Posts tagged Law & Economics
Today's Quote of the Day...

…is from this EconLog post by David Henderson (emphasis added):

If you think that the government should provide truly public goods, that is, goods that are non-excludable and non-rival in consumption, then you should think that government should provide the public good of preventing an asteroid from hinting earth. Here’s the problem: The U.S. government, which has access to more resources than any other government on earth, is almost certainly underinvesting in the technology to deflect or destroy asteroids. Just as private actors don’t have much of an incentive to produce truly public goods, neither do government actors.

JMM: In standard economic treatment of market failures, governments are treated as something of a deus ex machina. They can just come in costlessly and effortlessly to solve any problem by applying just the right remedy. On paper, it’s a simple enough story. But what incentives do governments face to provide such solutions (assuming away knowledge problems)? It’s unlikely they face incentives from voters. Market failures tend to be characterized by free-rider problems, and free-riders do not suddenly want to start paying, even if they benefit. Furthermore, the problems are often dispersed, making them hard to observe. Perhaps they are motivated by “doing the right thing,” and that’s all fine and dandy, but are we ready to assume all judges, bureaucrats, and politicians are purely motivated by the Greater Good?

On top of the difficulties of identifying a true market failure, we need to keep in mind the incentives people face.

Are Public Goods Necessarily Undersupplied?

In economics, public goods are goods which are non-rival (a person’s use of the good does not reduce the ability of another person to use the same good, eg listening to the radio) and non-excludable (people who do not pay cannot easily be prevented from using the good, eg when a burglar is arrested, everyone in a neighborhood benefits, not just those who paid for the security service). Because of this definition of public goods, we tend to teach undergrads that public goods will therefore necessarily be undersupplied, that in a free market the amount of the good produced is less than the socially optimal level of production. As such, government may be able to step in and, though use of taxation, correct this underproduction (see, for example, Page 369 of Modern Principles of Economics by Tyler Cowen and Alex Tabarrok).

But is it necessarily the case that public goods are necessarily undersupplied in a free market? It does not seem clear to me that it is.

The first question we need to ask is “as compared to what?” What is the free market outcome undersupplied compared to? It is compared to what would be the socially optimal level where everyone who benefits pays the cost (the intuition here is this: if an individual can earn more producing something, they will produce more of it, all else held equal. Supply curves slope upward).

Now we need to ask: is this an attainable alternative? In a free market setting, it does not appear to be so. After all, as we argued above, given the characteristics of a public good, they will tend to be undersupplied. Getting people to pay for their use is difficult. A more technical way of saying this is the transaction costs are high. The marginal benefit of receiving the payments exceeds the marginal cost of obtaining those payments. In a zero-transaction cost world, the socially optimal level would be easily obtained. There is some bargain that could be reached where those who enjoy the benefit without paying the cost (free rider problem) could be incentivized to pay the cost and production would increase. This is just an application of the Coase Theorem.

If, however, as posited by the public goods problem, the transaction costs of solving the free rider problem are too high, then the socially optimal level is not necessarily an attainable alternative. It’s a fantasy alternative. Thus, it is an irrelevant comparison. It’d like saying “I’d be better off with a fairy godmother who grants wishes than needing to work for my well-being.” Sure, but given faeries don’t exist, that’s a meaningless choice. The choice is between working and living well or not working and living poorly.

If the socially optimal outcome of the model is not a real alternative, then the situation is already at an optimal outcome. There is no undersupply. Thus, public goods are not necessarily undersupplied.

A note of caution: none of what I just wrote should be taken to mean that the free market outcome is necessarily the best outcome. There may be better alternatives. Government (or some other non-market force) may be able to achieve an alternative arrangement that is superior to the free market outcome. For example, better defining property rights can lead to less undersupply of public goods. But in movement from one alternative to the other, we need to consider the transaction costs. Do the benefits of moving from the market alternative to the non-market alternative outweigh the costs?

With this article, I reiterate a point made by Ronald Coase, Carl Dahlman, Harold Demsetz, and many others before me: transaction costs matter. We need to compare attainable alternatives and consider how institutions actually work as opposed to an idealized version of them. Comparing a market outcome to an idealized, but unobtainable, alternative does not provide any guidance to our thought.

Today's Quote of the Day...

…is from this 1997 Reason Magazine interview with Ronald Coase:

Reason: Can you give us an example of what you consider to be a good regulation and then an example of what you consider to be a not-so-good regulation?

Coase: This is a very interesting question because one can't give an answer to it. When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. But that doesn't mean that if we reduce the size of government considerably, we wouldn't find then that there were some activities it did well. Until we reduce the size of government, we won't know what they are.

JMM: Ronald Coase’s careful study of the data through the lens of theory is important for us to observe. Coase was unwilling to move to the conclusion that, just because the majority (if not all) the government regulation led to undesirable outcomes, it must therefore be true that all government regulation is necessarily harmful. He points out another answer that is contained within the very models used in the analyses: negative marginal returns.

Data cannot “speak for themselves.” Data without theory have no context and thus mislead. The man who looks only at data and ignores theory is not practicing science, but rather scientism.

From Spontaneous Order to Codification

A while ago, I did a blog post on the “Hayek Memorial Pathway,” one of a series of pathways that have developed on campus though people’s actions. Well, they’re doing a bunch of construction on campus and part of it includes paving the Hayek Memorial Pathway.

Some years from now, people will forget that the pathway was one unpaved and unplanned, that it was only by the constant movement of thousands of students that the path at all formed in the first place. All the “government” (i.e., George Mason University) did was codify what people already did.

Socialists and central planners often point out various institutions and state proudly “look at the good government is doing!” What they fail to see, however, is the spontaneous orders that predated those codifications. For example, they fail to see the development of the law that legislation merely codified. Or the development of money that legislation merely codified. These institutions were not part of government planning, but rather of government codification of already-in-action plans.

Likewise, this is why I disagree with “one-drop” libertarians (ie, those who oppose anything and everything government does, insisting it must inherently be inefficient). Not every institution the government codifies is inherently inefficient. When they merely codify what people are already doing, then that may not change the efficiency at all (indeed, given certain conditions, it may improve efficiency). GMU paving the Hayek Memorial Pathway does not in and of itself imply the pathway is in any way less a spontaneous order or less efficient.

On the Presumption of Liberty

“[Harvey] Weinstein’s behavior is certainly dreadful, but even dreadful people have the right to a criminal defense. Indeed, probably most people who are charged with serious crimes, whether guilty or not, are not nice people, and many are moral reprobates. Yet forcing the government to prove guilt before tossing our fellow citizens in jail—even the reprobates among us—is the mark of a free people.”

This quote is taken from John McGinnis’ fine blog post The Campus Mob Comes for the Presumption of Innocence. A presumption of innocence permeates our justice system: the government has the burden of proof to convict. What’s more, this burden of proof is extremely high. The prosecution does not just need to produce some theory that the defendant might have committed the crime. Even a preponderance of evidence is not enough to take away a man’s liberty. What is necessary is the government needs to prove guilt beyond a reasonable doubt. Until that threshold is met in the eyes of a jury, the defendant is presumed innocent.

A presumption of innocence has a parallel in the presumption of liberty. The presumption of liberty holds that in assessing government policy we must meet a high burden of proof in order to endorse a reform that reduces liberty. There may be occasions where such intervention is desirable, sometimes even for overall liberty, but the mere possibility of such exceptions does not in and of itself justify the exception. A burden of proof must be met.

No liberal society can suffer the lack of a presumption of liberty. As McGinnis says above, the presumption of innocence, even to moral reprobates, is the mark of a free people. Likewise, the presumption of liberty, even if dealing with moral reprobates, is the mark of a free people. Exceptions can be made, such as the moral reprobate being thrown in prison after being shown beyond a reasonable doubt he committed a crime, but they must be exceptions rather than general rules.

Trade cannot be kept as free as it is without a presumption of liberty. The “free trade = fair trade” and “only reciprocal trade is free trade” claims are damaging to liberal society, because they weaken the presumption of liberty. Managed trade, where freedom to exchange is treated as an exception rather than a rule, spells illiberalism. The presumption of liberty must stand.

Today's Quote of the Day...

…is from page 227 of the 6th edition of Robert Cooter and Thomas Ulen’s textbook Law and Economics:

In communist countries like the former Soviet Union, planners could not get the information that they needed to manage an increasingly complex economy, which caused the economy to deteriorate. An increasingly complex economy must rely increasingly upon markets, which decentralize information. In this respect, making law resembles making commodities. As the economy grows in complexity, central officials cannot get the information that they need to make precise regulations. Instead of centralized lawmaking, the modern economy needs decentralized lawmaking analogous to markets.

JMM: Oftentimes, complexity is given as a reason to justify increased regulation. But, just like with markets, more complexity means more knowledge, wisdom, and information are needed to formulate such regulations. What’s more, as complexity increases, the costs and likelihood of systematic errors increases. Law develops, emerges, and evolves not through some central planning process, but rather in the same manner as the market process: through challenges, trial and error, and good old-fashioned human ingenuity. Law is, like the economy, a matter of human action but not human design.

For more on this point, I highly recommend Bruno Leoni’s Freedom and the Law and Bruce Benson’s The Enterprise of Law

Jon MurphyLaw & Economics
Adam Smith and the Nirvana Fallacy

Adam Smith was no anarchist. Indeed, at the time he was writing, he was a fairly conservative liberal (interesting that those of us who follow Adam Smith’s teachings are considered radical). Adam Smith did have a strong presumption of liberty, but this presumption was not absolute. Under certain conditions, a jural superior (such as a sovereign or magistrate) could violate this presumption of liberty.

But Smith’s analysis did not stop there. He also explored the nature of the jural superior. While Smith does have a science of the legislator, he also repeatedly emphasized that jural superiors are also human beings like us.

To give one such example, in the Theory of Moral Sentiments, Smith writes on how it is a natural human reaction to feel resentment and revenge when once does something against us. Indeed, not rendering gratitude where gratitude is due can cause this passion to arise (see Part 2, and especially Section 2). This jealousy can cause us to act in a harmful and unjust manner; beneficence cannot be extracted by force. But, while Smith is examining jural equal relations here, he also applies this same sentiment to national governments and legislators. In The Wealth of Nations, when Smith is discussing a potential use of tariffs to reduce/eliminate tariffs by other governments, he begins by stating that, when one nation raises tariffs on another “[r]evenge…naturally dictates retaliation, and that we should impose the like duties and prohibitions upon the importation of some or all of their manufactures into ours. Nations, accordingly, seldom fail to retaliate in this manner“ (Page 467.38). Revenge, that natural emotion according to Smith, is applied to national governments here and not just individuals. Smith goes on to tell of a trade war between the Dutch and French which became a shooting war.

After this story, Smith lays out his potential exception to the aforementioned presumption of liberty (Emphasis added):

There may be good policy in retaliations of this kind, when there is a probability that they will procure the repeal of the high duties or prohibitions complained of. The recovery of a great foreign market will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods. 

Page 467.39

However, he immediately follows it up with a reminder that we are dealing with people here. The science of a legislator may recommend this policy, but we must remember we are dealing with people with passions, not necessarily a dispassionate legislator:

To judge whether such retaliations are likely to produce such an effect does not, perhaps, belong so much to the science of a legislator, whose deliberations ought to be governed by general principles which are always the same, as to the skill of that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of affairs.

Page 467.39

He then brings us back to the presumption of liberty:

When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people to do another injury ourselves, not only to those classes, but to almost all the other classes of them. his may no doubt give encouragement to some particular class of workmen among ourselves, and by excluding some of their rivals, may enable them to raise their price in the home-market. Those workmen, however, who suffered by our neighbours prohibition will not be benefited by ours. On the contrary, they and almost all the other classes of our citizens will thereby be obliged to pay dearer than before for certain goods. Every such law, therefore, imposes a real tax upon the whole country, not in favour of that particular class of workmen who were injured by our neighbours prohibition, but of some other class.

Page 467.39

By starting with a reminder that revenge is a natural passion within our breast and a story about a war of jealousy between two nations, Smith argues that the probability that higher domestic tariffs will lead to the reduction of foreign tariffs is not particularly high.

Smith avoids the trap that many economists after him would fall into: the Nirvana Fallacy. A term first coined by the late Harold Demsetz, the Nirvana Fallacy is when one compares an imperfect current situation to an idealized alternative. Mid-Century economists often made this mistake by pointing to market failures and justifying some policy to correct these failures. Public Choice economics expanded on the Nirvana Fallacy by assuming government actors are just like market actors. Smith did not fall into this trap, and thus his presumption of liberty was extremely strong in his eyes.

The fun thing about reading Adam Smith is seeing insights in his work that would, for one reason or another, be lost to economists only to be discovered centuries later. The example above of the Nirvana Fallacy is one, but Smith also had many insights into Law & Economics.

Adam Smith had a presumption of liberty, and while that presumption was not absolute, he was under no impression that the mere existence of a justification for policy X or Y was in any way sufficient to create policy X or Y. After all: “They whom we call politicians are not the most remarkable men in the world for probity and punctuality” (Lectures on Jurisprudence, Pg. 539).

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.

On the Optimal Tariff and the Law of Demand

In his 1987 Economic Review article detailing the history of optimal tariffs, Thomas Humphrey writes:

“[The optimal tariff model] assumes unrealistically (1) that foreign countries will not retaliate with tariffs of their own, (2) that elasticities of supply and demand in foreign trade are not so large in the long run as to render the tariff ineffective, (3) that the optimum tariff rate can be precisely identified and skillfully administered, and (4) that politicians can resist pressures to raise tariff rates above the optimum level” 

All four of these objections of the optimal tariff model are difficult to overcome when addressing the model as a policy procedure. I have written on some of these other points before (as have many people far smarter than I). However, I want to focus on point #2 and I’ll try to keep this not wonky.

That the optimal tariff model depends on elasticities of supply and demand is not controversial. Indeed, that is how the calculation of the tariff works. However, given condition (2) above, we can see the optimal tariff is, at best, a short-run policy. This follows from the Law of Demand.

Most people tend to think of the Law of Demand in its common form: all else held equal, an increase in the price of a good will reduce the quantity demanded of that good. But there is a second Law of Demand: the longer a price remains relatively high, the more elastic the demand for a good becomes.

Given that the goal of a tariff is to increase the relative price of a good, then as long as the tariff remains in place, the more elastic demand for that good becomes. Indeed, if the tariff remains in place and, again, everything else held equal, over enough time, the tariff could cause the demand curve for a good to become perfectly elastic. A perfectly elastic demand curve would indicate no consumer welfare gains from the trade. The elimination of consumer welfare would then mean that the tariff is a net welfare loss for the country in question. So, an optimal tariff cannot persist in the long run, only in the short run given the Second Law of Demand.

Some might object by saying: “But wait, Jon, you sly and handsome devil! That would just mean the optimal tariff would need to be reduced. There’s no reason to think the tariff would eventually become a net welfare loss.”

Indeed, it may very well be that some benevolent government can milk the tariff for everything its worth by constantly adjusting the optimal tariff as the elasticities change. However, this is where public choice comes into play. As Gordon Tullock discussed in 1975, government support of firms is very difficult to remove. Domestic producers have capitalized on the gains the tariff has provided them. To remove the tariff is not to eat up “extra normal” profit for monopolizing firms, but rather to eat into normal profit for them. These firms are legitimately harmed, profit-wise, by the removal or alternations of these protections like an optimal tariff. Any adjustment to an optimal tariff, even if demanded by the economic scenario is likely to be fought tooth-and-nail by affected firms. The resulting stagnation will likely result in an optimal tariff that is too high! Any short-run gains from the optimal tariff (assuming all the above conditions are met) would likely be eaten up by this un-optimal tariff that results from the changing elasticity and lack of change in the statuary tariff.

In a general-equilibrium theoretical framework, an optimal tariff makes perfect sense. But, once public choice enters the fray, the reasonableness of an optimal tariff goes out the window. And, as my professor Garett Jones likes to say: in a knockdown fight between general equilibrium and public choice, public choice wins every time.

HT to Dallas Weaver, whose comment on this Cafe Hayek blog post inspired this post.

Institutions Matter, Even for Monopolies

Noah Smith has a rather interesting new article at Bloomberg detailing new research and proposals on regulating monopolies. I have written on the dangers of knee-jerk regulation as a solution to various market failures and others have written on the dangers of the perfectly competitive model to measure market failure. However, there is a different flaw I want to discuss with Smith’s article:

The big question Smith needs to ask is this: what are the institutional arrangements that allow for the monopoly (granting that the effects discussed, lower wages and higher prices, are due to the monopoly) to arise and persist? Monopolies are not necessarily a permanent fixture in industries; they always face competition (think of once “dominant” firms that are now on the garbage bin of history: Sears, Blockbuster, Myspace, etc). Monopolies theoretically arise under only a handful of situations and are constantly feeling the pressure of competition. Why is it some of these firms can now effectively ignore competition and suppress wages?

Smith blames lax anti-trust regulation and implicitly blames low minimum wages and unions. (The irony, of course, of using these last two options to “solve” monopoly issues is that both minimum wage and unions are themselves means of building monopoly power). However, the issue may (and, I’d wager, likely is) not one of lax regulation but rather excessive regulation. Regulation, by its nature, restricts competition. Granted, some restrictions may be desirable (eg, a prohibition on using violence to conduct business), but that does not change the fact that regulations are designed to restrict competition and this provides some level of monopoly power to firms. So, what are these institutional arrangements? What legislation is in place? Occupational licensing? Tariffs? Environmental Regulations? All these things raise the fixed costs of suppliers, and when fixed costs rise, and subsequently barriers of entry imposes, one should not be surprised when monopolies arise.

By not considering the institutional framework in which economic activity takes place, Smith is mistaking symptoms for causes. Regulation, even if we ignore the public choice, law & econ, and behavioral economics concerns laid out in my linked article, would at best be treating these symptoms rather than the causes of monopolies. Indeed, ignoring institutional arrangements may lead to a regulatory action that worsens, rather than helps, the problem.

Whenever some “market failure” is supposed, the first question in any analysts mind should be “why did this outcome happen?” That is the line of inquiry for the economist, for the lawyer, for the scientist. We assume too much by ignoring that all important question.

Necessary But Not Sufficient

In my latest article for, I argue that the existence of a “market failure” is a necessary but not sufficient condition for government intervention in the economy.  A slice:

As with all economic questions, the answer is “compared to what?” Externalities, compared on an idealized hypothetical world where all information is known and transactions are costless, appear easy to solve via government regulation. However, when we compare a world of externalities to the real world, where costs and benefits are subjective and ultimately judgement calls must be made by analysts, we see that externalities are necessary but not sufficient justification for government intervention.

Jon MurphyLaw & Economics