All Commentary
Tuesday, August 9, 2011

Why Caveat Emptor?

A virtue of the real-world market.

The phrase caveat emptor is usually rendered, “Let the buyer beware!”  Whether it’s an apple at the grocer or a car at the dealership, the buyer should be cautious lest the seller try to pull a fast one.  The same goes for the seller – caveat venditor!

But isn’t competitive rivalry alone supposed to protect consumers against shoddy products and keep prices low?  Why, in a truly free market, would this principle still be important?

Market Imperfection and Government Regulation

If markets were as perfect as textbook microeconomics says they are, there would indeed be no need for caveat emptor.  Competition would guarantee prices at their lowest-possible level and product quality at its highest.  But real-world markets aren’t like that.  People aren’t perfectly informed, and communicating information is costly.

So isn’t this a good reason for government regulation?  In the case of less-than-perfect competition, shouldn’t people in government protect consumers (and sellers for that matter) from opportunistic traders?  Indeed, isn’t that why we have the Securities and Exchange Commission, the Federal Trade Commission, and a host of other regulatory bureaucracies that Congress is constantly legislating into existence?  Well, there are problems with that popular argument.

The first problem is that, as Public Choice economics and Austrian political economy (pdf) teaches us, people in the public sector are at least as self-interested and uninformed about the things that matter as people in the private sector.  However, at least buyers and sellers in the private sector have a material interest in accurately forecasting benefits and costs and in keeping a check on one another; in the public sector that incentive is effectively absent.  So if private-sector competition works imperfectly because of those human failings, it’s not likely to work any better – probably much worse — with the flawed and unmotivated humans in the public sector.

How then to eradicate cheating and opportunism on the free market?  The answer is – you can’t.  And if thought about it, you really wouldn’t want to.

(I recently wrote about how market inefficiency is a virtue; the idea here is similar.)

Tradeoffs in an Imperfect World

Paul Seabright, in his book In the Company of Strangers, beautifully explains the tradeoff in markets between “reciprocity” – trusting others to return favors – and “calculation” – not returning favors if you think you can do better by cheating.  If A always trusts others, others will take advantage of her and she will eventually stop trading.  If B always acts opportunistically, cheating and reneging on agreements whenever the chance comes his way, pretty soon no one will want to trade with him.  As Seabright puts it:

These considerations suggest that individuals who can simultaneously exercise trust shrewdly and inspire trust in others need to have some disposition for calculation in their dealings with others – but not too much, or no one will trust them.  They also need some disposition for reciprocity – but not too much, or others will exploit them, and the memory of past wrongs will cast too long a shadow on their lives.

A and B both need to discover for themselves what balance between trust and opportunism works for them. Some would never press an advantage, which is admirable, while others might on occasion. That kind of decision, necessitated by a world of imperfect knowledge and flawed human beings, is itself imperfect, of course.  A and B may never find exactly the balance that’s optimal, but at least free markets allow them to try.

The same goes, I think, for behavior that borders on the unethical.  Who owns an idea?  To this day, Mark Zuckerberg is defending himself against charges of stealing the idea for Facebook from others.  Some years ago the inventor of Napster was suspected of copyright violation.  Were they intentionally infringing on the property rights of others?  Maybe yes, maybe no.

I’m certainly not saying that unethical actions are necessary for the free market to create new ideas and products.  What I am saying is that as the free market unleashes the creativity of geniuses in art, culture, religion, science, and business, the legal and moral framework often lags behind.  And that means the line between what is acceptable and unacceptable, in each of the above-named areas, is often fuzzy.

Of course in a real free market (if it ever exists) there would still be out-and-out cheaters, liars, and frauds.  The grownup attitude is not to pine for a perfect world, but to work for a world in which despicable behavior is minimized.  The free market gives you the best chance of doing that.  But trying to abolish cheating, just like trying to abolish the threat of terrorism or pollution or crime, would take so many resources that there would be little else left, including our civil liberties.

No Pain, No Gain

An upside to the imperfection of markets, then, is that people, buyers and sellers alike, don’t always have to behave “responsibly” – that is, according to prevailing expectations, norms, and conventions.  It leaves room for the unexpected.  Think of how dull life would be without that edge.

True, creative people take chances that often offend and sometimes even harm.  In art, for example, this means shattering convention, leaving room for the genius of an Alexander McQueen in fashion design; but it also means leaving the door open to charlatans and some really bad clothes.  In business it allows Zuckerberg to create Facebook or Ron Popeil to build a gadget empire, but it also lets shysters try to sucker the gullible into buying questionable products (which, let’s face it, Ron Popeil may have done from time to time).

If we allow that kind of freedom, we need to keep our eyes open.  The beauty of the free market is that it lets us choose, not perfectly but better than any of the alternatives, how much we expose ourselves to that uncertainty, while at the same time it lets us enjoy the fruits of our own and others’ risk-taking.  There’s no gain without pain, and part of the price of liberty is caveat emptor.

  • 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.