Free Markets and the Perils of Compensation

Monday, October 30, 2006

Three years ago, the Financial Times was kind enough to publish a column of mine. It began with a picture that I fear not even the most astute reader could decipher. The picture shows a tree with a lot of apples. On one side, there are people standing on the ground, reaching out and grabbing the apples; on the other side stand people with ladders and hoists trying to figure out how they can climb up to gather the apples at the top of the tree.

The obvious query is, What on earth does a picture of a tree with a bunch of apples have to do with the question of how to organize various markets? As I looked at the illustration, I would have said that the picture contained an oblique reference to the temptation and fall of Adam and Eve as evidence that the private appropriation of natural resources is the source of all evil in the world. But my column had no such devious intention. To clarify matters, therefore, I will try to explain what the picture is about because it highlights the central theme of this essay: first and foremost, get the easy cases right, and then worry about the hard cases later.

keep it simple

The study of any complex social system leads, on reflection, to the comforting observation that the world contains easy and hard cases. The following characteristics are true of hard cases: they require a huge expenditure of intellectual energy in order to figure out their solution. Even so, when measured against some social ideal, our best choices invariably suffer from a very high rate of error, even when we do our level best. The happy side of this process is that we are likely to be damned no matter which alternative we embrace.

The advantages and disadvantages of any basic policy choice are hard to foresee. The only thing we can say with certainty is that some affected persons will win and others will lose.

So, if the law seeks to determine a very complicated issue, such as the optimum duration of a patent, it is easy to identify an infinite set of permutations, because the question of patent duration cannot be effectively decided in isolation without reference to patent scope, itself a highly technical area. To make matters worse, the field of patentable inventions may be too broad for a general solution to the problem. For example, the answer that seems to work well for pharmaceutical patents may not be as sensible for software patents. But the moment we decide that different patent classes should have different durations, then someone will be faced with the unhappy task of classifying a new generation of inventions that regrettably straddles a preexisting set of categories established in ignorance of the future path of technical development. Such is the case with computer software, for example. Given this shifting background, it is very difficult to conclude authoritatively that one patent duration rather than another is the best. Of course, we can make credible arguments that patent duration should be far shorter than copyright duration, but that still does not fix an appropriate length of time for either form of intellectual property. In the end, the best answers rely on educated hunches by persons who work within the field, who may differ substantially in their conclusions.

In some cases, the problems get even more difficult than patent duration because of the discontinuous nature of the basic choice. All too often, the world does not allow us the luxury of continually fine-tuning responses until we approach some social ideal. The question of whether to build a new airport or highway or rail system gives rise to an initial “yes or no” choice. Once that basic commitment is made, it will, of course, be followed by a host of smaller decisions, some of which can be fine-tuned, but others, not. The advantages and disadvantages of the basic choice are hard to foresee and are equally hard to evaluate quantitatively even when foreseen. Just think how hard it is to estimate the impact of a new airport on noise, pollution, traffic, land values, business growth, and the like. The only thing we can say with certainty is that some affected persons will win and others will lose.

Yet it is no mean feat to examine which persons fall into which class or to determine how much compensation, if any, is owing to those persons who are inconvenienced by the process. The difficulty of the subject matter and the nature of the political process restrict us to sharply discontinuous solutions, all of which could be far removed from the social ideal. Any choice is likely to contain large errors, but the same is not necessarily true of the difference in errors between two solutions. That figure could be small. Thus, if one error goes high by 1,000 and the other goes low by 1,000, then the error levels could be enormous but equally balanced.

There is a world of social difference between the harms inflicted by the use of force and those inflicted through competition.

We ought to take comfort in the thought that as long as people do their level best to get the hard cases right, then we should not protest too loudly if they get them wrong. The chances are that other people would have made similar mistakes, and we will never get able people to work on difficult social projects as long as we insist on judging their handiwork harshly with the benefit of hindsight. Our standard of criticism has to respect the decisions made in good faith by persons in positions of responsibility, so that they are not hauled into the dock when it appears they made the wrong decision. That principle lies at the core of the doctrine of official immunity. We have to learn to both live and prosper in a second-best world.

The appropriate response to hard cases, then, is an uneasy mix of patience and deference. The easy cases, in contrast, turn out to be miraculously important for the day-to-day operations of any system precisely because we can be confident that the wrong decision will lead to serious social dislocations with few offsetting benefits. That proposition holds when we look at how a society draws the interface between market choice and government behavior, which is my main theme. But, once again, we need to keep the basic point about economic organization in perspective.

In delineating the proper role for the market and the state, it is vital for people who believe in the principles of liberal democracy to get the easy cases right.

The truly great social catastrophes do not come from a misapplication of the basic principles of a market economy. They arise from a wholesale disrespect for individual liberty, which is manifested in tolerated lynchings and arbitrary arrests, and from a total contempt for private property, through its outright seizure by government forces intent on stifling opposition or lining their own pockets. The reason Great Britain and the United States did not go the way of Germany and the Soviet Union in the turmoil of the 1930s was that the political institutions in both countries were able to hold firm against such palpable excesses, even as they went astray on a host of smaller economic issues.

It was the failure to grasp this point clearly that led Friedrich Hayek, in The Road to Serfdom (1944), to be too gloomy about the fate of democratic institutions in Western Europe and the United States. Socialism does not always lead to national socialism as long as the critical minimum conditions for political freedom are respected across the political spectrum. Once this distinction is kept in mind, it becomes clear why we can properly count Franklin D. Roosevelt as a great American president on the political frontier even while taking strong exception, as I do, to the misguided economic policies that permeated his New Deal. Roosevelt’s contemporary competitors in the category of world historical figures were Adolf Hitler, Joseph Stalin, Mao Zedong, and Chiang Kai-shek. Out of that group, Roosevelt, along with Winston Churchill, stood as a beacon of liberty in a world that had plunged into disaster.

Winners and Losers

In delineating the proper role for the market and the state, it is vital for people who believe in the principles of liberal democracy, as I do, to get the easy cases right, even if they cannot reach firm agreement on the difficult questions, such as patent scope and airport location. In this spirit, I shall now concentrate on the easy cases and put the harder cases to one side.

The place to start, then, is not with airport relocations but with simpler problems with definite answers. To take but one conspicuous American example, no one should say a kind word about the wretched Wright Amendment that cripples competition in the large Dallas/Fort Worth airline market because one well-placed member of Congress fought a rearguard action against the welcome move to airline deregulation of the late 1970s. There is nothing about the complexities of airport siting that blocks tough head-to-head competition at every airport in the land. In these cases, we don’t have to create public goods. We only need to let ordinary individuals and firms enter into bilateral transactions to promote their mutual gain.

It is on this big, easy question that the rubber hits the road, for anyone who is committed to the classical liberal position will fight to the death against giving either legal protection against or compensation for losses arising in a competitive economy, notwithstanding the fierce resis-tance routinely encountered in practice. The common argument is that economic losses from competition are every bit as real to their victims as those that result from the use of force. If we allow compensation for physical injuries and injunctions against their future occurrence, then we should do the same for competitive losses, which should likewise be enjoined or compensated.

There is, however, a world of social difference between the harms inflicted by the use of force and those inflicted through competition. In the first case, we know that injury to the person and damage to property reduce the total store of resources available for human betterment. One person, to make himself better off, inflicts losses on a second person. That individual’s reduced stock of wealth necessarily reduces the opportunities for trade that are available to third persons. The externalities from coercion turn from generally positive to sharply negative. However much a single actor might benefit from her own use of force, no one thinks it is possible to prosper in a society that generalizes from that experience and that allows all individuals to adopt the same practices at will.

In contrast, competition may cause harm to one rival producer, but it also leaves his stock of labor and capital intact for a second transaction. By helping trading partners, it opens up new avenues to those individuals who receive goods at low prices and high quality and to the many third persons who stand to benefit in further transactions. Taking a broad definition of actionable harm transforms liability from an occasional occurrence, such as a car accident, into an inevitable and ubiquitous occurrence: If A’s success in competition is an actionable harm to B, then so too is B’s success to A. A’s claim only looks plausible when considered in isolation; it looks grotesque when its full implications are considered.

Compensation for or protection from competitive losses destroys the gains from trade at every juncture. It may well be that the disappointed trader loses more from competition than from petty theft. But from a larger point of view, competition as a process produces systematic social gains, whereas coercion and force as a process produce systematic social losses. The willingness to protect individuals against physical loss to person or property, or against defamation and other forms of molestation that involve either misrepresentation or threats of force, has the great virtue of allowing individual lawsuits to go forward when private and social welfare are perfectly aligned. But any offer of compensation or other protection to the disappointed trader has exactly the opposite effect: it places a giant wedge between individual and social welfare.

This point does not depend on the particulars of the product or service offered. It is not undermined by the most painful stories novelists or journalists can write about the havoc that demonic competition imposes on those who have found themselves displaced by market forces. It is a general proposition that is capable of general affirmation. It is one of those easy cases that it is absolutely vital to get correct. Simply put, there must be no compensation or protection against economic losses sustained through the operation of competitive markets.