Solow on Markets and Their Failures

In Pirates of the Caribbean: The Curse of the Black Pearl," Jack Sparrow describes Will Turner's father as a "good man and a pirate," a seeming paradox.  Outside of economics, many argue that conservatives trust markets to allocate resources and liberals do not, making it impossible for a  to see fundamental value in markets.  Robert Solow is a politically liberal economist and sees value in markets.  Saying that he is a politically liberal economist does not describe his contribution to economics, which can be summarized by noting that he was awarded the Nobel Prize in Economics in 1987 for his work on economic growth theory.  Because many incorrectly believe that a liberal could recognize the value of markets I will first establish his liberal bona fides and then provide a few quotes from his New Republic book review, "Hedging Markets," to demonstrate that he values markets but notes their failures.

A Wall Street Journal article notes that Solow has long advised Democratic presidential candidates and is an Obama backer.

Robert Solow, the Nobel Prize winning economist who long has counseled Democrats, said Barack Obama should roll back the Bush tax cuts for the rich but shouldn’t use the proceeds to cut taxes for the middle class, as the Democratic presidential candidate has proposed...

Instead, he would use the money “both for urgent needs now and for future deficit reduction,” he said. “The government needs that money and ought not to be using it to promote consumption [consumer spending.]”...

Mr. Solow was quick to add: “I understand this” — backtracking on a promised middle-class tax cut — “is not a politically easy thing to do.” He remains an Obama backer.

In "Hedging Markets," Solow gives an introductory lesson on markets and their failures.

My late colleague Evsey Domar, who was, among other things, a student of the Soviet economy, told us how the planning bureau began by setting production quotas for paper factories in tons per year. The result was paper so thick that it could not fit in a Soviet typewriter or anywhere else. So the clever planning bureau changed to setting quotas in terms of square meters per year. The result was paper so thin that even a member of the planning bureau could see right through it. The lesson is that it is so much simpler and more effective to tell paper producers that they have to compete to sell their paper to notebook manufacturers (who are also competing with each other), and live off the proceeds.

If this is how more or less free, more or less competitive markets can deal with something as simple as a spiral notebook, how much more remarkable it is that they can do the same for something as complicated as a computer or a refrigerator. But there seems to be no other practical way to run a modern economy efficiently. That is what Adam Smith understood: a competitive market economy, motivated primarily by individual pecuniary self-interest, can produce coordination where one might expect only chaos.

He invented for that process the memorable image of the Invisible Hand. In the following two centuries and more, an army of economists has spent an enormous amount of time and intellectual effort refining and elaborating Smith’s initial insight, teasing out exactly how far that logic can be carried, how the hand operates, investigating when and how it breaks down, and elucidating odd or complex special cases such as professional team sports, or Internet services, or health care...

Today, of course, no one is against markets. The only legitimate questions are: What are their limitations? Can they go wrong? If so, how can we distinguish the ones that do from the ones that don’t? What can be done to fix the ones that do go wrong? When is some regulation needed, how much, and what kind? More broadly: how to protect the economy and society against specified tendencies to market failure without losing much of either the capacity of a market system to coordinate economic activity efficiently or its ability to stimulate and reward technological and other innovations that lead to economic progress?Today, of course, no one is against markets. The only legitimate questions are: What are their limitations? Can they go wrong? If so, how can we distinguish the ones that do from the ones that don’t? What can be done to fix the ones that do go wrong? When is some regulation needed, how much, and what kind? More broadly: how to protect the economy and society against specified tendencies to market failure without losing much of either the capacity of a market system to coordinate economic activity efficiently or its ability to stimulate and reward technological and other innovations that lead to economic progress?

The subtitle of John Cassidy’s book illustrates the problem. Most market failures--they occur every day--are not even nearly calamities. They start with the existence of partial monopoly power in this or that industry, with the result that the market price is “too high” and the rate of production “too low” in the precise sense that everyone could be made better off if that error were corrected. They extend to cases [of  externalities] where the market does not impose the full costs of their actions on certain producers and consumers, with the result that economic activity is misdirected: the consequences may be minor (a small amount of pollution) or major (fish stocks collapse from overfishing) or potentially catastrophic (climate change from excessive unpenalized emission of greenhouse gases). And what are we to make of the stock-market collapse of October 1987, the largest one-day fall ever on the New York Stock Exchange? It was in one sense a calamity, but it left essentially no trace in the “real” economy of production, employment, consumption, and everyday life. Evidently being for or against “free markets” does not come close to being an adequate response to the problems that arise in a complex modern economy.

To be sure, Solow would tend to find more instances of market failure severe enough to justify government intervention than I, but we are generally viewing problems within the same economic framework.