Jun

5

Pick up almost any popular economics textbook, and you'll find a rash of examples of how ingenious math can illuminate, as well as anecdotal examples of how you the public are getting screwed, and why the free market doesn't work as well as intervention. A typical book, I currently am looking at The Economics of Information by Ian Molho, but any of Krugman's or Stiglitz's texts would do, is replete with topics such as adverse selection, asymetric information, auction manipulation, bargaining problems, bidders colusion, cartels, cheating, coordination problems, contract credibility (boiling in oil, credibility, rationing, game theory), dominance, nash equilibria, pooling, signaling, imperfect information, private information, interested parties, job market screening, non-truth telling, moral hazards, immorality, lying, overbidding, principal agents problems, lemons, reputation effects, risk aversion, ripoff models, search costs, free riding, legal rights to silence, the crossing problem, trading delays, tactical voting, welfare losses, and winners curse.

John Lott has written a book called Freedomnomics that shows that almost all of these market imperfections are figments of the academic professors' imaginations. The free market has an incentive to solve all these problems, there are enormous incentives for businessmen and individuals to behave honestly, and competition is constantly working to give the consumer a better price and quality for his buck.

Furthermore, Lott shows how seeming differences in prices that consumers receive are a proper adjustment of the market to differences in costs and utilities of consumers. Here are some examples:

Gas prices for self service versus full service gas stations are much lower for economy gas. The reason is that the consumer of economy gas spends more time and buys less. The same applies for wine prices at restaurants. Real estate agents get better prices for their homes than their clients by a few percent — the reason is that they make the improvements that are more likely to raise value. Insurance companies refuse to pay for Lojack, a tracking device that a manufacturer can hide — the reason is that the devices don't reduce costs because the cars are usually stripped before they can be found.

The second chapter of the Freedomnomics gives numerous examples where reputations insure that businessmen and politicians keep their word. The reason reputations work is that there are incentives for purveyors to keep their word — "The potential loss of profits stemming from the loss of a good reputation keeps business honest as long it is concerned with future profits." You might think that politicians won't care about future profits when their terms expire, and this is what economists call the 'last period problem.' Politicians however want to pass their reputation on to their children, and also seek other jobs where their previous honesty is important.

John Lott shows that incentives develop to give the customer a fair deal in almost every environment — "Incentives work to create a complex and fascinating process of markets evolve to solve cheating problems without government intervention." The classic example of this, (exhibit A in every economics book), is of asymmetric market information and the lemon principle in used car buying. A new car loses almost one third of its value the second it is driven from the car lot, based on the lemon principle. The underlying reasoning is that the seller knows more about the car than the buyer, and so the buyer assumes there must be something wrong with it, which is why the seller wants to get rid of it, and so the seller is punished with a lower price.

This story has so much the ring of truth to it and is so in vogue, that it has been good, with a little math team stuff, for a Nobel Prize or two. No one seems to have considered how come companies such as eBay haven't tried to solve this problem, until Lott came along. Lott found that in actuality a few days after a new care is bought, it sells for about 3% less than the blue book price, and some used cars, like their counterparts among aircraft, actually sell at higher prices than when new. Furthermore, extensions of the idea show that the lemon theory doesn't get the price of cars held for a year right either, and that truly they should have lower prices because of usage and obsolescence, not information asymmetry.

Freedomnomics takes about 50 of the commonly accepted ideas about the failure of the market system, and shows that in each case the market has solved the problem or that government intervention has made the problem worse. Lott points out that the value of reputations is paramount for a company, and that the competition to maintain a good reputation solves almost all the areas where a naive economist might think that the consumer gets cheated. The thing that protects the consumer is not the intrinsic honesty of the firm, but the reputation a firm seeks to maintain. The importance of a good brand name, and the asset that it represents can't be overestimated.

The third chapter of Freedomnomics is the weakest, but it covers a thousand examples of government intervention in areas like eminent domain, efforts to counter the free rider problems (such as in pollution), flood insurance, rescue services, and many more. Lott gives many great examples of how private enterprise solve these problems much better than governments can.

One good example is that polar expeditions funded by private sources had many less fatalities and made more discoveries than government funded expeditions during his sample period. However, Lott has a convoluted argument concerning diversified stock holding to explain some of his finding, that looks to be based on flimsy and weak evidence, and selected anecdotes. The same goes for his attempt to show that concealed gun laws are the main deterrent for crime — Dr. Lott lectured on this subject at the Junta, and I found his regression results completely overdetermined, the estimates of the effect very weak, with a high uncertainty, and generally based on too few observations in a few selected states. I am also critical of his argument that woman's suffrage is the cause of much of the increased government that we have experienced during the twentieth century.

It is amazing to see however, that John Lott has encapsulated in a few hundred pages, all the reasons that the free market does work, and repeatedly destroys the arguments of Freakonomics and most of the calls for intervention that we find in empirical studies and common sense economics.

At one point in his book, Lott offers the following summary:

"Countries that stuck with the free market have prospered. The reason is that the free market is based on the pursuit of economic self interest. The market acknowledges that peoples' behavior is largely determined by incentives. Allowing people the freedom to improve their own economic conditions helped to make society wealthier."

Riz Din replies:

I don't believe the free market offers solutions to all of life's ills, but I welcome questioning, inquiring thinking that challenges the orthodox prescription of how things should be run.

Glenn Escovedo remarks:

Readers might enjoy One-Armed Cowboy, a book about E. L. "Slim" Pond, a famous cowboy here in South Texas who happens to be my second cousin. 

Sam Humbert corresponds: 

As a follow-up, Chair asked me why I didn't worry about lemons when buying cars on eBay (one last year for myself, one this year for the corporate fleet). My off-the-cuff thoughts were: 1) Quality is much better than in years past so the overall incidence of lemons among late-model low-mileage (say, <50,000) cars is now quite low, and 2) The shift to leasing over the years has reduced the incidence of adverse-selection, because many (most?) cars now "automatically" find their way to the for-sale lot after three years, regardless of quality. 

Art Cooper replies:

1) Wouldn't quality be closely related to car make and model as well as low mileage, so that one would wish to restrict eBay purchases to models with a reputation for low incidence of problems?

2) If leasing is the cause of a diminished relative incidence of adverse selection, shouldn't one purchase only from vendors who sell leased vehicles (in addition to others), and not from individual vendors who are unlikely to sell vehicles that had been leased? 

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