“Government is wasteful,” libertarians argue. “Only markets create wealth.”

But markets also waste wealth. Predictably. (More)

The Darwin Economy, Part I – Why Markets Fail

This week Morning Feature looks at Cornell professor Robert Frank’s new book, The Darwin Economy: Liberty, Competition, and the Common Good. Today we consider why libertarian arguments for efficient markets misread Adam Smith and ignore Charles Darwin. Tomorrow we’ll examine why “starve the beast” is good public policy, if you starve the right beasts. Saturday we’ll conclude with why taxes are the most efficient and least intrusive ways to starve those beasts.

Note: Please welcome Dr. Robert Frank to Blogistan Polytechnic Institute. Dr. Frank is the H. J. Louis Professor of Management and Professor of Economics at the Johnson Graduate School of Management at Cornell University. He has authored or co-authored 11 books, and writes the “Economic View” column for the New York Times. Dr. Frank will join our discussion this week, as his teaching schedule permits. Please check back throughout the day for his comments.

Once upon an assumption….

There’s an old joke about a professional wrestler, a physicist, and an economist stranded on a desert island. They have a can of beans, but no can opener. The wrestler suggests breaking the can with a rock, but the other two argue that will leave bits of gravel in the beans. The physicist suggests heating the can over a fire until the internal pressure bursts it, but the other two argue that’s too dangerous and the beans will be lost in the explosion. They finally turn to the economist, who says “First, let’s assume we have a can opener….”

While Dr. Frank may cringe at that joke – and if so I apologize – it introduces what he argues as the central problem with current libertarian economic arguments. They are based on assumptions about how markets work, such as complete information, fully open competition, and the existence of Homo economicus or the rational economic actor. Progressives often challenge those assumptions, but Dr. Frank argues that those assumptions, while not entirely valid, are more valid now than ever in recent history. And while those assumptions are not valid as simplified for introductory economics classes, more sophisticated models do incorporate incomplete information, limitations on competition, and bounded rationality.

I highlighted the word those because Dr. Frank argues the central flaw of libertarian economic arguments lies in a different assumption – the myth of absolute quality.

Relative quality and positional spending

Let’s assume (mmhh, beans!) you have a job interview and need to buy a suit. Also, assume (baked beans, with molasses!) the price of a suit correlates directly to its quality, and that the quality of your suit correlates directly to the impression you make and whether you get the job. Finally, assume (where’s that can opener?) you can’t be overdressed for this interview. How much should you spend? Will a $500 suit be of high enough quality to get the job?

If the other applicants arrive in $200 suits, you look like a million bucks by comparison. But if another applicant arrives in a $1000 suit, you’re wearing rags by comparison. And that “by comparison” is the key part. Your $500 suit looks like a $500 suit, in terms of absolute quality. But whether that suit helps you in that job interview depends on relative quality … what the other applicants are wearing.

So you do a little opposition research. You find out most of the other applicants will be wearing $500 suits, but Sam Splurger is also applying for the job, and he bought a $1000 suit. Should you dip into your savings to buy a $1500 suit? And what else could you buy for that extra $1000?

Dr. Frank presents evidence that we do a lot of positional spending, buying status symbols that offer advantages. But those advantages derive from relative quality, not absolute quality, and the quest for those advantages spur the equivalent of arms races. In an arms race between countries, what matters is not the absolute size and quality of your military but the size and quality of your military relative to your rivals. Countries engaged in arms races get that money by borrowing (often more than they can afford) and/or under-spending on education, social welfare, and programs that offer less advantage relative to rivals.

The waste of positional spending

Dr. Frank argues that individuals do the same for positional spending, by borrowing (often more than they can afford) and/or under-spending on goods and services that offer less positional advantage, such as life and health insurance, savings for kids’ college and retirement, or extra time with our children or community activities.

Libertarians might argue “That’s a tradeoff and you must accept personal responsibility for your choices,” as Republican presidential candidate Ron Paul said in Tuesday night’s debate. But as Dr. Frank points out, that’s a false argument … because the “tradeoff” doesn’t happen.

Once other applicants know Sam Splurger bought that $1000 suit, any applicant who can will buy at least a $1000 suit, and those who can will spend more. When Sam hears someone else bought a $1500 suit, he’ll buy a $2000 suit. Finally four applicants, each seeking an individual advantage, empty their savings and max out their credit cards to buy $5000 suits. Those four are a combined $18,000 poorer and deeper in debt, and none of them has an advantage based on his/her suit.

Individual vs. collective interest

Positional spending pits individual against collective interest, in ways that harm both. Three of those four applicants will not get the job, despite emptying their savings and going deeper into debt for a $5000 suit. They’re still looking for work, and now they can’t afford to pay their bills or feed their families. That’s not a “tradeoff.” It’s a waste of resources, even for the applicant who got the job.

Sam Splurger may have the job, but he’s also $4500 poorer than he would have been had they all agreed to spend only $500 for a  suit. Because they were engaged in positional spending, based on relative quality, their individual interests did not serve the common good. But no individual could solve that problem. Any applicant who didn’t spend extra money for the suit lost out on the job. To solve that problem, the applicants would have to act collectively.

Dr. Frank cites the example of the National Hockey League’s helmet rule. In a survey, players said they would rather skate without a helmet, because helmets limit peripheral vision and hearing on the ice. Being the one player on the ice without a helmet offers a competitive advantage, and players thought that was worth the greater risk of a serious head injury. But if every player skates without a helmet, none of them gains a competitive advantage … and they’re all at greater risk of serious head injuries.

So while individual players would rather skate without a helmet, those same players voted overwhelmingly for a league rule requiring players to wear helmets. No one player is disadvantaged, and all players benefit by the lessened risk of serious head injuries.

Libertarians might call that “less freedom.” Hockey players called it “common sense.”

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Happy Thursday!