Waldfogel’s “Tyranny of the Market”

5 November 2007 at 10:40 am 3 comments

| Peter Klein |

Joel Waldfogel visited our campus last week to discuss his new book, The Tyranny of the Market. I wasn’t sure what to expect. Joel is a creative and original thinker, a careful empiricist, and a nice guy. He’s one of the small (but growing) number of accomplished economists (Steve Levitt, Austin Goolsbee, Greg Mankiw, Brad DeLong, Steve Landsburg, etc.) who take the time to write for a general audience, a particularly meritorious activity. On the other hand, while I haven’t read Joel’s book, I was underwhelmed by this summary in Slate, as was most of the econo-blogosphere (1, 2, 3, 4).

After hearing Joel’s presentation and discussing it with him afterwards I’m more sympathetic to his case, but only slightly. His basic argument is simple: Under increasing returns, if the number of potential users of a particular good or service is sufficiently small, and the fixed costs are sufficiently large, then the good or service will not be produced even though there exist users whose willingness to pay exceeds the marginal cost of production. This Joel characterizes as a market failure, a challenge to the view that market provision, unlike government provision, allows everyone to have his preferences satisfied. If the state provides one color of tie, selected by majority vote, then I may be stuck with a red tie even when I prefer blue, while under market competition we all get the color we want. Not so, says Joel; if only a few of us prefer blue and the fixed costs are high enough then blue won’t be offered for sale.

This point strikes many commentators as true, but not particularly profound or significant. Indeed, Joel overstates his case by calling Mr. Blue Tie a victim of the “tyranny of the market,” a play on Mill’s tyranny of the majority. The two scenarios are qualitatively different because under democracy and state provision, I am compelled to pay (through taxation) for a good I don’t want — an obvious deadweight loss — while in Joel’s scenario, a voluntary transaction that might have taken place under a different cost structure doesn’t materialize. Should we really worry about potential harm, or counterfactual harm, as much as actual harm?

Another problem is that Joel understates the role of market incentives in dealing with fixed costs. One of his favorite examples is local media markets (print, radio, television). If I live in a big city, I can find a local radio station catering to my idiosyncratic taste for 1980s post-punk. In a small town, however, the market for such music is too thin and nobody will provide it. But this is a particularly poor example, as Tyler Cowen points out, because internet radio and satellite radio have emerged to bundle geographically dispersed listeners into an economically viable demographic. More generally, technologies for production and distribution aren’t exogenous. Under market provision, entrepreneurs have incentives to reduce fixed costs, to devise creative pricing mechanisms (like two-part tariffs) to address them. What are the incentives for such innovations under state provision?

To be fair, Joel doesn’t call for state provision per se. Actually, his policy recommendations are rather mild: subsidies for public radio, essential air service for small towns, and the like. When challenged, however, he admits that it is difficult to judge, even in his own framework, whether these policies are welfare-enhancing given that preferences are unobservable.

NB: While pondering these points I came across this example of the market catering to idiosyncratic preferences. I think I’ll stick to my belief in the marvel of the market.

Entry filed under: - Klein -, Classical Liberalism, Management Theory.

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3 Comments Add your own

  • 1. Shawn Ritenour  |  5 November 2007 at 1:11 pm

    Isn’t it also true that the decision to invest at all is a marginal decision. BEFORE any investment the marginal cost of production includes fixed cost. Looking for inefficient outcomes only AFTER the capital has already been invested and hence fixed costs are already being incurred strikes me as taking a too narrow view of the production alternatives and hence a too narrow view of the welfare analysis.

  • 2. Peter Klein  |  6 November 2007 at 10:29 pm

    Shawn, I think you are right. On the other hand, the standard model might characterize this as an example of time-inconsistent preferences. In other words, before investments are made, I estimate a marginal cost, including a share of the fixed costs, of $x per unit. Once the fixed cost is sunk, however, my willingness to sell drops to the marginal cost less the fixed cost. I.e., unless I have buyers under contract before I invest, my ex post preferences are different from my ex ante preferences.

  • 3. Twofish  |  10 November 2007 at 11:59 am

    It would be interesting to see how this idea interacts with time and entrepreneurship. If the fixed costs have already been sunk, then there is no economic barrier to go after small groups. It’s also interesting to see how this works with concepts of risk.

    It almost seems as if the economically optimal thing to have happen is to have an large investment in fixed cost platform with the mistaken belief that it will be profitable. Once that investment is made and it turns out not to be profitable, then this reduces the cost to marginal cost. This seems to be the story of the internet.

    The other question which is missing is what the impact is of including “diversity” as a economic good.

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