Market Failure and Nobel Prize

HERYUNANTO

.

Despite the controversy it causes from time to time, the laureates that the Nobel Prize committee select to receive the Sveriges Riksbank Prize in Economic Sciences always reflect the issues that have been relevant to the world that particular year.

This is strongly so with the Nobel Peace Prize recipients this year: Congolese doctor Denis Mukwege and Iraq’s Yazidi activitst Nadia Murad. Mukwege is an obstetrician known for his lifelong dedication to treating victims of wartime sexual crimes, while Murad is a former Islamic State (IS) sex slave who is now a prominent human rights activist. Both are widely acclaimed for their roles in fighting against the use of sexual crimes during war and armed conflicts.

This is also the case with the Nobel Prize in Economics. In choosing this year’s laureate, it appeared the prize committee wished to highlight a major problem the world urgently needed to address. This year’s Nobel Prize in Economics was given to two US economics professors, Yale University’s William Nordhaus and New York University’s Paul Romer. Romer previously taught at Stanford University and briefly served as the World Bank chief economist, similar to 2001 economics laureate Joseph Stiglitz.

Nordhaus and Romer have contributed important ideas to address current global problems and challenges. Nordhaus developed a model to analyze the impacts of climate change on the economy. His model has been used by several international agencies, including the UN Intergovernmental Panel on Climate Change (IPCC). A recent IPCC report contains prediction models that were based on the model that Nordhaus had developed.

The report issued a stern warning that if current energy trends remained unchanged, their consequences on climate change would truly be life threatening. The IPCC adopted Nordhaus’ proposed solution to impose tax on carbon emissions to minimize the increase in temperatures and pollution across the globe.

Romer, meanwhile, was selected for his study on the relationship between science and long-term economic development, approaching scientific development and innovation as endogenous factors of economic growth. In an argument that incidentally complemented Nordhaus’ carbon emissions tax, Romer proposed incentives (negative tax?) for investing in science, research and technology.

Human behavior

Last year’s Nobel Prize in Economics was awarded to University of Chicago professor Richard Thaler, a renowned expert in human behavior economics.

It was long overdue but, in the end, the Nobel Prize committee appeared to use the award to remind the world that economics studies human behavior to discover how people choose between alternatives in order to achieve their goals amid certain limitations (maximization under constraint).

In giving the award to Thaler, the Nobel committee seemed to want to remind economists that, while they often see their science as exact, quantitative and reliant on complex mathematical models, human beings with all their unique traits – some of which may be irrational – remained the subjects of their research.

Such irrationalities will lead to uncertainties, which are always immeasurable and unpredictable. Therefore, whether all variables are treated as measurable with known probabilities or whether sophisticated methods are used to create models, the uncertainties will never be measurable or countable.

All probabilities, including those deemed highly improbable – often called “black swan” – may be measured, but uncertainties cannot. Thinking that all economics variables are measurable is a kind of misguided arrogance that can only lead to hubris.

John Maynard Keynes warned long before writing the seminal The General Theory that, outside of the probabilities that can be counted or predicted always lay uncertainties that we might never understand. Behavioral economics tires to look at human behavior comprehensively, including irrational behavior, in order to understand humans beyond homo economicus, which strive to reach equilibrium within the rational realm.

Simple theories like supply and demand promise an optimum equilibrium in which two entities may agree on a certain price. In this condition of optimum equilibrium, supply and demand is equal with neither a surplus nor a deficit. This condition is called “the market is cleared” [market clearing].

Theories on how capitalist markets work rapidly developed into what is known as the Efficient Market Hypothesis (EMH) during the Washington Consensus era of the 1980s and 1990s. Markets work to ensure that the right price is achieved by equalizing supply and demand in a state of optimum equilibrium.

Many economists view this market theory or hypothesis as a mantra that always results in an absolute and correct prediction. This is true neoliberalism. However, the 2008 global financial crisis tore down the belief in this mantra, similar to how the Great Depression of the 1930s tore down classical economics to bring forth the Keynesian school of thought.

In 2017, the Nobel committee seemed to be warning economists around the world to remind them that the subjects their research were human beings, with all their improbable unpredictabilities. The message was made clear when they selected Thaler as that year’s economics laureate.

Failure of Price Theory

In his article in The New Yorker (9/10/2018), John Cassidy wrote that the Nobel committee chose Nordhaus and Romer as this year’s recipients of the Nobel Prize in Economics precisely to highlight their ideas on the failures of the market economy.

I agree with Cassidy in that Nordhaus and Romer are united in their idea that the theory that markets always work to reach optimum equilibrium is not always correct. Many other economists have posed similar views before by highlighting the presence of externalities, or “spillovers” – results that do not adhere to price theory predictions that lead to economic equilibrium.

Nordhaus and Romer explain their ideas on the failure of market theory by referring to phenomena that affect long-term economic growth: climate change for Nordhaus and scientific development for Romer.

Nordhaus said that energy prices were determined only by the costs of exploring, discovering, processing and transporting fossilized fuel sources like oil and gas to consumers. Energy prices never included calculations to compensate for the environmental destruction that was caused by their use.

This “spillover”, or external diseconomy, is excluded from pricing calculations. Nordhaus argues that proper energy pricing should include compensation for future environmental destruction due to climate change. This can be done by taxing energy consumption based on the carbon emissions resulting from energy use.

The failure to include compensation for future costs had led to energy prices that were lower than needed to reach equilibrium. As the price of energy was too low, over-consumption reigned. Therefore, taxing consumption was necessary to halt unchecked energy use and minimize environmental destruction.

In his study, Romer highlights the economic externalities closely linked to science, research and innovation that have been excluded from the costs borne by those consuming or investing in human resources in the fields of education and science. This has led to under-production in scientific development and research. In order to rectify the system, subsidies must be provided for investments in education and science.

KOMPAS/RIZA FATHONI

J. Soedradjad Djiwandono

These two phenomena highlight the failure of the price theory in a capitalist market economy. Prices can be revised through government intervention, whether by imposing carbon emissions tax on energy from fossil fuels or by subsidizing investments in education and research.

First, negative externalities, or “public bads”, must be taxed. Secondly, positive externalities, or “public goods”, including education, scientific endeavors and research, must be subsidized. These are justified as the government’s role in the economy.

Surely, the next issue concerns the steps the government must take to correct these externalities, both positive and negative, to create solutions that lead to economic equilibrium that will benefit the people.

J. Soedradjad Djiwandono, International Economics Professor, S. Rajaratnam School of International Studies (RSIS), Nanyang Technological University (NTU), Singapore; Emeritus Professor, Business and Economics School, University of Indonesia