Economy 23-04-2024 10:01 13 Views

Why Even Insiders Underestimate Markets’ Power

Parked aircraft with detail of “winglet,” engineered to reduce drag and improve fuel efficiency.

Over more than four decades of reading, writing and teaching about economic policy, one of the lessons I have learned is that market forces are more powerful than we think. 

When people are faced with some problem in coordinating their economic efforts, they commonly say things like, “well, there’s not much we can do to change things” or “we might not like it, but we have no other choice.” That is, they tend to discount the possibility that markets, if allowed to work, could address those issues. Then, such false premises provide support for coercive government “solutions” as the default response. 

I can remember the 1970s, when I started graduate school, and OPEC dramatically raised oil prices. That, in turn, dramatically raised aircraft fuel prices. People expressed many versions of similar statements, implying that there was nothing much that could be done other than just live with the resulting higher costs of flying. But all sorts of things ended up being changed to mitigate the increased cost of aircraft fuel. Changing routes to a hub-and-spoke model increased the number of occupied seats, lowering fuel cost per passenger. Moving seats a bit closer together also increased load factors. Stripping paint off airplanes, installing lighter seats and tightening baggage and carry-on limits saved weight and thus aircraft fuel. Moving to fewer larger and more efficient engines also saved fuel, as did the now-common upswept wingtips, which convert otherwise wasted as turbulence into lift. Still more was done, some of which was not even anticipated by those considered experts in the field, but only discovered in response to the increased value of saving fuel.

Similarly, living in Southern California, I have heard about water shortages for far longer than my current students have been alive. But seldom did I hear about how government water allocations that far exceeded actual water availability and heavily subsidized water use dramatically increased the amount of water demanded, including shifting the production of rice, which requires the flooding of fields from other states (whose climate better supported such crops) to California. With water artificially cheap for many agricultural uses, too little attention was given to water-saving techniques such as rotating crops, introducing drip irrigation, leveling fields better to reduce runoff, shifting watering to times when evaporation was lower, and lining water ditches with concrete. Letting water prices rise toward market levels (reflecting what others are willing to pay for that water) would have increased the payoffs for discovering and implementing every such means of saving water. But implicit or explicit beliefs that such market adjustments would be unable to effectively address the problem meant that they generally weren’t tried. 

Anyone who has ever taken a competently taught economic principles course should understand why people tend to underestimate market forces for airline fuel, irrigation water, and so many other areas.

Such courses begin with the fact of inherent scarcity: we desire more goods and services than we can produce (though for those who will quickly jump to the “selfishness” attack, that desire is not limited to ourselves, but extends things we create for others or give away). Then, in dealing with the problems that arise amid scarcity, economic principles point to the implication that having more of one thing I want means I must give up some other thing or things I also want. That is what Thomas Sowell famously summarized in saying, “There are no solutions. There are only tradeoffs.”  

Those tradeoffs reflect the fact that in a world of scarcity, spending one dollar of resources on X forecloses spending them on Y. The same is also true of time and energy. In other words, the most basic relationship in economics is substitution: either/or relationships between alternative uses of resources, time and energy.

Not too long after that revelation comes the development and application of supply-and-demand analysis, much of it initially focused on which direction particular variables change in various relationships. When our attention moves, however, from which way variables change to how crucial those behavioral relationships are to a great many applications, substitution comes to the fore again. When we discuss elasticities of demand (how responsive is the quantity buyers are willing to buy to changes in the price of the good) and supply (how responsive is the quantity sellers are willing to sell to changes in the price of the good), because the number and goodness of substitutes are at the top of the list of determinants of both.   

On the demand side, more and closer substitutes mean it is less costly for demanders to shift to other alternatives when a good’s price rises or to shift from other alternatives to the good in question when its price falls. Further, the more time is allowed for such adjustments, the greater the number of alternatives available. That is summarized by saying the elasticity of demand is greater in such cases.

On the supply side, less-specialized resources can be shifted more easily among uses, making supply curves more elastic. On the other hand, the more specialized the resources, the more costly it is to shift among alternative uses (think of retooling an airplane factory). Further, the more time is allowed for such adjustments, the greater the number of alternatives available, and the more elastic supply will be as a result. 

This is what amplifies the power of market mechanisms to coordinate our behavior. The more elastic is demand, the more a price change will alter buyers’ purchases. The more elastic is supply, the more a price change will alter sellers’ willing sales. In both cases, allowing prices to adapt in voluntary market arrangements is more powerful at bringing buyers’ and sellers’ incentives back from misalignment to alignment. 

This is also why most of us, who are “outsiders” with respect to most market arrangements we observe, underestimate their power. There tend to be more and better substitution possibilities known to both buyers and sellers than we recognize from the outside of those exchange relationships. While not as pronounced, that may also be true of insiders, until some substantial change gives them more incentive to think carefully about those alternatives. For both insiders and outsiders, the effects will grow as the time to discover and develop such substitutes extends. In economics lingo, that means that the elasticities of both supply and demand tend to be greater than we realize. And that means market mechanisms are more powerful than we realize.

The years that have now made me an “old” economist have also led me to believe that conclusion needs more discussion. I have received the benefit of seeing that illustrated so many times in the hundreds of issues and industries my research and teaching has brought me into closer contact with, and the thousands more illustrations I have read or heard about. Experience has taught me, over and over and over, the power of voluntary, market arrangements, even when as an outsider, I cannot yet “see” all the ways it will manifest. My students have not lived long enough for a similar degree of education in this area, so I have increasingly emphasized this point to them. The sooner they can begin to acquire such wisdom, the better they will be served and the less coercion they will mistakenly support out of ignorance.

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