Part 3 (1/2)

So: if the right things are beingto the people who value theains in efficiency To put it another way, you can't get more efficient than a perfectly competitive market And it all fol-lows perfectly naturally from the truth contained in the price system: prices are true representations of cost to firms, and also true representations of value to customers

Life without markets Because Western society relies heavily on free ine what it would be like if we didn't, or to take a step back and see quite how profound the effect of the oods outside the oods are provided gives us a hint of the strengths and weaknesses of markets Think of your friendly local police force, which is paid for by a nonmarket systees- for one thing, when you dial 911 nobody asks for your credit card details The government is supposed to afford the sah it does not always seem that way

But the nones For instance, if a police officer is rude or incompetent, you don't have the option to shop for a different police force If you think that the level of police protection you receive is excessive, it's not up to you to cut back a bit Neither can you spend more if you de-cide that you'd like extra service No, you have to lobby your local politicians and hope they consider your de is another example of a nonmarket service that many of us use In both Britain and the United States, overnment-funded schools But those schools are different from each other- different atmospheres, different acadeood schools, and some are not The mar-ket solution for schools is sioes to the people who are willing-which also iovernment sec-tor there are no prices What happens instead? Parents line up, haggle, and protest They overnious schools often have the best academic records, so atheists take their children to church every Sunday in order to get good references froet their children into these schools

As with the police, the non the fact that the poor don't get the saain, the nonmarket system suffers from a serious problem: the truth about values, costs, and benefits has disappeared It is impossible to tell which parents enroll their children in church schools for religious reasons and which parents are just looking for better results It is also i to pay for more teachers and better e about how ood schools, and ould be willing to pay for theles with these basic questions

It seeood schools, and we see it eher in the areas of schools with the best reputation The nonives preference to local children, channels the ood school into the hands of property owners near existing good schools This hardly seems sensible A ood schools

The signaling function of prices Prices perform two functions, not just one In a ets to enjoy a liets to send their children to the best schools, an uncoovernive the sig-nal to build es if they're in short supply, and buy better er terness to pay for good schools into a lot of good schools, just as surely as it will transforh demand for coffee into a lot of cappuccino

Don't politicians know that we value good schools already? Should they be overnment money available? The diffi-culty is that politicians hear that ant good schools, but they also hear that ant more police on the streets, a better health service, lots of big roads, excellent welfare benefits, low taxes, and a double-shot caras, but prices, by forcing us to put money where our es, but many don't contribute to truth because we cannot choose whether or not to pay the to our wishes Because prices are optional, they reveal inforainst pro-viding a police service or a school system with a nones, but they also lose so important: information, information about wants, needs, and desires, and about inconveniences and costs Some-times the loss of inforains in equality or stability But sometimes the loss of infor in waste and confusion We think that the value we get from schools and police are more than what they cost us in taxes, but we don't know for sure Not so with the cappuccino

Efficiency versus fairness: Can we handle the truth?

A perfectly coiant superco power and sensors in every part of the econo even inside our brains to read our desires-thethe results perfectly Remember that when economists say the economy is inefficient, they mean that there's a way toanybody else While the perfectly competitive h to ensure a fair society, or even a society in which ould want to live After all, it is efficient if Bill Gates has all the money and everybody else starves to deathbecause there is no way toBill Gates worse off We need so we sometimes prefer the cozy white lies: it is expensive, for example, to heat the house of an elderly lady in Minnesota, but weher to face the truth of that expense

Even more than subsidies, taxes are a coovernment taxes ood things like police forces and schools Why are taxes inefficient? Because they destroy the information carried by prices in perfectly coer equals cost, so cost no longer equals value For example, a sales tax of 10 percent creates a ”lie” in the following circumstances: Cost of cappuccino: ninety cents

Price of cappuccino in perfectly competitive market: ninety cents

Price of cappuccino after tax: ninety-nine cents

Willingness to pay for cappuccino: ninety-five cents

Cappuccino sold: none

Tax raised: zero There was a sale that could have created five cents of efficiency gains (cappuccino cost ninety cents but was valued at ninety-five cents) but which never happened because of the tax What's worse, the tax wasn't even paid If the government were able to waive the tax in such circumstances, they would be no worse off, but the coffee buyer would be better off: a clear efficiency gain It's hard for tax officials to knohen to charge the tax (situ-ations where taxes will not change buyers' behavior) and when to waive the tax (because potential buyers would have avoided it anyway, by not buying coffee ) But they try to do so using the kind of price-targeting strategies outlined in chapter 2 Taxes are often higher when price-sensitivity is low For exaarettes, not for envi-ronmental and health reasons but because people who buy these products need to drive and are addicted to se their behavior e taxes We are faced with a dilemma We want to avoid inefficiency, because that would leave us passing up an opportunity to make somebody better off at no cost to anyone else But taxes cause inefficiency, and reater or lesser extent) fro two contradictory imperatives: avoid the needless waste that is ”inefficiency,” but make sure that wealth is at least somewhat evenly spread What we need is a way to make our economies both efficient and fair

Can we enlist markets to help with fairness?

Is it true that we have to choose between the efficiency of perfect overnovernhout the free world after the experience of the Great Depression and World War II President Roosevelt's ”New Deal” prograovern-ment, in response to the Great Depression In Britain, Cleovernment took control of much of the health, steel, air travel, petroleum, rail travel, and telephone industries Government-owned businesses took over partly be-cause in the deprived, exhausted yet hopeful years after the war, economists had some confidence in the experts who had ht not do a bad job of organizing the econoovernment-run economies, whether vast like the Soviet Union and China, or small like Tanzania or North Korea But even if they had believed that private markets were more efficient, this was neither here nor there in the 1940s: the postwar Labour government in Britain would have been content to live with some inefficiency if it meant a fairer society

But the old dilemma between efficiency and fairness was about to be shattered by a young New Yorker called Kenneth Arroho knew all about unfairness after watching helplessly as a teen-ager while his father lost his successful business and all his savings in the Great Depression The desire for social justice stayed with Arrow, but intellectually he couldn't just ignore the question of efficiency The young econo with the tension between the unerring efficiency of the free mar-ket and the imperative that some kind of fairness should prevail His solution was brilliant, twisting the traditional thinking about competitive markets and efficiency on its head He proved that not only are all perfect markets efficient, all efficient outco the starting position Arroent on to win every plaudit available to an econoest man ever to win the nobel Prize for Eco-noht so important?

I call it the ”head start theore on the enormous complexity of a real econoe: the 100-meter sprint The fastest sprinter in the race If you wanted all the sprinters to cross the line together, you could just change the rules of the race, ordering the fast runners to slon and everyone to hold hands as they crossed the line A waste of talent Or you couldblocks back, so that although each sprinter was running as fast as he could, obeying the usual rules and objectives of sprinting, the fastest had to cover enough extra ground that he would end up breaking the tape neck-and-neck with the slowest

Arrow de to balance the excesses of co with theblocks byonetiovernht hundred dollars; or alternatively, taxing everyone over the age of sixty-five eight hundred dollars; or al-ternatively, taxing everybody whose surnaht hundred dollars The point is that unlike an income tax or a sales tax on coffee, a lump-sum tax doesn't affect anybody's behavior, because there is nothing you can do to avoid it So unlike sales tax, it doesn't lead to an effi-ciency loss Siive eight hundred dollars to everybody whose name starts with H, a policy for which I would be happy to vote

In the 100- blocks back a few paces Inco the best runners to run backwards Both would have the effect of ensuring ablocks around doesn't slow anybody down

In the context of a sprint, it's fairly obvious that one of the ways to get a close result is to give the slower runners a head start In the context of an econooods, desires, raw materials, and talents, the head start theorem is a much bolder claim But it's true: you can allow the competitive econoe of every opportunity to trade, cooperate, educate, or investbut still get a fair outco perfect markets do the rest

The implication is that in a world of perfectneeded to ensure both fairness and efficiency is a ”head start” strategy: a program of appropriate lu The perfect mar-kets then find every possible opportunity topoints The question is, can this be done in practice?

Impractical examples Let's take an example American political philosopher Robert Nozick deployed a fa a view of ”jus-tice as fairness” In other words, he disputed the notion that one particular allocation of wealth could be deeument invokes Wilt Chamberlain, a bas-ketball star fa Chamberlain's talents made him wealthy; Nozick felt this was ”just” because Chaitimate decisions by fans happy to pay to see him play The situ-ation may have been ”just” in Nozick's sense of the word, but can any situation that leads to a highly unequal distribution of cash be considered ”fair”?

Perhaps taxing Chamberlain's income heavily would make the situation fairer, but Nozick warns that if Cha basketball and he was loaded doith heavy taxes, he ht seem more ”fair,” there would be neither the tax revenue, nor the basketball gaain So how is it reasonable to call a distribution of in-come ”fair” when everybody concerned, both fans and player, would prefer the ”unfair” outcome?

Thanks to Kenneth Arro know that, when faced with a er Woods, the solution is to levy a one-time lump-sum tax of several million dollars on hi golf, since he could not avoid the tax by playing less, as he would have to do in order to avoid a heavy incoh to pay off the tax bill and still retain enough to buy a fa In this scenario, there is no waste or inefficiency, but the result is ”fair” in that it produces a much more even allocation of wealth

The only trouble with this plan is that it's wildly impractical The problem is not that it's impossible to have taxes that only apply to one individual: President Franklin Roosevelt introduced an incoh that the tax was paid by only John D Rockefeller Rather, the problee behavior at all Ideally it would have been decided before Tiger Woods was born, because if he could have predicted that he would be liable for a tax as a result of his success he ht have chosen a different profession

This is, of course, quite impossible But we shouldn't abandon the head start theorem quite yet While we can't always use lump-sum taxation and redistribution, we can so because it preserves the efficiency and the truth of the co a welcome dose of fairness

A practical example A more practical application of the head start theore cold in winter, with-out da the environment In a typical winter in Britain twenty-five thousand seniors die as a result of inadequate heat-ing To address this concern, dos But that's a slightly odd way to deal with the probleovernments need to raise tax revenue-and all of them do, it seey would be to have the sa, because that wouldn't distort people's buying decisions too ” of chapter 2 Be-cause customers cannot easily cut down on fuel consumption, they are not very sensitive to the price of doovernment should levy a bit oods: custoe their behavior much and so the inefficiency would be small An even more sophisti-cated view (perhaps acquired from a peek ahead at chapter 4) would note that do it causes pollution, so the case for higher tax on doer

The case for lower taxes on dooods is hard to understand, until we start to worry about the elderly shi+vering in front of a lifeless gas or oil furnace that they cannot afford to switch on Is this just one of those hard choices that governments so the wrong rate of tax on everyone else, better to choose a ive the elderly a head start-because of their poverty and because, being frail, they have an additional need for heating The siive extra money to the elderly, money that they could use to switch that furnace on and stay wariven the money, pensioners will find their way to the efficient outco burned Not every pensioner feels cold, and those who do may find better solutions to the problem Some may use the money to move to Florida Some may insulate their homes Those who did not feel the cold in the first place can spend the s nobody will burn extra fuel unless they need to, and if they need to they'll have the money to meet that need

The lesson of the head start theore whether the proble blocks rather than interfering with the race This strategy isn't always practical, but because freeto harness that efficiency to hout this chapter, we've been on a flight of fantasy no more plausible than the story of Fletcher Reed The ”world of truth” is a world where markets are complete, free, and competi-tive In reality we're about as likely to achieve a world with com-plete, free, and co the truth to everyone