Search and Market Frictions

|Peter Boettke|

Barbara Petrongolo summarizes the insights of Diamond, Mortensen and Pissarides, and its policy importance.  Her own work, of course, is significant along these lines as well so she is the perfect person to provide such a summary.  I, like others, no doubt suffer from a "confirmation bias", but I read Petrongolo's summary as fitting with my own summary in a previous post, though she is in the market friction = market failure camp, and therefore in favor of government intervention in those cases.  Whereas, I am market frictions => market innovations camp.  We differ in perspective, in other words, but agree on the interpretation of the models in the search and market frictions literature.

Another way to capture the different positions beyond the 2 x 2 matrix I mentioned in the earlier post, is to think in terms of the perfect market, imperfect market (failure), perfect government, imperfect government (government failure).  The traditional dichotomy is betwen perfect market (laissez faire), and imperfect market (failure) corrected by perfect government.  This debate between laissez faire and market failure theory was enriched by the introduction through public choice theory of imperfect government or government failure.   What I am arguing is the debate can be enriched even further by recognizing that market frictions produce opportunities for market innovation.  Today's inefficiencies are tomorrow's profit opportunities for those who can find the right coping mechanisms.  $20 bills are lying on sidewalks all the time if we view the sidewalk at any point in time, but they do not persist if individuals have the freedom to pick them up.  If they do persist, it must be that they cost $21 to pick them up.

Markets fail, use the market to correct for those imperfections.  This is a model of market dynamics and entrepreneurial innovation.  It is a model of dynamic efficiency, not of static efficiency.  It is ultimately about human action, not the economics of automatons.  And thus as Petrongolo states, the economics of search and market frictions is at the core of both the wellbeing of society and high on the policy agenda, but the interpretation of those contributions is different if you think about these issues following Alchian, or if you think in the terms laid out by Diamond.

Comments

[Daniel Kuehn]

1. We need to get to the point where market failure -> intervention and market failure -> innovation are not thought of as two separate camps. I think it's naive to cling to either picture in isolation.

2. Did these insights about government failure really get introduced with public choice theory? They seem to me to have existed from the beginning of the profession. I've always felt like public choice theory is a formalization of some things that we've known for a long time. In that sense, you can think of Buchanan as the Paul Samuelson of the public secotr. A formalizer - someone that brings the discipline up to speed.

3. Generally of course I like the thrust of this post, but I think we should be careful about slipping into the same trap with government failure as some have with market failure. Failure without a solution is a concern on both sides. Innovation and success is also plausible on both sides. The question is, what are the strengths of each and the best prospects of each.

Overall Petrongolo is great. I got introduced to this literature through some things she co-authored with Pissarides. I learned some Mortensen and Diamond after I read Petrongolo and Pissarides. They have a good survey article on it - I believe it was in JEL.

[Jim Rose]

Excellent post on how some economists assume that information and knowledge are manna from heaven and blame the market when they discover that it is not.

Both Demsetz and Barzel pointed out that some economists want to stigmatize information costs. Alchian would be in this camp too.

Their response(Demsetz specifically ) was to ask why the costs of finding, digging up and processing an ore deposit is a legitimate cost, but the costs of finding and interpreting information are illegitimate costs.

There is an arbitrary classification of costs going on here.

[Jerry O'Driscoll]

Alchian was exactly on target with his price- searching paradigm. What are called frictions is often the market at work.

I'll pose a question to try to capture the differences. How does a businessman know when to change his price? What tells him to do so (up or down)?

[Mikekikon]

Isn't it pretty elementary to economic understanding that information is a valuable market good like any other? How can you be an economist and not realize this?

How can that possibly be considered a market failure? More like an econ education failure.

[Steve Horwitz]

@Jerry: I was reading the materials for the Brunner Liberty Fund today and I think Laidler's point that Brunner and Meltzer's version of Monetarism was distinct from Friedman's precisely because of the influence of Alchian on their microfoundations is a topic worth much discussion in two weeks. I think Laidler is dead on with that and it makes Brunner and Meltzer more congenial to a market process approach than Friedman's more Walrasian view.

[Peter Boettke]

Daniel,

One way to think about the perspective that I would try to get across to others is that I believe the market frictions people underestimate the entrepreneurial feedback role in the market, while they overestimate the ability of politics to deal with the imperfections of government. They would no doubt argue that I was overly optimistic in my assessment about entrepreneurship and overly pessimistic about my assessment of democratic government to respond effectively.

I am trying to push back conceptually, and I understand that the burden of proof conceptually and empirically rests on those like me, rather than on the other side professionally.

On the long history of public choice, I think your reading is a consequence of the success of Buchanan and Tullock. When they wrote in 1950s they were revolutionizing the way public economics was then done. Now if you go back to classical economists such as Hume, Smith and Say, the idea of self-interested politicians was not alien to them. Remember in Hume's "On Parliament" he argues that we must model men in power as if they were knaves. Smith rails against the sophistry of business/government who push for monopoly privileges. And Say also rails against state privileges granted to monopolies.

The real question is why did we lose these insights? My hypothesis is the evolution of what the nature of positive economics was taken to be. Lange in the socialist calculation debate even argued that questions of motivation were appropriate for psychology/sociology but not for economics. Milton Friedman in his review of Lerner's Economics of Control chides Lerner for not considering the administrative costs associated with public policy. And of course, when Jim Buchanan writes his response to functional finance, his argument boils down to a critique of the assumption that government will run surpluses during times of plenty to balance the budget over the life of the business cycle. No, the incentives of electoral politics will lead to permanent budget deficits.

Guys like Paul Samuelson were almost allergic to public choice, as they assumed a benevolent social planner at the core of public economics and public policy. Buchanan, Tullock, et. al. is not just a footnote to be considered, but politics must be endogenized in any policy relevant analysis.

Note the symmetry of assumptions I am insisting on in my categories in the 2 x 2 matrix. It is the insistence on the symmetry of assumptions that if often missed in the standard analysis.

Pete

[Jerry O'Driscoll]

@Steve,

My thoughts exactly. I hope you start that discussion. I do think this will be an excellent LF event.

Brunner/Meltzer have an excellent analysis of rational expectations. Individuals make the best use of available information, but cannot be assumed to know the structure of the economy.

[Bill Stepp]

The term "market failure" strikes me as a non sequitur. Markets don't fail, but people and firms do (e.g. Enron, a recently-opened dud restaurant, a gas station past its sell date).
Markets adjust to ever changing data and clear in their own time, at least when they're allowed to, which is sometimes quite quickly. Much so-called market failure is caused by government intervention.
One of the best books on the way in which government actually works, as opposed to how its advocates (Samuelson, Krugman et al.) think it does is Murray N. Rothbard, Power and Market: Government and the Economy.

[Michael Giberson]

I'd like to give up on both the "market failure" and the "government failure" memes. Rather that imply some sort of ideal or perfection as the standard, than theorize fixes for the failure gaps, start from gains from trade and build up.

[Ryan Murphy]

A question: is there anything in the market frictions => market innovations line of scholarship that can outline the conditions under which the market can and cannot be expected to find a solution? Or how quickly an institutional mechanism could be identified? If _hypothetically_ global warming imposes a massive externality that people simply are not reacting to right now, why should we believe that the markets will develop a workable solution before things go to hell? Or, if price stickiness is actually everything, and purely pathological (as opposed to institutionalized), AND if a culture has a taste 100% reserves, how do we know that a regulated currency wouldn't ultimately be beneficial?

It's not that I believe that either of the two hypotheticals is empirically relevant in the world we live in today. Nor do I not view Public Choice as being another important point in favor of markets. But I can conceive of worlds where the government does more good than harm before the free market solution exists. Maybe in an asymptote the market will have solved everything, but we don't live in an asymptote.

I don't think the paradigm of "not perfect competition" => market failure. But I don't think the market frictions => market innovations is the best way of looking at it either. In the spirit of South Park, it's almost like you're saying-

1. Market Friction!
2. ????
3. PROFIT

And you just need to simply unleash the powers of human ingenuity to fill in the question marks, but there may be times when no model fits in those question marks, and others where it took so long to find the market solution that we incur substantial costs along the way. In either case, a purely utilitarian standpoint wouldn't have issue with using intervention instead.

[Peter Lewin]

Entrepreneurship is hot now in Management studies. It starts with Kirzner - opportunity discovery - and continues with Lachmann, Mises, Knight - radical uncertainty, resource appraisal and judgment. Point: without frictions (aka, imperfections, uncertainty) opportunities would not exist and the entrepreneur would not exist. The government is not an entrepreneur and cannot "fix" these "frictions."

[Ryan Murphy]

Isn't that begging the question? The entirety of the interventionist literature is to show how government intervention can mitigate frictions. I wholeheartedly agree with questioning the reasoning of how intervention can do so. But I don't really agree with trying to recast everything in terms of entrepreneurship and saying the government can't do anything about it because it isn't an entrepreneur.

[Greg Ransom]

Economists lost these insights. People in the real world who didn't face the incentives of economists didn't lose these insights. People who weren't bewitched with the math constructs of economics didn't lose these insights. People who didn't have to pass muster with their economist peers to get articles published and dissertations written didn't lose sight of these insights.

The power structure of the profession determines the burden of proof in the discipline -- to the point where the Nobel committee is constantly giving Nobel Prizes to economists for "scientifically proving" what everyone already knows -- everyone accept the economists.

Peter wrote.

"The real question is why did we lose these insights?"

[Troy Camplin]

There is a reason why there must be a step ????

If there were not a step ???? we would have the mathematically pure, perfect markets too many economists pretend exists (and when the real market fails to match it, declare there to be a "market failure"). Or, if I knew what ???? was, I would do it and get rich. It is as people figure out how to define ???? in each case that opportunities are found and wealth created. It is thus absurd to complain that we cannot know what by definition we cannot know -- until it's discovered. It's not a "scientific failure" if we haven't learned everything there is to know (creationists notwithstanding in their complaints about "gaps" -- which is another example of how anti-market people are like creationists and intelligent designers).

The government can't do anything for several reasons. One, competition is a discovery process, and government doesn't compete. Thus, it can't discover. Thus, it can't fix those kinds of problems. Two, government is too short-sighted because our politicians are elected every 2, 4, or 6 years. This is an extremely short-range trajectory. One solution would be to just set up a permanent dictatorship, which would take care of those temporal problems (which is perhaps an explanation for why the Left tend to support dictators). Another would be to take such decisions out of politicians' hands, since they aren't going to have the incentives to look at things over the long term. So we have government failure either because of temporal shortcomings or because under dictatorship, there is a tendency to concentrate power even faster and destroy the very market it is supposed to regulate (which it cannot do because of knowledge problems -- another reason for government failures).

All I see are government failures. Market failures only exist in the fantasy land of the econometricians.

[Wonda Dewey]

I think you tackled this very well. Thank you for this great blog post. I wish everyone would put as much thought into their words as you do!

[Peter Boettke]

Ryan,

Recasting in terms of entrepreneurship is not just about entrepreneurship, but about institutional context, dispersed knowledge, ability to engage in rational calculation, and the lure of pure profit and the penalty of loss. I'd like to suggest two papers of mine (both with Chris and Pete) --- "Does the Market Self-Correct?" in RoPE, and "Saving Government Failure Theory From Itself" in CPE.

I think you are asking the important push back questions, but there is more embedded in the entrepreneurial response, I think, then you are acknowledging. On the critique of interventionism without recourse to public choice analysis look at Sanford Ikeda's The Dynamics of the Mixed Economy, or the special issue of Advances in Austrian Economics on The Dynamics of Interventionism.

Troy's last comment is also very useful for understanding the role of discovery in the market, and the inability for government to engage in _economic_ discovery. Government officials discover that which is in the their interest to discover, but those discoveries are not about economic gains from trade, but political gains from interaction. The context of discovery shifts, you discover different things. See my recent paper with Emily Skarbek and Nick Snow, "The Context of Context" in Advances in Austrian Economics. Also see my Hayek Lecture at the LSE, published in Econ Affairs.

[Jerry O'Driscoll]

Demsetz made the point that every putative market failure was an unrealized profit opportunity. He delighted in eliciting examples of how markets actually circumvented market failure.

Coase's lighthouse story remains my all-time favorite. But there is also the fable of the bees.

[Greg Ransom]

Excellent. I've never heard is said exactly like this:

"Troy's last comment is also very useful for understanding the role of discovery in the market, and the inability for government to engage in _economic_ discovery. Government officials discover that which is in the their interest to discover, but those discoveries are not about economic gains from trade, but political gains from interaction."

[liberty]

The static efficiency vs. dynamic efficiency dichotomy is similar to the income inequality vs. income mobility dichotomy. It seems that you have two camps shouting past each other.

One camp is saying "With a free market you have poverty and inequality, therefore we need redistribution by government!"

The other camp shouts back "Its only in a static picture that you see this poverty - its new people every year, because every year these people climb out of poverty! In addition, each year even the new poor are better off than the old poor were!"

I think the point made by the second camp is extremely important - and often the first camp misrepresents. Yet there may be something the first camp is saying that is not addressed by the second camp. What if the "friction" that allows some people to be poor for some amount of time, or that produces the magnitude of inequality, could be alleviated by redistribution: would there be any benefit? What would be the cost?

Similarly, the market frictions that are called "market failures" and which offer entrepreneurial opportunities - are there any that could be alleviated by policy better than by an entrepreneur - or could government facilitate the creation of entrepreneurial opportunities in the market somehow? etc.

[fundamentalist]

"It is said that when the Nobel Prize in economics was first established, prizes were given for using economics to teach people things they didn’t already know, e.g., that economic growth might increase inequality, that depressions are caused by central banks, that macroeconomic stabilization policy doesn’t work, etc. Now, prizes are given to economists who teach other economists things that regular people already know — politicians are self-interested, you shouldn’t put all your eggs in one basket, institutions matter, different people know different things, etc." http://www.adamsmith.org/blog/misc/tell-me-something-i-don%27t-know/

[jonathan]

Imperfect markets don't need to be corrected by a perfect government to make a big and positive difference. Take a look at the first cost benefit analysis of the Clean Air Act (1970-1990) before market-based policies were implemented.

http://www.epa.gov/air/sect812/

The estimates indicate very large net benefits primarily in the form of reduced morbidity and mortality. (hack, hack, cough) Sometimes the simple concept (market failure & externality) is the right one.

I would be interested to know how entrepreneurial efforts could achieve the same results (even in theory). Clearly, the "smog upon LA" in the 1960's demonstrated that, in practice, entrepreneurs were not up to the task.

[Russ]

It's a nice roundup article that Barbara did. Also posted here:
http://www.berfrois.com/2010/10/search-and-market-frictions/

[Peter Boettke]

See also http://faculty.chicagobooth.edu/brian.barry/igm/2010-nobel-prize_Shimer.pdf