provided. Now our author goes further. So long as the network effects arise through voluntary transactions that violate no one's rights, they are simply part of the competitive process. To "correct" the market, would not the government have to violate  rights? "The government would either have to initiate physical force against taxpayers to force them to subsidize the firm with the  new product or the government might somehow restrict the competitive ability of existing firms."(p.52) Here Simpson makes the decisive break with welfare economics orthodoxy. It does not suffice to justify government intervention that efficiency, as neoclassicals characterize it, would increase. To think otherwise is to place consequences above rights. Whether one should do this is a question for ethics, not economics.

Simpson calls for a conceptual purge. Network effects are an example of externalities, and this is an improper concept. "An 'externality'. . .is a cost imposed, or a benefit bestowed, on people other than those who purchase or sell a good or service. The recipient of the externality is neither compensated for the cost imposed on him, nor does he pay for the benefit bestowed on him." (p.85)

Against the use of this concept, Simpson makes a telling point. Almost all human actions have some external effects: "What about the external effects of beautiful and ugly people in general? Should others be forced  to compensate handsome men and beautiful women for the privilege of being able to look at them?"(p.96) The concept is not usually applied this way, but there is no analytically sharp division between externalities that we are supposed to count and ones to be rejected. The concept of externalities is ill-formed and best abandoned.

At one point in his criticism, though, Simpson has gone astray. In the course of an excellent account of how the market deals with externalities, he says: "Charitable contributions are a 100 percent positive externality because the recipient does not pay for the charity he receives, and the donor receives no compensation for his charitable contribution."(p.91) But the donor wants the recipient to have the contribution: otherwise, he would not donate. An externality arises only if someone else "gets in on the act." Suppose, e.g., that  someone else wants the recipient to have more money. Had the first person not donated, he would have done so; but now he need not. The person he wanted to help has been aided by someone else, and he is free to spend his money elsewhere. He, not the recipient, has gained from a positive externality.

As long as we are engaged in a conceptual purge, why not do away with the whole economic notion of monopoly? "The problem with the economic concept is that it leads to confusion because it can be used to say that no firm is a monopoly or that all firms are monopolies, depending on how broadly or narrowly one defines a good. It can also be used to say a firm both is and is not a monopoly."(p.32) Lacking an exact characterization, this concept is useless for economic analysis.

A further example of Simpson's skillful practice of dissection must here suffice .One of the most popular criticisms of the market involves asymmetric information. This term is "used to describe a situation where either the buyer or seller in a market exchange has some information that the other does not have."(p.189)

This situation, it is claimed, can lead to complete breakdown of a market. The most famous example is the lemons problem in the used car market, analyzed by George Akerlof. Buyers of used cars have much less information that dealers about which cars are "lemons." "Because of this uncertainty, buyers will be reluctant to pay as much money for any particular car when compared to a situation in which they know for certain that a car they are buying is not a lemon."(p.190)  Sellers will react by withdrawing the best cars from the market, since they will deem the prices offered for them inadequate. This in turn induces buyers to offer even lower prices, since, with the best cars withdrawn, the chances of getting a lemon increase. A spiraling process threatens to destroy this market entirely.

Simpson's strategy of response should by now be familiar. He first notes that the free market has means of supplying information to those who need it. "For instance, businesses often stand behind their products to show that they think their products are worth buying. They use warranties and guarantees to protect customers from defects and to insure that customers are satisfied." (p.193) If car buyers want more information about used cars, why will they be unable to secure it? And, after all, there is a flourishing used car market, Akerlof to the contrary notwithstanding. I venture to add an additional point. Why is it assumed that sellers of the best cars, when they set their asking prices,  will not take into account the buyers' lack of information?

Just as with network effects, Simpson carries his criticism further. It is almost impossible to find a transaction in which persons have exactly equal information. Asymmetries of information are everywhere present, and no acceptable criteria have been advanced for separating "acceptable" from "unacceptable" asymmetries. And suppose that a market does break down, in just the fashion that Akerlof has described. This would come about through the voluntary acts of people that do not violate rights. If so, the government is not justified in interfering , even if it could increase "efficiency" by doing so.

Less successful, I must say, is Simpson's claim that calls for intervention here involve altruism, since attempting "to eliminate asymmetric information would require the sacrifice of those who have the ability to gain knowledge through their own thought and effort to those who do not have this ability." 1(p.199). The interventions are ex hypothesi Pareto superior: they do not make anyone worse off. The valid criticism of such interventions is another one that Simpson provides: it is not justifiable to violate rights even to increase efficiency.

Simpson's book is a most valuable contribution, and I recommend it to all students of economics. Simpson is a gifted student of George Reisman, and he has been much influenced by Reisman's great treatise Capitalism.

1One of Simpson's main arguments against altruism lacks force. He claims that "to the degree that a man acts altruistically, he acts to achieve his own destruction."(p. 15) In acting altruistically, he has not put his own survival first and foremost. But this is only to say that altruism is not egoism, hardly a decisive point to those not already convinced of egoism.

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