Monday, October 29, 2001

Speculative Microeconomics for Tomorrow's Economy

J.Bradford DeLong & A. Michael Froomkin

Governments and societies that bet on the market system become more materially prosperous and technologically powerful. The lesson usually drawn from this economic success story is that in the overwhelming majority of cases the best thing the government can do for the economy is to set the background rules - define property rights, set up honest courts, perhaps rearrange the distribution of income, impose minor taxes and subsidies to compensate for well-defined and narrowly-specified "market failures" - but otherwise the government should leave the market system alone.

The main argument for the market system is the dual role played by prices. On the one hand, prices serve to ration demand: anyone unwilling to pay the market price does not get the good. On the other hand, price serves to elicit production: any organization that can make a good, or provide a service, for less than its market price has a powerful financial incentive to do so. What is produced goes to those who value it the most. What is produced is made by the organizations that can make it the cheapest. And what is produced is whatever the ultimate users value the most.

The data processing and data communications revolutions shake the foundations of the standard case for the market. In a world in which a large chunk of the goods valued by users are information goods that can be cheaply replicated, it is not socially optimal to charge a price to ration demand. In a world in which cheap replication produces enormous economies of scale, the producers that survive and profit are not those that can produce at the least cost or produce the goods that users value the most; instead, the producers that flourish are those that established their positions first. In a world in which the value chain is only tangentially related to ultimate value to users - in which producers earn money by selling eyeballs to advertisers, say - there is no certainty that what is produced will be what users value the most.

The market system may well prove to be tougher than its traditional defenders have thought, and to have more subtle and powerful advantages than those that defenders of the invisible hand have usually listed. At the very least, however, defenders will need new arguments. And at the most, we will need to develop a new economics to discern new answers to the old problem of economic organization.

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