Tuesday, August 08, 2017

A Refresher on Markets and Costs

In a capitalist society, people make mistakes about markets. I've blogged on this before. They attribute all sorts of erroneous things to markets: moral purpose, ethics, innovation, savings, the promotion of equality, the maintenance of democracy, etc. Some of this is not surprising. After all, if you live in a capitalist society, you tend to think that capitalism -- the use of markets -- is a good in and of itself that must be related to other goods. The problem is ... that these connections are problematic and tenuous. Markets do certain things. They have their uses and, even when they don't, there may be good reasons to not overly interfere with them because a high level of interference may hamper democracy. But, if we are going to effectively assess public policy -- the choices that we have before us as a society -- it is likely a good thing  for us to know what markets are all about and what they can and cannot do.

First, there is no necessary connection between markets and innovation.  Market theorists make this connection because they assume that everyone is motivated by a desire for cash. They call this self-interest as in we all want to be rich. This is actually problematic in terms of its veracity (but this is a discussion for another day).  This issue, like so many other issues related to markets, is an empirical question and not a theoretical question. Why? Because if we leave it a theoretical question ... what happens when we change theory? We get a different answer. If it is an empirical question, we at least have a chance of having a consistent answer. So ... do markets innovate?  The short answer is: not necessarily. There are been great innovations in human history without free markets (read over William Fogel's _Without Consent or Contract_). There have been amazing scientific discoveries (think Galileo) advances in mathematics and medicine, biology, genetics, amazing works of art were made and poems written. Today, perhaps the most innovative sector of the economy comes from the open source movements in software. Some people make money from this but others -- likely tens of thousands of others -- don't. Market economics can be innovative but so have been other economic systems and sectors of society that are de-commoditized.

Second, markets are efficient, as I have mentioned before, only if you use a specific definition of efficiency. For market economics, efficiency is getting a good to a person who is willing and able to pay for that good at the given price. It does not necessarily mean that more people get that good. To say this again, efficiency is allocation on the basis of desire and ability to pay. If I cannot pay for the good and don't get it ... that is actually a market efficiency. Sounds odd, I know, that impeding access to a good could be considered efficient but if you use the definition of efficiency used in capitalist economics, it is at least consistent.

An example a friend of mine used to explain this to me was downloading music for free (aka, pirating music). My friend argued that economists should, in fact, be happy with this because pirating music (aka, not paying for it), allowed people to make up their minds on the music to which they wanted to listen on the basis of the music (as opposed to having a cost intrude). He -- my friend -- did not expect free downloading to hurt innovation in music at all since, he believed, musicians would keep making music because that was what they did. Whether or not they were paid a lot for it, he said, would not affect the supply of new music since people will always make music. Hence, he was saying, the argument that we need to pay for music because otherwise people will not make it, was bogus.

What you can see in this example is that the argument for paying for music, then, has little to do with maximizing the distribution of music. Instead, it has to do with ensuring that those who can pay for music (a good) and like the music can get it. Thus, ability to pay is a key element of a market.

But, surely, at this point, someone says, markets lower the price of goods, increasing access to them. This is a key misunderstanding. Markets can work in this way, but there are limits. An example that is often used is one where there is no specific good in question. It goes like this: Company X produces good 1 and sells it for $1.00 per good, making a lot of money. The good is popular and there is, in fact, excess demand. Other companies notice X making money by selling good 1 and so they are drawn to the market and, because they are self-interested (aka greedy), they make the same good and lower their price in order to capture some of the market.  Company Z sells the good for $0.90 in order to undersell Company X. This forces company X to lower its price to $0.90. Thus everyone benefits. Because company X and Z are now making good 1, more of the good is make and the price is lower.

And, this can happen. But, not always. There are some instances where it might be good to *not* have new companies entering a market.  A key example might be industries that have something to do with national security. This could be weapons or anti-hacking software. Said differently, there may be security reasons to limit market access. This might not just involve the military. We might not care very much if there is a serious competition over companies looking to make toys for McHappy meals (although we want these to be safe), but companies that make airplanes or that run airports or make medicine are other matters.

In addition, there may be markets where the entrance costs are really high. Medicine is a key example of this. If you need the latest MRI or CT machine in your hospital ... well ... those are big start up costs. Running an airline (as we have seen in Canada) is another example. How many airlines have, in fact, failed in Canada (in one way or the other) over the last 20 years? Likewise, to continue this example, there can be markets where one product is connected to another and that connection cannot be broken. Think about the airports I mentioned earlier. Not only do these need to be heavily regulated for security reasons (meaning that you can't just open one up without some sort of government involvement), not only are there serious start up costs (how many of us have the money to just start an airport?), but the success of my airport depends on whether or not airlines use it and airlines will only use it if I have approval from government to run and airport, if it is safe, etc. In other words, I can't just open the Sackville International Airport and wait  for Air Canada to knock at the door.

I should note that I am not criticizing this. I am explaining the way things are. In general, I don't disagree with the restrictions on airports or the need for proper security matters. The point is to note the way in which there can be markets with very limited access owing to security, necessary connections to other products, the need for safety, and very high entrance costs (some things are simply expensive to build). What this means is that competitive markets become very limited or non-existent in some areas ...

... and health care, btw, is one of those areas.  There are all sorts of limits to market access in health care from the need to recruit highly qualified people, to building costs, to the costs of equipment, to the need for state oversight, to policing (we don't want people just strolling in and taking drugs and selling them on the street).

Third, markets are not about morality but are, in fact, a-moral. They do what they do without recourse to morality.  Sometimes, this means that markets will supply consumers despite the morality of those markets. Examples: dangerous and addictive drugs and child pornography.

In other instances, they do not lower prices or increase access (remember, again, they can but this is not an "always" situation). Can I give you an example? Yes, university tuition is the example I usually use. Imagine a university that has 100 students and charges $100.00 in tuition. It has a total revenue of $10 000. Imagine, further, that various costs (faculty, books for the library, grounds keeping, etc.) cost $9000.00. Our hypothetical university makes a profit of $1000.00 and it is happy. But, it can make more, It discovers that there are some people who really want a university degree and are willing to pay a lot for it (there could be all sorts of reasons for this, such as labour market integration).  It discovers that these people will pay not $100 in tuition, but $200.00.  The university now needs fewer students to make the same amount of money. Instead of having 100, students, it now needs to recruit only 50 students for make the same $10 000.00 in revenue. Moreover, because it only has half the number of students, a whole bunch of other costs can be lowered.  Our fictional university -- run on a market basis -- needs fewer recruiters, less books in the library, fewer dorm rooms, fewer faculty. In other words, it can cut its costs. Because these costs were realized on an economy of scale (see my post on 31 July about this concept), saving are not 1:1 but let's assume 25%. So instead of $9000.00, costs are $6750.00. Profits surge from $1000.00 to $3250.00.

All this was realized by actually reducing access and increasing costs. It is an example so before some says "you didn't calculate the cost of paper" or something like that, I know. The example is intended to illustrate a point and one that others have discovered already (this is Apple's model: they do not compete for what they view as "low end" markets). Fewer customers spending more can allow a company to realize a higher profit without any new investment. Our university could go the other way. It could try to increase student numbers to realize a profit but that would involve hiring more recruiters and faculty and building new dorm space, and the like. In other words, it needs to start competing in other markets that might have their own barriers to entry (you can only build new dorms, for instance, if you have land; if you don't, you need to buy it and if it is not available ... ).

Again, my goal here is not to say "here is everything that is wrong with markets" but to talk realistically about what markets can and cannot do.  They may promote innovation but innovation will occur regardless of markets and occurs for reasons other than the profit motive. Market economics promote efficiency but use a specific definition of efficiency that is different from common sense. These are confused at one's peril. Markets are not inherently connected to morality. Markets can facilitate immorality (in the case of child porn) or can focus on making money, which does not necessarily work to solve other problems. Where money can be made by lowering access and increasing costs (as opposed to broadening access and lowering costs), that can be a market stimulated choice.

There is more that could be said but I'll leave off at this point. There is an upshot to it, however, and that upshot is, in fact, the reason all governments seek state involvement in the economy. They do so in various ways and I am well aware that right-wing opposition politicians often talk about limiting state involvement in the economy. Once they get into power, however, and have to implement their policies, they discover that their discourse was just that: discourse. Barriers to market entry, security issues, morality, the need to deliver election promises, expanding capacity, providing further grounds for economic development (increased access to higher education), all begin to affect government decisions and even right-wing governments come to understand why we have a state and why that state needs to be involved in the economy.

Health care, as I said in my previous blog in the US, is a case in point. Here, premiums can be lowered by limited the access to health care if that access impedes profits or raises premiums. Unfortunately, the thing that increases costs in health care is sick people ... the very people who need the product.
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