The Efficacy Of the Market

Extract from Chapter 2, The Commercialisation of New Zealand.

Keywords: Health; Regulation & Taxation;

This is not an economics textbook, so we simply report a substantial body of economic theory as follows. The market may be thought of as a signalling system which coordinates the decisions of the various actors in an economy. It has two key features. First under certain circumstances (key features to be outlined shortly), the price signals reflect the social value of the resources being used or traded. Second the signalling system is self-enforcing, in that the actors have a practical selfinterest in obeying the signals.

The central notion here is that the price system sends signals which reflect social values which people act on. If you go into a shop and purchase a loaf of bread for a dollar, the price signal of the dollar says that the social cost of producing that bread was one dollar. Presumably your purchase reflects your belief that the bread is worth to you at least one dollar, so you are better off, and society (or, in this case, the shopkeeper) is no worse off, because it has exchanged something which was worth a dollar, for a coin which can be exchanged for something worth at least another dollar.

If every economic transaction – including trade but also the transformation (production) and use of goods and services – takes place under the conditions in which individuals participate only if the transaction makes them better off, then it may be there is an ongoing increase in general welfare of the individuals as each transaction occurs. Even before the modern computer was invented, economists saw the market economy as a computing device which enabled the economy to attain some maximum welfare. This simple idea hides a minefield of complexities, which economists have struggled with since at least the time of Adam Smith, and which no short account can summarize. But there are some critical issues for our purposes.

First, observe that whether the loaf is worth a dollar to a person not only reflects her or his personal circumstances and preferences, but also the quantum of money (or income) possessed. A person down to their last dollar is much less likely to part with it for the bread than a millionaire. Thus any social value embodied in the prices reflects the distribution of income and wealth in the nation. If the distribution was different the price signals might be different.

Second, we have to suppose that the individual has a clear idea as to what they are purchasing. This is not simply a matter that sometimes one sells an old couch without knowing there are some fifty dollar banknotes stuffed down the back. In many cases the product being transacted is extremely complex, with multifaceted aspects – a car, a medical service – so there is a problem about how well informed is the purchaser
Third, sometimes the transaction may have side effects which may be detrimental or beneficial to those not involved in the transactions and whose interests are not taken into consideration. The traditional example was a production process involving chimney smoke which pollutes the air, with soot descending on the neighbours’ washing. (Ironically while such polluting does not happen so much today, there is now the problem of the greenhouse effect, where carbon emissions into the atmosphere contribute to global warming. Today’s `neighbourhood’ may be the whole the world.) The soot involves the neighbours in additional costs which are not usually taken into consideration during the market transaction. Thus the price signals of the value of the good to the purchaser may not reflect the full social cost. Such phenomena are called externalities, briefly defined as the costs and benefits of a transaction which are not taken into consideration during the (internal) decisions concerned with the transaction. Externalities need not be detrimental.

Fourth, a standard market framework may be practically impossible. For instance it has not been practical to charge for a broadcasting transmission. Eventually cheap effective charging systems may be developed, but there are always other things in a society for which the market is totally inapplicable. How does it incorporate the values of honesty and kindness.

Fifth, in order to have some social optimum we require that the transformations and trade use the minimum possible resources. This is the `efficiency’ criteria. (Chapter 3) To use more would be to waste resources which could be used elsewhere to produce other goods and services, and an even better social outcome. A means of attaining this efficiency – one which is assumed in the market models we are considering here – is that the transactions take place in competitive markets, where competition means that there are numerous agents (firms) buying and selling (consuming and producing) in the market, none of which has significant market power (or influence). If there is not the competition, then the agents have less incentive to seek the most efficient (least wasteful) means of operations. A more complicated case is where there is a monopolist, because even though its internal operations are efficient, it will use its market power to set prices above the level which reflects social costs, so distorting the market signalling system.

This brief review of the strengths and weaknesses of the market casts some doubts upon the efficacy of the market for achieving best economic outcomes. The next question is harder. What is the alternative?

Before answering the question specifically, the general point must be made that there is no perfect solution to organizing something as complex as human society. Every method of organization resolves some of the difficulties, but other difficulties remain, are compounded, or are created. In practice there have to be compromises, in which worst outcomes are blunted, but some inevitable issues remain unresolved.

The world is populated with snake-oil merchants who have instant and simple solutions to every problem. It is easy to identify the charlatans by their failure to mention any side effects or disadvantages of their remedy. If negative consequences are not mentioned, either the advocate does not understand what is being proposed (which is incompetence), or does understand but does not want anyone else to (which is deceit). Often the quacks combine both ineptitude and dishonesty. That they have some qualification or position of power does not make their claim any more acceptable.

All the easy solutions to social problems have almost always been adopted, for the obvious reason that they are easy. The difficult problems, for which there are no easy solutions, are left. This is not to argue that improvements are impossible. First, society may want to change its trade-offs between what is acceptable and what is not. For instance past solutions treated women in ways which are likely to be unacceptable today. Second, new circumstances may offer new possibilities for solution. If free-to-air broadcasting evolved because charging was expensive, the feasibility of pay-TV opens new possibilities which may (or may not) lead to a better broadcasting system.

Designing an Economic System

There is not the room here to discuss all the possible designs of an economic system, even were we to confine ourselves to possibilities for late twentieth century New Zealand. Instead we begin with the vision of a social democrat, Australian social theorist Michael Pusey, author of the influential Economic Rationalism in Canberra, who wrote:

A first assumption of social democrats everywhere is that nation societies (and federations such as the emerging Europe) have not one coordinating structure but two. On the one side they have states, bureaucracies and the law, and on the other, economies, markets and money. It is with these structures we collectively coordinate our relations with the rest of the world, our work, our social interactions, and most other aspects of life we understand as `civil society’ and normatively define with notions of citizenship, democracy, and human rights.

While we may wish to refine the details of Pusey’s account, the notion of there being at least two coordinating systems of social activities is central to a modern democracy. Sometimes it uses bureaucratic coordination, sometimes market coordination, and often a mixture of the two.

However this vision does not tell us which coordinating system is to be used in any particular situation. For a social democrat, that is a pragmatic decision in which the various advantages and disadvantages of outcomes are weighed. Very often some mix of the two modes of coordination are synthesized. Chapters later in the book examine particular cases.

As it happens the production and distribution of most goods and services is left to the market mechanism, with a minimum of bureaucratic intervention. Even under the most interfering period during the Muldoon regime the production and purchase of bread was largely determined by market behaviour, as was that of other goods and services. Indeed it is very difficult for the bureaucratic mechanism to over-ride the market mechanism, where the conditions described above – of the market acting as a enforceable signalling system for social value – apply.

Where the conditions do not quite apply, so that the signalling is not quite perfect, it may nevertheless be better to rely on the market mechanism, since the alternative is likely to be much less satisfactory. Sometimes the bureaucratic mechanism will operate so as to enhance the market mechanism. The appendix describes how complicated bureaucratic interventions in the environment were replaced in the 1980s with ones based more on the market mechanism. Another example is the conscious strategy of `internalizing externalities’ by levying excise duty on alcohol and tobacco, so that their market price better signals the social costs of their consumption which are otherwise ignored by drinkers and smokers.

The advantage of the market mechanism is not only that it can often (albeit roughly) signal value the social value of resources. It is also self enforcing. On the other hand the cost-benefit analysis approach discussed in the previous chapter, is also a signalling system, but it is not self-enforcing. If proponents assumed project parameters, to get their desired outcome, there was no penalty to the advocates for getting a CBA wrong – only to the economy.

The Self-enforcing Market

To explain the strengths and weaknesses of the self-enforcing market mechanism we use `principle-agent’ analysis, and contrast a standard economic transaction where the self-enforcement works well, with a medical one, where it is markedly less effective. An agency relationship arises when one party (the agent) acts in the interests of another party (the principal). There are two crucial differences between the agent and principal; a divergence in interests between the two parties, and an asymmetry – an imbalance – of information between them. How are the interests of the principle and agent to be reconciled/

Consider a standard market transaction of purchasing bread. Suppose a person who in this case is the principal, goes to a shop to purchase the bread, where the shop assistant is the agent. As well as the transfer of product and money
– someone decides on the transaction;
– someone funds the transaction;
– someone/thing regulates the transaction.

In the case of the purchase of bread the situation is
– the decider is the principal (the shopper);
– the funder is the principal;
– the regulator is competition backed by the law.

Note that the agent’s interest is to sell the bread for the highest possible price, while the principal has an interest in the quality of the bread at the lowest possible price. The agent probably knows much more about the quality of the bread, its cost, and the going price in other shops. Yet the principal purchases from the shop, usually without looking at every other possibility and usually with only the most cursory assessment of the bread.

What makes a transaction possible despite the divergence in interests and the asymmetry of information? The answer is complex, and related to the regulatory environment.
– It is a repeated transaction. If shoppers get a bad deal they do not have to go back to the shop again. This is an incentive for the agent to perform well on the principals’ behalf to get the best long-run return.
– Competition is crucial. If the shopper had to go back to the same shop every week perhaps the service would not be as good.
– The transaction is underpinned by law. Few shoppers know their exact rights, but if anything dreadful happens – say a mouse inside the bread – there are channels for redress. The mere threat of litigation and public exposure keeps most shop owners very mindful of their customers’ interest: a court case is not only expensive, it could also be ruinous to the shopkeeper’s reputation.
– Although there is asymmetry of information between the purchaser and provider, it is not great, and in this case `the suck it and see’ test is relatively inexpensive.

There is a sort of `miracle’ of the supply of bread, for there is no dictator or bureaucracy who decrees that it should happen. Despite involving numerous people – cereal farmers, truckers, millers, bakers, and shopkeepers – most of whom are anonymous as far as the consumer is concerned, the market coordinates all their activities to provide the bread required. Principal-agent theory points out that in each transaction through to the consumer the incentives are aligned so that the myriad of complex transactions are effectively coordinated to supply us with our daily bread.

However, in most medical transactions the principal (the patient) is unlikely to be the decider. One of the reasons patients go to a medical professional (the agent) is because they do not have the technical information to diagnose and treat their conditions. In principle an unscrupulous doctor could commit the patient to all manner of treatment, without the patient being able to judge the appropriateness of the therapies.

Not only are patients typically not the deciders, at least not practically, but they are rarely the full funders. The incidence of disease is erratic. The patient may have medical insurance, while the community also moderates a full user-pays approach to health care for reasons of equity, and because private medical insurance is not an especially efficient way of covering for the erratic incidence.

If the decider is not the funder, the principal and the agent – that is the patient and the doctor – have an interest in pursuing a transaction (a treatment) without reference to the cost, since it will be borne by someone else. This is obviously true for the public health system, but it also applies to private medical insurance. Practically the patient and doctor can conspire against the medical insurer to generate treatments which are not in the insurer’s interests, nor in those of the economy as a whole. The resulting outcome can be very inefficient.

Because the principal – the patient – is not the decider, competition does not work as a regulator; and as the American experience shows, law – at least malpractice law – is not especially effective either. That is why most countries use additional regulators such as professional ethics, supervision, peer reviews, requirements for informed consent, and direct involvement, including the controls which exist in a hospital over the resources that its clinicians use, and government ministries getting involved in the minutiae of medical practice.

To summarise, in comparison to the standard market transaction, the typical medical transaction is as follows. While the provider (the health professional) is again the agent, and they receiver (the patient) is again the principal (but may not be the purchaser);
– the decider is usually the agent (rather than the principal);
– the funder is usually someone else other than the principal;
– the regulator is competition backed by the law as occurs in the standard market transaction, plus a range of other regulatory mechanisms.

As the self-enforcement mechanism of the market fails, bureaucratic mechanisms come into play.

The reader will observe here a very pragmatic account of the choice, in any particular instance, between the degree a society uses the bureaucratic mechanism for social coordination, and the degree to which it uses the market mechanism for coordination. The market mechanism, or the bureaucratic mechanism, is a practical means to a higher end. However, the commercialization strategy was not simply a practical application. It was enthusiastically applied to situations which economic analysis by itself could not justify. Indeed commercialization seemed to become an end in itself. Its justification was ideological.

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