Values, and Markets, and Commons

05Jan07

Commons are, in one sense, a means of allocating resources. Markets are another means of doing the same thing, so in developing the economics of commons, it is necessary to first deal with the notion that markets tend to create the optimal allocation of resources.

One great advantage of the marketplace, in allocating goods, is that market transactions simultaneously coordinate the benefits that people derive from goods as consumers, with the costs that people incur as producers in the making of the goods. The negotiation that goes on between buyers and sellers in the marketplace brings about this coordination of benefit and cost since goods for which buyers and sellers cannot agree on a common price will stop being produced. Once established, the market price that results from these negotiations provides, all in one package, information about what people want, information about what it is feasible to make for them, and incentives for everyone to do something about it. It’s a wonderful thing.

But we commit a fallacy if we then say that markets should be the sole means of allocating goods in an economy. Just because an institution has a virtue, we cannot conclude that it is entirely virtuous. Like any other institution, markets have strengths, but also weaknesses. And like many other factors of production, the weaknesses increasingly undercut the strengths if the market is relied on exclusively.

Since the strength of the market lies in coordinating benefits with costs, let’s look at two specific problems of market allocation that effect the measurement of benefits and costs: the way that benefit measurements are skewed by income, and the way that cost measurements are skewed by market power.

In an auction where everyone starts with the same amount of money, the bidding for a variety of goods will result in each person getting the goods that they want most. The outdoorsman will end up with the camping tent because he’ll bid more for it than the guy who is a couch potato. The couch potato, in turn, will bid more for the outrageously large TV than the triathlete, and the triathlete will end up with the bicycle because she bid the most for that. Starting with equal resources, their relative bids reflect the actual differences in their relative desires for the different goods, and its easy to see how competitive bidding brings us to an optimal solution that maximizes value for everyone.

But the moment that we eliminate the equal distribution of income, this automatic maximization of value ends. To start with the extreme case, let us say that our outdoorsman suddenly inherits more money than the rest of the bidders combined. In this scenario, the outdoorsman can now buy all of the goods, leaving nothing for the others. The preferences of the parties involved have not changed, nor has the usefulness of the goods, but the change in relative wealth changes the allocation of the goods entirely. Which is to say that, if the income distribution in our little community becomes sufficiently skewed, then the prices and allocations created by bidding in the marketplace no longer reflect or communicate anything meaningful about the value which these goods could bring to the community. Every couple of weeks the outdoorsman decides he feels like watching TV for an hour, and when that happens he always uses the bicycle to peddle over to the local grocery for a couple of beers to sip while he watches. Otherwise, both the television and the bicycle sit unused and wasted. A sufficiently skewed income distribution keeps them from going to the people who would use them to maximize their realized value.

Having the outdoorsman possess more money than the rest of the community combined is an extreme case. But I hope it is apparent that the divorce between the market outcome and the optimal outcome occurs for any level of income inequality. To the degree that incomes and wealth are not equal, then a market allocation is not inherently optimal, or let’s say that reaching the optimal allocation through a market becomes a matter of luck and the odds of getting lucky go down in direct proportion to the degree of income and wealth inequality.

None of this constitutes an argument for abandoning markets entirely and embracing some centrally-planned, equality-enforcing state. But it does constitute an argument for acknowledging that markets, like all institutions, have inherent faults and weaknesses along with inherent strengths and virtues.

Of course, market outcomes aren’t purely a matter of distributing goods to potential consumers, they are also a comparison of benefits to costs. However, the market’s assessment of costs is also susceptible to skewing by market conditions. In this case, I’m thinking about market power.

The supply and demand model of classical economic theory shows how sufficient competition between firms creates a market price that perfectly captures the price of production of the product. The pressure of competition means that a producer can charge a price that covers the expense of all the factors that go into the product and nothing else. But there are few industries that can be described as being in or near a state of perfect competition in the United States or any other industrial economy. Industrialization tends strongly towards firms with significant market share, sufficient share to constitute market power as defined in the theory of monopolistic competition. And the bedrock fact of market power is the ability (or the necessity, if you are a profit-maximizing corporation) to set a price above the marginal cost. Because of this, market prices reflect, not just costs, but the differing levels of market power of different producers in different industries. Just as market outcomes reflect the distribution of wealth among consumers along with consumer’s actual demand for a good, market outcomes also reflect the degree of competition in an industry, along with the costs of producing a good. In both of these ways, the calculation of benefit and cost by the market is distorted by other factors.

And there is no question but that these other factors are inherent in markets. The market steers producers towards the best use of their resources by rewarding people who can successfully trade with consumers more than it rewards people who cannot, or can less. When you reward people differently then you have income inequality, and eventually, wealth inequality. Eliminate the inequality and you eliminate the ability of a market economy to guide people’s efforts and achieve the productivity and efficiency which markets are famous for.

A vital question for social policy is then whether or not market-generated inequalities tend to be re-absorbed; canceled out by other and newer developments. If that is so then inequalities of wealth and market power may not be significant for social policy. But if market-generated inequality feeds on itself, then you end up with millions of working people who can’t afford health care while a Paris Hilton does nothing productive at all but ends up with hundreds of millions of dollars. At that point, a significant fraction of what occurs in the marketplace no longer bears any resemblance to the actual contributions being made to the economy or the optimal distribution of goods from the economy.

Leaving that question aside, my argument here is that markets have inherent flaws as well as inherent strengths, and as we have seen with income and wealth inequality, the strengths and flaws are the two sides of the same coin. The policy implications of this analysis comes from the question of whether or not we always receive the flaws and strengths in equal measure, or if markets have a net benefit function that shows increasing net benefits up to some optimal point and then diminishing (or even negative) net benefits after that point.

If the latter point is true, then past the sweet spot of using markets to organize the economy, you need to complement them with other institutional arrangements. Like commons.

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