Saturday, December 24, 2011

A little regulation brings out the best for all of us

Ask economists who is the father of economics and almost all of them will say Adam Smith. But a new book makes the amazing claim the true father is Charles Darwin. And if you ask economists the question in 100 years' time, that's what they'll say.

The book is The Darwin Economy, by Robert Frank, professor of economics at Cornell University.

Smith was the Scottish moral philosopher, who published his most famous work, The Wealth of Nations, on the eve of the industrial revolution in 1776 (just a few years after Captain Cook visited Botany Bay).

Among all his insights about how the economy works, the one for which he gets most credit is the "invisible hand". This is the notion that impersonal market forces channel the behaviour of greedy individuals to produce the greatest good for all.

Why does a business owner go to the trouble of designing a new product that consumers are likely to find appealing? Why does he invest such effort to revamp his production process to reduce costs? Simply to make more money - as many people realised before Smith.

What they didn't see was the response those actions would provoke from rival business owners, and how the ensuing dynamic - the invisible hand - would produce outcomes very different from those intended, Frank says.

If one producer comes up with a cheaper way of manufacturing a product, he can cut his price slightly and steal market share from his rivals. In the short run, his profits soar, just as he'd hoped. But the loss of market share by rival firms gives their owners a powerful incentive to mimic the original innovation.

And once the innovation spreads industry-wide, the resulting competition drives the product's price down to a level just sufficient to cover the new, lower production costs. The ultimate beneficiaries of all this are consumers, who enjoy steadily improved products at ever-lower prices.

There's much truth to this and it does much to explain why the market system has raised our material standard of living so far over the past 200 years.

So why does Frank then think economists will come to see Darwin as the true father of economics rather than Smith? Because Darwin's study of the natural world led him to a deeper insight about the often flawed nature of competition.

Although Smith was careful not to claim it, many economists (and many libertarians) have taken his invisible hand to mean that regulation of markets is unnecessary and undesirable because unbridled market forces can take care of things quite nicely on their own.

In fact, Smith was well aware that unregulated markets didn't always produce the best outcomes. For the most part, however, he imagined market failure to be the result of inadequate competition. Firms would find some way to nobble their competitors and overcharge their customers.

Critics on the left have long focused on anti-competitive behaviour as the key to understanding why markets fail. But they (and Smith) are missing an important point.

"Darwin's view of the competitive process was fundamentally different," Frank says. "His observations persuaded him that the interests of individual animals were often profoundly in conflict with the broader interests of their own species."

Consider the outsized antlers of bull elk. These antlers function as weapons not against predators but in the competition among bulls for females. Since the bull with the biggest antlers gets to mate with the females, while the others don't, the process of natural selections has given male elk ever-bigger antlers.

But big antlers are a big disadvantage when elk are being preyed on, making them more likely to be killed and eaten by wolves. So what's in the interests of the individual bull is actually contrary to the interests of the group.

While no individual bull would want to be disadvantaged by having smaller antlers than the others, all the bulls would be better off if all of them had the width of their antlers narrowed by, say, half a metre (which would leave the relative size of their antlers unchanged).

You can tell the same story about peacocks' tails, huge elephant seals and many other animals that compete to be the sexual top dog. They all suffer a "collective action problem" - they're locked in a kind of arms race from which no individual can escape, even though all individuals realise how costly the race is. The only solution to the individuals' problem is for the animals - human animals - to act collectively. For them all to agree on a truce - a strategic arms limitation treaty, so to speak - or for some external authority, such as a government, to impose a solution on all of them. All would benefit from such an imposition so, contrary to the assumption of the libertarians, all are likely to welcome it.

The Nobel-prize-winning American economist, Thomas Schelling, quotes the case of ice-hockey players. When helmet-wearing is voluntary, no one is prepared to suffer the small competitive disadvantage of wearing one. But, since helmets do increase safety, all players would vote to make them compulsory.

Frank argues that for competition to give rise to collective action problems - wasteful arms races, if you like - is more the rule than the exception. Why? Because in many important areas of life, performance is "graded on the curve". It's not your absolute score that matters, it's your relative score - that is, where you rank in the comp.

"The dependence of reward on rank eliminates any presumption of harmony between individual and collective interests," Franks says, "and with it, the foundation of the libertarian's case for a completely unfettered market system."

Frank says since individual humans' reproductive success has always depended first and foremost on "relative resource holdings" - which males look the best physical specimens and the best providers; which females look the best child-bearers and homemakers - it would be astonishing if the evolved brain didn't care deeply about relative position.

Hence the tendency as we become ever-more affluent for a growing share of our income to be spent on "positional goods" - that is goods or services which, as well as doing whatever it is they are supposed to do, also signal to the world by their expensiveness our superior position in the pecking order.

Frank concludes that the real reason we regulate markets is to protect ourselves from the consequences of excessive competition.