Posted by: captainfalcon | June 25, 2013

Infomercial Alert: A Sketchy Review of Libertarian Paternalism, Path Dependence, and Temporary Law

This is an interesting essay on path dependency in markets.  Its basic claim is that  even competitive markets can sometimes find themselves in a inefficient equilibria, and that passing temporary law isa low-risk way for government to shift them from those equilibria to more efficient ones.*  It is thus an argument for regulation of competitive markets that is consistent with the view that promoting efficiency (or something in its ballpark) is the only legitimate purpose of market regulation, which is what makes it interesting.

Competitive markets can find themselves in suboptimal equilibria as a result of path dependency — i.e. as a result of the happenstance of how the market was configured — for several reasons.

First, it could be that the coordination costs of reconfiguring the market are too high.  It might be that certain goods in the market are only in demand if others of the same good are also on offer in the market, e.g., to use the example in the essay, it might be that bar-goers in a college town are overwhelmingly bar-hoppers, so they are only interested in nonsmoking bars if there are other bars that are also nonsmoking (as what could possibly be the value of nonsmoking bars — no breathing in carcinogens, no clothes that smell of smoke in the morning — can only be realized by bar-hoppers if there are multiple nonsmoking bars).  If that’s the case, the switching costs for a bar to go from smoking to nonsmoking could be too high unless multiple bars make the switch simultaneously, and the coordination costs for getting multiple bars to make the switch could be too high to incentivize the simultaneous switch.  This could be the case even though the new equilibrium that would result would be more efficient than the old. 

Second, if the behavioral economic literature on the subject is sound and we really do regularly deploy the “availability heuristic” in assessing probabilities, it could be that publicans give undue weight to present customers over future potential customers.  Simply because of familiarity with their present customers, they misestimate the odds that shifting from smoking to nonsmoking will give rise to a greater or more lucrative customer pool.  The happenstance that their present customers are smokers leads to an inefficient equilibrium.

Alternatively, another behavioral economic explanation, it could be that publicans are “hyperbolic discounters,” such that “even though the benefits discounted by their ordinary discount rate (the one . . . use[d] when comparing the costs or benefits of two future events) exceed the costs, the immediate costs loom larger.”  As a result, the could be discouraged by the immediate costs of switching from smoking to nonsmoking even though, ultimately, the benefits outweigh the switch by their economically rational counterpart’s lights.

The essay lists a few other possible explanations why an inefficient equilibrium might arise, and then proposes as its (clever) solution temporary laws.  The idea is that, if we have reason to think that a market is in an inefficient equilibrium, we should pass a law meant to eliminate the possible path dependency that has trapped it.  (In the smoking case, a temporary ban would solve the switching costs problem, as well as the various systemic irrationalities that could otherwise explain an inefficient equilibrium.)  The law should then be repealed so that market forces can settle on the more efficient equilibrium.

The essay is sketchy as it stands — especially glaring is its failure to address the possibility that temporary law could force a suboptimal equilibrium [although it does note rough proxies by which we could check for that, e.g. comparing revenue levels before and after the temporary law].  Also, its putative real-life example of a temporary law’s forcing a more efficient equilibrium is simply inconclusive.  But it’s a nifty idea nonetheless, especially because it argues from a premise that a great many default opponents of regulation in competitive markets accept [that market efficiency is an important or overriding goal] to the conclusion that regulation is sometimes appropriate even in competitive markets.

* I’m roughly following the usage in the essay when I say “inefficient equilibrium.”  Roughly, a market is in an “inefficient equilibrium” for our purposes if, once the market is shifted from it, the market will settle on a new equilibrium where, in aggregate, suppliers’ and consumers’ market-ends are better served than they were previously, so “wealth is maximized.”  This may be an idiosyncratic definition of efficiency — I don’t actually know what efficiency means, in large part because it is sloppily bandied about in the economic literature — but it seems like a property that we’d want a market to instantiate.

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