Some years ago, Nobel Prize-winning economist Robert E. Lucas, Jr. was asked what subjects he thought were on the economics frontier. He replied, “In economic policy, the frontier never changes. The issue is always mercantilism and government intervention vs. laissez faire and free markets."
Many economists would agree: the fundamental issue in applied economics is how much of the economy's goods and services should be allocated by government and how much by markets. Some economists, including me, believe that the burden of proof should almost always rest with those who advocate government allocation. Over the last thirty years, my side has convinced a few people, but we haven't--this is a significant understatement--convinced everyone. And we may now be losing ground.
I think this is partly because we have not argued our side as well as we could have. In economics courses we focused for too long on the model of perfect competition and its aptly-but-creepily-named Invisible Hand. The formal model is abstract; it rests on extremely restrictive assumptions, assumptions that are easily criticized; and as one famous economist, Harold Demsetz, pointed out long ago, it is not really a model of competition at all.
A better way to try to convince people is to patiently accumulate and present many examples of the market at work. These examples, in turn, can be shown to rest on a simple premise: the market provides big incentives to enhance social welfare. The argument for government intervention is usually either that something good is not being provided, or not being provided sufficiently, or else, something bad is not being stopped, or not being lessened sufficiently, by the market. But in all such cases, there is a huge profit incentive for someone to solve the problem. And experience shows that individuals in free markets are incredibly imaginative and resourceful in doing just that. (The solutions require that the individuals be able to appropriate some of the gains from the solutions but that requirement is also subject to satisfaction through imagination and resourcefulness.)
Which brings me to John R. Lott, Jr.'s new book, Freedomnomics. (Amazon states it will be published June 4, but my older daughter has already seen it in D.C. area bookstores. I got an advance copy courtesy of John.) Freedomnomics focuses on incentives. It presents a wonderfully rich set of examples of how people respond to incentives. No background in economics is necessary to understand and enjoy these examples. The book uses them to make four points.
1. Problems that the market supposedly can't solve often are. My favorite example of this in the book is radio. In the early days of radio broadcasting "radio hosts and entertainers usually had to work for free" (p. 87, footnote omitted). No one had figured out how to make radio a viable business. The problem was that once a radio show was created and transmitted through the air, anyone with a receiver could listen. So why would listeners pay? Note that this is an example of the infamous free rider problem by which the market allegedly sometimes fails to provide good things. But in 1922, with the "discovery" of advertising, radio became a viable business. Another example of a supposedly difficult problem is that a new car's value plummets "as soon as a buyer drives it off the lot", but Lott reports that this isn't, factually, really a problem (pp. 35-37). A third alleged problem is that businesses will try to cheat and defraud customers. But Lott describes in detail a market mechanism--reputation--that strongly disciplines such attempts (pp. 49-82).
2. If "bad" practices persist in the market, we almost always find that these same practices also provide large incentives for socially good things. Why is there "price gouging" after disasters? Why are pharmaceutical and gasoline prices so high? The puerile grandstanding of politicians who try to make "price gouging" illegal notwithstanding, these high prices are usually due to the fundamental forces of supply and demand, and these same high prices induce firms to produce more of scarce goods. More production has large social benefits (pp. 15-24). Why are alcohol sold in restaurants and short-notice air travel priced so high? They are both more costly, albeit in subtle ways, to provide (pp. 27-30).
3. On a couple of topics that aren't directly related to the government vs. markets issue, Freedomnomics shows how people's response to incentives can explain important social phenomena. For example, why did the crime rate in the U.S., which rose sharply in the 60s and the 70s, decline during the 90s? Lott argues that increases in the arrest and conviction rates, the increased penalty for serious crimes (the death penalty), and the spread of concealed-carry laws--all of which operate directly on the incentives of criminals--explain a substantial part of the decline (pp. 132-144). Also very interesting is Lott's explanation for why government has gotten so big: women's suffrage (pp. 160-66).
4. Finally--and a good reason why advocates of government intervention should have the burden of proof--Freedomnomics explains, and illustrates, why incentives for government employees to increase social welfare are weaker, or are even sometimes perverse. He reviews the examples of the 1980s savings and loan crisis, government flood insurance, and eminent domain (pp. 89-91). Less familiar to most readers will be the theory and evidence that indicates incentives for "predatory" behavior--much feared but infrequently observed in the private sector--tend to be quite strong for government-owned enterprises.
It should be noted that while Lott discusses these topics without using math and without presenting much technical detail, his discussion draws on his professional research, research that has been published extensively in the economics profession's leading peer-reviewed journals.
This is a fine book. It is an especially good book to give to a young person who hasn't made up his or her mind about public policy issues. It is also a good book to give to Liberals, especially the very angry kind. It will probably annoy the hell out of them, which is one of the few good things currently insufficiently provided by the market.