Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (7 page)

 

Some academics cite the poor sales of LoJack, a vehicle anti-theft device, as a textbook case of market failure.
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LoJack is indeed an interesting idea—it’s a small tracking device a manufacturer can hide in a car. If the car is stolen, the police can use the device to emit a radio signal that allows them to find the car. LoJack would seem to have an overall societal benefit—since criminals won’t know which cars are protected, even cars without LoJack should benefit.
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But, as the argument goes, this creates a problem: you don’t install the devices on your car, but hope other car owners will. That way, if auto thieves don’t know which cars are protected, you benefit from the overall drop in car theft stemming from the presence of LoJack on some cars, while only other car owners bear the cost of installing the device. So in the end, no one installs it, because everyone hopes that everyone else will do it.

Is this a case of market failure? Not quite. If these devices worked, this problem would solve itself. For example, if only Porsche installed LoJacks on its cars, car thieves would learn to stay away specifically from Porsches, and thus only Porsche would reap the benefits of the device. The incentive, in fact, would be even stronger; thieves would pass up Porsches for other cars, meaning thefts of cars without LoJack would likely
increase
as thefts of Porsches declined. Rather than having too little of an incentive to install LoJacks, any single company would have too much of an incentive to do so.

So if the market is working properly, why aren’t car manufacturers installing LoJack? The clear answer is that LoJack’s benefits are greatly exaggerated. Most auto insurance companies give “no discount for
LoJack except in states where discounts are mandated.”
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Amy Kelly, a sales agent with GEICO insurance, points out that the device doesn’t effectively deter theft because by the time a stolen, LoJack-protect car would be found, “it would [already] be wrecked.”
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Moreover, academic research was unable to confirm the benefits originally claimed for the device.
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With $8.4 billion worth of cars stolen in 2002, car companies would love to have access to an effective anti-theft device. Reducing the rate of theft would make any car model very attractive to consumers by lowering insurance premiums and giving buyers confidence that their cars won’t be stolen. In this case, the market works but the product doesn’t.

Anti-corporate hostility can be especially damaging when it’s embraced by judges. If accused of wrongdoing, companies, like individuals, are entitled to a fair hearing in court. When such cases entail a lone individual squaring off against a company or corporation, judges are responsible for evaluating the competing claims and rendering an impartial judgment based on the evidence. As we will see from the following examples, however, judges can become overly-sympathetic to individual plaintiffs, especially the poor, the sick, or those suffering from other difficult circumstances.

It’s human nature to want such plaintiffs to win their cases—who could possibly hope to see a “greedy” corporation with high-priced lawyers emerge victorious over a poor single mother or a critically ill patient? But in allowing their hearts instead of the law to decide such cases, judges fail to consider the larger economic consequences of their judgments. And these trends, ironically, often are most harmful to the poor, the weak, and the ill—in other words, the exact kind of people the judges are seeking to help. By assisting one individual, justices inadvertently harm a much larger number of people.

Take a well-publicized case from Washington, D.C.
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A mother on welfare wanted to buy a $514 stereo system on credit from a store that had previously sold her such items as a bed, a washing machine, and four kitchen chairs. The store agreed to sell her the stereo but asked her to grant a lien on her previous purchases—if she proved unable to pay off the stereo, she would have to give the items back to the store. When the mother defaulted, the company turned to the courts to enforce its contract. The courts initially ruled in favor of the company, but on appeal a D.C. Circuit Court found it “unconscionable” that “with full knowledge that appellant had to feed, clothe and support both herself and seven children on [just her welfare payments], appellee sold her a $514 stereo set.” The court thus invalidated the contract.

The ruling clearly assisted the woman by allowing her to keep her previous items. And the judges probably felt good after helping a poor woman take on a richer, more powerful company. But the judges don’t seem to have considered the likely effect of their ruling on the store’s other poor customers or on other stores that knew about the verdict.

Because the mother was on welfare, the store took a big risk by selling her a stereo. Without the assurance of collateral, the store would probably have refused to extend credit to the woman. Reclaiming the stereo in the event of a default was not a sufficient guarantee for the store because it may have been difficult and expensive to retrieve the unit, and it may even have come back damaged. The most sensible reaction to this verdict—for this particular store and others—would simply be to stop extending credit to poor people. And the people this would most harm, obviously, are the poor; poor people are big credit risks, but they are also frequently the customers most in need of credit. In this case, the market created a method—collateral—to help the poor gain access to expensive goods, but the courts effectively took it away from them—in order to help a single poor person.

Another important and particularly heart-breaking case involved an eight-month-old girl, Anita Reyes. She was diagnosed with polio two
weeks after receiving a polio vaccine made by Wyeth Laboratories.
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In 1970, Anita’s father sued Wyeth, claiming Reyes contracted the disease from the vaccine. The court understood that Anita clearly had contracted the disease before she was vaccinated, as the strain she contracted differed from the strain used to make the vaccine. But it wanted to hold someone liable for the suffering of this poor little girl, so it ordered Wyeth to pay what amounted to over $850,000 in today’s dollars.
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The court argued that
someone
had to be compelled to assist families such as Anita’s “until Americans have a comprehensive scheme of social insurance,” and that this someone should be the vaccine manufacturers. Judgments like this established a precedent that companies can be held liable for problems for which they are in no way responsible, just so that
someone
will pay for whatever problem has arisen.
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The court’s desire to help out Anita’s family was fully understandable. But once again, the decision had larger economic effects that harmed other disadvantaged people. When the courts began holding vaccine companies liable for large judgments unrelated to their products, the firms had to raise prices on their vaccines in order to cover these higher costs. And these liability costs are now enormous, accounting for over 90 percent of the price of childhood vaccines.
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The unfortunate economic reality is that by improperly favoring individual children like Anita, courts have forced the price of vaccines high enough that some poor families can no longer afford them; liability rule changes decreased the number of children getting vaccinated by an estimated 1 million.
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Anita’s family got paid, but other poor children are forced to go without vaccinations and are more likely to get the very disease that afflicted Anita.

Let’s look at one last example of harmful court intrusions into the free market. This one involved workers’ rights to sue their employers for job-related injuries.
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Many jobs that are particularly dangerous
include a premium to compensate for these risks; although the overall wages for such occupations may not be high, they are higher than they would be if the jobs were safe. For some occupations, such as policemen and firemen, the potential hazards are direct and immediate. For others, such as those that may expose employees to toxic chemicals, it may take years before the harm becomes evident.

Until the late 1970s, worker compensation insurance gave workers easy access to compensation for job-related injuries without having to hire lawyers. In exchange, lawsuits against employers were strictly limited. During this period, the salaries of American workers who faced the average occupational exposure to carcinogenic hazards—workers in industries such as tobacco manufacturing—included a “risk premium;” these higher wages over their lives totaled over $185,000 in today’s dollars.
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Not too bad, especially when you consider that the highest estimates that someone will get cancer from job-related exposures range from 0.004 to 0.016 percent.
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But in the late 1970s, a legal change made it much easier for workers to sue their employers. As a result, firms no longer had to pay such high salaries to compensate workers for job-related risks. The risk premiums included in the wages for these jobs were either largely or completely eliminated, and salaries fell accordingly.
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This legal change created real economic imbalances for jobs—such as those that risk exposure to carcinogens—where illnesses only appear after a long period of time. True, employers were partly compensated for the lawsuits by the decline in wages. But workers who had been employed prior to this legal change had already been compensated for these risks with higher wages over many years. Allowing them additionally to sue their employers essentially compensated them twice for their risks. The end result was that workers were laid off and companies went bankrupt.
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Judges are usually smart people, but some of them have yet to learn an important lesson: the free market works.

Reputations are a vital element of our economy and our society. They are infused in everything from the pricing of consumer goods to the management of political campaigns. But their importance is frequently overlooked by analysts, legislators, and even the general public. This poses some important problems, for misunderstanding reputations can have profoundly harmful consequences. In the political arena, it has led to the adoption of the McCain-Feingold bill and other campaign finance laws that inadvertently favor incumbents, lower the competitiveness of elections, and reduce voter participation rates. Overlooking the value of reputations has also resulted in the application of excessively high penalties for high-income criminals and for companies convicted of fraud.

The reason for these unexpected outcomes becomes clear if one applies a little economic analysis to the overall role played by reputations in our society. We intuitively understand how reputations work in many aspects of our lives, but we rarely consider how they affect our
political and economic systems at large. And whether we look at political fund raising, criminal sentencing, or corporate behavior, we find that reputations permeate our decisions and actions in surprising ways.

What restrains politicians and businesses from acting dishonestly? A lot of people would answer: nothing. Periodic political and corporate scandals have created a popular image of politicians and businessmen as little more than a collection of cheats, liars, and crooks. However, while there will always be some dishonest people in any profession, the vast majority of American politicians and businessmen do not end up being frog-marched out of their offices in handcuffs before a gaggle of news cameras with their heads held low in shame.

Cynics will argue that many cheaters are simply getting away with it. This notion often stems from a general view of our political and economic systems as inherently corrupt; perhaps “the system” takes otherwise good people and subverts them, or perhaps merely allows the dishonest to flourish. Either way, we are habitually told that politicians and businessmen are not to be trusted. The popularity of books propagating this view—Michael Moore’s
Stupid White Men
, for example, was the bestselling nonfiction book of 2002
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—testifies to the widespread perception that our political and economic systems provide a welcome home to the irredeemably depraved.

What this argument fails to acknowledge is that in both politics and economics, there is a strong, omnipresent incentive to behave honestly. One might assume this refers to the threat of prosecution for dishonest conduct—surely, not many people want to go to jail or pay heavy fines. But what about lesser kinds of cheating not subject to legal sanctions? What incentives do politicians have not to break their promises? What keeps businesses from flooding the market with low-quality or unreliable products? As it turns out, there is a powerful incentive toward
honest behavior that is built into our democratic political system and free market economy—that of maintaining a good reputation.

Let’s begin by looking at businesses. High-quality products are usually more expensive than lower-quality varieties—think of the extra cost as a high quality “premium.” This premium has to be even higher than the extra cost of materials and production incurred in making a high-quality item. The additional premium represents the charge for buying from a firm with a reputation for selling high-quality products.
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The future profits from this premium is what a firm stands to lose if it cheats its customers. For example, imagine if a reputable maker of deluxe, expensive sports cars suddenly begins selling cars that quickly break down. Customers may initially pay high prices for the new cars, but as word spreads that they are unreliable, the firm will lose its good reputation. The company will then have to lower its prices because customers will no longer pay the high-quality premium for a car they know tends to break down.