Economics – Value Free?
Economics is central to public policy and economic policy affects centrally the lives of citizens. Economics allows us to explore the likely outcomes of particular economic activities and to examine how policy impacts on different groups in society – who benefits and who loses – and to come up with proposals for change.
However, economic policy analysis is rarely value-free, but is shaped by the values we hold and the goals we want to achieve. So it is important to understand the value judgments underlying economic policy recommendations and to critically examine the implicit assumptions. The answer that is provided to any economic question is influenced by the underlying assumptions. As a toolkit, economics is only as good as the assumptions underlying the particular model – the simplification of human behaviour – which underlies economic theory.
At present, both world-wide and in this country, the competitive market model dominates and is largely unchallenged in public discourse.
It is important to recognise the strengths and weaknesses of the market model. Its strengths are its ability to generate economic growth, consumer choice, and freedom.
The weaknesses of the market model lie in its propensity to produce inequalities in income and wealth and regional imbalances in economic development, the insecure position of employees, and the inadequate attention to the environmental consequences of economic activity.
Over the past decade, Ireland has provided a case study of both the virtues and the downside of the market model. On the one hand, our economy has produced unprecedented growth which has dramatically raised average incomes and reduced unemployment. By 2001 Ireland was exactly twice as rich, measured in real terms, as it had been in 1990; its income per head is now higher than the EU average. However, this increased income is very unevenly distributed. In 2000, the share of ‘equivalised disposable income’ of individuals which went to those in the highest income group (the top 20% of the population) was 39.2%. In contrast, the share received by the bottom 20% was 7.7% and this had actually declined from 1994 when it was 8.7%.1
Current social spending as a share of GNP has declined and remains substantially below that of many EU countries. There are serious inadequacies in many of our public services – in health care, early education, public transport, support services for families, and long-term care for groups such as the elderly.
We are challenged not just by the inequalities in our own country but by even starker figures which highlight how profoundly unequal is the world in which we live. The UN Human Development Report for 2003 refers to the “grotesque” level of global income inequalities. “Incomes are distributed more unequally across the world’s peoples .. than in the most unequal countries.. The richest 5% of the world’s people receive 114 times the income of the poorest 5%. The richest 1% receive as much as the poorest 57%.”2
Equity and Wider Human Well-being Must be Central Concerns
In the face of domestic and global inequality and of the environmental threats arising from our current model of development, it is important to challenge the assumption that the concern of economics should be with maximising profits and satisfying consumer demands to the exclusion of the social goals of redistribution, or of overall human well-being.
The currently dominant economic theory assumes that individuals try to maximise income and consumption, and that companies are motivated only by profit. Although these may be significant influences on individual and corporate behaviour, human motivation is not purely economic: we are guided also by moral, social and cultural values. Many of the most important aspects of our lives – personal relationships, civic and spiritual values, culture – cannot be reduced to commodities which are bought and sold. Economic justice demands that we go beyond the individualism of the marketplace and recognise the values of mutual support and solidarity.
A just economics, therefore, will address issues of equality and the distribution of income, resources and economic power, alongside the issue of economic efficiency. Who pays, who benefits, who loses, who owns and who controls must be central questions.3 Economic liberalism stresses freedom and choice, and these are important concerns. However, when access to resources is profoundly unequal, when people are struggling on minimal incomes, there is no real freedom and neither is there any real choice.
Market Effectiveness – Why Markets May Give the Right Answer
Economic theory posits the notion of perfect competition which serves to maximise the benefits of market operations.4 While the simplified conditions of perfect competition are rare in the real world, for many goods and services this model is a reasonable approximation of reality. Competition in the market between alternative suppliers helps keep profits and prices in check, produces higher quality goods, promotes innovation and prevents collusion between suppliers. Competitive conditions ensure availability of a choice and variety of goods and services, for those who have the income to pay for them. Few today would quarrel with the efficiency of the market for products and services such as clothing or coffee shops.
There are, of course, areas where competition is ineffective or absent, where there is a monopoly or a small number of dominant firms who collude. Dominance in advertising budgets or in distribution can create effective barriers to real competition even if the underlying product is easy for new entrants to copy – Coca Cola and Microsoft are examples of strong brand monopolies.
Powerful vested interests such as lawyers, doctors and publicans have successfully restricted entry, limited competition, and maintained price levels artificially high. Professions may argue these restrictions maintain quality where in reality they just sustain high prices. Introducing more competition where there are artificial monopolies or oligopolies brings gains to consumers in terms of lower prices.
Market Failure – Why Markets May Give the Wrong Answer
The Acknowledged Failures
Classic economic theory recognises that there are certain goods which the market may fail to supply in sufficient quantity or will supply only at too high an economic or social cost. These are:
1. Goods which of their nature we share collectively – what are called ‘pure’ public goods, such as policing, public lighting, clean air.
2. Goods where the benefits to society are greater than the benefits to the individual, or where the costs to society are greater than the cost to the individual – here the market gives the wrong answer, over-producing pollution or traffic congestion, or under-producing education, or health and care services. Subsidies or taxes are needed to adjust for these externalities. The familiar ‘polluter pays’ principle requires individuals and firms to pay for the social costs they impose on others.
3. Natural monopolies – where economies of scale mean that competing small-scale producers would be a costly and inefficient solution so that one or two large-scale producers provide a much more efficient response. For example, electricity transmission is a natural monopoly. These goods are best retained in public ownership. Liberalising markets is not a workable strategy where there is a natural monopoly but this is sometimes not acknowledged and there is an imposition of competition merely for ideological reasons. However, natural monopolies may change with new technologies, as, for example, when mobile phones replaced fixed land lines.
To prevent publicly-owned monopolies being run for the benefit of insiders rather than the public or the taxpayer, it is important to have independent oversight and to ensure competitively priced inputs. That can be achieved either through competitive tendering for inputs or by ensuring that internally-sourced services cost no more than the competitive market price.
Lack of Information
At its heart, the model of the perfect market assumes a well-informed consumer who can always spot the best value. That requires information on both price and quality. While it may be easy to work out the best value for standard items on the supermarket shelves, it can cost time or money to work out the best value in a mobile phone billing arrangement, in a pension plan, in a second-hand car. Professions like doctors or dentists have been slow to advertise their prices, and in any event shopping around is not easy for personal services of this kind. Markets are imperfect where the costs of acquiring information, and the risks in acting without it, are significant.
We cannot know how long we will live, what illnesses we will experience, or what inflation will do to our pension savings after retirement. Some of this risk may be spread through pooling of risks through insurance. But insurance itself is a flawed market, where the existence of insurance changes behaviour, allowing us be less careful. Another flaw is termed adverse selection. People who feel they are high risk are more likely to take out insurance, whereas people who are low risk may take a chance. Older people are more conscious of the need for health or care insurance because the risks are more immediate. Insurers try to price their services in proportion to the known risk; however, since this could make health insurance prohibitively expensive for the elderly, the law requires community rating, or a pooling of risk over generations, by health insurers.
There are certain contingencies that no private market will insure against – the risk of unemployment, or the risk of relationship breakdown. No effective insurance is available against the costs of getting Alzheimers. The state fills this gap in the market through compulsory social insurance and welfare programmes.
Since markets so often do not satisfy the stylised conditions of perfect competition, the state has an important role in overseeing and regulating markets – and at times intervening directly in them – to ensure that wider social ends are achieved. Whether the right answer is more competition, greater regulation or public ownership depends on whether competition is naturally absent because of economies of scale or whether it is absent due to artificial restrictions on entry. Regulation may take the form of encouraging greater competition where that is appropriate; of ensuring minimum standards of food, accommodation, or worker safety; ensuring consumers are properly informed; or levying taxes or charging subsidies where there are external benefits or costs.
Indeed, according to the economic theory of the second best, developed by Lipsey and Lancaster,5 government intervention may be preferable to trying to bring about a freer market, where this is not in practice attainable. As markets for different products and services are interdependent, the optimal result for the system as a whole may be to intervene with corrective taxes or subsidies rather than pursue an unattainable goal of free unfettered competition. In other words, competition, with corrective government intervention may work out better than competition which is almost but not quite like perfect competition. Whether more competition or a ‘second-best’ correction is appropriate must be studied on a case by case basis.
Why Government too May Fail
While market failures point up the need for government intervention to achieve better social outcomes, it has to be acknowledged that, no more than markets, government intervention may also fall short of the ideal.
Regulators may be effectively ‘captured’ by the industries or interests they are supposed to regulate, so that they act less objectively and with less attention to the wider public interest that they should. Self-regulation of professions is at particular risk of regulatory capture – can solicitors or dentists really regulate themselves in the public interest or are they trying to keep potential competitors out? Government departments may be captured by particular interest groups – do teacher interests dominate the Department of Education and Science, or farmer interests the Department of Agriculture and Food? Licensing arrangements intended to guarantee quality standards may give rise to cartels who fight to retain the premium value of their licence – as occurred in the case of the taxi service.
Powerful vested interests may succeed in securing or maintaining subsidies which serve to distort the market rather than correct market failures. For firms and sectors, subsidy-shopping may be an easier and more profitable strategy than seeking new markets, a major criticism of industry levelled by the 1992 Culliton report.6 Under the Common Agricultural Policy, incentives have encouraged farmers to chase subsidies or intervention to maximise their incomes rather than concentrating on getting the best market for their products. Monopoly state services may be captured by producer interests, become characterised by bureaucracy, offer little choice, or provide poor quality services. Ghost power stations, fully staffed, show the strength of producer interests. For years the telephone monopoly was characterised by long waits for new phones and unsatisfactory customer service.
Vulnerable public service users may have little voice – for example, the homeless or mentally ill. They have little alternative where services or facilities are below standard. It is important, therefore, to have mechanisms to ensure accountability and underpin an ethos of genuine public service. Such mechanisms include freedom of information, efficiency audits, consultation with users, consumer representation, and economic instruments such as competition. Introducing competition between alternative public sector providers on quality, service and cost may enhance performance.
Income and Wealth Distribution
While the market system is broadly effective at creating wealth and distributing goods and services, it is less effective at distributing incomes fairly. With widely unequal incomes, people come to the market with widely different buying power.
In the stylised world of perfect competition, each unit of labour or capital or land is used in production up until the point where the return from the last unit used is exactly equal to the value of additional output produced by that unit. In the real world, economic rewards reflect not just hard work, effort and talent. Earnings reflect differences in education and skills which in turn are highly skewed by differential class participation and achievement in education. Much work of immense social value remains underpaid or unpaid because the market system puts little value on it – care of the sick and elderly, child care. The Community Employment scheme has supported work of social value to communities who could never afford to pay for it. In a world of market rewards, those who cannot sell their labour – people who are retired, unemployed, ill, or have caring responsibilities – remain on the outside.
Inequality in incomes derives not only from differences in productive capacity and economic efficiency but also from differences in ownership and control of resources. Major wealth ownership usually has its origin in exceptionally profitable business or ownership of assets which have risen sharply in value. Business acumen, effort, and a willingness to take risks may yield exceptional returns, but luck also plays a part in determining which risky investments pay off and which go under. An unanticipated surge in demand for a good will bring excess profits to those already in the business of producing it, that is until new entrants come in and start increasing supply. Such excess profits can be capitalised into sizeable gains in share values for the firms concerned.
Asset ownership has the potential to generate sizeable windfall gains – for example, when population growth and rezoning decisions put up the value of potential development land. Wealth can generate further wealth which can then accumulate across generations. Inequalities in wealth lead to inequalities in income and market power.
The state has an important role to play in redressing the inequalities in income thrown up by the market, and the inequalities in wealth which may cumulate over generations. The main instruments for redistribution are the tax and social welfare systems. In Ireland, taxes on wealth and its transmission have been substantially diluted in recent years. For example, capital acquisitions tax has been halved from 40% to 20%, probate tax has been abolished, and capital gains tax rates have also been halved. The trade-off between lower income taxes and moderate pay increases was at the heart of social partnership, and improved competitiveness which resulted has played its part in the economic growth of the Celtic Tiger years. The scale of tax cuts, however, has gone way beyond what was agreed under social partnership, and the benefits of tax reductions have disproportionately favoured those on higher incomes. Social welfare increases, while exceeding inflation, have grown slower than earnings. The result is that tax and welfare policy during the boom years have actually served to widen the gap between rich and poor.
Expenditure on education, often seen as promoting equality of opportunity, disproportionately benefits students from higher-income backgrounds whose participation levels are greatest. Any long-term strategy to redress inequality of income should include successful measures to address the substantial class gradient in educational participation and performance.
There are goods and services which we see as fundamental to human well-being and dignity, which should not depend on ability to pay – access to a good education, to health care, to housing. There is widespread agreement in principle that it is morally and ethically unacceptable to leave provision entirely to a market system which would see many go without. We consider it is wrong that life-saving medical treatment should only be available to those who can afford to pay. We think it unacceptable that educational opportunities should be restricted by the ability or willingness of parents to pay. We believe that those who cannot afford accommodation should not be forced to live on the streets.
There are, however, sharp political differences as to where the line defining adequate provision should be drawn. There are sharp differences as to whether social services like these are made available as a right of citizenship or are tightly restricted.
I see quality public services as an essential part of social and economic infrastructure, part of social citizenship. We can build solidarity through services we all share, and achieve redistribution through the tax system.
The alternative view on the right emphasises the value of self-reliance and, despite the recognised failures of the market system, seeks the maximum use of private markets to achieve social ends.
This is a world of low taxes, limited public services, means tests and personal responsibility – the minimal welfare state. While it is claimed that this focuses more resources on the poorest, in practice selective systems achieve less redistribution because selective services tend to be the least generous, redistributing less income than the encompassing welfare states.7
Business and Power
The dominant economic power today is exercised not by small owner-run businesses but by major corporations. Large multinationals are often bigger than many nation states. Many of these owe their market power to strong brand names backed by heavy advertising, creating wants, not just meeting demand. Global media companies dictate aspects of a global culture. Global media in turn promote global brands for sportswear, soft drinks or other products. In a world where many go hungry, the power of these corporations to shape global tastes and direct spending power towards meeting such created needs is enormous.
The power of individual nation states to regulate or restrain mobile companies is limited – they may simply move elsewhere. Only a number of governments acting together, for example EU regulation of environmental standards, is likely to form a successful counterweight to the economic power of large business.
The dominance of business funding of politics may help secure the election of pro-business parties and frequently places elected governments under a compliment to major corporations or the business sector as a whole. Thus governments may be reluctant to take on cartels. Governments may skew tax breaks and incentives towards the business sector in a way which protects inequalities in income distribution or distorts economic performance.
Shareholders and stakeholders
The theory of the market is that the search for profit drives competition in goods and services and the creation of new goods and services. The search for shareholder value is thus seen as directing resources towards where they will yield the highest return.
Most frequently, the shareholders are divorced from those who run the business, who work in the business, or the customers. ‘Investment’ in the stock market is only occasionally about lending risk capital to new ventures or for business expansion. More often it is the purchase of pieces of paper based on expectations of capital gain. The value placed on these pieces of paper should in theory reflect the underlying profitability of the business and its prospects. The roller-coaster markets we have seen during the last decade suggest that market sentiment rather than underlying realities frequently dictates what a business is worth. This is well-illustrated in the dramatic – if short-lived – increase in the price of dot com companies during the stock price rises of the late 1990s. Speculative share trading which is divorced from business realities may be unsuccessful in directing resources towards where they are most productive.
The purpose of any economic system ought to be to serve the greater good of a society and to ensure that the basic human needs of all its people are met in a way which is both fair and efficient.
Economic success on its own is not enough unless it contributes to achieving a fair and equal society. Economic policies are the means to an end, not ends in themselves. Economic success may sometimes come at too high a price – in terms of human relationships, in terms of the environment, in terms of social justice. Increased prosperity can provide the means to tackle poverty or deliver better public services, but only if the fruits are fairly distributed
Mainstream economics acknowledges that there are significant areas where the market does not offer the right answer. This, however, tends to be ignored by those who hold an ideological view that private is good, public is bad and so advocate that the priorities in policy should be liberalising markets, privatising public assets, cutting taxes, and deregulation.
In Ireland over the past decade an ideology with a blind belief in market forces has progressively permeated public debate on economic policy. This has supported a rolling back of the state and a decisive swing against public services during the fastest growing period of economic growth in our history. It has supported tax cuts on a dramatic scale which has been sharply skewed towards the rich.
There is room for an alternative economic voice, one which places justice and redistribution at the heart of our economic values. This is a voice which acknowledges and supports what markets do well, but wants intervention to correct market failures. It is a voice which recognises that sometimes the state is best placed to pursue the public interest, and which has no preconceptions that the private solution must be best.
1. B. Nolan (2003) “Income Inequality During Ireland’s Boom,”Studies, 92, 366 (summer), p. 136.
2. United Nations Human Development Programme, Human Development Report 2003, New York: Oxford University Press, p. 39.
3. In asking the questions, ‘Who pays’? ‘Who benefits’? it is important to distinquish the actual effect of any policy from the supposed effect, on paper – to examine what economists call the incidence of a tax or subsidy. For example, subsidies to new housing may ultimately benefit owners of building land, because in a tight market housing prices tend to rise by the full amount of the subsidy.
4. The idealised model of perfect competition assumes: large numbers of producers and consumers so that no individual consumer or company can affect the market price; free entry into and exit from the market; identical products; well-informed consumers.
5. R. G. Lipsey and K. Lancaster (1956) “The General Theory of the Second Best,” Review of Economic Studies, 24, pp. 11-32.
6. Industrial Policy Review Group (1992) A Time for Change: Industrial Policy for the 1990s (The Culliton Report), Dublin: Stationery Office.
7. W. Korpi and J. Palme (1998) “The Paradox of Redistribution and Strategies of Equality,” American Sociological Review, 63, pp. 0661-687.