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Saturday, May 24, 2008

"The Invisible Hand Is Shaking"

I recently talked about relative prices as signaling mechanisms in the economy, and how distortions in these signals relate to Fed policy (see False Signals). Part of the discussion noted that "Market failure can also cause distorted prices, but ... this is outside the Fed's purview, so ... that's for another discussion." Conveniently, Robert Frank takes up this issue:

The Invisible Hand Is Shaking, by Robert Frank, Economic Scene, NY Times: Adam Smith's modern disciples are far more enthusiastic about his celebrated invisible-hand idea than he ever was. ...

If you believe, with Smith’s modern disciples, that unfettered pursuit of self-interest always promotes society’s interests, you probably view all taxes as a regrettable evil — necessary to pay for roads and national security, but also an unwelcome drag on economic efficiency. The problem, according to this view, is that taxes distort the price signals through which the invisible hand guides resources to their best destinations.

Smith’s more nuanced position supports a different view of taxes. When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses. ...

The production and consumption of many ... goods ... generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. ...[M]arket forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.

The upshot is that gasoline consumption is inefficiently high ...[, a] classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it.

Doing so would not only raise revenue to pay for public services; it would also make the allocation of society’s resources more efficient...

Efficiency is important because any policy that enlarges the economic pie necessarily lets everyone have a bigger slice than before. Economists opposed suspending the gas tax because doing so would make the economic pie smaller.

Of course, when millions of voters feel the pinch of rapidly rising prices, politicians find it hard to stand idly by. But as the late economist Abba Lerner once remarked, the main problem confronting the poor is that they have too little money. The best solution is not to reduce the prices they pay, but rather to bolster their incomes — for example, by selectively reducing the payroll tax for low-income workers or increasing the Earned Income Tax Credit. Suspending the gas tax would encourage rich and poor alike to do more ... driving. It would also promote sales of fuel-intensive vehicles. Because the gas tax reduces waste, it actually makes more resources available to help low-income families.

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. ... That the invisible hand often breaks down is actually good news. After all, we need to tax something to pay for public services. By taxing forms of consumption that generate negative side effects, we could not only generate enough revenue to eliminate budget deficits, but also help steer resources toward their most highly valued uses.

Because such taxes make the economy more efficient, it makes no sense to object that they impose hardships on low-income families. Again, an efficient policy is one that maximizes the size of the economic pie. And with a bigger pie, it’s always possible for everyone to get a bigger slice.

With regard to the size of the pie and who gets what, this is not the only basis for arguing for income redistribution, but I think you can base redistributive policy on a market failure argument, i.e. that distribution mechanisms have failed to reward factors of production according to their contributions to the production process. Some have received too much and others too little, and more could be done to counteract this so that we have a better chance to realize the possibility of everyone getting "a bigger slice."

    Posted by on Saturday, May 24, 2008 at 01:44 PM in Economics, Market Failure, Oil, Taxes | Permalink  TrackBack (0)  Comments (35)


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