The markets paradox

A new paper (pdf) by Nick Bloom and colleagues shows that there is "substantial dispersion" in the quality of management across US manufacturing establishments, which confirms earlier research. This raises a paradox.

The very fact that many poorly-run firms stay in business shows that market forces do not strongly and swiftly select against inefficiency.

Bloom's is not the only evidence we have here. Alex Coad's survey of corporate growth around the world found that firm growth is a "fundamentally random process" which is largely unrelated to past productivity or financial performance. Geroski and Gregg found that it was almost impossible to predict from past performance which firms got into difficulty in the 1990s recession. "Market selection criteria may be rather myopic" they concluded. And Bjorn-Christopher Witte has shown that market forces can sometimes actually select in favour of stupidity; they favoured irrational trend-followers in the tech bubble and risk-seeking banks in the mid-00s, for example.

All this suggests that markets do not select in favour of efficient firms nor against poorly-run ones as rigorously as free market fanatics would have us believe.

Which brings me to the paradox. Despite all this, it seems clear that freeish markets are responsible for large chunks of productivity growth (pdf) - though the best natural experiment we have on this (the division of Korea) tells us that lots of emphasis (pdf) should be placed upon the "ish".

How, then, is it possible that market selection works so imperfectly and yet markets are key to prosperity?

There are (at least) two possibilities. One is that central planning of whole economies or of companies is so terribly inefficient (beyond a certain point) that even imperfect markets are a big improvement.

The other is that markets are not merely a technology but also a culture. As Gregory Clark and Deirdre McCloskey have argued, markets encourage - over time - the cultivation of "bourgeois virtues" such as hard work and prudence which themselves encourage growth. This helps explain why shock therapies of immediate transitions to market economies have had indifferent results.

Comments

[Robertnielsen21.wordpress.com]

Great post. I think people need to realise that the market is not perfect and that inefficient firms do exist and stay in business. If we view the market as it is, not as it should be, then we can properly understand and use it.

[chad]

I'd be willing to bet that the height of the barriers to entry is inversely correlated with management efficiency.

[aragon]

It seems to me that economics is bunkum and that while it may apply to primitive markets, the invisible hand and price as information are now obsolete in the information age.

We don't even need cash as a medium of exchange, we have an information and communications infrastructure more than capable of transferring information and allowing analysis of performance and allocating resources much more efficiently than free markets based on price and pre-existing resource distribution.

If we can live without money we are already capturing in much more detail the price information and are capable of much more efficiently allocating resources and measuring efficiency.

Communism, your time has come!

[gastro george]

The problem with your argument is that use of the term "freeish markets", which provokes comparison with a term like "almost a virgin".

"Free markets", as used by people like Tim, just don't exist - instead we live in a world of very unfree markets that exist in a spectrum of regulation and state control.

For alternatives to the wonderous "freee market" then regarding innovation, I only need to say the words Tim Berners-Lee; regarding industrial level productivity and development, then you only need to look at South Korea.

[Greg vP]

Please let the "culture" idea go, Chris.

Here's a counter-example. The New Zealand Land Wars (as they are now called) of the 1860s - 1880s were prosecuted primarily because Maori were out-competing the English settlers in the marketplace.

Maori are famously adaptable and innovative, having developed both trench warfare and passive resistance during those same wars, but it is not credible that several peoples could all acquire "market culture", could suddenly learn habits of hard work and thrift, in a decade or so. Culture doesn't work that fast. Narratives, on the other hand...

People are people. They tell themselves stories about their lives, they respond to incentives and they want a better life for themselves and their kids if they can get it. The narratives, the dominant discourses, are greatly overlooked in economics.

Following the land wars, Maori were portrayed as "a dying race", and they mostly ended up believing it. The result has been five or six generations of health problems.

Later New Zealand history chimed with this. The narrative associated with the Rogernomics shock was that New Zealanders were hopelessly uncompetitive, so they had better sell their assets to foreigners who would do much, much better. NZers took that message on board, as their subsequent income (non-)growth shows.

Incentives dominate, though. Acemoglu and Robinson, in "why Nations Fail", provide several examples of peoples who "acquired market culture" overnight, and lost it again just as quickly when their incentives changed.

[Greg vP]

Turning to your question, Schumpeter answered it more than adequately. It is not actual and present competition that is feared by companies, and that keeps them working to innovate, but fear of future competition. The new product that suddenly obsoletes all of yours.

The market system encourages innovation. That is its key difference with central planning. Economists need to get over their obsession with efficiency; efficiency has always been a secondary consideration.

This "fear of the future", as well as explaining why market systems do better than central-planning systems, also explains why productivity growth has been much greater in the production of goods than in services. Goods are more readily substitutable one for another.

[aragon]

Creative Destruction!

Intellectual property retards creative destruction, rather than promotes innovation.

Once you recognise that technology and innovation are the real sources of wealth do you need capitalism ?

Could this be why the semi-planneed economies like South Korea have done so well ?

https://en.wikipedia.org/wiki/Economy_of_South_Korea

"In 1990, South Korean manufacturers planned a significant shift in future production plans toward high-technology industries. In June 1989, panels of government officials, scholars, and business leaders held planning sessions on the production of such goods as new materials, mechatronics—including industrial robotics—bioengineering, microelectronics, fine chemistry, and aerospace."

State investment is the real driver of fundimental research and the ultimate source of wealth.

Capitalism just seeks economic rents!

[Andrew]

1. Conflicting findings from your cited research. The first paper finds that growth is consistently linked with good management practice.

Yet you cite other research that finds growth is unpredictable, which you use to support the idea that good management isn't rewarded by the market.

[Andrew]

2. The existence of poorly managed firms says nothing per se about their expected survival or selection pressures against them.

[Andrew]

3. You conflate efficiency with competitiveness. A firm, e.g. a state controlled one, may be vastly inefficient, yet competitive for many other reasons.

Efficiency is only favoured all other things being equal. Which they aren't.

[Andrew]

"How, then, is it possible that market selection works so imperfectly and yet markets are key to prosperity?"

Another reason might be that markets favour innovation, which is entirely independent from operational efficiency, but might make the overall society wealthier over the long term.

[css1971]

Isn't this primarily because lenders are most definitely *not* operating in a free market?

They therefore provide credit terms to inefficient, uncompetitive businesses at the bequest of their political masters, their lackeys and cronies, with the full knowledge that they will be bailed out at the public's expense when their poor decisions cause losses?

This will continue until the lender of last resort is removed.