Nirvana Fallacy Watch: Stiglitz Edition

by Levi Russell

Joseph Stiglitz recently put out a column called "Monopoly's New Era." He starts off with the standard story that unregulated markets lead to monopoly and that anti-trust is an important check on that process. He talks specifically about power relationships and gives the example of asymmetric information.

Stiglitz claims that, since perfect competition theory can't explain many of the monopolized industries we have today, that his brand of economics, which takes the tendency of "unregulated" markets to monopolization as a fundamental assumption, is rising in popularity.

That may be the case, but, I think, not for the right reasons. Stiglitz seems to think that Smith, Schumpeter, and other "free market" economists take a simplistic econ 101 view of competition:

In today’s economy, many sectors – telecoms, cable TV, digital branches from social media to Internet search, health insurance, pharmaceuticals, agro-business, and many more – cannot be understood through the lens of competition. In these sectors, what competition exists is oligopolistic, not the “pure” competition depicted in textbooks. A few sectors can be defined as “price taking”; firms are so small that they have no effect on market price. Agriculture is the clearest example, but government intervention in the sector is massive, and prices are not set primarily by market forces.

Of course, free market economists don't take that simplistic view, as I've discussed previously here, here, and here. It is this comparison, between wise intervention tutored by Stiglitz's theories and the vagaries of the free market, that I think is problematic.

Stiglitz is right to point out that many industries lobby for special government favors, but he doesn't acknowledge the reality that policies designed to correct market failures are often the cause of monopoly. As I noted in a previous post:

Government regulations essentially amount to fixed costs that prevent new firms from entering markets and existing smaller firms from competing with larger firms. Maybe these regulations are still justified, but it's not plainly obvious using the static model Thoma seems to prefer. From their inception, anti-trust suits were and still are brought mostly by competitors, not consumers. A look at the data from the late 19th and early 20th centuries doesn't tell the same "Robber Baron" story we hear in 9th grade history texts. Output was expanding and prices falling in the industries accused of being dominated by monopolies.

Stiglitz's mistake is that he compares the real world with a rose-tinted view of government regulation:

Many of the assumptions about market economies are based on acceptance of the competitive model, with marginal returns commensurate with social contributions. This view has led to hesitancy about official intervention: If markets are fundamentally efficient and fair, there is little that even the best of governments could do to improve matters. But if markets are based on exploitation, the rationale for laissez-faire disappears. Indeed, in that case, the battle against entrenched power is not only a battle for democracy; it is also a battle for efficiency and shared prosperity. 

Arnold Kling's article on Masonomics effectively responds to Stiglitz's claim:

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market. 

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets. 

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell. 

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.

Stiglitz is right that static models of perfect competition don't explain the economy well, but he makes an unfounded leap of logic based on his idyllic view of policy. Harold Demsetz warned about these leaps of logic when he wrote about the Nirvana Fallacy. Avoiding this fallacy is, I think, an important part of policy analysis.

P.S.
Don Boudreaux points to one tragically bad prediction of Stiglitz's model: Venezuela.