The Importance of Applying Market Process Theory

I came across an interesting post by Chris Dillow on markets vs gov't direction of resources. He starts off by criticizing an article in the Telegraph about privatization as a solution to the tragedy of the commons.

He rightly points out that many commentators fail to provide a sophisticated analysis of the markets vs gov't trade-off. Dillow deserves kudos for mentioning (if only briefly) the work of Elinor Ostrom in analyzing non-market and non-gov't solutions to the tragedy of the commons.

However, his own analysis of the market vs gov't trade-off lacks the important insights of market process theory. His discussion of the role of transactions costs in the examination of this trade off is problematic as well. He writes:

As Terry Anderson has shown (pdf), the emergence of property rights requires among other things that technology permits a lowish-cost enforcement of those rights.

and later

 This is, of course, a variant on Coase's famous point (pdf) - that there are costs to market transacting. These costs must be weighed against the costs of other forms of economic organisation - be it the firm or state control.

There are a couple of problems here. He claims that property rights require "lowish-cost enforcement of those rights" and that said costs "must be weighed against the costs of other forms of economic organization." First of all, there is the question of who is responsible for "weighing" these costs. If it's the state, there is clearly an incentive for politicians and bureaucrats to claim the costs of property rights are too high and that the state should control the resource on efficiency grounds. The same incentive problem exists for firms that are in a position to lobby the state for exclusive rights to the resource. Markets are clearly at a disadvantage in these cases.

The other problem is a failure to understand the way in which the market process continually chips away at transactions costs. Take the used car market. The seller knows more than the buyer and so, theoretically, is in a position to take advantage of the situation. Had the gov't nationalized the used car market, say 50 years ago, we might not have ever seen the development of the wonder that is CarFax (which has been around since the 1980s). Akerlof's paper on the market for used cars wasn't, as some believe, an argument in favor of the gov't nationalizing this or that industry. It was an explanation for why we have warranties.

Here's Dillow again:

This applies to issues much nearer home. Whether public sector services should be privatized depends upon precise institutional detail: is it possible to write contracts which ensure a high quality of service without excessive rent-seeking? In Coasean terms, is the cost of market transacting lower than the cost of in-house production? 

The answer will vary from service to service and place to place.

And herein lies my beef. In the case of lions and the NHS, this point is overlooked in favour of ideological soundbites: "Markets - yay!" "Neoliberalism - boo!" In fact, the issue is more technocratic than that. It all depends upon subtle details.

What Dillow is missing here is that institutions and technology don't magically change independently of the choice of markets vs gov't. High transactions costs present a profit opportunity to firms. CarFax and Yelp exist because of this incentive. To the degree that gov't has control of an industry, this profit opportunity (and its associated benefits) is precluded.

There is a fundamental assumption of perfect knowledge on the part of the gov't (or whoever the Great Decider is) in Dillow's framework. Since this perfect knowledge isn't possible, the sort of cost-benefit analyses he says are required aren't possible. Understanding the market as a process, rather than a static black box, allows us to properly compare two imperfect institutions: markets and governments.