Posts tagged Knowledge
Market Failure, Epiphany, and $20 Bills on Sidewalks

There’s a joke economists like to tell:

Two economists are walking down the street. One spots a $20 bill on the sidewalk in front of them. He bends down to pick it up. “What are you doing?” says the other. “I am picking up this $20 bill,” says the first. “Nonsense! If that were a real $20 bill, it would have already been picked up!”

Economists like to tell this joke as an effort to demonstrate that profit opportunities tend to be quickly accounted for in a market: if there was indeed a $20 bill on the sidewalk, then the “market” is “out of equilibrium” and someone would have recognized this, picked up the bill, and the “equilibrium” would have been restored.

But there is a subtle assumption in this joke, namely that the two economists would have been aware of an opportunity to pick up the $20 bill. There is some behavior they are doing (such as paying attention to the sidewalk) that allows them to be susceptible to notice this profit opportunity. Perhaps everyone else walking down the street had their eyes upward doing window shopping.

Perhaps a literary tale will better tell this story: “The Verger” by W. Somerset Maugham. In the Verger, the verger of St. Peter’s was sacked for being illiterate. In his sadness, we wandered the neighborhood and fancied a cigarette. He noticed no tobacco store existed and alighted upon the idea to open his own store in the neighborhood. It was a roaring success (this story is recounted in Dan Klein’s book Knowledge and Coordination, and much of this blog post is inspired by that book).

Many people walked the streets the verger did. Why was the verger able to notice the metaphorical $20 bill on the sidewalk and not the many others who were walking? It appears it was because he was in a position to notice this particular $20 bill. He was in a certain frame of mind that allowed him to notice this particular “market failure,” this profit opportunity.

Dan Klein, in the aforementioned book, calls this form of discovery “epiphany.” This has an interesting implication for regulatory economics in that market failure needs to be “discovered.” The “market failure” in the verger (that the quantity supplied of tobacco products was less than the quantity demanded) was discovered only when the verger was in the right frame of mind to notice it and in a position to reduce transaction costs (he made have had passing thoughts in the past on the lack of a tobacconist, but given his job as a verger, did not possess the resources, such as time, to act on this market failure). Thus, market failures are something that arises from the market process. But likewise, the solution to this market failure had itself to be discovered. It was discovered in an alert mind: this street needs a tobacconist!

That both the failure and solution need to be discovered gives us great pause when considering law & economics. Mere welfare analysis does not capture this discovery process. Indeed, your standard economic analysis assumes all knowledge is known by all actors. Once we realize that such knowledge is dispersed and cannot easily be obtained, the whole concept of activist government to “fix” market failures becomes extremely shaky to say the least.