Markets, Incentives and a Krugman (et al.) Fail

Pity the poor teenager taking an AP Economics course whose father is an economist. Especially when the local school district has adopted a text that is based on Paul Krugman’s Economics (3rd ed., coauthored with Robin Wells). Even more especially when the father-economist has a fundamental disagreement with much of what Mr. Krugman has become since surrendering his academic credentials for political punditry. Yeah, that’s my lucky kid.

So of course, I had to thumb through the text. I suppose I shouldn’t have been too surprised to find on only the third page of Module 1 a gross error in explaining the trouble with command economies. After explaining the failed history of command economies, the text asserts (p. 3):

At the root cause of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices.

Where to start? How about with the simple fact that incentives always exist, no matter the type of economy. And there were plenty of incentives in the former Soviet Union (the textbook example of a command economy–literally in this case). I remember the late Nobel Prize-winning economist James Buchanan sharing the story of his visit to Moscow shortly after the fall of the Soviet empire during which he was surprised to learn of a market for burned out light bulbs — because people could use them to steal working light bulbs from their workplaces when they couldn’t get light bulbs in the stores. People responding to incentives. It’s The Basics 101. The problem with command economies is not a lack of incentives–but a lack of incentives that are based on the wants of consumers themselves and a lack of incentives for innovation or efficiency. In short–the absence of the incentives created by a free market economy.

More importantly, the focus on incentives misses the point in a way that has significant implications for what the text goes on to say about economic policy. At the root of the problem with command economies was the lack of information available to decision-makers about the wants and desires of an entire population of individual consumers with different tastes and preferences and about the conditions of scarcity and desires in dispersed local markets across the society’s economy. As F.A. Hayek (another Nobel Prize winner) explained, the fundamental role of markets is to discover and reveal information based on the complex interactions of individuals across product types and geographic space.These interactions result in prices that reflect the relative scarcity and value of goods across society. Those prices create incentives, and those incentives are fundamentally important in guiding individuals to use their resources in ways that innovate, create value, and serve consumers. But the incentives are secondary–derived from the information discovery role of the market that cannot be replicated in a command economy.

Why is this such an important distinction? Because of the way the text goes on to describe the objective of policy making. After (fairly accurately) explaining how prices create incentives, the authors state (p. 3):

In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to do so is more likely to succeed.

The implication? All we need to do is create incentives (implicitly, in the form of taxes, fines or subsidies) to create financial incentives for manufacturers (or people) to do what we want them to do. But this line of argument ignores the more fundamental question of determining whether the plan makes social or economic sense in the first place. What is the economic basis for whether we uses fines or subsidies and how large they should be? At what point, if any, would doing nothing be economically more efficient than doing something? By taking away the fundamental information function of the market and jumping immediately to incentives, we skip the whole messy discussion of the information requirements by legislators, bureaucrats and policy makers in coming up with “the plan” to begin with. All we need to do is trust the omniscience and beneficence of policy makers to know what the “right price” is–and to set arbitrarily the incentives to get the outcomes we want. But that’s exactly why command economies fail.

The root problem of a command economy is not that there are no incentives, but that there are socially inefficient incentives. The incentives are socially inefficient because it is impossible for a central authority to know the value individual citizens place not only on existing goods and services, but on the latent value of potential goods and services that can only be discovered by innovation and experimentation–and a central planner cannot think beyond her own imagination in the realm of possibilities. And it’s not only true of Soviet-style planned economies, but of any central decision-making authority–including the US federal government–even in the context of a heavily market-dominated economy.

Note: AP Economics students (and teachers), remember….the correct answer on the test may not be the right answer in reality. Answer the questions from the textbook based on the information in the textbook. But in your real life as a consumer of information and participant in the market place of ideas and politics, be sure to get to the fundamentals rather than the superficial.

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