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Wednesday, March 11, 2015

Are Markets Myopic?

The illusion of government looking out for the long term

We often hear that individual investors are myopic. They make decisions based on a relatively short time horizon, so forget about the long run. That’s why we need government officials to step in with regulations, as well as corrective taxes and subsidies, to guide the market toward long-term social goals. Or so the story goes.

Though this view of markets versus government is common, it has things exactly backwards: markets do contain sophisticated mechanisms for rewarding long-term planning, and democratic political institutions encourage extremely short-term thinking.

The fundamental institution for promoting proper planning is private property. The owner of a piece of property has an incentive to take actions that enhance its market value. For example, consider the owner of a giant tin deposit who must decide how rapidly to extract the resource.

Those who are naïve about the operations of a market economy might suppose that the greedy capitalist owner would “strip mine” the deposit as quickly as possible, channeling all of the accessible tin into projects serving the current generation while ignoring the needs of future generations. A moment’s reflection shows this is nonsense.

The greedy capitalist owner is at least vaguely familiar with the notion that tin deposits — unlike apples and wheat — do not naturally replenish themselves year after year. An extra pound of tin extracted and sold this year means exactly one fewer pound of tin that this deposit can yield in some future year. Once we realize that the greedy capitalist doesn’t want to maximize revenue but instead wants to maximize market value, it is obvious that he must take the future into account when making current decisions.

Specifically, to maximize the market value of his asset, the owner should extract additional pounds of tin in the present (putting the proceeds in a financial investment earning the market rate of interest), until the point at which he would earn a greater return by leaving the next pound of tin in the deposit, to be sold next year at the expected market price. For example, if tin is selling today at $8 per pound, and the interest rate on financial assets is 10 percent, then the owner would halt his operations if he ever came to confidently expect the price of tin next year to be $8.80 or higher. (I’m assuming the marginal costs of extraction and selling are the same, year to year, just to keep things simple. See this article for a more comprehensive explanation using oil.) Once he reaches this point, the best “investment” of his additional units of tin would be to leave them in the mine, “ripening” for another year.

Thus we see that a greedy capitalist would implicitly (and unwittingly) take into account the desires of consumers next year when making current production decisions. He would be guided not by altruistic concern, but instead by personal enrichment. We see the familiar pattern of market prices guiding even selfish individuals into promoting the general welfare. If for some reason tin were expected to be scarcer in the future, then its expected spot price in the future would be higher. This would lead owners to hold tin off the market in the present, thus driving up its price even today, in anticipation of the expected future price. Modern financial and commodities markets — with futures and forward contracts, as well as more exotic derivatives — refine things even more, drawing on the dispersed knowledge and different risk appetites of millions of people.

The critics of capitalism would probably complain again at this point, bemoaning the fact that the greedy owner was now “undersupplying tin” and gouging today’s consumers with artificially higher prices. But if so, the critics need to make up their minds: do we want the tin going to the present or to the future? There’s a finite amount of it to go around — that’s the whole (alleged) problem.

Notice that even if a particular owner of a tin deposit is diagnosed with terminal cancer, he still has an incentive to behave in this “efficient” manner. The reason is that he can sell the tin deposit outright. The market value of the entire deposit will reflect the (present discounted) future flow of net income derived from owning the deposit and operating it in the optimal manner indefinitely. If the owner ever thinks, Well, if I had 10 years left, I would run the operation in such-and-such a way, then that decision won’t change just because he only has one year left. Instead, he can sell the operation to the highest bidder, including people who do have 10 or more years left of expected life.

Thus, we see that contrary to the critics, a pure market economy contains sophisticated mechanisms to guide owners into acting as farsighted stewards of depletable natural resources. In complete contrast, political officials who control natural resources face no such incentives. Because they can’t personally pocket the revenues, or bequeath the asset to their heirs, political officials have the incentive to maximize the current income from the natural resources under their temporary control, to the extent that they are guided by pecuniary motives.

Even here, it’s usually not the case that the government sells access to a resource in order to maximize current receipts. Rather, what often happens is that the government officials will give sweetheart deals to private interests (such as a logging company operating in a state-owned forest), allowing these officials to develop a business relationship that will benefit them after leaving government.

Private owners in a free-market economy have the incentive to maximize the long-term value of their property, which implicitly leads them to consider the desires of future generations. Democratically elected government officials, on the other hand, act as temporary custodians who will not personally benefit from maintaining the market value of the assets they control.

Rental car companies would be foolish to suppose that their customers will put the more expensive high-octane gas into their vehicles, even though the customers might do so if they personally owned the rental car. Yet, for some reason, millions of voters think that politicians with two-year terms will be more farsighted when it comes to economic resources than private shareholders will be.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.