Firm Functionalism By Bryan Caplan

“My dear Martin, yet once more Pangloss was right: all is for the best.” – Candide

I have little sympathy for the Panglossian view that the status quo is socially optimal – or even socially satisfactory. When I look at the world, I see vicious government policies, awful wars, and grotesque waste. You could chalk this up to my libertarian priors, and not without just cause. But in my defense, individual behavior often strikes me as sadly dysfunctional, too. People would be markedly happier if they second-guessed their impulses, built a Beautiful Bubble, and walked away from their own misanthropy. They don’t, but they should.

Still, one major form of social organization strikes me as highly functional – not merely from the point of view of the organizers themselves, but for society as a whole. Ironically, it is arguably the most-maligned form of social organization: for-profit business. Though I freely acknowledge the many shortcomings of the business community, it is far more sinned against than sinning.

How can I say this, when every intro econ textbook has multiple chapters packed with models of socially dysfunctional business arrangements? By using my generic rebuttal: Most of these accusations casually assume away crucial constraints. Once you take these constraints seriously, the performance of the business world is objectively outstanding.

Let’s start with mainstream economists’ classic complaint about the market: Firms fall far short of the textbook model of perfect competition. Sure, they say, markets would be great if every industry had a vast number of tiny firms. But in the real world, perfect competition is rare. Indeed, if you define markets narrowly (e.g. upscale Italian restaurants within five minutes of my house), monopoly is everywhere.

My specific rebuttal: Perfect competition is socially optimal in industries with constant returns to scale. But in the real world, almost every industry has increasing returns to scale; firms can produce twice as much at less than twice the cost… at least over a big range. Given increasing returns, it’s good that we don’t have tons of tiny firms, because each of them would have needlessly high costs of production.

Yes, this allows successful firms to earn monopoly profits. But the opportunity to earn these monopoly profits is a great incentive to make (and keep!) your firm great. When you see a big firm, don’t ask, “Is this a monopoly?” On the textbook definition, the answer’s almost always “Yes.” But so what? The important question is: “How did this firm become a monopoly in the first place?” If your answer is something like, “By offering great products at low prices,” you’re seeing the world my way. Amazon, Netflix, CostCo, Wegmans… I love you all.

Next, take the textbook case against “monopolistic competition.” With homogeneous products, monopolistic competition is a clear waste of resources, because every firm produces above minimum average cost. In the real world, however, monopolistic competition arises in industries with differentiated products. Why do firms differentiate their products? Because consumers value variety! This is even more important than it seems because variety takes many forms. Products don’t merely physically differ from each other. They also differ in their location; a grocery store across the street is better for consumers than an identical store thirty minutes away. Indeed, the difference can be purely psychological; sometimes a firm pleases consumers by weaving a fun image for a physically unexceptional product. Think… Hatchimals.

Cycling through the standard textbook complaints, critics often claim that markets perform poorly due to imperfect information. In the real world, though, businesses continuously help their customers cope with imperfect information. Firms have always taken reputation seriously; now, with the rise of online reviews, they prize them. These reputations don’t make information perfect, but they’re extremely informative nonetheless. The same goes, naturally, when firms sell their products with a warranty. When consumers read “100% satisfaction guaranteed,” they feel the weight of uncertainty lift from their shoulders.

What about the twin evils of adverse selection and moral hazard? Here too, firms are tirelessly on the job. In the insurance industry, one of actuaries‘ main functions is to handle these frictions. Indeed, when you pay close attention, non-economists’ main complaint about insurance is that firms charge riskier customers higher premiums. In a simple adverse selection model, firms would lack the knowledge to do so.

Last case: In recent years, economists have resumed worrying about monopsony (or at least monopsonistic competition). They’re trivially right: Few workers can painlessly choose between thousands of competing employers.

Once again, though, I say that when these market structures arise, they’re socially functional. Monopsony allows firms to realize economies of scale; economies of scale raise worker productivity; and higher worker productivity allows better pay and working conditions. An analogous point holds for monopsonistic competition. Just as monopolistic competition gives consumers product variety, monopsonistic competition gives workers job variety. Professors should have no trouble accepting this point: When we choose between two university employers, we don’t just care about salary. We also consider colleagues, location, student quality, campus facilities, and much more. If gray uniformity is the price of perfect competition, just say no.

General lesson: Instead of bemoaning monopsony, you should ask, “How did this firm become a monopsony?” If the answer is something like, “By offering workers a better deal than the competition,” take a deep breath and relax.

Are there exceptions to the rule of firm functionalism? Of course.

Business has yet to solve the grave evil of unemployment – though it’s doing well for the time being.

Firms’ have many creative remedies for externalities, but their response to both positive and negative externalities remains disappointing.

Plenty of businesses engage in socially destructive lobbying, though I’d take them over populists and NIMBYs any day.

And yes, when consumers like junk, firms mass produce junk. See the astrology “industry.”

Rather than fume, though, let us give thanks. Compared to the abundance and choice that business provides, these are minor failings. Business isn’t just underrated. Business isn’t just more socially functional than any other forms of social organization. Business is a shining role model for what human cooperation can accomplish.

P.S. Capla-Con 2018, my annual festival of nerddom, is this weekend. Email me for an invite!