The Molotov Cocktail Economy
The knowledge problem inherent to the mixed economy
The phrase “mixed economy” or “mixed market economy” has certainly gained steam in the time since Mr. Gorbachev tore down that wall. The idea is a sort of forced marriage between market action and central planning, and it has trended toward higher levels of prevalence. Today, we can see the mixed economy discussed with reverence by multiple outlets and multiple politicians – in other words, it’s not going away. This concept is the short-run compromise between the free market and the central planning advocates, it mixes free market action with central participation in multiple levels of the national economy. Most notably, this mixed economy relies on government participation in the market process as either a public-private partnership, like many Zoos, a public option, like government-run services, or solicitation, like a local district office requesting bids to build a new building.
I’ll discuss two problems with this modern concept of mixed economies. The first is one economists have mentioned numerous times, and the second is a proximate cause that is under-analyzed. Let’s begin by invoking the great F. A. Hayek and discuss knowledge and its ability to be leveraged outside of a market setting. Knowledge does not refer to knowledge in the colloquial sense, knowledge here refers to the insights and information that are required to accurately coordinate an economy. For example, consider the commodity price of iron and the many markets that make use of this input. Should the price of iron increase, all of the firms that utilize iron in their production process will swiftly shift production to substitute metals wherever it is cost-prudent to do so. Effectively, firms that are practically able to shift their production away from iron and to another metal (able to do so without significantly hurting quality, incurring a higher cost, increasing production time, etc.) will make this shift without knowing the reasons iron has increased in price. Here, price acts as a knowledge disseminator, the firms are incentivized to economize on iron without knowing why iron needs to be economized (economize here simply means that firms decrease iron usage due to the relative scarcity of it).
But the knowledge train doesn’t stop here. Prices do not convey all the knowledge required to coordinate the market. Knowledge is dispersed, context specific, and emergent of the market process. Each of these individually indicates that there is local knowledge in a market, that knowledge is subject to situational factors, and that knowledge is spontaneous within market activity respectively. Prices disseminating relevant knowledge is a strong example of the context specific nature of economic knowledge, the other two factors remain unaccounted for through the price mechanism. Local knowledge refers to information that would be known… locally. Take this literally, this is knowledge that is only known by those individuals who are participating in an action or are located in such an area where their experience has provided relevant knowledge to production processes. A simple example would be a family of farmers who have learned through the generations that a certain crop does not grow well in this specific soil.
Emergent knowledge is derived from the profit and loss incentive and its direct effects on entrepreneurship. In economics, or at least in my view of economics, the entrepreneur is a resource shuffler. Through the profit and loss incentive, the entrepreneur is constantly attempting to discover higher-value uses for current resources. This process is inevitably volatile and unpredictable, and is driven by both successes and failures. But through this process, economic progress and emergent knowledge develop. Emergent insofar as the knowledge birthed by the entrepreneurial process is inherent to it and spontaneous within it.
Without this discovery process, certain knowledge required for market success would never be discovered and leveraged because that knowledge was only available within this system with its given set of incentives to drive behavior. It’s difficult to ascribe a simple example of this sort of knowledge, but, in a way, that’s the point. This type of knowledge is largely indescribable though it is absolutely actionable. Not every firm will discover it, and not every firm that does will effectively leverage it, it is simply knowledge from the market that is of the market.
In all these forms, knowledge presents an impossible problem for the mixed economy. The obvious case of this issue is that of the “public option”. Nationalized health care, for example, falls victim to each and every one of these knowledge factors in that it is a program that simply cannot leverage any of them. A central planner could not know the local knowledge required to cover a given group effectively, for example, a central planner could not know local risk tolerances for health treatments, nor could it simply ask for this answer and expect it to be accurate. I covered this subject in greater detail here, but in short, individuals would be incentivized to lie regardless of the induced incentives outlined by the central planner (promise less coverage for reporting a high risk tolerance, people will underreport. Promise more coverage for a high risk tolerance, people will overreport. Etc.).
The central planner could not leverage context specific knowledge, as it is inherent to the price system. For example, how would a central planner economize on treatment x? The treatment is necessarily scarce but there is no price associated with it to indicate whether that scarcity is relatively low or high. Perhaps more doctors are sick today, how would a central planner effectively plan who still gets treatment x and who is shifted to treatments y or z? How will the central planner know how the sickness to those doctors affects treatments y and z? These aren’t items that would be solved with more data, these are items that would not exist practically without price to indicate the economizing procedure. Obviously, a nationalized system would run outside the market system, and thus, without the emergent knowledge required to plan successfully.
However, consider these issues applied to public-private partnerships and solicitations. The public-private partnership is able to leverage local knowledge through the private firm which does so through the hiring of local individuals. It is somewhat able to discover context specific knowledge through the price system. And it is somewhat able to discover emergent knowledge. As well, the solicitating government entity is less able to leverage local knowledge, less able to access context specific knowledge, and less able to discover emergent knowledge. The problem here is not necessarily these entities’ ability to utilize these knowledges, but a problem inherent to the governmental “firm” specifically.
The government operates as a super firm. This concept comes from Ronald Coase and his seminal essay “The Problem of Social Cost”. As with many theories that have sprung from Coase’s work, this idea of a super firm is squarely rooted in contract law. Consider a contractual negotiation where one of the negotiating parties is also the entity that will ultimately enforce the contract. A simple example here would be a business owner negotiating time off with an employee. The negotiation would run its course and, at the end of it all, the business owner can choose to not enforce the agreed upon time off schedule. In this case, the business owner cannot explicitly coerce the employee to abide by this top-down decision he or she made, but the employee certainly may lose their job if they do not comply. The power of the government goes even further.
In any contractual negotiation where the government is a negotiating party, it is also the enforcing party. It effectively acts as both party and arbiter. Therefore, any contract negotiated with the government is one where “good faith” shoulders a heavy burden. Just because a given government has not chosen to wield this power does not mean it does not have the power to wield it. A government entity could solicit bids from local contractors to complete repairs on the state highway. The bid process may proceed as normal, however, if that entity does not like the bids it has received, it is possible for the state to conscript a firm to complete the repairs at a price decreed by the state. Again, I’m not suggesting this has happened before or is even a frequent occurrence, the point is that it is possible for the state to decide to do this. The power of the government to enforce its own contracted agreements with private parties is what earns it the label of super firm. The government can choose to circumvent the market in any given negotiation in which it participates.
As it is with many things in economics, this potential exists on a spectrum. The “good faith” private negotiating parties will have in the government to not wield its super firm ability will necessarily impact the negotiatory incentives facing those private parties. The mixed economy falls somewhere on this spectrum. In any given negotiation involving a government entity, there is some chance that the super firm will circumvent the agreed upon terms. Taken at face value, this would incentivize dishonesty in the negotiation process, distort price signals communicated to the government in the market process, and generally distort the very market the government is participating in, be it through solicitation or the public-private partnership.
In each case, the fact that the government is a super firm necessarily impacts the knowledge available to the government in these markets through the distortionary effect it has on price signals and negotiation incentives which will impose downstream effects that cannot be explicitly outlined but are certainly negative.
The primary problem with the mixed economy is the lack of aggregable knowledge. The proximate cause is the simple distortionary presence of the government in a market setting. When left to its own devices, the market process produces dispersed and actionable knowledge sufficient enough for multiple actors to coordinate economic activity. By inserting a super firm into the mix, not only do we limit the knowledge emergent of the market system, we distort the dispersed and contextual knowledge through the incentives implied by super firm participation. Ultimately, the mixed economy is simply a bad idea and one that falls victim to the same pitfalls in knowledge and planning ability that befell previous socialist economies.
