All Commentary
Friday, December 1, 2000

Markets Aren’t Efficient?

Kinsley Is Right to Challenge the Realism of Mainstream Economics

In his August 22 Washington Post piece, “What’s New About This Economy?” Michael Kinsley summarizes the prevailing orthodoxy among economists:

In the church of economic theory, as in that other church, the central symbol of the faith is a cross. Only this one is tilted and looks like an “x” not a “t.” As any communicant learns early on, the x represents supply and demand “curves” (usually portrayed as straight lines) . . . . [W]here the two lines cross is the blessed point of “equilibrium,” where the price is exactly what is needed for supply to equal demand. At that point markets clear, utility is maximized, lions are beaten into plowshares, bread walks on wine, and so on.

Kinsley then makes a remarkably brave confession: “Having been inducted into the faith in college, I’m a fairly devout believer in the basic doctrines. But I have always been troubled by doubts on one item: In my innermost heart, I wonder if the supply curve really slopes upward. (There, I’ve said it.)”

Those of us who have been excommunicated from the mainstream must applaud Kinsley’s courage. He recognizes, as we do, the utter absurdity of the doctrine of entrepreneurial infallibility. Kinsley is perfectly correct to challenge the standard assumption that marginal costs always rise. But that’s not the half of it.

The really radical response to the neoclassical practice of drawing all sorts of elegant cost curves is not simply to wonder whether they rise. The first question must be: What are these curves supposed to mean? They do not accurately describe the decision-making process of real businesspeople; nor do these unrealistic models make accurate predictions. The entire enterprise of modern mainstream economics can only offer a simplified analogy to the real economy in hopes that the study of this theoretical world can offer us insights into the real one.

It is a common mistake to say that economics is about money. As such, when people talk about the “marginal cost” of production, it is believed that this refers to the dollar amount spent on raw materials, labor, and so forth. But cost is the value of opportunities forgone, and it is always estimated in an ex ante sense; cost is never “realized.” A woman chooses one out of many competing suitors. The benefits of her choice are clear enough. But the costs are not the money spent on the wedding and dowry—these would have been spent anyway if a different man had been selected. Rather, the true cost is the subjective value she places on a lifetime spent with the next best suitor. It is clear that this value will never be known, for it is a lost opportunity; a fortiori, no outsider can calculate it.

After his confession, Kinsley elaborates further on neoclassical theory. In a competitive market, price equals marginal cost. (If it were higher, a rival would cut prices to capture the entire market, and if it were lower, firms would make more money by restricting production; only when P=MC is everyone happy.) Marginal costs have to be rising “to avoid the embarrassment of supply and demand curves that never cross.” Further, at the point where supply and demand intersect, it had better be the case that marginal cost exceeds average total cost—otherwise the firm would be losing money. Kinsley finally gets to his point: “[T]he news these days is full of controversies where the basic problem is that marginal costs do not rise. They start out below average cost and stay that way.”

Already the reader should be skeptical. When someone laments that costs are not higher than they already are, chances are this person is drawing an illegitimate conclusion from an economic model. (This same phenomenon occurs when critics lament that Microsoft did not charge enough for its browser. These people are afraid of low prices, just as Kinsley is afraid of low costs.) Airline seats, says Kinsley, are a good example of this: Once the first 20 seats have been sold, it costs the airline virtually nothing to sell the 21st seat. But clearly each person can’t be charged this marginal cost, for the average cost of an airline seat is much higher.

One wonders what the big fuss is about. Kinsley himself acknowledges the airlines’ solution: Charge different amounts for the “same” seats. On any given flight—even restricting ourselves to those flying coach—each passenger does not pay the same price for his or her seat. Already we have abandoned the world of neoclassical models, where P is uniform. Moreover, the seats really aren’t the “same” good; those who bought their tickets well in advance presumably paid much less since, unlike those who procrastinate, they were willing to forgo flexibility and commit to a certain date. Taken to the other extreme, discount theater tickets are always available to those who forgo the luxury of knowing which show they will actually attend that night.

Most of the problems Kinsley raises are due to the necessity of avoiding the “embarrassment” of disequilibrium. But whenever a plane, bus, or subway has empty seats, that’s a surplus, or glut, in the neoclassical’s book. As one who frequently uses public transportation, I can attest that I am absolutely delighted by disequilibria. And the owners are not hurt either. It is true that they would prefer to sell all the seats at a high price, but the demand is lacking. If the choice is between “clearing the market” (selling all seats) at a low price, and leaving a few empty at a higher price, which earns them greater profits, it is quite likely the airlines will adopt the latter strategy.

Kinsley believes the features of the New Economy “[undermine] the case for a free market.” By this he undoubtedly refers to the mainstream definition of efficiency: If there exists a technologically feasible alternative arrangement of society’s economic affairs, an arrangement that is unanimously preferred to the current arrangement, then the status quo is “inefficient.” But this definition tells us nothing about how to improve the situation. Indeed, all the “market failure” literature teaches us is that if certain industries behaved in the way assumed in the various models, then we could logically imagine the world being a better place. Any argument that uses these results to justify government intervention is a complete non sequitur.

Such condemnations of the free market are even more dubious when it is realized that these models do not at all capture the ingenuity and resilience of unshackled entrepreneurs. Low marginal costs were no problem for Sam Walton or other founders of wholesale clubs, in which the customer pays a flat membership fee for the right to purchase goods at huge discounts.

Kinsley is right to challenge the realism of mainstream economics. But he must realize that the problems of “the one true faith” (as he calls it) run far deeper than he has imagined.

—Robert P. Murphy
Ph.D. candidate in economics
New York University

  • 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.