The unseen effects of government policy


Dr McLaughlin may have been honest, but his competitors were not. So instead of electric belts that cure everything, we only have vibrating belts that ‘aid’ weight loss.

When George Akerlof submitted his seminal paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism“, to the Journal of Political Economy, they rejected it on the grounds that if the paper’s theory was true then markets would simply not exist. After all, almost every market has some level of information asymmetry or information imbalance between sellers and buyers, and very few traded goods can claim to be truly, uniformly consistent in terms of quality. The implications of Akerlof’s paper were clear; so long as a market has an information asymmetry, and sellers know which of their goods are ‘peaches’ (a high quality product) or ‘lemons’ (a low quality product), then buyers will not take the risk of paying the price of a peach (for fear of receiving a lemon), and in turn sellers are not going to sell their peaches at the price of a lemon (because why would they?), and so there is no equilibrium price where buyers and sellers will trade and the market ceases to exist altogether. The Journal of Political Economy’s rejection pointed out that lots of markets have uninformed buyers and deceitful sellers, yet trade still occurs and markets obviously exist, so clearly something must be wrong with Akerlof’s paper or else “economics would be different”. Sounds like a fair point!

I don’t recall the exact quote, but Akerlof’s response to that critique went something like this: Maybe information symmetry hasn’t wiped out every market on the face of the earth, but how many markets would exist today if information symmetry *didn’t* exist? In other words, who knows if in a perfect world we would have had thousands or millions more goods and services to choose from, but because of information asymmetry those markets were wiped out (or never got off the ground to begin with) and we just don’t know it?

Picture the snake oil salesmen of the 1800s, roaming from town to town in the Wild West peddling their tonics and ointments to improve strength, cure disease, maximize libido, etc. Imagine if one of those salesman was indeed selling an honest potion that worked as advertised, but because his competitors were all frauds who hoodwinked their buyers our honest salesman couldn’t get his a fair price for his wares in any town which he set foot, so he gave up and eventually moved onto the next most popular occupation of that time (likely involving cattle or booze). Did the editors at the Journal of Political Economy consider the plight of our poor salesman in their curt response to Akerlof? Was he not a victim of the information asymmetry dynamic sketched out in Akerlof’s paper? How many more goods and services fell to the same fate over the course of history? And – most important of all, from a policy perspective – how many markets will fail in the future because of the information asymmetry risks that exist today?

I really like Akerlof’s answer, because it highlights an often overlooked question in cost/benefit analyses for government policy – over time, would a given policy make trade in future goods, services, or markets completely unfeasible? And is that an acceptable cost to future consumers, restricting their choice and ability to trade in order to pass the policy today?

Take trade policy, and specifically the Trump administration’s purported plans for implementing tariffs (import taxes? Dumping fines? Trump naughty fees? Not sure what to call this part of Trump’s ‘economic independence‘ plan). Passing tariffs will hurt consumers today through higher prices, but will also have a second order impact of destroying markets in the future that would otherwise exist in a tarriff-free world. For example – if Trump picks a trade fight with China, he may succeed in bringing parts of the technology supply chain back to the US, but he may inadvertently end the supply chain that would have helped develop the next big technology fad to follow smartphones and VR systems. I couldn’t tell you right now what specific technology product would no longer exist – but going back to Akerlof, we could be talking about thousands or millions of digital devices that could potentially disappear in Trump’s world if he were to restrict trade with China.

The same logic also applies to minimum wage laws, which many blue states are looking to aggressively raise. Taking a simple example, the restaurant industry relies heavily on below-minimum wage labor, not just in the restaurant service but also in the upstream farming/food picking/food sorting businesses as well. Because farms, food distributors, and restaurants are able to pay that lower wage, many unique restaurant types and cuisines exist throughout the country that save useless cooks like me and refined diners like you, dear reader, from having to subsist on Subway and Taco Bell – think of the various categories of locally sourced, farm-to-table, mom-and-pop, or ethnic cuisine restaurants that form a big part of the identity of cities like L.A, New York, and Seattle. Raising the minimum wage would have multiple impacts on the restaurant industry; making small restaurants less profitable to run, and making local food-supply chains more expensive. The consequence – fewer local farms and small restaurants are opened in the future. Instead, the future dining landscape is dominated by chains who are able to leverage economies of scale to pay higher wages to service staff, and can consolidate food supply chains nationally/internationally to reduce costs. Would the loss of the small, locally run restaurants that form a big part of the culture of American cities be sufficient to offset the gains from higher employment wages for a subset of workers?

My overall point would be this: market failures and regulations have an ‘unseen effects’ – affecting the existence of both real and hypothetical goods and markets. Those unseen effects can be a major burden on future consumers by restricting their level of choice, freedom, and consumption. When the cost of a government regulation is that it leads to entire markets and goods disappearing in the future, then you need a damn better reason than “I know what’s best” to justify enacting that policy.

Categories: Economics, Policy

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