Tuesday, February 23, 2016

Masonomics and Externalities

During a conversation a couple of weeks ago on externalities and market failure, a colleague of mine noted that my perspective on these topics seems to be in line with that of the economists at George Mason University. This is slightly misleading since the origin of GMU Econ's perspective is quite diverse (and thus not uniquely their own), but GMU is certainly a hotbed of research and education in the path-breaking economic work of Alchian, Buchanan, Coase, Demsetz, Hayek, Mises, Ostrom, Williamson, and others.

Given GMU Econ's unique perspective, it's no surprise that a term like "Masonomics" was coined. In an article back in 2007, economist Arnold Kling laid out several characteristics that make Masonomics unique. Below I reproduce the section of Kling's essay on the "cure for market failure."
At the University of Chicago, economists lean to the right of the economics profession. They are known for saying, in effect, "Markets work well. Use the market."

At MIT and other bastions of mainstream economics, most economists are to the left of center but to the right of the academic community as a whole. These economists are known for saying, in effect, "Markets fail. Use government."
Masonomics says, "Markets fail. Use markets." 
Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market.

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets.

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell.

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.
This is a (well-written) summary of my own view on the topic. Thanks to my exposure to this perspective in graduate school I continue to develop interests and to work in the political economy of agriculture. What do you think? What problems can you identify with the Masonomics view of externalities?

Russ Roberts also has a nice blog post giving his take on Masonomics here. Several Farmer Hayek posts have addressed externalities and market failure over the past year and can be read here, here, here, here, here, and here.

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