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Market failures, part VI maj 7, 2008

Posted by Fredrik Gustafsson in Nationalekonomi, _In English_.
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I denna del fortsätter diskussionen om skalfördelar. I nästa del kommer strategisk handelspolitik att tas upp.

Economies of scale, continued

There are other, less extreme examples of economies of scale as well; cases where there are economies of scale up to a smaller level of production and, therefore, where the industry can still be made up of a fairly large number of firms that all produce at an efficient scale. From a dynamic efficiency point of view, the most interesting economies of scale are those that apply to discovering or developing new technologies, products are resources.

One activity that comes to mind, and that is coincidentally regarded as being associated with significant economies of scale, is research and development (R&D). Some for instance claim that, since R&D has to be carried out on a very large scale in order to be profitable, small firms cannot “afford” these investments in R&D. Hence, new technologies, products and resources are not developed and the dynamic efficiency of the economy is hampered[1].

This is however a very poor excuse of an argument. Economies of scale will never deter private firms. Economies of scale just mean that the investment has to be of a certain size in order to be profitable. As long as the investment is profitable, firms will invest. In fact, bigger is better as a larger investment means larger profits. If in fact money could be made by investing in R&D, and if the only thing preventing established firms from doing so is their own fear of large projects, someone else will make the investment, put the established firms out of business and make them regret their cowardice. Because, assuming that there is a working credit market (which we do assume) a small firm will always be able to finance large profitable investments through debt.

Furthermore, if it is profitable to carry out R&D if and only if one single firm or institute carries out all R&D, what prevents the firms in the relevant industry from forming a joint company with the specific purpose of carrying out R&D that will be made available to every individual owner of the company? The claim that economies of scale will deter private firms from investing in, for example R&D, is simply ludicrous.

Although this might be straying from the topic a little, a very similar argument is often made for risk; that the presence of large risks means that a market failure that might reduce dynamic efficiency could be created. For example, due to the fact that R&D is such a risky undertaking—where little of value can be salvaged if the research fails to yield any results—a small firm might not be able to “afford” taking the risk of investing in R&D[2].

The argument is then that by funding or undertaking R&D, the state can spread the risk more evenly across different firms and consumers in the economy. Through this, it might be able to achieve a more rapid rate of development. A similar argument is that private firms are “too” risk averse, which slows down the rate of development as “not enough” resources are devoted to discovering new technologies, products and resources. Therefore, some claim, that the government should in some way encourage firms to take greater risks or that the government should bear the risk for them.

It is however not difficult to see that these arguments are flawed as well. If the expected returns of investing in R&D are large enough, but the firm hesitates because there is a small chance that the investment will not make any profits, there is a great number of methods available on the free market that the firm can use to divest itself of some of the risk.

Furthermore, there is also a great risk involved in passing up an investment opportunity; in doing nothing. A firm cannot expect to continue to earn money by producing the same thing it has always produced, in the same way it has always produced it. A risk-averse firm might just as well invest in R&D or in a new form of production to minimize the risk that it is left behind when rival firms make important discoveries and upsets the status quo. The best defense is after all a good offense.

Lastly, it is unclear whether risk-averseness in itself can be considered as a source of market failure or that individuals can be “too” risk averse. The reduction of risk is an economic good like any other. Confronted with two projects with equal expected rates of return, but where one project is associated with significantly greater risk, the firm might be willing to pay to gain access to the second project.

For example, it is probably not very far-fetched to assume that a person would be willing to sell a lottery ticket with a 50 per cent chance of winning ten million dollars for a sum considerably less than five million dollars (which is the expected return of the ticket). To call this action a market failure just because the consumer attaches a value to the reduction of risk is clearly erroneous. As Demsetz writes:

Once it is admitted that risk reduction is […] an economic good, the relevant question for society is what real institutional arrangements will be best suited to produce risk reduction or risk shifting […] [T]he taste for risk reduction must be incorporated in the concept of efficiency […] Given the fact of scarcity, risk reduction is not available at zero cost, so that the risk averse efficient economy […] does not produce a complete shifting of risk but, instead, it reduces or shifts risk only when the economic gain exceeds the cost[3].

That is, firms may avoid investing in risky projects because they value reducing risk in the same way as consumers will buy red cars because they prefer driving red cars. For the government to intervene case because entrepreneurs are “too” risk-averse is as unjustified as the government intervening because consumers prefer red cars, when in reality green cars are much nicer. If one uses a subjective theory of value, entrepreneurs, investors, and consumers cannot be “too” risk averse any more than blue cars can be said to be objectively more beautiful than red.

References

[1] Grabowski, “The Successful Developmental State”.
[2] Kenneth Arrow, “Economic Welfare and the Allocation of Resources to Inventions”, Nelson (ed.), The Rate and Direction of Inventive Activity, (Princeton, NJ: Princeton University Press, 1962).
[3] Demsetz, “Information and Efficiency”.

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Kommentarer»

1. Jokke K - maj 9, 2008

Fredrik, jag fortsätter med ovanan att rekommendera dig mer litteratur istället för att kommentera din text:

http://www.cambridge.org/us/catalogue/catalogue.asp?isbn=9780521888158

Denna bok representerar en totalt annan vy till beskattning vad som förekommit på denna hemsida. Den verkar intressant och temat har med ekonomisk utveckling att göra!

2. Fredrik Gustafsson - maj 9, 2008

Känner till dessa teorier. Att skatter leder till en mindre dålig politik än oljeinkomster, bistånd, och så vidare är självklart. Om staten får sina pengar från monpol, utländska stater osv finns det ingen accountability. Om staten missköter sig kan invånarna inte göra något. Om pengarna kommer från beskattning har invånarna större anledning och möjlighet att protestera om politikerna missköter sig. De kan till exempel vägra att betala skatt. Det är lättare än att få Väst att sluta betala bistånd eller ta statens oljereserver i beslag. Av detta följer det logisk att det system med den största accountabilityn av alla, dvs där finansieringen av staten är frivillig och där invånarna har en laglig möjlighet att inte betala skatter om de är missnöjda, är det bästa.

Åsikten att det automatiskt skulle uppkomma krigsherrar som skulle stjäla från oss om staten slutade stjäla från oss är dock direkt löjlig.

3. Jokke K - maj 9, 2008

Fredrik, du tar väldigt lätt det solklara problemet med frivilliga skatter: free rider -problemet skulle vara enormt. Skatter är lösningen till finansieringe av allmänna nyttigheter (public goods).

4. Fredrik Gustafsson - maj 10, 2008

Det finns inget free rider-problem där du frivlillig kan välja att betala skatt på ett kontrakt om du vill ha möjlighet att ta en eventuell tvist till en domstol. Att andra betalar för att fiansiera en domstol som jag inte har någon rätt att vända mig till innebär ju inte att jag kan åka snålskjuts. Given modern teknologi är väl nationellt försvar den enda statliga funktionen som lider av ett allvarligt free rider-problem. Du får gärna dela med dig om du har fler exempel.

5. Fredrik Gustafsson - maj 10, 2008

Kan gå igenom statens funktioner punkt för punkt:
– Domstolsväsende: Man betalar om man vill få sin sak hörd. Inga free riders.
– Brandkår: Man betalar för brandskydd. Om man inte betalat och ens hus börjar brinna kommeer brandkåren visserligen att rycka ut, men inte för att rädda ditt hus utan för att elden inte skall sprida sig till deras kunder.
– Polis: Huvudsakliga uppgifter i dag är att stå för säkerhet vid evenemang o.dyl. och utreda brott efter de redan begåtts. Om du vill att polisen skall sköta säkerheten eller utreda ett brott betalar du, inga free riders.
– Försvar: Kan finnas free riders.

Ett annat exempel på free riders jag kommer på är det faktum att vi som inte bär dolda vapen kan åka snålskjuts på de som gör det. Det vill säga, om x% av befolkningen bär ett dolt vapen är risken att rånare stöter på väpnat motsånd större och de kommer inte att utföra lika många rån eftersom offret kan vara beväpnat. Så om du är oroad över free riders borde din första åtgärd vara att betala ut någon form av stöd till personer som bär dolda vapen, vilket gör oss alla andra säkrare 🙂

6. brake repair mechanic - december 30, 2018

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Market failures, part VI | Liberala axplock


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