John Cochrane: “Fair or Unfair: Do Competitive Markets Give Everyone a Chance?”

Jonathan Berk: Hi, I’m Jonathan Berk, professor of finance at the Graduate School of Business at Stanford University.

Jules van Binsbergen: And I’m Jules van Binsbergen, a finance professor at the Wharton School at the University of Pennsylvania. And this is the All Else Equal podcast.

Jonathan Berk: Welcome back, everybody. Today we’re going to talk about a somewhat controversial subject, which is how do competitive markets work, and why do they lead to such good economic outcomes?

Jules van Binsbergen: Compared to the alternative.

Jonathan Berk: Exactly.

Jules van Binsbergen: So, the way to introduce the topic is as follows, Jonathan. It’s a very simple example that I use a lot in class. I say to the students, “We’re with a hundred people here in the classroom, and imagine that we’re spending the day making shoes. Everybody can only make one shoe, so you can either make a left shoe or a right shoe. At the end of the day, it turns out that 99 of us have made a left shoe, and one student in the class has made a right shoe.”

“I then say to that student, ‘I made a left shoe, you made a right shoe. A pair of shoes goes on the open market for a hundred dollars, so it seems more than fair to me that we both get $50. What do you think? Do you take my proposal?’ And invariably, the student says, ‘No, I’m not taking your proposal. You’re saying I’m the only one here with the right shoe. There are 98 other people that have a left shoe. So, I’m not going to give you $50 and I’m getting $50.’”

And then I ask the students, “Well, if the 50/50 isn’t fair because, let’s be clear, Karl Marx said it was fair. He said there’s a labor value of goods, of commodities, which implies that the amount that something is worth is how much time it took you to make it. Given the fact that we both spent exactly the same amount of time making each shoe, that should mean that they’re both going for $50.” Clearly that is not the outcome that the class agrees with.

So, then I ask, “Well, how much money do you think the left and the right show would go for?” and they say generally the right shoe should go for $99 or even more, and the left shoe should go for close to nothing. Don’t you think that’s interesting?

Jonathan Berk: Well, Jules, what I find interesting about that is, the outcome is really unfair. Right? Most people get nothing for their shoes, and one guy gets $99 for the shoe. Yet the students in your class — and I’m sure it would happen in my class, too — think the right outcome is that the one guy gets $99. There’s no sense at which the outcome where we split the money 50/50 is the right outcome. And I find that interesting. And I think there’s a reason for that.

Jules van Binsbergen: I agree. And I think the reason is that people realize that if you have something special that other people don’t have, or what we call in economics, if you have something in short supply, then that implies that you’re going to get more for that thing in short supply compared to the thing in large supply, which in this example is the left shoes.

Jonathan Berk: Exactly. And of course, that leads to a lot of unfairness. And you might think that when there’s unfairness, people would side with the fairness argument. So, I think what we want to understand today is why people don’t think that way. And so, let’s think about this. I really like your example, Jules. I want to keep it going.

Imagine I’m in a world with 50 consumers and producers making shoes. For whatever reason, the producers have made 99 left shoes and 1 right shoe. And now we have to distribute these shoes amongst 50 consumers. And the question is how do we do that? Well, first recognize that only one of those consumers can wear shoes today.

Jules van Binsbergen: Yep. Regardless of what system we pick, only one of them can wear shoes.

Jonathan Berk: Exactly. Now let’s contrast the two systems. So, in a communist system, what would happen is the government would take all the shoes. They would throw away most of the shoes. They would take one pair, one left and one right pair, and fairly distribute that pair to the 50 consumers. And one way of fairly distributing is just have a lottery, okay, and randomly pick one consumer to wear the shoes. Okay? That consumer will pay some amount for the shoes, and then the government would distribute that amount of revenue that they got for the shoes equally amongst producers. That, I think, is the way a communist system would solve this problem.

Jules van Binsbergen: Absolutely.

Jonathan Berk: And now what would happen in capitalism. In capitalism, there would be one consumer who’d wear the shoes. And who would that be? That would be the consumer with the greatest willingness to pay. Now what’s important to understand is, that’s not a very fair system, because willingness to pay is determined by two things. One thing is your need for shoes. Obviously, firefighters are going to pay more for shoes than people going to watch the ballet. On the other hand, richer people are willing to pay more for shoes than poorer people. So, what it means is, it is likely that one person who gets to wear the shoes is the richest person in the world. Okay? So, that’s going to lead to unfairness.

Jules van Binsbergen: And there’s a second level of unfairness, which is on the production side. So, on the production side, we’re going to get that the person who made that one right shoe is going to get all the rents, all the proceeds from selling the pairs of shoes in the capitalist system. Whereas in a communist system you just proposed, the government took all the shoes from everybody, sold it, and distributed the revenues equally.

Jonathan Berk: Exactly right. And I think it’s worth even thinking about what they will get. Let’s imagine then that the person with the highest willingness to pay gets the shoes. How much does he pay? Well, he’ll compete with everybody else for the shoes. How does he compete? He pays the highest price. So, what’s the highest price he’s going to pay? Well, he needs to produce a price higher than the person with the second-highest willingness to pay, but not much.

So, how much would he pay? He’ll pay one cent above the second-highest willingness to pay a person, which is going to obviously a high amount. And who’s that going to go to? Well, the producer of the right shoe will negotiate with a left shoe producer. And just as we have in the example in class, the left shoe producer, his alternative is throwing away the shoes. So, all the money will go to the right producer.

Jules van Binsbergen: Yes. The left shoe producer has no negotiation power in this whatsoever.

Jonathan Berk: And so, it’s a very unfair outcome. And those are the two equilibria. The communist one is fairer; the capitalist one isn’t. And based on that criteria, you might think that the communist one works better. But there’s one huge caveat: what happens tomorrow?

Jules van Binsbergen: And that is what it’s all about. And that’s where the key insight from competitive markets comes in, which is incentives. What incentive do we have to change things up tomorrow? And so, in the capitalist system where the right shoe is going for close to a hundred dollars, and left shoe is going for close to nothing, and we post those prices above the door. When we’re coming to the classroom tomorrow and everybody sees that right shoes are going for a hundred dollars, what shoes do you think they’re going to be making?

Jonathan Berk: Right. There’s a huge incentive now to produce right shoes. In fact, it might be an over incentive. There may be too many right shoes produced. So, it depends how sophisticated the shoe producers are. Will they anticipate that everybody’s going to want to make right shoes, and so their left shoes will be in short supply, or do they not? It may take a bit of time for that equilibrium to come back to 50 right shoes and 50 left shoes. But I assure you, as prices change, we will go to an equilibrium where 50 right shoes and 50 left shoes are produced because the prices of those shoes will be the same. Now, in that world, how many people get to wear shoes? Answer: all 50 get to wear shoes.

Jules van Binsbergen: And so, in that sense, now that everybody has shoes, wouldn’t you say that that’s fair?

Jonathan Berk: Yes, no question. It’s fairer now that everybody gets to wear shoes. There’s another sense where it’s even fairer: how much are they paying for those shoes? In the previous equilibrium, only one person wore shoes, and they paid the price of the second-highest willingness to pay, so they paid a very high price. In this equilibrium, the price they pay is the person with the lowest willingness to pay. Right? Because if the shoe producers want to sell their shoes. Right? If one shoe producer is not selling their shoes, they can always sell their shoes by lowering the price. Right?

And so, they will lower their price to the point that every consumer’s consuming. And if you want every consumer to consume, the price has to be set by the person with the lowest willingness to pay. Obviously, no lower, because then the producer’s just throwing away money. So, the price will be the price of the person with the lowest willingness to pay.

Jules van Binsbergen: And so, the key insight here is that the people benefitting the most from this competitive system is, in fact, not the producers. It is going to be the consumers, because all consumers will be paying substantially less for a pair of shoes compared to the price of the pair of shoes that we had before.

Jonathan Berk: And they’ll be walking in shoes. You look at these two equilibria, and there’s an enormous difference in welfare. On the next day, welfare is much, much higher. But not under communism. Because under communism, since everybody got paid equally, there’s no incentive to change production. And so, the next day we get the same imbalance of left and right shoes, and only one person gets to wear shoes.

Jules van Binsbergen: So now, what if somebody says, “Yeah, well, wait a second. Can we not have a government who’s going to fix this for us? Can we not just have somebody who said, ‘I want both the fairness, and I want to have 50 pairs of shoes. So, the way we’re going to solve this is, the government will tell 50 people to make left shoes and 50 people to make right shoes. Aren’t we done?’”

Jonathan Berk: Yes, Jules, and that’s the obvious answer to me. “Jonathan, come on. Just have the shoe manufacturers make the right pair of shoes.” And of course, in this simple example that’s true. But the problem is this is a very simple example. In the real world, these are incredibly complicated decisions. How many iPhones versus television sets should we make? That is too complicated a decision for a government to make.

Jules van Binsbergen: Now for some reason, if you listen to debate on the topic today, despite the fact that communism has been tried in close to 50 countries and has essentially failed every time, there’s still people that say, “Yeah, but that’s just because it hasn’t been tried properly.” And so, the latest argument, I think, that’s brought forward is the argument to say now that we have big data, now that we can analyze and forecast demand better, couldn’t we now have the government with the supercomputer implement what’s called a planned economy and get end fairness and perfect resource allocation? What do you say to that?

Jonathan Berk: Well, I think it’s a bit naive. I think we’re a very, very long way from having a technological sophistication to actually solve these complicated problems. But let’s assume that away, and assume that, in fact, we did have that technology so we could redistribute and maximize welfare.

The concern I have, Jules, is in order to do that, you need an enormous amount of information. And the government has to know a tremendous amount the economy. And I think that can be abused. Once the government knows a lot of information about its citizens, I think the government can use that information in a way to abuse that information.

Jules van Binsbergen: And so, in that sense, the fact that so many communist regimes have turned out to be totalitarian regimes may not be a coincidence.

Jonathan Berk: I don’t think that’s a coincidence at all. I think the reason why communist regimes become totalitarian is because of the requirements of information that they have that then allow them to abuse the information. And the beauty of the capitalist system is you don’t have to collect the information. There’s no requirement. The prices reveal it. They do not have to be collected in aggregate. So, there’s much harder for that economy to become totalitarian.

Jules van Binsbergen: Because it’s a decentralized information system.

Jonathan Berk: I think the key thing to realize here is the unfairness of the system is the reason the system works. Right? The reason why people produce more right shoes is because the price of right shoes goes to $100. We needed that unfairness in order to make things work.

Jules van Binsbergen: To get the incentives for people to change their behavior and start making the other types of shoes.

Jonathan Berk: And that led to more fairness. But we needed that unfairness. And I think a mistake, an all else equal mistake that many people make, is to not recognize that tradeoff, to think that capitalism can work without having the unfairness.

Jules van Binsbergen: No, and the way that people say it is why can’t we keep capitalism, but do away with the bad parts and only keep the good parts? And of course, that’s an all else equal mistake, because you cannot have the good bits without the bad bits.

Jonathan Berk: And the bad bits — let’s be clear about this — there is unfairness in the system. But often, the competitor of forces work to remove the unfairness. Right? And in that sense lead to more fairness. Not always. Somebody who’s born with particular productive skills — for example, a basketball player — a really good basketball player is going to be a richer person in the economy by mere fact that they have the talent. Probably also with hard work, but also that they have the talent. And that was a luck of the draw of being born with basketball talent.

So, there will still be unfairness in the system. But the fact is, the unfairness causes people who play basketball, and therefore entertain all of us. And we get tremendous welfare gains by being able to watch Michael Jordan play basketball.

Jules van Binsbergen: No, and I think that one of the reasons why we see a bit of confusion in the debate today is that when there are particular parties that get excessive rents, it is often not because there’s too much competition. It is because we have too little competition. And so, encouraging competition can make sure that excess rents are not being earned by particular parties.

In the example of Michael Jordan, everybody understands that the reason why the person gets the high salary is purely because they won the competition in an extremely competitive setting where there are hundreds of people competing with each other for being the best player. If you end up on top, you’re just the best. But if you’re a company and you make a lot of money because you’re a monopolist, that of course is a different matter.

And so, in many cases, I think people confuse the competitive system with unequal outcomes. They think it’s because there’s too much competition, but in fact, there’s too little of it.

Jonathan Berk: Very often there is too little competition. Okay, Jules, so I think the time is right now to introduce our guest for the day.

Jules van Binsbergen: I agree. We are very, very happy to have John Cochrane, who is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution at Stanford University. Previously, he was a professor of finance and economics at the University of Chicago, and he writes The Grumpy Economist blog and is a cohost of the GoodFellows podcast at the Hoover Institution. John is one of the prominent free market economists of our time who takes seriously the importance of clearly communicating economic ideas.

So, John, just as a first question, in general, why do you think economies that have free markets do so much better than economies that do not?

John Cochrane: That’s a good question. Let’s start with that I think is the clear observation of history. We don’t start with theory. We can just start with experience. Look around. How’s things doing in North Korea, Venezuela, Cuba, and the rest of it versus the somewhat freer markets of the United States? So, our job is to understand that undeniable historical fact told to us over and over again.

Free markets is actually halfway down the step. These days I like to call it incentive economics. Because really what it’s all about is giving people the incentives to work, save, invest, to serve their neighbors. Why should someone spend eight hours of their day down at Whole Foods checking out your groceries and doing you a wonderful service? Well, they have incentives to do that, incentives to start new businesses. Plus, competition. There are not just incentives, but there’s competition.

Those are the two key, I think, ingredients: the ability to start new businesses to kick out incumbent businesses that aren’t doing a good job to innovate to make things better for all of us. And nobody likes competition. People in businesses hate competition. Free markets is not a pro-business stance. It’s actually very revolutionary to existing businesses. The taxi monopolies hated Uber, and they still do, but we get better rides and people get better opportunities to work.

Jonathan Berk: Well, so, with competition, of course, comes inequality, because competition implies winners and losers. And so, is that a necessary outcome? Do we have to have that inequality?

John Cochrane: Yes. Now I think this is a big topic which we could spend a lot of time on. The degree of inequality, I think, is vastly overstated. The numbers have been really pushed. The idea that inequality is increasing dramatically is overstated. Our society is, in fact, much more equal than, say, the Soviet Union. Now not on reported numbers, but you had to be a high up member of the communist party to get access to anything that was then given to you, so you didn’t report lots of numbers. But it was horrendously less equal.

Jonathan Berk: It’s interesting you say that, John, because like you, I’m most astonished at the perception of inequality. In the last 30 years, we’ve pulled more people out of poverty in the world than in the entire history of the world. I mean, it’s just a remarkable achievement in terms of pulling people out of poverty, and therefore making people more equal. Why do you think it is that people haven’t celebrated this fact more?

John Cochrane: Yeah. We’ll get around to your question of why we need some inequality, but let’s think of the bigger issue. First big issue: global inequality has declined precipitously in our lifetimes. Vast numbers of poor Chinese people are now lower-middle-income Chinese people. That’s something to celebrate tremendously.

I would ask you why do you care about inequality. I care about prosperity. I care about opportunity. I think a lot of people bemoan inequality in the United States are really using the wrong word. But they see a fact which is true, that a lot of people on the lower end of our economic scale are denied opportunities. They are faced with horrendous public schools in the thrall of teachers unions. But that’s not inequality. That’s a problem of its own. That’s a lack of opportunity and prosperity. What does the kid in Fresno who’s having trouble getting a high school class that will teach him algebra, what does he care whether a hedge fund manager flies in a Learjet or a Gulfstream? Not at all. Let’s focus on the problem that’s actually there and not, frankly, envy.

So, there’s good inequality and bad inequality. The Internet titans, found new companies, gave us wonderful products, and pocketed for themselves billions, which are tiny percentages of the welfare they gave the rest of us. I think that’s good inequality. We all got better off; they got a little better off than we do.

There’s bad inequality, the oligarch inequality, people who can use the power of government to enrich themselves at our expense. But those are symptoms of underlying problems. Those are not problems themselves. Why does there have to be some inequality? Because there has to be incentives. And some people will take the incentives and some people will not take the incentives. There has to be a reward for risk. If it’s from each according to their abilities to each according to their need, and we all get the same amount, then nobody works hard, nobody starts a business, nobody takes hard classes. We all take art history, which is a whole lot more fun than accounting, and then there’s no one left to balance the books.

So, there’s a budget constraint. It’s a big word in economics. You can’t have everything you want. You always have to balance incentives with insurance. The more insurance you give people, the less they take care of stuff. So, there has to be incentives, and the result of incentives is a certain amount of inequality. But the picture of capitalism as this horrible place where some are dying in the streets and some are making bazillions unless the government forcibly redistributes is simply false. An opportunistic capitalism allows people all sorts of ways to improve themselves, and a decent amount of social insurance. I’m not advocating we get rid of social insurance.

Jules van Binsbergen: So, in the tradeoff between insurance and incentives, we can take different countries and put them on a different scale. Right? Do you think that the maximum is pretty flat, meaning that it doesn’t really matter whether you do things the way that Sweden does it versus the U.S., or do you think there’s a lot of fine tuning that is required?

John Cochrane: I think there’s tremendous fine tuning that’s required. And by the way, I can tell by your accent, Jules, that your listeners may not know you know something about Europe, unlike most progressives in the U.S. who don’t know anything about Europe.

Jules van Binsbergen: Yeah.

John Cochrane: Northern Scandinavia handles incentives a lot better than the U.S. does. They have higher taxes and more welfare payments. But they are very hard-nosed about, say, work requirements, which the U.S. is getting rid of in our social programs.

Jules van Binsbergen: Definitely.

John Cochrane: If you don’t pay your mortgage in Sweden, they garnish your assets. You live on 15 grand a year until you pay it back again. The U.S. you just give it away. So, they have a little more — They have managed those with a little — They have a bigger carrot, but they also have a bigger stick, and they’re pretty hard-nosed about that sense of personal responsibility.

Jules van Binsbergen: Yep.

John Cochrane: I focus on the long run. And I think, first of all, much of our redistribution is not from rich to poor. Almost all of our redistribution is to politically important groups from middle class to middle class. With trillions of dollars of government redistribution going on, there is no reason that there are homeless people, schizophrenics out on the street. It’s not going to them. It’s going to farmers, it’s going to businessmen, it’s going to homeowners, it’s going to builders. So, I think we vastly overstate how much it’s actually going from rich to poor, which it really isn’t.

The U.S. has a vastly more progressive income tax system than Europe as well. So, it’s not clear [there]. But to the point, I think what’s being forgotten is long-run growth. We may have a balance of incentives you could argue on the annual income on who chooses to go to work and who doesn’t. But disincentives are particularly pernicious when they pile up year after year. And the U.S. is, since 2000, growing at half the rate that it did in the post war era, and far more is possible. So, that’s where the incentives to get a good education, start a business and so forth really kick in.

Jules van Binsbergen: So, you think it’s mainly incentives or could it also be population growth that’s slowing down that’s causing that slowdown in growth? You think we could do so much better than we’re currently doing, which that’s a hopeful message in some sense for growth.

John Cochrane: Well, growth per capita has slowed down dramatically.

Jules van Binsbergen: Yeah.

John Cochrane: And so, now there’s some — When you guys have Chad Jones on and the fancy growth theorists on, there is some intertwining on the rate of population growth and the rate of growth per capita. But the first order, what matters is growth per capita, and that’s slowing down dramatically as well. That doesn’t get fixed with stimulus. That doesn’t get fixed with programs. Growth per capital gets fixed only by greater productivity growth, which is innovation. And not just technical innovation, but better, more competitive, more cost-efficient businesses.

Jonathan Berk: In society today, if somebody does not have an education, there is no job. Right? You’re denying them the means of production.

John Cochrane: You used the word not educate. Let’s just go to not allow education. If we simply allowed them choice in which schools they went to, people could do — We’re not allowing them opportunity, creating an average [underclass].

Each bit of growth is hard won. We think of it as there’s this automatic two percent a year. No. Every bit of that two percent was just scratched and clawed away by difficult process. And part of the wonderful thing that happened in the U.S. economy from the 1950s until the 2000s was education. Universities did not used to be meritocratic. Universities used to be where the WASP elite go to meet the other WASP elite and go to easy jobs.

And what happened in universities, and to some extent in what used to be good public high schools, especially California which used to have excellent ones, we allowed smart people to match up with jobs that used their smarts. Women, minorities, all were allowed in on this wonderful meritocratic system. It used to be each of us, if our father was a butcher, we’d be a butcher. And just because you’re smart enough to be a finance professor, well, the finance professor jobs were held by the finance professor guild. Allowing people the opportunity to develop their talents and to match them with tremendous productive opportunities that now you have in specialized cognitive tests, that is a lot of the growth we have. And that came out of a meritocratic education system.

So, I’m going on here because I think we’re in deep trouble. And the decline of the K through 12 education system and universities abandoning the meritocratic ideal is, I think, really going to hurt us in terms of long-run growth just because you got smart people whose lives are being wasted being good drug dealers rather than learning some math and going on to be an accountant.

Jules van Binsbergen: So, John, what do you think is the most effective response against these trends that we’re seeing against free markets, the shareholder model versus the stakeholder model? Well, how do you see the future developing and what do you think the most effective response is to this movement?

John Cochrane: I would say three. We tend to be very historical, and we’re actually rubbing out lots of our history. The case for incentives, which leads to free markets, for a system based on property rights and rule of law rather than government telling you what you need to do, that case does not have to be a moral or ethical case. It can simply be an experience case. People tried the other one and it didn’t work.

When the pilgrims showed up in the U.S. in 1620 — I hope we’re all still allowed to talk about them — they actually did buy and receive permission, by the way, from local natives to show up. When they showed up, the first thing they tried was communal agriculture because we’re all in this together, and they starved. And about two years later they figure, you know what, everybody needs their own vegetable plot. And all of a sudden, people start putting in a lot more effort in the vegetable plot and they didn’t starve so much anymore. So, we’ve had this experience over and over again that a system where you have incentives is the only one where we all don’t end up worse.

Second, tell the truth, and expose the truth. Stakeholder capitalism is a word salad, an Orwellian word salad, for political control of how companies work. And I would add, my biggest two cents in favor of let’s call it — I don’t like the word capitalism because Marx invented that word, and it was not designed to be a pleasant word. And it focuses too much attention on the accumulation of capital, on putting money into businesses. Businesses don’t take a lot of money today. Businesses take time and organization and people and skill and technology. But it’s not Sir Topham Hatt with the enormous amount of money that goes into it.

But the system we’re talking about, the incentive system, the rights-based system, the rule-of-law system, the you-do-what-you-want-with-your-property system, that is the only — the ethical claim I’ll make for it is it’s the only peaceful system. The only system that does not involve at the end somewhere somebody threatening violence to take what you have and tell you what to do or threaten violence to tell you what to do. That’s just inescapable.

If you think we need more government redistribution, in the end someone’s going to show up with a gun at your front door and say, “Give me that stuff.” And what you like to call capitalist system, it’s just the system of freedom. It’s freedom applied to economic areas as well as social areas, the system of freedom, rights, and rule of law. It’s the only peaceful one that’s ever been imagined.

Jonathan Berk: John, thank you very much. That was a really insightful discussion. I think you brought up some very important points that are often not appreciated.

John Cochrane: Thank you. We try our best. Keep thinking outside the box, guys.

Jules van Binsbergen: Thanks for being with us. It was great. All right, Jonathan. I think that was a great conversation. I think there were lots of insights there, also with respect to the educational system.

Jonathan Berk: Yeah. I mean, I really resonated with that because capitalism works because of incentives. But people need the means to respond to incentives. And without an education, you can’t produce.

Jules van Binsbergen: And so, I think that really comes back to the discussion between equality of opportunity versus equality of outcome. If we want to get equality of opportunity, we need to give people the means to respond to incentives.

Jonathan Berk: And that requires a good education system. And if you ask me what my biggest worry about capitalism in America is, it’s that our education system has deteriorated over time.

Jules van Binsbergen: And it’s failing a lot of people.

Jonathan Berk: Yes. Okay, in two weeks, we’re going to talk about corporate bankruptcy, and in particular, how bad corporate bankruptcy is and whether or not we should have government programs to stop corporations from going bankrupt.

Jules van Binsbergen: We hope you will join us in two weeks.

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