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Tuesday, October 27, 2020

David Friedman – Speaks at Liberland 5th Anniversary

What I want to talk about is the general issue of market failure, and in particular, its relevance to the issues raised by the current pandemic.  I am going to claim that market failure is indeed a real problem, but it is not a problem that is specific to markets, it is a problem that exists in a wide variety of different contexts. 

Market failure is often used as an argument for government intervention in the economy or in the world, and it in fact is an argument for that, but I want to claim there is a stronger argument against the alternative, that market failure is a reason why a laissez-faire free market does not always do the right thing, but there is a stronger reason why the alternative to a laissez-faire free market is unlikely to do the right thing, and I think that’s true even in the case of contagious diseases, which some people would argue, perhaps correctly, are one of the stronger arguments in favor of government. 

Let me start by explaining what market failure, in my view, is.  Market failure describes a situation where individual rationality does not lead to group rationality, where each individual takes the correct action in his own interest, and yet, we’re all worse off as a result.  And the reason that can happen is that each individual acts in terms of consequences for himself and those he cares about.  Sometimes individual actions have effects on other people, so it is possible to have a situation where my act benefits me, but harms us, your act benefits you, but harms us, and we’re both worse off as a result. 

The standard example that any of you who have taken Econ courses have probably encountered is the Prisoner’s Dilemma, that’s a two-person example of market failure, where the two prisoners both confess, when they would be better off if they both kept their mouths shut, because each one correctly believes that he is better off confession, than not confessing. 

My favorite standard example is one which would happen somewhere pretty close to where Liberland now is, about 1000 years ago.  I want you to imagine that you are one of a line of 10,000 men with spears, your spears are all pointing in that direction, and the reason they are is that another 10,000 men on horseback with spears  are coming at you.  You do a very quick cost benefit calculation, you say if we all stand our ground and keep our spears solidly planted, with luck, we can stop their charge.  And some of us will die, but most of us will live.  If we run, horses run faster than we do.  I’m sorry, I made a mistake, I said, “we.”  I don’t control him and him, I only control me.  If I run and everybody else stands, one man out of 10,000 has a very small effect on the outcome of the battle, and I won’t be one of the ones killed stopping the charge.  If everyone else runs and I stand, I’m dead.  Whatever everybody else does, I am better off running.  We all make that calculation, we all run, and most of us die.  Welcome to the dark side of rationality. 

Let me give you a less exotic example, but one you may well have experienced yourself.  You’re in a restaurant with friends having a pleasant conversation, but the restaurant is a little bit noisy.  So, in order for your friends to hear you, you have to raise your voice a little.  Of course, everybody else is doing the same thing, so you have to raise your voice even more, and when it’s over, the restaurant is very noisy, as restaurants unfortunately often are, and nobody can hear anybody else, because you’re all speaking loudly.  And that’s the same logic as my situation with the army running away, in which each individual takes the correct action, given what everybody else is doing.  But my action has negative effects on the rest of you, so does your action, and we all end up worse off. 

Let me now talk about market failure in the context of the ordinary private market, the sort of laissez-faire system that most of us are in favor of.  One of the nice things about the private market is that most of the time I bear the costs and receive the benefits of my actions.  So, most of the time if an action is on net worth taking for me, it’s on net worth taking considering the effect on all of us.  And the reason for that is the price system.  If I want to use an input, say somebody else’s labor to make something, I have to pay him enough so he is willing to work for me.  That means I have to pay him enough so he is better off working for me than doing anything else he could do, so that’s transferring the cost of his working from him to me in the money I’ve got to pay him.  If I produce sometimes valuable, I can sell it.  The result of my selling it is that the value to the people who are getting what I’m producing is transferred to me in the price they pay me.  So, roughly speaking, in a well-functioning free market each individual bears the cost of his actions, receives the benefits and therefore has the right incentive, the incentive to take those actions that produce net benefits and avoid those actions that produce net costs.  That’s one of the attractive features about market system. 

But it isn’t always the case, because there are situations where I can take an action where some of the costs are imposed on other people, the standard economist example would be air pollution; or, take an example where some of the benefits go to other people and I can’t collect them, for example, if I think up a new idea which other people can then use.  You could think of lots of other examples, but basic research is one of the standard textbook examples of this kind of issue.  So, that means that there are situations on the free market where something happens that shouldn’t happen or fails to happen that should happen, therefore market failure exists on the free market, but on the free market is the exception, not the rule.  It occurs only when the normal mechanisms are not working in the way they usually work.  But it does provide an argument for government action, because it means that a sufficiently wise and benevolent government could under some circumstances intervene and make things better.  The problem, of course, is the shortage of sufficient wise and benevolent government actors, because market failure also occurs on the political market. 

If you think of the individual voter who is supposed to be what makes democracy work, the individual voter knows that his vote has a very low probability of changing the outcome of an election.  If by spending a lot of time and energy in figuring out who to vote for, by one in a million change, his vote is decisive, the right person gets elected, and the benefit from that goes to everybody in his country, and therefore only a tiny fraction of it goes to him.  So, the voter is in a situation where in economic language the externality of his action is something like 99.9999%.  The result, of course, is that most voters are rationally ignorant.  They vote according to which candidate looks handsome, or which candidate their friends like, or reasons of that sort. 

The same thing is true of other actors on the political market.  When an interest group lobbies for a tariff, its members receive the benefit of the tariff, other people pay the cost of higher prices or fewer exports to exchange for imports, the various costs the tariff imposes. 

If a judge makes a bad decision and sets a bad precedent, he probably never knows it and he bears none of the cost.  There is actually a real US case in which a panel of judges made a logical mistake that a smart high school student should have been ashamed of making; they confused an annual cost with a lifetime cost.  The result was a decision that almost certainly killed some thousands of people because it resulted in a delay in reducing vaccines due to an incorrect liability decision.  I could give details if people were curious, but you probably aren’t.  None of those judges ever suffered for doing that. 

There may be an exception I haven’t thought of, but I think it’s pretty close to true that no actor on the political market either receives most of the benefit of his action or pays a significant fraction of the cost of his fraction.  Hence there is no good reason, on the free market there is a reason why most of the time individual rationality leads to group rationality, there is no reason to expect that on the political market individual rationality will lead to group rationality.  And the implication is that shifting decisions from the private market to the political market is more likely to make things worse than to make things better. 

Let me discuss the application of this to the particular issue we are now all facing of a pandemic, the coronavirus.  Unlike Jeff Berwick, I do know people who have gotten the disease.  There is a nice lady who generously designed the covers for two of my more recent books, her husband got the coronavirus very seriously.  Her daughter who has recently done a modification of my webpage which will be up pretty soon, because it looks much prettier than my version of the webpage, got it, fortunately not seriously, so this is not an imaginary disease, it’s no more fake than the Spanish Flu was fake a century ago, or the Black Death seven centuries ago.  It’s a real problem and it is a real problem for which private action will not result in people doing the perfect things.  Unlike what libertarians would often like to believe, the free market is a very good institution, but it is not a perfect institution, because there aren’t any perfect institutions. 

So, what’s the problem with private action with regard to contagious diseases?  The problem is that when I avoid getting infected I am producing two benefits.  I’m producing a benefit for me, because I don’t get sick.  But, I’m also producing a benefit for other people, because if I’m not infected, they can’t catch it from me.  Furthermore, when I’ve already caught it, going out imposes a cost on other people.  That is, if you wish you can call it aggression if you like, but it is in fact a real cost on other people, not on me.  So, I have an inadequate incentive to avoid catching the disease and an inadequate incentive to avoid spreading the disease.  Hence, if we really had a perfectly wise benevolent ruler who could tell me when I could or couldn’t go out, that could really produce benefits, but again, we have a shortage of such rulers. 

So, let’s compare the situation to the political actors.  In the case with the private actor, I have an inadequate incentive, but I have a pretty strong incentive because I don’t really want to get the disease and die, I’m 75 years old and male, which puts me in two of the high-risk groups.  So, I have a strong incentive to take precautions, and in fact I’ve been self-quarantining for several weeks, and we’re set to do so for another month or so, maybe longer, even if not the ideal incentive we’d like me to have. 

What about political actors who are making decisions for me and for other people?  And the answer is that the political actors on the healthcare market, at least in the US, I’d be talking mostly about the US because that’s what I know best, in general, they have resulted in the medical system being a good deal worse than it otherwise would be.  The FDA makes rules about when medical drugs can be introduced.  An economist by the name of Sam Peltzman, University of Chicago, many years ago studied the effect of one change in the FDA regulations, a change that was designed to make sure that drugs were not only safe, but also were useful.  And his estimate was that introducing that change which raised the cost of bringing drugs to market reduced the number of medical drugs brought to market each year roughly in half and had no detectable effect on their average quality.  So, I think that suggests what I think is almost certainly true, that if the FDA did not exist, there would be a much larger range of medical drugs available and almost certainly at a lower cost, because the FDA by essentially being over cautious because a failure in the direction of the thalidomide case gets on the front page, whereas the mere fact that they don’t approve the use of a drug and an extra 10,000 people die doesn’t make it on the front page, but that’s an extra 10,000 out of 200,000, however many would have died if you did have the drug. 

So, furthermore, the government intervenes in a number of other ways.  If you are a hospital and you want to expand your activities, you in effect need permission from other hospitals.  If you want to build a new hospital, you in effect need permission from other hospitals.  The theory of this is we don’t want excessive medical facilities, but of course, it’s always in the interest of a firm to try to keep competitors out.  So, that means that the government reduces the availability of hospitals and hospital beds.  In order to practice medicine you have to be licensed by your state and in practice the medical profession has historically used that control to hold down the number of doctors.  During the Great Depression the American Medical Association sent a letter to the medical schools telling them that they were producing too many doctors and they all cut back as a result, because they knew that the AMA had effective control over whether their school got recognized for licensing.  So, that’s one respect in which government intervention has made us less willing, less ready to handle the problem. 

For specifics this time around, we know that the Chinese government initial suppressed the information that the coronavirus existed.  When one of the doctors went public with it, they took fairly strong actions against him.  We know that the US government, when the problem appeared in the US, forbade people from using tests other than the tests that the Center for Disease Control and the FDA had approved of.  It then turned out that the tests that the Center for Disease Control was putting out didn’t work, and that cost us, I don’t know, probably a month or so, three weeks to a month, before we got useful tests.  We know that the Center for Disease Control for weeks told people they shouldn’t wear masks because it didn’t do any good, that was clearly false at the time.  A blogger who I respect for his care in reading scientific articles had a long article going through the existing literature from which it was clear that we did not know how much protection masks provided, but the masks provided substantial protection for other people and some protection for the person who is wearing the mask.  The CDC eventually reversed its position, they now are in favor of you wearing masks.  As far as I know, they never got around to saying, by the way, we made a horrible mistake which killed thousands of people, which almost certainly is the case, given that people were following the bad advice they had given.  I am reasonably sure that nobody at the FDA has been hanged or even fired as a result of that mistake and I think that stands fairly clearly for the general point that people in the political system rarely bear the cost of the mistakes that they make. 

Similarly, the CDC has finally reversed its position on saying in effect that only American respirators count, on saying that you could use N-95 but not KN-95, KN-95 being essentially the Chinese version of N-95, and again, the government is in various ways getting in the way and therefore making the problem worse.  Now, the government has probably done some useful things, as well.  I suspect that telling people that they were not allowed to have gatherings of large numbers of people actually showed the contagion.  But the question, the argument, you always have to make an argument for the free market, is not it’s perfect, not there’s nothing government can do better,  but that we have no way of having a government that is restricted to things they can do better.  And so the question is whether the ways in which government makes things worse are or are not greater than the ways in which it makes things better, and I’m arguing that even in the case of a contagious disease, probably we are better off without them. 

Now, that raises the interesting question of what would happen if we had no government because, of course, I’m an anarchist.  Individuals still have an incentive to avoid being infected.  Without a government I would still be self-quarantining.  I in fact cut short my speaking trip in Europe and canceled the last two talks that might or might not have happened anyway in order to come home, because I recognized I was at risk and my younger son persuaded me that I was being unreasonable in assuming that because it had always been safe before, it would be safe this time.  If there were no legal restrictions on raising prices when there is a shortage, we would have had a larger incentive to stockpile for emergencies.  We would have had more incentive to ramp up production when shortages appear.  If this sort of situation were really common in a market system, which it isn’t, then the private law would have been modified in various ways to recognize the fact that when you impose a risk of infection you’re imposing cost on other people. 

If I had more time I’d go into more detail, but I’ve just gotten the 30-second message.  So, let me end by saying that if you want more information to all of this stuff, is this readable?  Unfortunately, it’s mirror image because of the way the system works, by my webpage (daviddfriedman.com) has lots of my books and articles, it has recordings of many of my talks, you can also find my vlog for my webpage, and that will give you more than I am able to say in 20 minutes.  Thank you all, have a good day. 

Jillian Godsil
Blockchain Advocate, Founder, Conference Chair, Women in Blockchain Advocate, Keynote Speaker, Crypto Journalist, Broadcaster, CEO, Writer, Homelessness Advocate, Former European Parliament Candidate, Law Changer, Mother, Choir Member, Hill Walker, Dreamer

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