Is there a perfect market for everything?

// first version published 9/4/2015, updated 14/04/2015 & 23/04/2015

This is one part of a series dedicated to the question "why is Anarcho-capitalism a bad idea?".

Is there a perfectly working market for every good imaginable? Perfect markets are a requirement if a free market should yield an allocation of resources which is optimal for society. So let's first look at the seven conditions which are required for a perfect market:

  • Perfect market information
  • No participant with market power to set prices
  • Non intervention by governments (ie. price controls)
  • No barriers to entry or exit
  • Equal access to factors of production
  • Profit maximization
  • No Externalities

This blog post is dedicated to just one requirement: perfect market information. What are the consequences when there isn't perfect information available? One good example is the production of electricity which as of today still largely relies on fossil fuels. Burning fossil fuels has the inherent downside of realeasing greenhouse gases (ie. water vapor, carbon dioxide, methane, nitrous oxide, and ozone) into the atmosphere and causes climate change or more specifically a rise in temperature.

Climate Change 2014, Synthesis Report, Summary for Policymaker (0):

Warming of the climate system is unequivocal, and since the 1950s, many of the observed changes are unprecedented over decades to millennia. The atmosphere and ocean have warmed, the amounts of snow and ice have diminished, and sea level has risen.

The standard argument against climate policy from libertarian policy makers is that a free market already accounts for such undesirable externalities, such as climate change. Online commentator Rich Matarese outlines one way in which free markets can account for such external effects with the concept of "public nuisance". Such public nuisance is demonstrated on the example of a tannery:

[They] Tanneries reek. And they require not only water input but also the disposition of waste water output. Especially in pre-industrial times, tanneries were not only major sources of “public nuisance” negative externalities, but because pre-industrial methods of production and transportation, there had to be a lot of tanneries spread across the countryside to handle the hides harvested.

So means had to be devised to abate the “public nuisance” imposed by the presence of a tannery in each farming town. It was impossible to do without these tanneries, and it was impossible – for reasons of health; polluted drinking water will kill you – to ignore their “nuisance” effects.

In English common law (upon which we Americans depend for our own common and statute law) we see the beginnings of key codifications formalizing agreed methods whereby the operation of tanneries – and other sources of “public nuisance” – can be structured to mitigate their negative externalities to the satisfaction of the people outside the tanneries afflicted by those enterprises’ air and water befoulment.

Jack the Tanner gets to dumping his filthy waste water in a place where it gets into Mulch the Miller’s well. Mulch tastes what he damn well knows is tannery run-off in his drinking water, and tells Jack to quit his incontinent practice. Jack tells Mulch to bugger off. Mulch takes the matter to the town magistrate (or whoever else functions locally as the responsible officer of civil government). A determination is made on the basis of custom or formally codified common law prevailing. The magistrate issues Jack an order to cease and desist the offensive dumping. Absent compliance (or in addition thereto), Jack may have to provide Mulch and other well-owners in the area compensation for material damages done. Punitive damages may be imposed also.

Within the tannery example the free market perfectly works and takes into account the external effects which are caused by the tannery.

However this example is not applicable to the case of global warming, because the negative (and potentially also positive) effects of the climate change are difficult to estimate for the different enterprises and people. In other words: the originator of public nuisance cannot be accurately determined. A coal-fired power plant in a remote part of China might just have a negligible effect on the local population but at the same time could significantly worsen air quality in a very distant location such as California.

Furthermore, while the net effect of less greenhouse gas emission would be beneficial to all, it might not make sense for an individual country or single enterprise to reduce emissions, due to a decrease in competitiveness. It's a classical prisoner's dilemma due to the existence of a suboptimal Nash equilibrium. A Nash equilibrium exists when two or more parties (in this case two companies) individually choose an utility maximizing solution (given that all the others keep their decision unchanged) which is less preferable than the option that could be chosen if the companies were cooperating. In the case of greenhouse gases: If just one company decides to reduce these emissions then that company has higher production costs and is hence less competitive. If all companies would cooperate then everybody would benefit from lower emissions. Now in the case of the prisoner's dilemma this cooperation between the parties cannot happen because the prisoners are not allowed to talk to each other. However in a free market this would undoubtedly be possible.

The problem regarding effects of greenhouse gases, is that it's unknown who will be affected and who won't. Hence some will be net losers from a reduction in greenhouse gases (those who would in any case remain unaffected) and winners (those which eventually will benefit from reduced global warming). However the affects of greenhouse gases on the atmosphere are not immediate, there's a time lag between the production and the external effects. These two properties: the lack of information on who will be affected and the time lag disallow any consensus within a free market (or any other entity for that matter) on what the right amount of production and emissions is. Namely because there's no actionable information to accurately determine the costs of greenhouse gas emission for each company.

Now, just because we have proven that the market can't arrive at a reasonable optimum, doesn't mean the government could - quite the contrary actually, if the free market can't determine an optimal allocation, neither can a government. Hence the existence of a prisoner's dilemma by itself does not validate a government intervention - it merely proves the existence of an inefficient market. This kind of market inefficiency cannot be overcome by anyone and we could end the discussion right here. So for any further arguments we will relax the assumption and assume that we actually have information on who will be affected by climate change. Because if the individuals and organizations which are affected by climate change can be determined with reasonable certainty as well as the costs incurred on them we can create further arguments, still in favour of government intervention.

It's uncontested that introducing regulations on emissions will reduce these emissions (if the government creates a sound law without loopholes). However it seems also clear that as a result of the regulations productivity (due to emission caps) will drop. The climate might be just doing a little better and consumers have to pay a bit more for products. In summary the welfare of a society would remain unchanged. Michael Porter contests this vision and says that as a result of the emission caps society would be better off. He argues that high emissions are essentially a result of waste, or more poignantly a result of inefficencies in the production process. By introducing emission regulation, Porter argues, a government can kickstart innovation and thanks to the resulting (forced) efficency gains in the industry, a society is actually better off after the introduction of emission caps. This is the so called Porter hypothesis (1).

Gardiner and Portney introduce the obvious critique (2), that if efficency gains can reduce waste and increase productivity, then there's no reason why an enterprise shouldn't seek these efficency gains (and pollution reduction) without government intervention:

New regulations do have costs. These costs should be weighed against the social benefits of reducing pollution.

So at first sight there's little doubt to the aforementioned explanation why government regulations on emissions are hence useless. However Robert Mohr (3) introduces an intuitive explanation to why Portney's criticism is unwarranted. Mohr's explanation (and hence the fundamental argument for government internvention) are outlined in the following paragraphs:

Using a general equilibrium model with a large number of agents, the model shows that environmental policy can simultaneously increase productivity and welfare. These gains come even without accounting for the value of a cleaner environment.

Mohr argues that a governemnt introduced regulation forces all companies to introduce their (initial) productivity losses at the same time:

Changing technologies has short-term costs, however. We assume that, no matter how many agents switch to technology g, the productivity of this technology will initially be less than the productivity of technology f. To define this condition, let ts denote the time at which agents switch completely from technology f to technology g. Even if all of the society’s labor is devoted to technology g, some perhaps small period of time, α, exists such that [...] productivity temporarily declines.

If just one company introduces the new technology (which reduces productivity but lowers emissions) then this will in the short term reduce their profitability - even though the company will benefit from the new technology in the long term (after enough experience has been collected how to implement and adapt to the new technology). With this argument we can see that this is essentially a synchronization problem, where governments need to force all companies to comply with environmental policies at the same time in order to make the switch sensible for all companies.

Again Mohr can describe this much clearer:

Equations (5) and (7) present a barrier that prevents the application of a new technology. Following Eq. (5) , each agent would like to switch to the new technology, given that enough other people have done it first. However, consistent with Eq. (7), the initial use of the new technology imposes short-term costs. Therefore, agents gain a second-mover advantage if they wait for someone else to bear the short-term costs of adopting the new technology. Thus, the introduction of a new technology allows for the possibility that firms can jointly increase long term productivity. At the same time, external economies of scale prevent individual firms from applying such a technology. If government introduces a regulation that favors or requires use of the new, ‘‘cleaner’’ technology, then environmental policy could simultaneously improve environmental quality and eventually increase productivity.

In conclusion: Environmental regulations introduced by governments make sense, not because enterprises arrive at an inefficient equilibrium between pollution and production but because the introduction of new technology (in the field of pollution prevention) often causes a second-mover advantage. And it is the role of the government to synchronize the introduction of this technology so that no individual organization can benefit from such second-mover advantages. This effect is applicable to many other markets aside from those including environmental factors.

Regarding some empirical proof: A study on total factor productivity in Quebec by Paul Lanoie, Michel Patry and Richard Lajeunesse (4) reveals:

Our empirical results suggest that: (1) the contemporaneous impact of environmental regulation on productivity is negative; (2) the opposite result is observed with lagged regulatory variables, which is consistent with Michel Porter’s conjecture; and (3) this effect is stronger in a subgroup of industries which are more exposed to international competition.

There might be another post in the future about equal access to factors of production. There are important questions that remain to be answered. For example: What happens when a monopoly can limit access to a factor of production (like oil) which all other competitors require? Can an efficient market still persist or will the barriers of entry rise too high?

(0) IPCC, 2014: Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, R.K. Pachauri and L.A. Meyer (eds.)]. IPCC, Geneva, Switzerland, 151 pp. URL: http://www.ipcc.ch/pdf/assessment-report/ar5/syr/AR5SYRFINAL_SPM.pdf

(1) Michael E. Porter and Claas van der Linde. Green and Competitive: Ending the Stalemate. Harvard Business Review. September–October 1995. URL: https://hbr.org/1995/09/green-and-competitive-ending-the-stalemate

(2) Gardiner and Portney. Does environmental policy conflict with economic growth? Resources 115, 21-23. 1994.

(3) Robert Mohr. Technical Change, External Economies, and the Porter Hypothesis. Journal of Environmental Economics and Management. 2002.

(4) Paul Lanoie, Michel Patry and Richard Lajeunesse. Environmental regulation and productivity: testing the porter hypothesis. Journal of Productivity Analysis. 2008.

Additional Remark: In Mohr's model (3) the productivity of a single agent (eg. a company) depends on the cumulative production experience of all agents using the same technology. This is equal to saying that efficency gains achieved by understanding/adapating a certain technology is shared among all market participants. This model is applicable if the technology providers for a certain production factor are separate from all agents. For example; all coal fired power plants buy their furnaces and generators from external suppliers and don't build the whole power plant by themselves. If they did, they could keep all efficency gains from newer technologies for themselves and there would be no second-mover advantage (however they would carry the entire burden of the R&D expenses, because they could not sell the superior technology to others). From what I know, most power plants don't design and build their own technology for energy production (with the exception of highly specific and government funded power plants like the fast breeder nuclear reactors built in the UK).

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