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.
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None of Their Business

The executive and legislative branches of government have found yet another problem that they must tackle.  Consumers prefer the Internet to traditional news outlets to get their news.  Joelle Tessler of the AP describes Federal Trade Commission workshop designed to solve the problem in, "FTC explores future of journalism in Internet age."

WASHINGTON — The federal government is wading into deliberations over the future of journalism as Americans abandon printed newspapers, television stations and other traditional media outlets for the Internet.

With the media business in a state of economic distress as audiences and advertisers migrate online, the Federal Trade Commission began a two-day workshop Tuesday to examine the profound challenges facing media companies and explore ways the government can help them survive.

Media executives taking part are looking for a new business model for an industry that is watching traditional advertising revenue dry up, without online revenue growing quickly enough to replace it. Government officials want to protect a critical pillar of democracy — a free press.

"News is a public good," FTC Chairman Jon Leibowitz said. "We should be willing to take action if necessary to preserve the news that is vital to democracy."

The emphasis added is mine.  Public goods have two defining characteristics: they are nonrivalrous in consumption and nonexcludable.  Nonrivalrous means that my consumption of the good does not affect yours.  A firework display  is  an example.  Nonexcludable means that the person who provides the fireworks cannot exclude others from enjoying the display.  These conditions create free-riders, people who benefit from the provision of the public good without paying.  Economists have demonstrated that the free-rider problem results in under provision of the public good. 

News does not fit the description of a public good.  News papers can exclude people from enjoying their presentation of the news.  You have to subscribe to the paper or buy it on a daily basis.  If the paper is presented on the Internet, the owners can exclude readers from content by requiring subscription and excluding content from search engines line Bing, Google, and Yahoo.  To open their content, they must provide code for search engines to find their content, and allow nonsubscribers to view it.  Then news is a public good but the owners have made it so.  They have found that it is their best option to remain commercially viable.   

The problem faced by newspapers and traditional news outlets face is too much competition.  Subscriptions are falling because consumers can get news in a more timely manner with a greater variety of perspectives for free from the Internet.

Some scholars and politicians see a problem with the variety of news providers.  Cass Sunstein, a brilliant scholar whose work spans law and behavioral economics, believes that Internet provisions of the news can lead to systematic bias where people only read news that agrees with their opinions compounding confirmation bias as if their wasn't enough to go around already.  With liberals only reading the Daily Koss and the Huffington Post, and conservatives only listening to Rush Limbaugh and Sean Hannity, group polarization hardens. 

Ben Van Heuvelen of Salon summarizes the problem in the preamble for an interview with Sunstein in "The Internet is making us stupid."

Freedom of choice is not always good for democracy. This observation is at the heart of University of Chicago law professor Cass Sunstein's book "Republic.com 2.0" (an update of "Republic.com" in 2001), which argues that our country's political discourse is fracturing in the information age. Sure, the Internet has been a boon to democracy in all sorts of ways, Sunstein acknowledges -- but if new technology gives us unprecedented access to information, it also gives us more ways to avoid information we don't like. Conservatives are increasingly seeking only conservative views, liberals are seeking only liberal views, and never the twain shall meet...

What gets lost in these polarized times, Sunstein writes, are traditional civic virtues like civility, self-criticism and open-mindedness. He uses experiments and statistical analyses to back that up: One study of hyperlinking patterns on the Web shows that political bloggers rarely highlight opposing opinions -- of 1,400 blogs surveyed, 91 percent of links were to like-minded sites. A central problem, Sunstein argues, is that Americans now think of themselves more as consumers than as citizens. When it comes to the Internet, we demand the right to reinforce our own beliefs without embracing the responsibility to challenge them.

Attempting to read between the lines with a public interest perspective, perhaps supporters of tax subsidies believe that traditional news outlets provide more balanced news and thereby counter confirmation bias, fostering public civility, self-criticism and open-mindedness. 

I expressed my opinion in the title, but must acknowledge that my favorite news program is the NewsHour with Jim Lehrer precisely because it has the civic virtues lauded by Sunstein.  I do not worry as much about the described problems as Sunstein while acknowledging their existence.  My fear is that public subsidies will contaminate the news process and increase government oversight of another industry, one that is to act as a counter weight to government and requires independence from government to do so, and be yet another burden on the "forgotten man," the taxpayer.

What do you think?
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Things I Learned in California: Thomasson and Health Insurance

I spent a bunch of time this weekend traveling to and from California.  In flight, I read Melissa Thomasson's "The Importance of Group Coverage: How Tax Policy Shaped U.S. Health Insurance," American Economic Review, Vol. 93, No. 4, 2003.  I picked out two quotes from the article.  The first deals with the emergence of employer provided health care.

The development...employment-based insurance in the United States can be traced to several factors: a provision in the 1942 Stabilization Act that allowed employers to use fringe benefits to attract labor during World War II; the ability of insurance companies to counter adverse selection by selling to employee groups; and perhaps most importantly, a tax policy first introduced in 1943 and codified in 1954 that exempts employer contributions to employee health plans from taxable employee income.

Adverse selection is the idea that those that have the greatest health care needs will be the first to try to buy insurance, imposing their higher than average costs on others that buy insurance.  As costs rise, the health may abandon the market.  The cost can be lowered in several ways including screening applicants for preexisting conditions.  Some people oppose screening on normative grounds.

Thomasson attempts to measure the impact of a 1954 revision of the Internal Revenue Code that codified the tax exempt status of wages paid to purchase health care through company plans. 

Overall, the results suggest that by increasing the incentive to purchase insurance through the workplace,  the tax subsidy both increased the amount of insurance purchased and increased the probability that households would buy coverage. 

If the Congress desires something closer to universal coverage and wishes to increase incentives of people to buy insurance through markets, it should extend the tax subsidy received by employees with employer provided health insurance to those without it.  This amounts to extension of the tax subsidy for all buyers.  Subsidies to buyers increase demand. 

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Prosperity Without Wealth

I previously suggested that the Obama administration might use the campaign slogan, "No Citizen Gets Ahead."  I have a suggestion for a campaign slogan for Congressmen on the House Financial Services Committee, "Prosperity Without Wealth."  Jim Kuhnhenn, an AP reporter who wrote, "US government seeks to rein in executive pay," explains that Congressmen

...on the House Financial Services Committee said Thursday the administration's efforts to hector the private sector into reining in executive pay might not go far enough.

The administration contends that excessive compensation contributed to the U.S. financial crisis, but rejects direct intervention in corporate pay decisions.

Instead, the administration plans to seek legislation that would try to rein in compensation at publicly traded companies through nonbinding shareholder votes and less management influence on pay decisions.

"I do differ with the administration in that hope springs eternal and their position seems to be that if we strengthen the compensation committees we will do better," said the committee chairman, Rep. Barney Frank...

Rep. Brad Sherman...said that instead of giving shareholders a nonbinding voice on pay, their votes should be binding on boards of directors.

[these Congressmen] and administration officials agreed that companies across the private sector need to adjust compensation practices to avoid damaging the economy.

Please note, as did Barney Frank, that the administration's rhetoric is stronger than the brief description of the legislative proposal.  The administration claims without evidence that excessive compensation contributed to the financial crisis, but rather than limit executive compensation, the administration proposes nonbinding shareholder votes and less management influence on pay decisions.  The new rules might increase executive compensation.  Michael Jensen and Kevin J. Murphy (CEO Incentives--It's Not How Much You Pay, But How," Harvard Business Review, May-June 1990, No. 3) make just this

Paying top executives "better" would eventually mean paying them more...There are serious problems with CEO compensation, but excessive pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem--how CEOs are paid.

The administration's proposal as presented by Kuhnhenn aims to change how CEO's are paid and many economists see problems with the corporate incentive structure that determines pay.  Lucian Bebchuk and Jesse Fried ("Executive Compensation as an Agency Problem," Journal of Economic Perspectives, Vol. 17, No. 3, 2003) describe list several reasons why corporate directors may overpay executives: directors generally like to stay on boards, and CEO's play a big role in nominating directors for the board; directors typically have a small equity interest in the firms they serve; market forces are not sufficiently well defined as to guarantee optimal contracts.  They recommend a solution that does not involve government action.

The conclusion that managerial power and rent extraction play an important role in executive compensation has significant implications for corporate governance, which we explore in our forthcoming book (Bebchuk and Fried, 2004). It is important to note, however, that this is an area in which widespread recognition of the problem might contribute to alleviating it. The extent to which managerial influence can move compensation arrangements away from optimal contracting outcomes depends on the extent to which market participants, especially institutional investors, recognize the problems we have discussed. Financial economists can thus make an important contribution to improving compensation arrangements by analyzing how current practices deviate from those suggested by optimal contracting. We hope that future studies of executive compensation will devote to the role of managerial power as much attention as the optimal contracting model has received.

Bebchuk also explains how government action may create perverse incentives (Cari Tuna and Joann Lublin, "Risk vs. Executive Reward," Wall Street Journal, June 15, 2009). 

Mr. Bebchuk, who directs Harvard's corporate-governance program, worries that federal officials are pushing banks to adopt practices, such as granting restricted stock and giving shareholders an advisory vote on executive pay, that may make the problem worse. That is because many banks' share prices are now so low that shareholders, with little to lose, may support executives' taking big risks.

When markets are self correcting, and government action could damage market performance, government officials should opt for the wise policy option of doing nothing. 
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