Perfect markets make for a sweet fantasy, but they are not the same as reality. And few strawmen have been killed as often as the idea that the story of markets hinges on the perfection of markets, and thus the inevitable failure of real-world markets to match this textbook output undermines the argument for using markets. Some of the strongest defenders of the market system, such as FA Hayek and Israel Kirzner, reject ideas such as perfect markets, perfect information, perfect competition, and so on. Their argument for the use of markets is not based on the particular perfection of markets, but instead on the real-world dynamics that accompany the ongoing and evolving market process. Markets are useful not because in a market-driven world there are no $20 bills on the side of the road. Markets are useful because they create the right environment to find out those $20 bills.
One real-world conflict in real-world markets is price stickiness. In the fictional version of perfect markets, prices adjust quickly. In the real world, prices can be sticky – they may not change, or they may change slightly. One reason for this is transaction costs. Sometimes, changing the price is not free. A textbook example of this is called “menu costing.” Even if the cost of food and various ingredients change, restaurant prices can stick and stay the same. To change their prices, restaurants will have to print a new set of menus with the revised price for each dish. This costs money and time. If the price of potatoes goes up slightly, it’s usually not worth the time and effort for a restaurant to print a new set of menus with updated prices for all foods that include potatoes.
But like asymmetric information, transaction costs have a lifetime. In markets, there is an incentive to find ways to reduce transaction costs and thereby reduce price stickiness – because finding ways to reduce transaction costs is itself an opportunity to make money. Menu costs are an example of this as well. Another way I’ve seen restaurants incur menu costs is by simply not having prices listed for certain menu items. If a restaurant in a coastal town tends to serve freshly caught fish or lobster locally, they may face large fluctuations in the cost of those items. To accommodate this, they often list such dishes on the menu as “market price” rather than a fixed dollar amount.
Lately, I’ve seen many restaurants put their menus on digital displays instead of print, and some have completely removed physical menus and replaced them with a QR code on each table. You scan the QR code with your smartphone, and it opens a website with the latest menu. This greatly reduces the transaction costs associated with menu pricing, and makes prices more flexible. Price stickiness is a real problem – but at the same time, the existence of that problem gives the market incentive to find solutions. That’s why Arnold Kling said: “Markets fail.” Use markets.”
On the other hand, there is also a problem with policy adherence. When governments make policies to try to solve a particular social problem, those policies themselves stick. It is surprisingly easy for people to overlook this issue. A wonderful book by James C. Scott Seeing as Kingdom provides an extended view of how policy interventions go wrong. Towards the end of the book, he gives a few tips that can help improve the situation, such as:
Love the change. He prefers interventions that can be easily corrected if they turn out to be wrong. Irreversible interventions have irreversible consequences. Intervening in ecosystems requires special care in this respect, given our great ignorance of how they interact. Aldo Leopold captured the spirit of caution required: “The first rule of sounding wise is to keep all parts.”
Not that this is bad advice in the abstract. But the idea that interventions can be “easily reversed if they turn out to be wrong” is less compelling when one considers that policies also stick. In practice, it is often very difficult to reverse an intervention no matter how wrong it is. Policies stick because, as Pierre Lemieux often says, any government policy benefits some at the expense of others. This quickly became a public choice issue. As soon as the government implements some kind of intervention, it creates a new interest group that will be invested in keeping that intervention alive, while the benefits of ending that intervention are so dispersed that no one in particular has a strong incentive to try to end it. It is not for nothing that Milton Friedman joked that “‘Nothing is as permanent as a temporary government system.’
This sub-heading is over-implemented – not all policies are so rigid that they become immovable objects. But it’s really a problem. One classic example is mohair yarn. This plan was originally created to ensure that the United States military would always have enough fur for their clothing. But eventually, the military stopped using this fur in their uniforms and started using synthetic materials instead. Nevertheless, the federal government continued to spend tens of millions of dollars a year subsidizing mohair production long after the original basis for doing so was gone. The system was finally completed (mostly) – more than forty years after the switch to synthetic materials.
This 1993 report detailing ongoing efforts to end this funding includes comments from Senator Charles Schumer, who says he has spent years trying to reverse the policy. If ever there was a policy to be “reversed easily,” you’d think this one should be as easy as it gets. But policy adherence can be such a strong force that even something as obvious as “stop spending tens of millions of dollars a year subsidizing something you stopped needing decades ago” takes years of hard work to finally accomplish. Speed James C. Scott, “interventions that can be easily corrected if they go wrong” are found only in fiction, not in reality.
While markets provide the incentive to find ways to reduce and reduce price stickiness, politics provides the incentive for the beneficiaries of policies to make those policies stick as much as possible. In markets, you can make money by finding ways to reduce transaction costs. In politics, you protect your supremacy by ensuring that transaction costs are as high as possible. In the real world, price stickiness is proverbial and policy stickiness is proverbial history.
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