An Interesting Question

Don Lloyd of Catallarchy asks the following:

Take two theoretical economies as follows:

Economy A – An economy that has 1000 industry segments each of which initially contains two similar products, such as Coke and Pepsi, each of which is produced by separate firms which are not allowed to merge even if they desire to do so.

Economy B – An economy that differs only from A above in that firms ARE allowed to merge, resulting in Coke and Pepsi being only separate brands of a single firm, for example.

Both of the above economies are to be considered as starting points, which may further evolve.

Given that an omniscient being is to select between the two economic structures with the goal of maximum overall welfare, what criterion should be used in the selection?

I think this is a worthwhile question to ask, but at the same time, I think it needs emendation if it is to be of greatest value. In particular, that bit about an "omniscient being" has got to go straightaway, as the concept of omniscience is not just problematic on its own terms, but also does away with what makes this such a potentially fruitful query: we aren't omniscient creatures, after all, and the importance of markets lies especially in the fact that they serve as a means of distributed information aggregation, a view championed most vigorously by those of the Austrian school of thought to which the Catallarchists are known to be partial.

No, the ideal question ought to be this: given the choice between the two alternatives above, and knowing that we cannot see what the future holds, which alternative should we choose?

If we assume that innovation is unimportant, and market power is everything, then our tilt will be towards the first option, in which the ability to abuse said power is constrained by the prevention of monopolies; all else being equal, this is almost certainly the welfare-maximizing option, particularly if we assume that players in different sectors of the market won't ever stray into each others' turf.

If, on the other hand, we take a more dynamic, Schumpeterian view of how markets work, and we take on board that new innovations will emerge that will not only create whole new markets but might also lead to the wholesale extinction of old ones, and if we acknowledge the importance of extraordinary profits as an incentive for entrapreneurs to take extraordinary risks, then an economic system that prevents market consolidation starts to seem a lot less inviting, and a detailed analysis might even suggest to us that we go the extra mile by granting temporary monopolies to innovators - as indeed we currently do, through the patent system.

There is a connection between all of the above and the historical failures of socialism, whether it be the Stalinist variety or the "market socialism" promoted by Oskar Lange and Abba Lerner, and it is one I first saw articulated by Joseph Stiglitz (of all people) in his excellent book, Whither Socialism? The crucial connection is this: both the neoclassical economic model and market socialism are predicated on the existence of perfect markets in which neither producer power nor innovation have any role to play whatsoever, and for that reason, both come to faulty conclusions about what markets really are good for, and why they're good at it. Markets are hardly ever perfect, but they don't need to be to do their job well, a job one has to be willing to look beyond the static general equilibrium picture to see - the rewarding of innovation, the fostering of creative destruction.

Were it possible to ignore the innovation question, then there is no reason in principle why market socialism shouldn't have been a success, as the market socialists could have enjoyed the scale advantages of monopoly while utilizing the power of government to see that all of the extra consumer surplus a private monopolist would have extracted would be available for the common good. The gigantic steel combines of the Stalinist era might have enjoyed tremendous economies of scale when they were created, but decade after decade they kept on producing steel, even as the terms of trade moved away from steel in favor of products whose very creators hadn't even been conceived when Stalin died in 1953, and this was one reason why the heady growth figures recorded by the Soviets in the post-war era (to the extent that such figures were reliable) petered out into the stagnation of the Brezhnev years. Well over 90% of all economic growth in the West over the last 100 years has come from innovation, not from additional capital accumulation or longer working hours.

But all of this fails to address the question raised by Don Lloyd head-on, and my own response to him would be to say "It depends, though I lean towards choice B." Even if one fully takes on board the Austrian insistence of the importance of innovation, one still isn't obliged to accept that a complete lack of restraint on market power is a good thing, and I for one see little empirical evidence to support so strong an assertion. Here I must part from the anarcho-capitalists by stating that this is not a question that can be definitively answered by Cartesian ratiocination detached from all evidence, however sophisticated such reasoning may be.

Comments

[j]

not related to this question, but an observation on (I believe) an underappreciated element of capitalism

the average person I meet in business is much more concerned and dedicated to meeting the needs of others than the average intellectual or artist

it seems that most artists and intellectuals are much more concerned about satisfying their own egos whereas successful businesspeople who build long-term viable enterprises must dedicate themselves to others

i know this is basically expressed in adam smith's invisible hand, but from my experience it is not all that invisible, successful businesspeople really do care about others whereas intellectuals and artists spend most of their time aggrendizing themselves

if anyone has feedback, i would be interested in hearing - thanks

[Don Lloyd]

Abiola,
Thank you for your interest in my post.

The followup post,
http://catallarchy.net/blog/archives/2004/10/16/choice-of-economies-a-followup/

makes it clearer that I have no interest in omniscient beings, but want to emphasize that the 'figure of merit' of an economy is related to the level and variety of goods and services that are produced and consumed over time and not with any measures of prices. Profits are not only the key to future expansions of consumption, but directly indicate the degree by which the economic value of a final consumer product exceeds the sum of the economic values of its production factors.

Regards, Don

[Abiola Lapite]

Don,

Thanks for the pointer to your second post. I would like to point out, however, that profits in themselves aren't sufficient to distinguish between free market economies and market socialism of the Lange-Lerner variety, as the latter explicitly envisions state enterprises acting as profit-maximizers; in theory, there is no good reason why total state-ownership should not also lead to a multitude of goods and services calculated to satisfy every possible niche. That this is never so in real life goes without saying, but concentrating on efficiency criteria will not suffice to capture just why there is such a gap between market-socialist theory and practice.

In a nutshell: even if a completely planned market-socialist economy were more (or at least, equally) efficient in the allocation of goods and services in the short and medium term, it would still fall short over the longer term, not because of inefficiencies in its provision of goods and services to meet consumer tastes or because it failed to maximize economic value, given existing technologies, but because it makes no provision for the encouragement of new, unforeseen technologies, and the brand new markets they can give rise to. As such, questions of value-maximization are essentially a red herring; an America utilizing 1904's technologies at a welfare-maximizing level would still be a far poorer place than one utilizing today's techonology in a less than optimal fashion (as I'm certain is actually the case today).

It is with all the above in mind that I found your mention of omniscience problematic, as by ignoring the importance of profits to incentivizing knowledge discovery and exploitation, one throws out the very engine of the prosperity we enjoy presently, and I'll note that despite your mention of entrapreneurs and new ventures, the overwhelming importance of innovation still isn't explicitly addressed in the second post you've made. To clarify the distinction, I offer an example: the Roman Empire had no small number of entrapreneurs and new ventures in its heyday, but the production technologies they employed advanced minimally in the course of hundreds of years, and consequently, so did Roman standards of living, once all the gains to be had from peace, good roads and open borders had been realized.

[Julian Elson]

This is an interesting question. There are some other things that we need to know about A and B, like:

-How substitutable are different segments with each other? (i.e., does the Coke-and-Pepsi segment face competition not only from each other, but also from orange juice and iced tea?) Higher inter-segment substitution argues for B, since monopolies aren't as damaging within a segment
-Do the firms in these segments know enough about each customer and have enough control over sales to price-discriminate effectively (like colleges), or not? Better price-discrimination argues for B, since monopolies will just tend to lead to a transfer from consumer surplus to producer surplus, not an overall social loss.
-What is the production function like, anyway? Are the benefits of increasing returns big?

Something like, oh, integrated steel production presents a tough case. There are few substitutes (as far as I know), and it'd be tough to price discriminate, since, unlike college admissions, it's a readily transferable commodity, implying one price. So that would seem to argue for A. But the returns to scale are big, so we should do B. This is, of course, exactly what makes market socialism so tempting.

Overall, it seems that, as you said, it's an empirical, a posteriori matter, but not just for the economy as a whole, but for every goshdarn segment of the economy too. Of course, some, like Julian Sanchez, would say that that's dangerous thinking, it invites government micromanagement of the economy when what's really needed are clear principles and transparency, property rights, etc.

[Julian Elson]

What was Walras's position on this? Something like: "We can have a socialist economy as efficient as a capitalist economy, but only if relative prices and allocations are exactly the same, so you have the same inequalities, but with the nasty government screwing the workers instead of the nasty capitalists." Or something like that?

[Abiola Lapite]

"Of course, some, like Julian Sanchez, would say that that's dangerous thinking, it invites government micromanagement of the economy when what's really needed are clear principles and transparency, property rights, etc."

I share that bias myself, but where I differ from most libertarians is in acknowledging that it is a bias, and that one can't rule out a priori the necessity of at least some government intervention.

Even if anti-trust were to be abolished, there'd still be the patent system, trademarks, copyrights and other government-enforced measures in place acting to protect the profits of innovators, so we'd hardly be looking at a "pure" free market in any case, and I find it extremely hard to believe that a system without any safeguards to ensure that innovators capture at least some of the benefits of their ideas would lead to the sort of prosperity we enjoy today. The examples of ancient civilizations like Rome and China, which had well developed travel networks, high literacy, sophisticated merchant classes, etc, and yet which never managed to make the leap unto the high-growth path the West has been on over the last 200 years, certainly argues against the notion that a society without at least a few government-backed incentives for innovators will be a high-growth one.

In short, I think what exactly constitutes "property rights" is a fundamental problem that is simply assumed away by most standard libertarian boilerplate.

"What was Walras's position on this?"

I don't know offhand, but I'll take a look later in the day and see if my copy of Blaug's "History of Economic Thought" has anything to say about this.

[Don Lloyd]

Abiola,

My use of 'omniscient being' was merely an attempt to indicate that no individual or group can possibly have access to enough information to make a comparison of different economies. My only interest in optimization is that pursued by individuals and individual firms in their own interest.

My follow-up post preceded in time your reference, so innovation was not mentioned explicitly, although it cetainly is a major part of entrepreurship.

Monopolies, in the unpriviliged single-supplier sense, sometimes emerge as the result of individual firms acting to maximize their own profits over time, and are not to be feared or impeded. As long as monopolies are maintained by satisfying consumers in price, variety and quality, as opposed to physical threats, they are entirely appropriate, and not necessarily permanent.

I find the entire idea of 'consumer surplus' as generally useless, as the price that a consumer is willing to pay for a given good is extremely unstable and path dependent. It also seems strange to use a measure that highly overweights the Bill Gates of the world whose time opportunity costs prevent even just the amount of thought required to form an opinion of a price for most goods.

My point overall is that prices are an allocation tool and a signal, not a collective value measure.

Regards, Don

[gene berman]

All of you guys find a particular tree and "bark up it." And, in so doing, the particular tree that hasn't been barked up but has been pissed on by neglect is the most important of all: some method for determining the composite valuation of future goods as against those in the present. No other method than that furnished by a private market for the real things comprehended in the words "tools of production" and a capital market which produces loan prices (to include not only the presently prevailing discount of future goods but also ineradicable riskiness arising from the intended project itself) can possibly enable a director to determine the magnitude called "costs." The mere allocation of raw materials and labor to the production of specific goods chosen on some basis that seems rational to the director is only a small part of the total problem. Thwere are matters to be considered having to do with whether to construct large machines which will operate at the highest capacity possible or many smaller machines

[gene berman]

shit--posted accidentally before finishing. But that's OK--you get the idea.

[gene berman]

It should also be noted that only by making the comparisons referred to can the "director" establish whether or not the project is proceeding properly, whether it is not (i.e., incurring losses) and to what extent and at what rate such capital must be replaced (to avoid consumption of the "seed corn"). I'd say "back to the drawing board," except that's the wrong place to solve the problem posed.