A Way of Looking at Markets

Fellow, RIETI

Arguments denouncing the "evils of market fundamentalism" seem to be in vogue lately. They brand Japan's recent economic reform as being based on market fundamentalism, call the ongoing trend toward globalism the "Americanization of the world," and blame market fundamentalism for increasing inequality and disparities in today's society. Listening to these arguments, I feel as if I am watching the revival of Britain's 19th century ideological conflict between liberalism and conservatism. Many times throughout history, humans have experienced unproductive ideological disputes between those arguing for the "suppressing of market forces" and those insisting on "leaving everything to the market forces" in addressing countless social maladies. I would side with John McMillan, who says: "Markets are too important to be left to the ideologues." (McMillan, 2002)

Properly functioning market can be best remedy against poverty

It is often the case that people using the term "market fundamentalism" have a fixed idea of "market = rationality = efficiency (= economy)," which in their view represents a world alien to (or, in some cases, contrary to) ethics and social norms. However, markets themselves are as old as civilization and deeply related to the social lives of people. In addition, markets are neither omnipotent nor omniscient. Being an artifact created by boundedly rational mankind, markets do have elements of imperfection similar to those of humans. Nevertheless, markets are the "only natural economy" that is deeply rooted in the true nature of people, as former Czech Republic President Vaclav Havel put it.

It remains disputable whether markets are an outcome of spontaneous or instituted development. As widely known, Friedrich A. Hayek maintains that a market system has developed as a spontaneous order, not as something planned and instituted. In contrast, if I remember correctly, Karl Polanyi in his book, The Great Transformation, defines capitalism as an event instituted by a certain class of people. However, today's markets almost undoubtedly have both of these aspects; they have developed in part spontaneously and in part have been instituted.

Indeed, we have seen, from time to time, just how malicious markets can be. McMillan (2002) details how patent-holding pharmaceutical companies keep the prices of antiretroviral drugs for HIV/AIDS treatment at exorbitant levels and how the inaccessibility of these drugs to poor HIV/AIDS victims in Africa developed into an international issue. However, we must remember that market incentives are what have prompted and accelerated the development of a number of life-saving drugs to date. The problems concerning HIV/AIDS drugs, which at one point escalated into a major international dispute, were eventually solved by flexibly changing the rules governing intellectual property rights and redesigning the pharmaceutical market to allow the production and marketing of generic drugs. As indicated by this case, a market - though in and of itself not a panacea - can be a solution to certain kinds of problems provided that institutions underpinning the market are properly redesigned.

Markets are capable of doing what no other manmade system can. Economic growth is essential for poverty elimination. However, recent statistical studies suggest that institutions enabling markets to function properly must be adequately in place if economic growth is to lead to poverty elimination. That is, markets can be the best remedy for poverty only if they function properly.

Markets can also be a useful tool for implementing public policies. In one example, as a means of reducing sulfur dioxide (SO2) emissions, which are the primary cause of acid rain, the U.S. Environmental Protection Agency (EPA) introduced emissions allowances, or rights to emit a fixed amount of SO2, and established a market for freely buying or selling them. Under this market-oriented system, the U.S. has been able to make significant progress combating acid rain; overall SO2 emissions have been reduced to a level 30% below the government-imposed "cap" on the total emissions from all regulated sources. Most importantly, the market transaction revealed that the costs of emissions reductions were far lower than initially expected (McMillan 2002).

It does not take overtly libertarian thinking to understand the benefits of markets. Markets must be used as tools for our benefit; and for that, we must let them function properly. Markets have a great capacity for adaptability, taking various forms - ranging from bazaars in ancient Athens to present-day online auctions - in order to function properly under given environments and technological conditions. At the same time, however, markets can become dysfunctional when improperly designed, as with the Californian energy market. It is exactly in a place like this that economics should come into play.

Markets demonstrate collective rationality

The term "market economy" is often taken to mean something governed by efficiency and rationalism, which is totally unrelated to the unique values and cultures of each society. It is widely known that Adam Smith, in his book The Wealth of Nations, noted that competitive markets function properly even if (or because) all players in the market are completely driven by selfish motives. However, as the author of The Theory of Moral Sentiments, Smith also pointed out that sympathy lies in the foundation of man's attitude toward others. (Lately, many people prefer the word empathy; referring to the ability to understand another's feelings.) One recent branch of economics, which includes game theories and experimental economics, is starting to emphasize that functions of institutions (including markets) are significantly influenced by social norms and customs, rather than merely governed by rationality. Many studies have been made in this regard and I would like to introduce just a few of them.

One classic example of experimental studies examining the impact of social norms is "ultimatum game" experiments (Roth, Prasnikar, Okuno-Fujiwara, and Zamir, 1991). In these experiments, pairs of players decide how to divide $10. The situation looked at is as follows: in each pair, Player 1 proposes how to divide the money and Player 2 decides whether or not to accept the proposed division. If Player 2 accepts, each player earns the amount proposed by Player 1. If Player 2 rejects, each earns nothing. These two-player bargaining game experiments were conducted in four different countries - Israel, Japan, the United States, and Yugoslavia. If the game is played between entirely self-interested players, the expected result is that Player 1 receives almost all the wealth. This is because Player 2 will accept any positive offer rather than rejecting it and earning zero, and so Player 1, being well aware of Player 2's circumstance, will design a proposal that brings him/her the greatest possible benefits. Outcomes of these experiments, however, turned out otherwise. Although there were often rejected offers in which both Player 1 and Player 2 ended up with zero gain, most pairs split the money roughly equally. However, some differences were observed between countries; whereas the modal offer by Player 1 in Yugoslavia and the U.S. was to split the money equally, Player 1 in Japan and Israel typically offered to give 40% of the money to Player 2, and keep 60%. This may suggest that Japanese people tend to try to take advantage of the other person's weakness.

Henrich et al. (2001, 2004) conducted a series of ultimatum game experiments in 15 small-scale societies in 12 countries on four continents, and compared the results across groups. Among the sample groups were foraging societies, those practicing slash-and-burn horticulture, nomadic herding groups, and sedentary agriculturalist societies. Player 1 offers observed in these experiments showed considerably more variation than had been found in similar experiments conducted earlier, with the mean offers ranging from 26%-50% and the modal offers from 15%-50% across different groups. Also, substantial variation was observed in the behavior of Player 2.

Henrich et al. ranked these small societies using five indices: 1) market integration (frequency that people engage in market exchange), 2) payoffs to cooperation (whether people carry out productive activities collectively or individually), 3) anonymity (prevalence of anonymous roles and transactions in a society), 4) privacy (ability of people to keep their activities secret from others), and 5) complexity (occurrence of centralized decision-making above the household level). Regression analysis of the results revealed that out of the five, only the first two (market integration and payoffs to cooperation) are significant; accounting for some 50% of the variation among societies in mean ultimatum bargaining game offers. The higher the degree of market integration and the higher the payoffs to cooperation in productive activities, the greater the level of cooperation and of the amount offered. Interestingly, these results indicate, though subtly, the possibility of market transactions inducing people's cooperative behavior.

In a separate study, Fehr, Gächter, and Kirchsteiger (1997) conducted experiments on the supply of work effort. Employers are to offer a "contract" specifying the wage w and the desired effort level e* expected of employees, while employees are to accept the wage w as proposed by the employer but choose effort levels e on their own (these effort levels do not have to match the effort level e* stated in the contract). Employers' gains are calculated as 100e-w, while employees' gains are w-c(e) wherein c(e), which represents the cost of effort, is an increasing function with an increasing marginal cost. The wages are represented by numbers ranging from 1 to 100, and effort levels by numbers between 0.1 and 1.

The wage level specified in the contract does not depend on the effort level. Thus employees, if self-interested, are inclined to choose the lowest possible effort level irrespective of wage levels proposed by the employer. If employers anticipate employees to behave in such a manner, they are inclined to offer the lowest possible wage; an amount just enough to attract the employees, represented by numeric value 1. However, employees in the experiments behaved differently; the higher the level of offered wages, the higher the level of employee effort.

This simple model was then modified to enable employers to reward or punish employees; the modified model is designed so employees, at the cost of 1, can either increase or decrease gains for employees by 2.5. (Self-serving employers should have no interest in this option because it costs them money.) Experiments, however, found that many employees chose to punish employees who opted for effort levels below what was stated in the contract and reward those who opted for higher effort levels. The result was a remarkable increase in the overall effort levels selected by employees. Introductory economics textbooks explain as if wages are determined by demand and supply curves. The results of these experiments suggest that wages are serving as a signal for reciprocity between employers and employees. The wage-effort exchange between employers and employees rests on a subtle, reciprocal relationship.

Findings from these studies have recently been summed up by Gintis, Bowles, Boyd, and Fehr (2005) in the proposition that a large proportion of people are "strong reciprocators," defined as having two aspects - being "conditional cooperators" who cooperate as long as others cooperate as well, and being "altruistic punishers" who are willing to incur personal cost to punish those who behave unfairly according to the prevalent norms of cooperation.

Findings from these experiments suggest that people, as market participants, behave in a way that incorporates social norms of their respective countries with diverse cultural and social backgrounds. Despite such evidence, why is it generally assumed that market transactions are characterized by the rational selfish behavior of market participants? This is probably because markets have the function of aggregating the behavior of individual players, including irrational ones, into rational market outcomes (Becker 1962). Certain experiments have in fact demonstrated that the allocative efficiency of markets is not so dependant on the rationality of individual market participants and that markets, even with "zero-intelligence" traders who submit random bids and offers, can achieve allocative efficiency as long as a budget constraint is imposed, i.e., if traders are not to permitted to sell below their costs or buy above their values (Gode and Sunder 1993). Markets are systems that accept various behavioral rules at individual levels, yet produce general rational outcomes. Conversely, it may be argued that we cannot see into the behavioral rules of individual market participants acting under the influence of their respective social norms simply by looking at rational outcomes generated by markets.

Economic expertise is needed to redesign and improve markets

Criticisms of competitive markets are oblivious to these markets' enormous benefits. As persuasively argued by Rajan and Zingales (2003), it may be that "capitalists" with vested interests (incumbents) are ostensibly championing the poor and distressed but are actually seeking to protect their vested interests by demanding that markets be suppressed. However, as exhibited by successful practices of microfinance, competitive markets can greatly contribute to helping the poor and distressed. Though markets have their negative aspects, we have no other choice but to try to make them function properly and in a way more useful to people.

As shown in recent economic research, operations of present-day markets are supported by diverse complementary institutions (Aoki 2001, Dixit 2004). Therefore, there is certainly room for redesigning and improving markets, which is exactly where economic expertise needs to come into play. Viewing markets as being in conflict with social values is not necessarily correct. Markets are to some extent regulated by social norms but, at the same time, they do have influence on those norms. That is, markets exist and operate as an integral part of our social life. We need to look upon markets tolerantly because, after all, the limitations of markets are our human limitations.

February 13, 2007

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Fehr, Gächter, and Kirchsteiger (1997), "Reciprocity as a Contract Enforcement Device: Experimental Evidence," Econometrica, Vol. 65, pp. 833-860.

Gintis, H., S. Bowles, R. Boyd, and E. Fehr (2005), Moral Sentiments and Material Interests: The Foundations of Cooperation in Economic Life, Cambridge: The MIT Press.

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Smith, A. (1776/2000), The Wealth of Nations, (Japanese translation by Hiroshi Mizuta and Chuhei Sugiyama, Iwanami Shoten).

February 13, 2007

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