In his book Law’s Order, David Friedman analyzes the insurance business and finds it has historically had two problems: moral hazard and adverse selection. On the basis of these, he proclaims the insurance market “inefficient.” The market for used cars has a “lemons problem.” Inefficient, says Friedman. Pollution imposes some uninternalized external costs on others. Inefficient!
Friedman sets up the lemons problem as follows:
Sellers know more about their cars than buyers do, and the worse the car, the more willing the owner is to sell. This time it is the seller who has private information — with the result that his willingness to sell is at least weak evidence that the car is a lemon.
Buyers reduce what they are willing to offer to take account of that evidence, making sale even less attractive to owners of cars in good condition.
The result may be that “only the worst car sells… or many cars go unsold.” Now on its own terms, the example is strange. For there are by stipulation owners of non-lemons. These people may want to sell for any number of reasons: they want a new car; they want to lease rather than own; they struck it rich and want an expensive model; etc. There are other reasons to sell one’s car beside to unload a piece of junk on an unsuspecting victim. And there are fraudulent sellers in every market, not just for used cars. The mere act of putting a car for sale is not by itself evidence, even weak, that the car is bad.
What does it even matter what the seller knows? The only issue is whether the object is worth the money to the buyer. Why not, for example, take the car to a mechanic before signing the contract? If doing so over and over is expensive, why not get a detailed report from a reputable mechanic that the car is decent? Why can’t mechanics advertise their integrity at certifying used cars?
But granting the assumption, why believe that this problem is unsolvable? Friedman has clearly identified the lemons difficulty as some sort of fundamental metaphysical evil in the world, such as perhaps scarcity or inevitability of death. He has looked deep and learned exactly “what’s wrong with the world.” The “inefficiency” is an eternal defect in this vale of tears.
Yet his own words belie this claim:
A friend of mine who was looking for a used car devised an ingenious way of inducing sellers to reveal their private information. Having located a car he liked, he asked the seller if he was willing, for an additional payment, to provide a one-year guarantee. The seller declined. My friend continued looking. Eventually he found a car he liked whose seller was prepared to sell him a guarantee as well as a car. He bought the car — without the guarantee.
Apparently, increases in “efficiency” which the “bureaucrat-god” Friedman did not foresee are possible. Perhaps five years from now another friend of his will come up with a still more clever idea. There is no absolute efficiency: yesterday’s methods of production and business practices are less efficient than today’s, and today’s will be less efficient than tomorrow’s.
Friedman is insolent enough to tell used car buyer and sellers, including those who are do it for a living, how to go about their business. He has declared the problem forever beyond human power to solve. And this is wrong.
Similarly, insurance entrepreneurs are quite capable of improving their ways of doing business and indeed their “efficiency” without any input from Friedman. He complains that the discovery of a reliable genetic test that can tell us who has bad hearts and who does not can make us “on the net worse off,” since it can make unhealthy people unable to buy life insurance. Well, so what? There is no God-given right to have life insurance. You can’t be insured against things that are under your own control such as suicide, and you can’t be insured against death that you know is inevitable within a definite time frame. People with bad hearts before the invention of the test were simply exploiting insurance companies, one might say almost unjustly. They were also raising the costs of insurance to people with good hearts. That they are uninsurable is neither a moral or legal problem nor an economic inefficiency. It’s interesting how in the consideration of this problem, Friedman proposes several “rules,” such as “The test is banned; nobody is allowed to use it”; “Individuals are permitted to be tested… Insurance companies are forbidden…” Presumably, every new market invention must be evaluated by Friedman personally or by the state for its “efficiency.” What is efficient will then be determined by the bureaucrats not by consumers. And after this Friedman dares to call himself a supporter of free trade!
In any case, just as before, in 100 years, for all we know, the insurance business model will be improved with new technology that will mitigate both moral hazards and adverse selection. Friedman did not invent insurance; he did not predict that the insurance industry would arise or what it would look like; he merely studied the state of the market during a short time slice: the present day. He cannot argue that what exists right now is the final word on the “efficient” ways of doing business.
The real reason why negative externalities are inefficient is not that too much of a certain good is being produced right now, but that the producer of the good has diminished incentive to increase his efficiency in the future by struggling to lower his costs of production. On the contrary, he faces an incentive to lower his internal costs by converting them into external costs borne by others. In this sense externalities do check economic progress.
It’s ironic that Friedman feels pained by market inefficiencies yet contends that the common law is efficient. In 20 years, the market will be totally and unpredictably different from what it is now; what is efficient today will not be efficient tomorrow; numerous present-day inefficiencies will be fixed and eliminated. Yet the common law in 20 years will stay largely the same. But judges are fallible humans who make mistakes. My research into abortion cases in the United States has made it clear to me that even the highest judges indulge in atrocious reasoning. Friedman may as well say that physics is efficient, because if it were not, it would have been equilibrated toward perfect understanding by scientists long ago. There is no invisible hand guiding lawyers and political philosophers toward truth. Therefore, Friedman is free to innovate by proposing more efficient (or just) judicial legislation. But he should not presume to instruct businessmen on how to do their jobs.