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Behavioral Science Explains the Failure of Free Markets

March 23, 2016

Most of you know me as a behavioral science guy, but I have to make a confession: my initial training is in Economics and business administration. Being born in a country with a communist dictatorship, with a centralized economy and spending much of childhood and teenage years in a chaotic backwards transition to market economy, I firmly believed in the virtues for free markets.

 

Perhaps because of this experience and seeing what free markets can do in a society unaccustomed to how they work, made me think hard if free markets are as virtuous as I thought them to be. And the answer is ambivalent: on the one hand, yes! It is absolutely obvious that a free market economy is far better than a centralized and corrupt one. On the other hand, however, free markets can be extremely perverse and lead to severely sub-optimal results (equilibrium).

 

Too often free markets fail to achieve the goal of maximizing consumer benefit.

 

When thinking about the pros of free markets, there are two prevalent assumptions:

(1) people (buyers) fully understand what they are buying and

(2) people can punish sellers by not buying from them anymore.

 

When these two assumptions are met and when there is competition among sellers, free markets work just fine.

 

 

Consider the example of fruit and vegetables. Anyone can understand what they are, anyone can quickly assess their quality, even if not necessarily before purchasing. Since they are bought frequently anyone can punish a seller by not buying from him or her next time they are shopping. Moreover, if the product is faulty, the damage to the buyer is minimal.

 

Another similar example is that of hair-dresser saloons (establishments). Anyone can quickly assess if they are happy with their new haircut, with the service provided etc. Although we don’t usually visit the hairdresser as often as we buy fruit and vegetables, the purchase of such services is frequent enough to allow the buyers to punish the sellers by not going to their establishment next time they get a haircut. Again, the damage caused to the buyer if the service is faulty is relatively low (unless it’s your wedding day).

 

In such situations free markets work just fine with minimal (common sense) regulation.

 

When the two assumptions of (1) people (buyers) fully understand what they are buying and (2) people can punish sellers by not buying from them anymore are not met, free markets are disasters waiting to happen.

 

An obvious example is the banking / credit market. For the huge majority of people a loan is a difficult to understand product and not seldom banks (credit institutions) make them even more complicated than they should be. Understanding the exponential relationship between the cost of the credit and the duration of the loan is extremely difficult even for trained economists. Fully understanding the maze of interest rates and fees requires a chess-master’s mind coupled with lengthy deliberation, computations and spreadsheets. The huge majority of people who take loans do not have these abilities or afford the necessary effort and time. Instead they rely on simple / simplistic rules of thumb (heuristics) such as how much do I like the person selling this or which one has the smallest monthly payment.

 

 

 

Since some loans are by their very nature long term (i.e. mortgages), it is virtually impossible for the buyer (loaner) to punish the seller (bank) if the product is faulty. If you consider the duration of 20-30 years for a typical mortgage, you probably realize that many marriages don’t last that long.

 


Moreover, if the product is faulty – a loan has hidden costs or other vices, the impact on the buyer is huge. For example, between 2006 and 2008 in Romania (my country of birth) there was a frenzy of loans in Swiss francs. The people who took out those loans ended up paying more than double what they should have repaid because the exchange rate Swiss Franc to Romanian Leu (local currency) doubled. In other words, when the loan was contracted you needed 2 Romanian currency for every Swiss Franc; a few years later you needed 4 Romanian currency for every Swiss Franc. More on this here: http://naumof.blogspot.com/2015/01/the-black-swan-of-swiss-franc.html

 

Financial products are not the only ones that make free markets produce failures every other year and disasters every (other) decade.

 

Take the example of medical services. I don’t like doctors, but I have to admit that getting through medical school isn’t easy and becoming a full medical doctor requires lots of learning and training.

 

 

In the case of medical services, the client (patient) is almost always completely incompetent and incapable of evaluating the quality of the service. In some milder cases, of course, the patient can see if she recovers or not after the prescribed treatment or procedure. This, however, is not always the case.

 

Consider a root-canal treatment and a new “fake” tooth. It is almost like a mortgage. It should work fine for ten-twenty-thirty years, but on the moment it is extremely difficult to evaluate. It is very hard for the buyer to punish the seller if the product is faulty simply because quality is very hard to evaluate and purchasing is infrequent. Moreover, the quality of a good (root-canal) treatment includes the durability of the work. 
 

Naturally, in case of faulty medical products (services) the impact on the buyer’s well-being is huge.

 

Some might disagree with me on the points made above, particularly on the medical services. Some might say that they are capable of properly evaluating the quality of medical services. In fact, in many countries, patients are asked to evaluate the doctors who treated them.

 

Patient evaluations are a vicious by-product of free market thinking. It is well intended, it makes some sense and it is absolutely wrong.

 

Without proper medical training it is extremely difficult to assess if the doctor did a good job or not. As in the case of (long term) complex loans, even people with specialized training find it difficult to properly evaluate the quality of the product or service.

 

Why do some people believe they can evaluate the quality of medical services?

 

These people do not evaluate the quality of the actual medical procedure – the medical act. They are evaluating, at best, reasonable proxies.

 

For example, someone who had a root-canal treatment can evaluate how clean and modern was the dental clinic (i.e. general aspect); she can evaluate how much pain she was in; she can evaluate how the doctor and staff treated her and how much empathy they shown.     

 

All of these are, at best, correlated with the quality of the actual root canal treatment procedure. It makes sense to assume that doctors who give a lot of attention, put in a lot of effort in the actual medical procedure would have nice looking practices, while those who don’t give a damn on their work would do the same with the aspect of their practice.

 

But this is, at best, a correlational, not causal relationship.

 

Behind these (quality) evaluations is a cognitive process called “attribute substitution” in which we answer a difficult question with the answer of an easier one. When asked the difficult question of what was the quality level of the medical procedure you went through, people give the answer to the easier question of how they felt about it (during).

 

People can evaluate how they felt – the quality of the experience, not the quality of the medical procedure.

 

Free markets and a free market way of thinking (e.g. incorporating patient evaluations in doctor’s compensation) can create vicious situations that are clearly not maximizing the benefit of the buyer.

 

Patient evaluation and free markets in the medical services can lead to situations in which a competent, but grumpy doctor is overtaken by an incompetent, but very agreeable one.  

 

 

Free markets fail when it is difficult for the buyer to assess quality and it is extremely difficult to punish the seller for faulty quality of the merchandise may it be goods or services.