Is it time to update econ 101?
By John Komlos
Markets don’t work the way economics textbooks say they do. While I do believe in the power of markets to cultivate social good, they have many natural limitations that any credible scientific approach must recognize for public policies to be effective. Listed here are fifteen curses—yes, I call them curses—that markets must deal with to work as the textbooks say they do.
Curse 1: Incomplete or asymmetric information poses a huge obstacle to the efficient functioning of markets. Actually, it makes efficiency rarely attainable. Information is costly to acquire and is unequally distributed, and therefore not everyone has access to the same information, given the unequal distribution of wealth.
Curse 2: Opportunistic behavior refers to the problem that free markets open up myriad possibilities for people to take advantage of situations in an immoral, unprincipled, cunning, crafty, or deceptive manner or with guile.
Curse 3: Rationality assumption is a “no starter,” according to Nobel laureate psychologist Daniel Kahneman. In fact, no psychologist today would agree that humans are as rational as armchair economists insist.
Curse 4: Cognitive endowment of people participating in the marketplace is quite heterogeneous. This poses an independent challenge for standard economics insofar as textbooks tacitly assume that the people who participate in the marketplace are homogenous—that is, everyone is equally capable of solving the complex economic problems posed by today’s global system.
Curse 5: Children are completely disregarded in most of economics. Perhaps economists need to be reminded that we are not born as adults and we do not enter the economy with fully developed tastes as adults.
Curse 6: Time inconsistency refers to the serious problem that our actions today continue to have consequences far into the future, and in the future we might well regret the actions we took in the past. In short, we might change our mind.
Curse 7: Society does not exist in blackboard economics, only individuals who hardly interact with one another. In other words, economists completely neglect the disciplines of sociology and social psychology.
Curse 8: Power imbalances are also neglected by mainstream economics, even though they are enormously important, because they skew economic policies in favor of the wealthy and lead to political power imbalances that further the privileges of the elite while at the same time threatening the basic ideals of democracy.
Curse 9: Uncertainty is a formidable challenge to markets. The human brain has great difficulty processing information with uncertainty involving the calculation of probabilities. The subprime mortgage crisis demonstrated just how much pillaging can result when people misunderstand risk, misprice it, and do not assess it properly.
Curse 10: Financial markets are inherently unstable because of fractional banking and because its assets are long term while its liabilities are short term. As we have seen hundreds of times since the Industrial Revolution, and most vividly in 2008, financial markets, as a human invention, can go haywire.
Curse 11: Transaction costs put a damper on welfare and hinder efficiency, because they use up resources but do not increase welfare. However, they are not mentioned in Principles of Economics textbooks. There are search, information, policing, and enforcement costs.
Curse 12: Time and space are not firmly integrated into mainstream thinking. This is a serious conceptual shortcoming because both variables are essential to the understanding of why markets are generally inefficient.
Curse 13: Nonexistent markets pose a serious challenge to our welfare and the welfare of future generations. Markets, by themselves, produce too much pollution because no one owns the atmosphere. Consequently, pollution has become our very biggest global challenge.
Curse 14: Setting limits and standards are extremely difficult by decentralized markets. The inability of market to set limits gives us too many different incompatible standards and too much inequality.
Curse 15: Safety is not easily provided by markets inasmuch as it is a difficult-to-ascertain, intangible attribute and there is a psychological bias toward the present on the part of both producers and consumers.
Of course, there are many practicing economists who disagree with the primary thrust of the mainstream view of their discipline and even chide their colleagues for not questioning their own assumptions more seriously. To be sure, conclusions reached by deduction from assumptions practiced by the mainstream are logically valid on the blackboard but often turn out to be toxic at street level.
These curses of “pure economics” need to be taken into account if we want to create market systems that function in a healthy and productive manner while simultaneously promoting societal wellbeing for people and planet.
November 1, 2015