The Parable of the Mini-Cow: The Limits of the Market’s Ability to Price Accurately and the Less vs. More Government Question

To give some context to what I am about to say here, let me first clarify that I cannot rightfully claim to be a tree-hugger, nor a cow-hugger. I was a vegetarian for many years, and it is surely no coincidence that I was more fit and healthy during those years than ever before or since. But as the transition from young to middle adulthood brought more responsibilities my way, there were certain things that the natural force toward equilibrium inevitably moved aside. One of them, unfortunately, was my once-healthy diet and general level of attention to what I put in my mouth.

So, it is in that context, as someone who has nothing in particular against meat-eating, in theory, creed, or practice, that I’ll say that it was while I was listening to some commentary on the economics of meat that some fundamental insights on the market’s ability to accurately price became clearer to me.

I was listening to Talk of the Nation on NPR, and the guest was an author who had recently published a book on the role of food in the development of societies. I tuned in mid-way through his appearance on the program, at the moment that he happened to be discussing with a caller the tradeoffs that are involved when someone eats a steak.

By eating a single steak, a consumer is eating part of a cow (or bull, of course) that may, before its slaughter, have eaten many meals that included grain that could, theoretically, have been fed to human beings instead of livestock -- especially human beings in parts of the developing world where both cattle and grain are scarce and expensive commodities. So one could argue that, for every cow that humans consume for meat, many more meals worth of grain have been made unavailable for human consumption.

The discussion about steak was actually prompted by a caller’s question, and it didn’t venture deeply into the implications of the example of grain for humans vs. grain for cows for the question of how accurate the market is in factoring this tradeoff into the cost of a steak. But the author, interestingly, segued from the steak discussion into an analogy with the cap-and-trade debate, implying that cap-and-trade is nothing more than an attempt to recapture an environmental cost of carbon emissions that is not priced in by an unregulated market.

Producers and consumers of fuel, in other words, are not by nature inclined to think about the external side-effects of carbon emissions when they negotiate a price based on immediate issues of supply and demand. They, and by extension the entire market of producers and consumers, are blind to this hidden cost, because it does not affect their transaction directly. It’s the same phenomenon that explains, for example, why no automobile owner would voluntarily stop by the local department of highways and drop a few pennies on the counter to cover his daily share of wear-and-tear on the roads.

This was an “ah-hah” moment that helped me better contextualize the dogmatic debate on cap-and-trade that’s going on. But it also provided some basic insights into the limitations of markets in setting prices.

To illustrate, let’s take a brief look at a simple model. Imagine two islands. Island 1 is populated by people who don’t have the capacity to grow their own crops or raise their own livestock, so they are dependent for their food supply on importing food from elsewhere.

Island 2 is populated by three types of people: (1) farmers of Magic Sprouts that are nutritious for either human beings or livestock; (2) farmers of Mini-Cows that take about one year each to mature to slaughtering age, are well nourished by the Magic Sprouts, and are of a size that provides a single meal of beef for one person; and (3) Meat Lovers who eat one meal of Mini-Cow beef every day and do not eat Magic Sprouts.

The Magic Sprout farmers have two choices: they can sell to the distant inhabitants of Island 1, or to the Mini-Cow farmers, who are their neighbors on Island 2. Let’s assume, first, that the daily nutritional requirement for one human being or one Mini-Cow is met by the same amount of magic sprouts, that each inhabitant of the Island 1 is able to pay $5.00 (including freight) for a day’s supply of Magic Sprouts, and that the Mini-Cow farmers are also able to pay $5.00 for a day’s supply of Magic Sprouts for each of their Mini-Cows. All other things being equal (more on that later), the first choice of the Magic Sprout farmers will be to sell to the Mini-Cow farmers on their own island, since the cost of delivery will be much lower than the shipping cost of exporting to Island 1.

So each meal a Mini-Cow eats, in theory, makes a meal of Magic Sprouts unavailable to an inhabitant of the Island 1. And since it takes a year for a Mini-Cow to mature, the Mini-Cow requires 365 meals to provide one meal to one of the Meat Lovers on Island 2, meaning that an inhabitant of Island 1 loses 365 potential meals whenever a Meat Lover on Island 2 eats a Mini-Cow. This trade-off, in addition to being an inherently inefficient way to feed the Meat Lovers, also imposes a formidable cost on the inhabitants of the Island 1. Yet this cost is unlikely to be factored into the price that the local Mini-Cow farmers and Magic Sprout farmers negotiate (at least in the short term). But it undoubtedly will be incurred in some form by the inhabitants of Island 1, taking many possible forms, including:

• Suffering and ill health effects from hunger and malnutrition
• Higher prices needed to motivate the Magic Sprout farmers to increase their exports
• The cost of finding alternative food sources
• The cost of developing other goods that would appeal to Island 2 and whose exports would provide additional money that could be used to purchase more Magic Sprouts.

These costs could be incurred at the individual or societal level by the inhabitants of Island 1, but, one way or another, they will be incurred. But eventually, even if further out in time, these costs are also likely to affect the inhabitants of Island 2. This, again, could take many forms, such as:

• An eventual war between the islands
• Trade warfare in which the inhabitants of the Island 1 may withhold or exorbitantly raise the price of goods or services that Island 2 may need
• Foreign aid extended by the Island 2 to help feed and appease the hungry, angry inhabitants of Island 2

If this is beginning to bear some resemblance to some of the international economic and foreign policy issues now facing the United States, perhaps it is no coincidence.

As a side note, this model points to some possible inherent inefficiencies in a society whose diet centers on meat from domesticated livestock. Livestock farming creates entire populations and even subspecies of animals that otherwise would not exist -- and quite likely could not survive -- in nature, and that must, before they are slaughtered, consume numerous meals that may consist at least in part of foodstuffs that could provide meals to humans. It seems, then, that a vegetarian-centered diet is the more efficient solution to the need to feed humanity. Beef cattle, in other words, are very inefficient and expensive “middlemen” in the food chain. So factors that have little to do with efficiency must underlie the focus of the food market in the U.S. toward meat as the primary staple.

But more important to my main argument is that we see in this model a compelling illustration of how a given transaction can create external or longer-term costs that may not be fully factored into the short-term price that buyer and seller negotiate. This is one limitation on the market’s ability to accurately price. Markets price accurately only within the context of information that is available to and cared about by the buyer and seller at the time of the negotiation. That is why economists are so fond of the “other things being equal” disclaimer. Factors that are external, unknown, or not cared about by either party do not affect the negotiation.

The Mini-Cow model is simple, and from an imaginary world; but one doesn’t have to look far for real-world examples that fit at least partially. For example, the adverse health costs of cigarette smoking were not known for a long time. And even after they were known, the tobacco industry and smokers either didn’t understand well enough or care enough about the health effects to price them into the cost of the product. Health factors were not priced in until the situation reached a critical point at which regulation, taxation, and litigation forced the prices to be adjusted. And even now, after significant price increases, it seems impossible to make the case that the cost of a pack recoups the staggering human cost of premature deaths and debilitating illnesses among smokers. What is the life of a nicotine-addicted lung cancer victim worth to him or herself and to his or her family? Would a tax of $10,000 a pack be high enough?

The issue of costs that are hidden, external, or disregarded in transactions negotiated between buyers and sellers in the free market is precisely why we must have governments, taxes, and regulations, however much we may viscerally dislike them. Taxes and government budgets can be looked at, in part, as blunt instruments that enable us to make allowances, however imprecise, for such unknowns.

We often, and perhaps most of the time, don’t get it quite right, but it’s a must. Someone has to pay for the roads and bridges we break down with our cars and trucks. No one will make these payments voluntarily, and the sort of decentralized, privatized system some have called for of numerous local providers of road construction and maintenance seems laughably inefficient on the face of it. And someone has to fund the military of Island 2 to prepare for the possibility that the citizens of Island 1, eventually, may begin to feel that that they are being treated unfairly and get very, very angry.

Or, to bring the argument even closer to home, someone has to fund a social safety net that’s sufficient to prevent state unemployment insurance funds from going broke and tent cities from emerging when the economy tanks. Oops. Those things are happening now, aren't they. I guess someone hasn’t been paying enough taxes.

Again, the measures available to governments to compensate for the shortcomings of markets are blunt instruments, whose flaws can sometimes only be identified when there are failures in certain areas, the kinds of failures we see now. If financial practices were permitted that ended up undermining our entire financial system and putting out of work and homes a disproportionate number of honest, hard-working people who had always played by the rules, then there must have been a failure of regulation. The fact that there aren’t sufficient funds available to the federal government to carry the nation through our current crisis without incurring significant additional debt suggests that sufficient revenue, for an “economic insurance policy,” of sorts, was never being collected in the first place.

Even if you buy the argument that safety nets should be funded not by government but by individuals through personal savings, the insufficiency of personal savings to carry affected families through the crisis suggests that savings were not adequately incentivized, a phenomenon that involves a complex interplay among the governmental, commercial, educational, cultural, and familial domains.

As much as dogmatists on the right may continue to spout the old, Reaganite “government isn’t the solution, it’s the problem” clichés, the present indicators seem to suggest that it’s more government that we’ve needed over the past 30 years, not less. So, after a marked rightward swing of the pendulum 30 years go, we are now making an adjustment and swinging back in the other direction. There is, of course, a possibility that we’ll swing too far; and if that’s the case, we’ll just have to adjust again.

But my hope, and belief, is that with each swing, we are also making improvements to the complexly intermeshed gears and springs that drive the pendulum, putting what we have learned with each swing into adjusting the underlying technology of the clock so that the entire system continues to progress in how intelligently and effectively it operates.

We learned some good things from the swing 30 years ago that are unlikely to be lost, especially in terms of reaffirming fundamental values of entrepreneurship, work ethic, and self reliance. And no matter where the pendulum ends up stopping in its current arc, we’re sure to learn some good things again, this time around, that will also be retained for the long run, leaving us stronger still. Sphere: Related Content

The Private Sector Always Allocates Resources More Efficiently: Myth or Fact?

If you listen to conservative talk radio (and in the market I currently live in there’s not much other choice), you’re likely hearing the likes of Rusty Humphries, Glenn Beck, and Rush Limbaugh continuing to preach against an active role of government in managing the economy, based on the long-held premise that “the private sector always allocates resources more efficiently.”

But I don’t think one needs a PhD in economics to realize that this premise isn’t one that deserves serious credence anymore, if it ever really did. Like governments, businesses are run by people, with the same human failings. And the bigger businesses get, the less they become about money and efficient resource allocation, and the more they become about other things like the egos of their owners and management. If the efficient resource allocation premise were unconditionally true, then every company car would be a small hybrid. No executive would drive a company-owned Mercedes.

Having said that, I also believe that there’s nothing inherently wrong with businesses making decisions on criteria other than efficient resource allocation. Other things being equal, if a business that is legally and fairly making enough of a profit to float something like a $1.2 million office renovation, then so be it. If it’s okay with the ownership, senior managers, or shareholders, and if it’s not done by a company in the process of being rescued by taxpayers, then it’s okay with me. But it’s almost an insult to one’s intelligence to suggest that it’s an efficient allocation of resources.

When I saw former Merrill Lynch chairman John Thain on television trying to explain
away his $1.2 million office renovation, I had, on one level, the same visceral, “how dare he” reaction that most people probably did. When he tried to explain the issue away by saying that the office in its previous form just wouldn’t have been effective for him to use, there did seem to be an element of condescension and entitlement in his tone. It was almost as if he was saying, “You little guys just can’t possibly understand how essential a $1.2 million office is to a high-powered executive like me.” In the current context of economic calamity, rising unemployment, and huge corporate bailouts, Thain’s press appearance was surreal, a bit like a latter-day version of the “let them eat cake” incident.

But at another level, I also couldn’t help but feel a little embarrassed for the guy. There was something almost pathetic about his hopeless effort to explain himself. In a way, it was almost like a scene you could imagine of some poor schleb who’d managed to claw his way into middle management trying to explain to his boss an excessively pricey dinner on an expense report.

The whole incident seemed to confirm the idea that Thain had risen to his position in an environment that encouraged executives to think of such extravagances as perfectly acceptable. As Nick Foulkes wrote in a column in the April 6 issue of Newsweek, “John Thain's $1.2 million office refurbishment spree would probably have been regarded as perfectly unremarkable 18 months ago.” That’s exactly the point. Numerous factors that have nothing to do with efficient allocation of resources can drive private-sector entities to a point where excess is not only tolerated but encouraged.

The executive compensation question is similar. The AIGs of the world have defended lavish bonuses and compensation packages by asserting that they are essential to recruiting and retaining top talent. By extension, this argument follows the efficient allocation of resources line of reasoning – the fat paychecks go to the talented business geniuses who deserve them.

But, again, there’s a strong case for the fallaciousness of this argument. As Seth Godin puts it eloquently in a March 23 blog post on “The Myth of Big Salaries,” “Sometimes markets get stuck because there is a disconnect between what something costs and what you get.” Godin argues that at compensation levels above $1 million per year, the game has become about things other than money. And, by extension, I would argue that it has also become about something other than allocating resources efficiently.

When corporations reach a certain size and level of power, they tend to take on quasi-government attributes and become prone to many of the same pitfalls, such as inefficient, bureaucratic management structures and self-serving motivations of the people that run them. So it’s naïve to believe that the “invisible hand” of resource allocation choices made by businesses as “rational decision making units,” a self-regulating mechanism, is the only regulation that is ever necessary. Like individuals, businesses don’t always act rationally. So checks and balances are as essential to businesses as they are to governments.

Where those checks and balances should come from – shareholders, boards, associations, governments, etc. – is of course a highly fluid and context-dependent question. But let’s get real and stop swallowing the simplistic notion that everything would be fine and dandy if we just stepped out of the way and let the self-regulating mechanisms of the free market run their course. Sphere: Related Content