Economics in Two Lessons, Chapter 11

by John Quiggin on June 6, 2018

Thanks to everyone who commented on the first ten chapters of my book-in-progress, Economics in Two Lessons.

Here’s a draft of Chapter 11: Market failure: Information, uncertainty and financial markets
. Comments, criticism and praise are welcome.

Earlier draft chapters are available. These aren’t final versions, as I am now editing the entire manuscript, but you can read them to see where the book is coming from.

Table of Contents
Chapter 1: What is opportunity cost?
Chapter 2: Markets, opportunity cost and equilibrium
Chapter 3:Time, information and uncertainty
Chapter 4:Lesson 1: Applications.
Chapter 5: Lesson 1 and economic policy.
Chapter 6: The opportunity cost of destruction
Chapter 7: Property rights, and income distribution
Chapter 8:Unemployment
Chapter 9: Market Failure
Chapter 10: Market failure -Externalities and pollution.

Feel free to make further comments on these chapters if you wish.



Simon 06.06.18 at 4:04 am

Hi there,

New to Crooked Timber but I gave the chapter a read. Some quick thoughts:

Would be useful to discuss price transparency less abstractly. For example, you could talk about the process of buying an airplane ticket and how aggregates like Kayak and Google Flights changed the business.

You say “To sum up, the EMH implies that private enterprises will always outperform governments, and that governments should confine their activities…’ but I don’t think that’s the key takeaway for EMH. Earlier you say “[EMH] enshrines the market price of assets as the summary of all relevant information” and to me that is the real core of EMH. That asset prices reflect intrinsic value because the market bakes in all available information into the price.

It would be interesting if you moved up “Bounded Rationality” to directly below EMH and talked about Thaler’s work a bit to show the limitations of the hypothesis.

Finally, I think it’s worth making the point that speculators provide liquidity for markets and reduce the bid-ask spread!


Peter T 06.06.18 at 11:12 am

First, might it not be useful to distinguish between uncertainty and ignorance? There are many things about which we are uncertain, but there are many more about which we are completely ignorant. If, for instance, I launch a new product, and calculate the price on the basis that the up-front costs will be recovered from the sale of so many units, then I am uncertain about exactly how many I can sell. But I am ignorant of the various issues which might cause me to sell much less (or more) or none at all. If I were not ignorant then my pricing would be different. [interestingly, I once met someone who retired in luxury after selling many many copies of a specialised software product than he had anticipated. A court decision made purchase of such a product almost mandatory for a large number of companies – and his was pretty much the only one available. Clearly he could not know – nor could anyone – that such a court case would arise, and be decided in that way].

Second – Lesson 1 treats “price” as unproblematic and obvious, as if all things were priced like apples in a market. But the full price of many things is not obvious. That’s why we have comparison sites, and life-cycle cost calculations. A good example is home printers – the makers sell the printer cheap and make their profit on the inks. But how many inks will be sold? They make an educated guess. Will the EU rule on generic inks (as it has mobile phone chargers)? Will recycling become required? They do not know. Yet these guesses/uncertainties/areas of ignorance are factored into the present price. For that matter, can the individual consumer calculate how much ink they will use over the next few years? Only with a large margin of error. The prices of a great many things, from toll roads through cars to irrigation pumps have this character.

Third, and following this, “price” in markets equates to money price. The other costs are not factored in. Yet they are there (as you previously noted, externalities are pervasive).

Fourth, Hayek’s statement is, if you think about it, absurd. The causes of a change in the price of tin make a great deal of difference to the consequent decisions. Is it permanent? Then changes in investment follow. Is it temporary, or likely to be so? Then no action is needed. Is it due to regulation, war, speculation, weather, a new technology? Each of these will call for a different response. The change itself may at most direct attention to the need for more information – by itself it conveys remarkably little. Again, the image in Hayek’s head is that of the buyer of apples at the local shop (“Pink Ladies are up a bit, so I’ll buy Jonathans instead”), or maybe the financial day-trader in the share-market, not the actuality of decisions in an industrial economy.


nastywoman 06.06.18 at 11:36 am

”There is no general answer to the question of whether speculation is beneficial or harmful”.
and @1
”Finally, I think it’s worth making the point that speculators provide liquidity for markets and reduce the bid-ask spread”!

If the information is accurate that the general economy is currently mainly running by ”speculation” -(aka: ”the money slosh” – aka ”financial markets”) – the question if it’s beneficial or harmful seems to depend if we are talking about ”The Poor Mans”- or the ”Rich Mans” – Economy – as in the poor mans economy it’s always harmful – as ”the Poor” can’t pay ”speculative” prices – especially NOT in housing.

While for the ”Rich Mans Economy” – all of these pondering about ”Market failure: Information, uncertainty and financial markets” – becomes some kind of ”ignorable academic ecxercise” if ultimately ”teh market” only goes up and up – and all of the busts -(aka: ”market failures”) – are just like ”tiny speed bumps” – on the way to even more ”Riches” – and that doesn’t say it’s actually ”harmful” – as there (supposedly) is always ”the trickling down” to the Poor Mans Economy – kind of like in London or NYC where the Rich depend to the utmost degree on their ”Service Personal” – and at least in London a ”good service slave” – Ups – I meant ”a good Service Worker” can earn a livable wage – if he commutes every day from ”the Rich Mans Ghetto” to the ”Poor Mans Ghetto” –
Uuups? –
I meant ”from beautiful London Center” to ”Sub-land”…


Mike Huben 06.06.18 at 11:56 am

I’m heading out in a few minutes for two days or so, but thought you might appreciate an idea I had, inspired by the quote from Hayek.

Ant nests are built as if by an invisible hand: the analogy can be extended quite a bit. Market prices are the pheromones. The idea that you don’t have to know the why of prices to use them. There is a capitalist caste and a worker caste. Ants are a dominant form of life because of their information exchanges. Etc. Here is the first link I found using the keywords ands and markets:

This does much to reduce the “glory” of markets and entrepreneurs. They function with relative blindness in a system designed by governments (as opposed to genetics) for the competitive purposes of government.

More general review later.


nastywoman 06.06.18 at 11:58 am

– and about @2 ”prices” and ”pricing”…

In the Rich Mans Economy ”price is no object” – and a completely irrational price -(for example for a Bugatti) – could mean that somebody who wants to pay such an ”irrational” price has to wait longer for (mostly) ”his” Bugatti because too many want to pay a price which is no object anymore…


Robert 06.06.18 at 2:11 pm

Somewhere I have read an interpretation of Keynes that makes the distinction between thick and thin markets central.

Investment in long-lived capital equipment mandates that firms enter into thin markets. What is the market for a second-hand, used factory of a specific type, history, and location? For the machines in such factories?

One can pretend that these markets are equivalent to thick markets in shares or stocks in firms. But what is liquid for individuals remains illiquid for the community.

Fluctuations in investment are an important driver for fluctuations in aggregate demand, through multiplier effects. So the need for a second lesson in economics also shows the need for Keynesian macroeconomics, for the reason given in this chapter.

Make of this idea what you will.


Gregory J. McKenzie 06.06.18 at 9:17 pm

It seems that the redistribution of wealth and income towards the upper deciles range is fueling speculative activity. In the past the real economy was more important than the money economy. But the enduring lesson of 2008 in general, and the subprime financial disaster of 2006-07 in particular, was that market failure may be triggered by speculative bubbles in the money economy. Now we have Nano trading taking supervision of financial markets out of the reach of regulators. Speculative activity can only get worse if unregulated. In Australia we have cartels and collusive trading making this worse. Our regulatory bodies are too reactive in managing such market behaviors. The repetitive nature of market failure begs the question: How can the side effects like double digit unemployment be minimized? This is a question begging for a answer sooner rather than later.


Anarcissie 06.07.18 at 2:08 am

Paying a high price for a Bugatti is not irrational if one loves the Bugatti, or Bugattis in general. Or, while not loving the Bugatti, one might see it as an instrument towards the accomplishment of a different project, such as raising one’s social status, leading to success in business or romance or repair of one’s self-esteem. In these cases the rationality of acquiring a Bugatti would depend on whether one’s assessment of its effect was correct. If there were irrationality, it would be in the culture of the society as a whole.


nastywoman 06.07.18 at 4:28 am

”Or, while not loving the Bugatti, one might see it as an instrument towards the accomplishment of a different project, such as raising one’s social status, leading to success in business or romance or repair of one’s self-esteem”.

You might be up to something? – that in the Rich Mans Economy the irrationality -(or rationality?) of price doesn’t depend anymore mainly on ”the price” -(aka: ”If it’s cheaper I buy it) – as if ”it’s cheaper I buy it” – is just how the poor mans economy HAS to… ”function” – while ”price is no object” if it might come to raising one’s social status, leading to success in business or romance or repair of one’s self-esteem”.

And doesn’t that mean that ”economical (rules) rationality” have to be adjusted accordingly – asked bey somebody who knows nothing about ”economics” but a little bit about ”social status”?


nastywoman 06.07.18 at 8:10 am

”There is a capitalist caste and a worker caste”.

– which supports the idea – that we need not only two lessons in Economics – but two different lessons for the Rich- and the poor mans economy.

As the biggest problems of ”economists” -(and economics) in the last years has been – that ”all theory” had so little to do with ”reality” – especially if we take the major economical problem for ”the people”: How is anybody -(in the poor mans economy) still able to ”pay prices” – while the Rich Mans economy isn’t charged high enough ”prices”?

Which could lead to another idea – that there could be another set of economic lessons for ”Predominant Consuming Countries” as the ”Predominant Producing Countries” seem to run with a completely different set of ”economics” – too? –
As what does an economists from a ”Producing Economy” think when he sees Mr. Kudlow mumbling:
“The trade gap will narrow if we are allowed to export more to all these countries,”

”Export” – What?!


Anarcissie 06.07.18 at 11:36 pm

nastywoman 06.07.18 at 4:28 am @ 9 —

I am sure no one will be surprised to hear that I know almost nothing about economics. However, I can do some literary criticism, and in reading Ei2L as linked above, and some of the other things said around and about it, I get the idea that the subject has a funny way of shifting about in a manner which may lead to the unwanted production of libertarian nostrums (for example, ‘free market’). For instance, there is slippage between value, a constantly changing mental state of an individual or collectivity with regard to some object or objects, and valued stuff (often referred to as ‘value’) which is, however, not the same as value and whose value-dimension depends on a host of shifty evaluators. (Hence the many ways of thinking about a Bugatti.) I’m sure you can see where I’m going with this, so I’ll shut up; but I would like to see a consideration of those fundamental facts which seem to have been ignored or glossed over, thus adding to my already chronic confusion.


nastywoman 06.08.18 at 7:13 pm

”thus adding to my already chronic confusion”.

There is no reason to be confused about ”economics” or as the US Investment Banker told my parents when they gave him their money:
”Are you confused how these investments work”? –
and my parents told him:
”not really” as they opted for medium risk -(aka a return between 6 and 7 percent per year) – and then he asked them if they are worried to lose some of it –
and my dad answered:
”not really as ultimately the market always is – up” –
and the Banker said: Yes.

and that’s how not confusing economics are…


John Quiggin 06.08.18 at 8:57 pm

@2 I should certainly draw this distinction more clearly. Unawareness is my main theoretical research topic at the moment.


nastywoman 06.10.18 at 4:47 am

– but perhaps the most interesting lesson about Economics gave Von Clownstick at this meeting of all these very nice and reasonable world leaders.

Economics has become… ‘something’ where you tell ‘the people” that ‘it’s a ten’ – while actually and in reality it is as absurd as US subsidized corn and steaks against subsidized milk – and how in the world will US ever fight against European Countries subsidizing everything by offering their people free educations?

The only way US could get to some ”no tariffs pricing without barriers” is offering every American a free education too – and all academics would have to be employed by the German Government – which even that he is German too -(he said so) Von Clownstick never will allow – because Canadians are far tooo ”mild”!

And all what one could write is just not insane and ”incoherent” enough.


Mike Huben 06.10.18 at 2:05 pm

This is a very graceful opening, but I would prefer that there was a statement about lesson 2 right at the beginning, to show how this chapter is relevant.

“Where financial markets fail, generating inappropriate investment signals and leading to speculative bubbles and busts, Lesson 2 is more relevant.”
Why is this sentence backwards? Easier to read if you start with “Lesson 2 is more relevant.”

“Reasoning in terms of opportunity cost suggests that the premium is higher than it should be, if Lesson 1 were applicable.”
Why? That is not clear to me. It might make sense as a simple average gain. You would need to show long term gains being higher. What exactly is the premium?

“The magnitude of the equity premium is a puzzle because it seems to imply that the opportunity cost of additional income or consumption in periods of booms is very low. An additional dollar of income in a boom period is given the same value, by stockmarkets, as an additional 50 cents of income in a recession. For a variety of reasons, most economists find this implausible.“
Are none of those reasons simple enough to present? To a layman such as myself, it seems obvious that it would be harder to earn more money during a recession.

Present failure of EMH FIRST, then show how it makes the claims and implications false. Do not repeat the propaganda first: that merely reinforces it.

11.4 Speculation
Retitle this “Speculation in markets” or something equivalent. At first I though you meant that YOU were intellectually speculating.

“ In modern markets, even microseconds can matter.” Put in “with automatic computerized trading”.

“The rest is devoted to speculative financial ‘engineering’, largely designed to minimise taxation and exploit inconsistencies in regulation.” You seem to have dropped predicting future prices on the floor here. These two issues are totally divergent from your previous subject of market speculation.

Where is the number describing the opportunity costs that are the inputs for the financial sector?

Do you want to point out something along the lines that in thin financial markets, gains by one investor are matched by losses of another? And that predation occurs?

11.6 Bounded rationality
You seem to have omitted cognitive biases, which are also heuristics and a problem when applied outside of where they are valid. Exploited by predatory investors.

The concept of store of value is questionable for gold, art, jewelry and many other things. It depends on the demand being continuous and nothing else.

Over all, this chapter feels more bloodless and passive than it needs to be. You could be more assertive about how lesson one is insufficient to describe what we know about market failure. And all other economics in your other chapters.

Comments on this entry are closed.