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Wednesday, November 14, 2012

The Virtue of Market Inefficiency

Markets are often rightly characterized as extraordinary problem solvers. Under the right rules of the game (including private property, free exchange, and the rule of law) people following their own self-interests can coordinate their plans with one another more or less successfully, generating an overall order without being aware, or needing to be aware, of how it all gets done.  That’s why economists sometimes say that markets are a lot “smarter” than any single person.

But I think markets are more important for the problems they “create” than for the problems they solve.

In 1920 Ludwig von Mises explained that a given individual in society can only plan rationally—that is, find the most efficient, least-cost means to achieve a given end—if she has money prices to guide her.  Would it be better from her point of view to build a bridge out of molybdenum or steel or perhaps some combination of the two?  Or should she build a bridge at all rather than invest in a ferry service?  These questions are difficult enough in a world with money prices, but they would be impossible to answer absent money prices for steel, molybdenum, and all the other inputs used to build a particular kind of bridge (or a particular kind of ferry service, for that matter).

In this way money prices—prices that emerge from the free exchange of private property in a free market—help her solve the problem of how and whether to build a bridge.  With their help she is at least in principle able to estimate what the cost of the various alternatives might be.  And the one that generates the most profit, where she estimates the expected benefits to exceed the expected costs the most, will also tend to be the most efficient (that is, she will be getting the highest return on her investment).

About 20 years after Mises’s article, Friedrich Hayek explained how these market-created prices enable an imperfectly informed individual to coordinate her plans with a vast number of people scattered across the global economy without needing to know that or how she is doing it.  If the price of gasoline goes up, no one has to tell her to use less, even though this is precisely what the increased relative scarcity of gasoline (which is behind the higher price) necessitates.

Taken together, Mises’s and Hayek’s analyses of the market economy added greatly to our understanding of what Adam Smith in the mid-eighteenth century referred to as the “invisible hand.”  Considering that the process of coordination, enabled by prices, is repeated again and again for all goods and services produced in an economy, it’s easy to see why many economists are impressed by the problem-solving capabilities of the market.

This coordination process also sheds light on how government policies, collectivist or interventionist, that eliminate or distort these prices tend to make the world a whole lot dumber.

As marvelous as the market economy is at problem solving, in a sense the real genius of the market process is in how it brings problems to people’s attention in the first place.  Before you can solve a problem, you have to be aware that there is a problem.  This, I believe, is the great insight that Israel M. Kirzner, beginning in the 1970s, contributed to our understanding of the market—in particular, that it is a process of entrepreneurial discovery of error.

One implication of this insight is that government policies that undermine the (admittedly imperfect) reliability of money prices also make the discovery of inefficiencies profoundly problematic: undermining prices casts doubt on the very meaning of inefficiency.

Strictly speaking, an inefficiency exists when, for a given person at a given time and place, the cost of an action outweighs the benefit.  We’ve seen that to rationally calculate costs and benefits you need money prices of inputs and outputs, of steel and bridges.  So when government erodes private property rights, interferes with trade, distorts prices, and manipulates money, it doesn’t just make it harder to be efficient; it also pulls the rug from under the very ability to spot inefficiencies at all.

Using the rules of arithmetic, for example, it’s easy to see that the statement 1 + 2 = 4 is wrong, but what about  _ + _ = _ ?  What’s the solution to this “problem”?  Is there even a problem here?  Money prices fill in the blanks; they “create errors”—i.e., reveal mistakes that no one could see without them—that alert entrepreneurs might then perceive and correct. If mistakes and inefficiencies remain invisible, the search for better ways of doing things could never get off the ground.

An economy without inefficiencies is either one where knowledge is so perfect that no one ever makes a mistake, or it’s one in which government policy has effectively foreclosed the very possibility of inefficiency.  In a world of surprise and discovery, of experiment and innovation, the former is impossible; the latter sort of economy, as Mises showed almost 100 years ago, is impossible as well as intolerable.

So a living economy needs to “create” inefficiencies, and lots of them, to set the stage for greater efficiency and ongoing innovation.  And that’s just what the market process does all the time—thank goodness!

(A version of this article previously appeared on TheFreemanOnline.)

  • Sanford Ikeda is a Professor and the Coordinator of the Economics Program at Purchase College of the State University of New York and a Visiting Scholar and Research Associate at New York University. He is a member of the FEE Faculty Network.