The Economics of Enough_ How to Run the Economy as if the Future Matters - Diane Coyle [103]
What’s more, there is much empirical evidence that in many practical situations people with all their cognitive limitations and inconsistencies nevertheless do make choices leading to exactly the outcomes predicted by textbook economic theory. One of the pioneers of this research was Vernon Smith. He shared the 2002 Nobel Prize with Daniel Kahneman but popular attention has focused on Kahneman’s experiments casting doubt on market efficiency rather than Smith’s experiments demonstrating the validity of classical economic theory about markets. The dual award demonstrated precisely that both psychological frameworks, the rational and the “behavioral,” work in certain circumstances—the trick is in applying the right framework in a particular set of circumstances, and I’m not aware of any systematic approach for deciding this. Smith and others have demonstrated that markets frequently do deliver the efficient outcomes predicted by the theory, in effect through a process of trial and error.4 Participants do not consciously think of themselves as solving a theoretical economic model but nevertheless act as if they are following the laws of demand and supply—just as their physical movements show them acting as if they’re following Newton’s laws.
The experimental research has also shed much light on the way the rules of engagement in markets affect the prices and quantities. This literature has led to the creation of a discipline of market design. Governments have been able to sell assets for which it would once have been hard to conceive of a market—radio spectrum, for example, or permission to emit pollutants like sulphur dioxide or carbon. Market design can also improve the way government licenses are issued and sold, the way regulations are imposed, or even the way trading can occur on financial markets. In short, it acknowledges that markets are designed, and this can either be accidental or more deliberate. Given that government rules and laws set the framework in which all markets operate, how much better it is to think explicitly about their impact.
Markets are essential but flawed. They are essential for exactly the reason spelled out most clearly by Friedrich von Hayek, the conservative economist beloved of more recent free marketeers. That is that markets alone can encompass the masses of detailed information required to match demand and supply in an economy of any size and complexity, coordinating everyone’s activities through the signals sent by prices and the impact prices have on people’s decisions. In his 1945 article, The Use of Knowledge in Society, he wrote:
The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction.5
Hayek was highly influential in the move toward market-based approaches to economic policy in the 1980s and 1990s. The pendulum has swung decisively the other way, but it’s essential to hold on to the effectiveness of markets in so many circumstances.
In sum, it is markets that can meet the huge variety of different demands and wishes people have, and do so astonishingly efficiently, giving people great choice. It’s fashionable to say we have too much stuff, have become too materialistic. But markets don’t only deliver “unnecessary” goods, whether you think that means designer handbags or tacky plastic toys. Markets bring us a huge array of services from haircuts to design, an ever-growing number of book titles and movies, astonishing scientific and technological innovations at prices that the great majority of people can ultimately afford. Markets consolidate a vast amount of information in the price—information about companies’ costs, and about consumers’ preferences and demands. The prices set in markets in turn create incentives for behavior that will