The Pyramid of Economic Insight and Virtue

Bryan Caplan wrote an article some years ago presenting a tiered view of macroeconomic knowledge. I want to present here a similar tiered view. I’ve been thinking on it for a while, and I recently found similar thoughts in Anthony J. Evans’ book Markets for Managers:

Or, as Arnold Kling puts it, there are three schools of thought. To Chicago economists ‘markets work, use markets’. To Keynesian economists ‘markets fail, use government’. But to Austrian economists ‘markets fail, use markets’. If there’s inefficiency, then there is waste. And all waste is a profit opportunity. It is precisely because markets fail that there’s an incentive for entrepreneurs to find new ways to do business. The identification of friction does not cast doubt on the ability of markets to serve as a coordination device. As my professor Peter Boettke would say, if it wasn’t for real world friction we’d fall over whenever we tried to put one foot in front of the other. The ‘information economists’ are right – friction is the norm. But this isn’t necessarily a bad thing. After all, try to imagine a world of perfect information. In the movie ‘What Women Want’, Mel Gibson had the power of understanding exactly what women were thinking. There was less of an information asymmetry. But even if such a world were possible, it wouldn’t necessarily be desirable.

Tier 1, the Folk Position (Markets fail a lot, government works better, use government always): Markets are horrible and zero sum. We need to heavily regulate every single aspect of them, or even try nationalising some industries, restrict free trade. In the extreme, were if not for the practical problems, implement central planning.

Tier 2, First Semester Economics (Markets work well, government fails a lot, use markets always): Markets are great. They can solve every issue you may think of effortlessly. Governments will always make things worse if they intervene.

Tier 3, Second Semester Economics (Markets fail often, government works sometimes, use government sometimes): Markets fail. There are externalities, public goods, and market failures around. Therefore, while markets are very nice, there is an important role for government to regulate them and ensure they work properly. Fully free markets are a fantasy.

Tier 4, Public Choice (Markets fail a bit, governments fail a lot, use markets): Governments also fail. Market failures have to be balanced against  government failures, and turns out that in many cases, the costs of government interventions outweight its benefits, therefore it’s better to leave market failures alone.

Tier 5, Institutional/Cultural analysis: (Markets work well (but are imperfect), government doesn’t work as well (it is also imperfect), use markets) Voluntary action, institutional, cultural, and moral rules can solve, to an extent, and given time, externalities, market failures, and provide public goods. People are not fully self-interested, and can craft clever institutional arrangements and contracts to make cooperation more robust. Standard economic conditions for market and government efficiency are seen to be sufficient, not necessary. This explains why governments work better than what Public Choice would describe, but also why markets also work even better than what some theories suggest.

The curious reversal is that Tier 5 is very similar to Tier 2, which is a far less sophisticated view, which in turn may explain the relative impopularity of Tier 5. Tier 5ers may seem like ‘market fundamentalist’ Tier 2ers, unaware of the insights of Tier 3.  Bryan Caplan illustrates the reversal here:

So just to play into your fears, I’ll begin by quoting Dr. Horrible’s Sing-Along Blog.  In this scene, Penny is telling Dr. Horrible about her last date – never realizing that Dr. Horrible is secretly in love with her.

Penny: But, he turned out to be totally sweet. Sometimes people are layered like that. There’s something totally different underneath than what’s on the surface.
Dr. Horrible: And sometimes there’s a third, even deeper level, and that one is the same as the top surface one. Like with pie.

This scene perfectly captures what I’m going to tell you about health care.  On the surface, a free market in health care seems like the best approach.  When you look a little deeper, the free-market approach seems naive and dangerous.  When you look deeper still, however, the free market approach turns out to be the best after all.

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