Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't John Jr. (the dot read aloud .txt) 📖

risk in their everyday lives, different people are willing to pay different amounts for insuring quality. If a person wants the maximum guarantee that a car will perform as it should, he can shell out lots of money to buy a new Lexus. But for some people, price is more important than more quality assurance; they are willing to face a high risk of a car breaking down in return for paying a low price for it. As firms increase quality guarantees to avoid high fraud penalties, prices rise as well. Suppose that all firms were forced to make cars as dependable as a Lexus. We’d end up with very few accusations of fraud, but we’d also have many people who could no longer afford a car.

Aside from fraud cases, reputations factor unexpectedly into other aspects of business management. Let’s look at just one everyday example—the franchising of gas stations. There are a lot of advantages to franchising. Franchises tend to be well-run because the owners, with a direct interest in profitability, are right there on the premises overseeing operations, as opposed to sitting in some remote corporate headquarters. Having well-managed franchises also burnishes the reputation of the franchisor corporation, whose logo, of course, is attached to the franchise.

So why aren’t all gas stations franchised? The answer becomes apparent if we look at areas where corporations prefer not to franchise. Corporate headquarters tend to operate directly the company’s own gas stations in areas without many repeat customers, for example, next to a superhighway. The problem with a franchise in this situation is that the owner has less of an incentive than usual to operate the business because satisfied customers are unlikely to return to the station anyway. If customers get cheated or are subject to poor service, however, they may stop frequenting that chain in many other places, thus damaging other franchises carrying the same logo. The franchisee that actually provided the poor service will not suffer much of the consequences of its own poor service.84

Reputations play an important, though often unacknowledged, role in society. Notwithstanding the high-profile corporate and political scandals that will always occur from time to time, concern over reputations helps keep people honest; the loss of a good reputation can easily devastate the future prospects for a politician, corporation, or an individual, as we have seen. As long as this remains true, reputations will continue to function as a vital component of our free market democracy.

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Government as Nirvana?

People frequently call for government intervention in the economy whenever the market is believed to be acting imperfectly.1 Implicitly, the comparison is between the flawed way the market actually works on the one hand, and a nirvana-like state of government-run perfection on the other. Do distortions ever develop in the free market? Of course they do. Few people would argue that the market is flawless. But it’s a long leap from showing that such imperfections exist to proving that they would be solved or even mitigated by government intervention. In fact, government intrusion in the economy tends to result in more inefficiency, unfairness, and even predation than we would find in a completely free market.

C’mon and Take a Free Ride

One of the most common methods of government intervention is to encourage certain beneficial actions through subsidies. Recall our earlier discussion about LoJack, the car antitheft device. LoJack’s social benefit—the overall drop in car thefts we would allegedly see due to the fear among thieves that any car might have a LoJack—was said to be ten times larger than the benefit for any individual LoJack users.2 But the government would have to subsidize the device in order to get car manufacturers to install it in enough vehicles to capture the full social benefit.3 Advocates of such a subsidy used this kind of argument to justify forcing insurance companies to give discounts to LoJack users.4

Remember the counter-argument, however. Porsche could solve this problem for its customers by putting LoJacks on its own vehicles, and thieves would consequently steal fewer Porsches and more of every other kind of car. But this would harm everyone who doesn’t drive a Porsche. In that case, instead of being rewarded with a subsidy for installing LoJack, Porsche should instead have to pay a tax on it.

Here we see that having a subsidy when there really should be a tax—or visa-versa—is worse than doing nothing. If we subsidize a harmful activity, we end up encouraging it. If we tax a beneficial activity, we inadvertently discourage it. And if a subsidy or tax is too large or too small, we create market distortions. Smoking may be unhealthy, but excessively high cigarette taxes will create a black market in cigarettes. Similarly, growing wheat may be vital for feeding the country, but over-subsidizing it will induce farmers to stop growing other crops. In the case of LoJack, if the device has no significant impact on auto theft rates, as attested to by car manufacturers, insurance companies, and recent academic research, then the product should not have any special subsidies or taxes at all.

Even if the benefits of LoJack were confirmed and the proper subsidy could be precisely calculated, there is another problem: trusting the government to approve the right subsidy. Politicians representing districts where LoJacks are made would probably support a subsidy far in excess of the correct amount, while politicians representing competitors’ districts would likely seek to reduce the funding.5

A similar example involves concealed handguns. Those who carry permitted concealed handguns deter criminals from attacking others in their localities because criminals fear that any potential victim may be carrying a gun. Despite this social benefit, it’s not clear that the government should subsidize concealed handguns. As with most cases of government subsidies, the problem lies in the difficulty of calculating how much the subsidy should be. Even though a clear social benefit exists, figuring out the subsidy would require complex estimates of the number of crimes that would have taken place if concealed