Monday, September 15, 2008

The Beautiful Free Market

Lehman Brothers, a big investment bank, just declared bankruptcy and American Insurance Group (AIG) is not far behind.

I've been teaching in Principles of Microeconomics about the beauty of the price system and creative destruction. While our in-class examples are much less complicated than today's real-life one, the underlying principles are the same. Today's turmoil and consolidations are part of the beauty of the market. Economists even have a nice phrase for events like today: A market correction. Something that was overpriced is now regressing to its true value.

In capitalism entrepreneurs are rewarded/punished for the risks they take. They use scarce resources to provide a service that they think is valued at a higher price than what it costs them to provide it (ie: they think they can make a profit).

I ask my classes:
"What if the entrepreneur is wrong and he goes out of business? Is that bad?"

Students tend to think about this, they usually come back with "Well, for him it's very bad."

"So, what about for us? What about society? What if the government intervened to keep him from going out of business?"

The answer is that it's good for him to go out of business so that the resources he was using to lose value on can be reallocated to a product or service of higher value to society.

If the government kept him in business, we'd be left with a company producing something that people wouldn't value very highly. It would have to use our tax dollars to do so even though we wouldn't want the company's product on the market.

The government would then have to intervene for other businesses, and then there is a moral hazard problem-- people entering a business wouldn't have to worry about using resources efficiently because the government would insure their personal profitability regardless. We'd be left with a whole host of products/services on the market that consumers would prefer not to have, and there would be fewer resources available for entrepreneurs wanting to try other products that consumers might value more highly.

Is it painful for those entrepreneurs and those investors who joined them in the venture? Yes.
But is society better off that they are allowed to fail? Absolutely.

I think one reason people are horrified today is that we see commercials on TV for AIG and Merrill Lynch and we hear "safety and security" practically guaranteed when there is no such thing. If there was no such thing as risk then there would be no rewards for entrepreneurs and therefore no creativity. If you eliminate the destruction then you also eliminate the creation.

1 comment:

Dawny said...

Justin, you see beauty where I see peril...:) My hunch is that we've only seen a tiny tip of the iceberg. Hopefully this is the beginning of a positive fundamental change.