Monday, June 16, 2008

Market Outcomes Are Not Pre-Ordained


Interesting chat with one of our friends this evening. We were batting around the big problems of the day; energy crisis, resource exhaustion, pollution, that kind of thing and looking at the various solutions proposed and possible.

One thing kept coming up, namely the fact that as energy prices soar, alternatives become more affordable comparatively and more time and interest focusses on solving the problem. Which sounds a lot like the magical guiding hand of Adam Smith taking care of us, if only we would be dispassionate voracious consumers interested solely in our own narrow self-interest.

Indeed, a lot of the issues, such as localizing production, encouraging more efficient usage/technologies, and lots of other necessary tasks are all addressed by the increasing cost of oil. So we don't have to do anything, apparently. After all higher prices and decreasing supply of oil (the peak oil theory) might force consumers to really solve the issue of climate change, to address it with hard choices that might actually impact their lifestyles and make a real difference.

Things such as driving less (or not at all), buying locally produced produce rather than that flown in from other countries, and using less energy. Once again, lassez faire economics solves a thorny issue in the most efficient and effective way possible, or so it would seem.

What's missing, though, is agreement to prevent alternative, just-as-bad (or worse) technologies from showing up as solutions to the "problem" of high oil prices. That is, the guiding hand may very well discover a solution worse than the original problem. Particularly when we do not have an economic cost associated with pollution, the market does not attempt to optimize out the pollution. Of course, that's what the cap-and-trade proposals are about, making the cost of pollution visible to the market forces. How successful they could be remains to be seen

The author spots the flaw in the assertion, credited to Adam Smith, but not what he actually said. He did not say there was mystical force at work – the so-called invisible hand metaphor was not a general statement about what happens.

It was not a theory, or a concept: it was a metaphor used in a particular instance to explain to those readers who did not follow his explanation for some merchants choosing to send their capital abroad to the British colonies in America or to the East India Company(both of which held Royal Charters that awarded them monopolies trade), and other merchants who chose, from their risk aversion to trade locally.

Nor did he advocate laissez faire (words he never used). He actually supported, in the interests of national defence) the Navigation Acts which only permitted British ships, with British crews, and British owners to trade with the colonies.

His analysis of market trade in Books I and II of Wealth of Nations did not mention invisible hands or guiding hands or laissez faire. It explained how price changes could influence suppliers to increase or decrease output and consumers to increase or decrease their purchases. In markets, it’s not what everybody does in the same way but what a majority do that determines and outcome.

If more people economise on oil products and switch to benign alternative fuels, then the eventual outcome would be as the author of the blog seeks; but if more people choose ‘worse’ alternative technologies it won’t be. Which it will be is not predictable, though we do know from experience that the choices imposed by governments are usually less than optimal.


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