Inside Story

Markets are great, except when they’re not

Books | John Quiggin’s new book should be compulsory reading for policymakers and commentators

Richard Holden 14 May 2019 1215 words

The man behind the hand: philosopher Adam Smith watching over Edinburgh’s High Street. George Clerk/iStockphoto

Economics in Two Lessons: Why Markets Work So Well, and Why They Can Fail So Badly
By John Quiggin | Princeton University Press | $29.99 | 408 pages

I’m not sure that the title of John Quiggin’s wonderful new book exactly plays fair. After all, Economics in Two Lessons does run to sixteen chapters, and I certainly learnt more than two things from it.

The title is a play on Henry Hazlitt’s 1946 book Economics in One Lesson. For Hazlitt, the key lesson of economics is the power and virtue of the free market — and his one lesson is basically that we need to get out of its way. Quiggin has no quibble about the power of markets, but he wants to sharpen our focus on the flip side of that coin — their limitations. Hence the two lessons. For me, Quiggin’s book might just as aptly be titled Markets Are Great, Except When They’re Not.

This message comes at a crucial time for public policy debates, in Australia and around the world. The nature of our political choices — seemingly between free-market fanaticism and democratic socialism — might easily be captured in a 2020 US presidential contest between Donald Trump and Bernie Sanders. As is usually the case, though, things are a fair bit more moderate in Australia, but here, too, pro- and anti-market camps seem to dominate, with little middle ground.

Quiggin’s way of reconciling the virtues and vices of markets is to observe that “market prices reflect and determine opportunity costs faced by consumers and producers.” This is Lesson One. Lesson Two is that “market prices don’t reflect all the opportunity costs we face as a society.” That is, there are externalities that fall outside the price mechanism and drive a wedge between the outcomes markets deliver by themselves and the social outcomes we would like them to deliver. The classic example of a negative externality is pollution, and the classic way of dealing with such externalities, as first proposed by the British economist Arthur C. Pigou in 1920, is to tax them.

Quiggin helps us understand how market-failure problems like pollution can be understood in terms of opportunity cost, but he includes the other big market failures as well: unemployment, monopoly and under-provision of public goods. He then takes this Lesson Two, Part I out for a spin and applies it to policies to deal with income distribution, mass unemployment, and environmental policy.

Quiggin’s treatment of the basics is accessible but comprehensive. He introduces the idea of “opportunity cost” and illustrates it in terms of both consumption decisions and household production. We then move on to the idea’s too-little-known intellectual history, which brings in Benjamin Franklin, Friedrich Hayek and the pioneers of modern taxation theory Peter Diamond and James Mirrlees.

This key building block is then embedded in a market in chapter two, where we learn that market prices provide information about opportunity costs. The logic flows beautifully into the concept of comparative advantage, the gains that come from trading, and the inescapable conclusion that market price must capture all the gains from “mutually beneficial exchanges.” And, although it appears in a footnote, this is the point at which we can conclude that a competitive equilibrium yields a Pareto-optimal allocation of resources — the “first welfare theorem” that establishes the conditions under which Adam Smith’s aphorism about the “invisible hand” is true.

The world is more complicated than the rather stylised one developed to this point, so Quiggin adds some complications — time, information, uncertainty about the future — and shows in chapter three how the previous Lesson applies in these richer settings.

Chapters four to six put this — what a Chicago economist would call “price theory” — to work. Price theory helps us understand why rent control is typically bad, because it drives a wedge between the prices people are willing to buy and sell at; how we can think of one of war’s downsides as the opportunity cost of peace; why natural disasters are usually economic disasters; and why, in fixing social problems, one often wants to fix the allocation of property rights.

Quiggin then seamlessly switches gears to discuss macroeconomic fluctuations and the business cycle, and again weaves through the narrative the need for government to play a role in smoothing out fluctuations. Aware that some readers will query the transition from microeconomics to macroeconomics, he questions the very premise of the distinction:

In standard economics courses, analysis of opportunity cost and market failure is typically confined to courses on microeconomics. This is a mistake. Lesson Two tells us that market prices don’t reflect all the opportunity costs we face as a society. There can be no clearer case of this than that of an unemployed worker, willing to work for the prevailing market wage, but unable to find a job. Workers trade their labor for the goods and services that they buy with their wages.

Under conditions of high unemployment, workers would like to make this trade at current wages and prices but are unable to do so… Mass unemployment, then, is a clear illustration of Lesson Two. The market wage does not reflect the opportunity cost faced by unemployed workers, who would willingly work at this wage and could, under full employment conditions, produce enough to justify their employment.

The succeeding chapters highlight the downsides of monopolies — again because they cause private and social benefits to be out of alignment, both in the product market and the increasingly in the labour market. Pollution and public goods are treated comfortably within this framework as well.

If there is one chapter that comes across as a slight stretch it is chapter eleven, which covers information, uncertainty, bubbles, the efficient markets hypothesis and behavioural economics. To be fair, this is hard material to integrate. For me it seemed something of a missed opportunity: after Quiggin introduces the economist Friedrich Hayek’s extraordinary 1945 article, “The Use of Knowledge in Society,” he could have more fully explored the connection to the rational expectations equilibrium models developed by Sanford Grossman, Joseph Stiglitz and others in the 1970s and 80s.

Chapters twelve to sixteen deal with what policymakers should do, and here Quiggin’s passion is evident. Moreover, what comes through perhaps more than anything is a sense of balance. There’s what we might want to do and then there’s what the immutable laws of economics — so neatly laid down in the preceding chapters — will let us do. Whether it’s the distribution of income, full employment, or protecting the environment, constraints exist.

But those constraints offer guidance. Quiggin notes, for instance, that “the best way to help poor people, at home and abroad, is to give them money to spend as they see fit, rather than tying assistance to particular goods and services. In other words, it is better to fix the inequitable allocation of property rights in the first place than to fix the resulting market outcome.” Whatever the topic, the framework disciplines and sharpens the policy thinking.

There is little doubt that Quiggin’s Economics in Two Lessons will be an instant classic and feature on university reading lists around the world. It should also be compulsory reading for policymakers and public commentators, who all too often lack a framework for thinking clearly about the costs and benefits of markets. The good news is that Quiggin has one — and he’s happy to share. •