Friedman and Hayek

A former student wrote this week to ask some questions about an old lecture. I directed him to what I think is one of the very most important ideas in economics: The notion that a fundamental role of prices is to convey information that guides individuals' choices in a socially productive direction.

I can't improve on what Nobel-laureate Friedrich Hayek wrote about this in 1945, so I'll just link to it.

Focus on H.21 through H.24, in particular. (H.24 might be my favorite paragraph of economics ever. It totally rocks!)

Thomas Friedman, the NYT columnist, will be speaking in SLC next month, and a frequent theme of his columns is that we need to get the price signals right so that people will make socially efficient investments in energy technology. He supports higher taxes on carbon-based fuels.

This notion of getting the price signals right is straight out of Hayek. Now, there's nothing in Hayek about taxes and further Hayek's work is often held up as an intellectual justification for free markets not government taxation. How do we get from Hayek to "tax carbon"?

In Hayek's conception, prices come from perfectly competitive markets with no externalities. His discussion of tin, for example, fits this. Perfectly competitive markets without externalities "work", in the sense that they achieve a socially efficient allocation.

My interpretation of Hayek is that when markets "work" --- which they very frequently do --- we should be really, really careful about messing with them. Because government interference can mess up the price signals, which will mess up individuals' choices. Government subsidies for housing loans, for example, can mess up the prices (that is, interest rates) for home loans, and cause people to make poor choices. (Sound familiar?)

But, economists have learned a lot about when markets "work" and when they don't. Markets can fail to achieve the best outcome when externalities are present. In cases like this, prices will send the wrong signals, and we'll get a not-the-best outcome. Friedman's point is that we need to use the power of markets (with a boost from tax policy) to send the right signals.

So, go listen to Friedman (and look for me there), and read Hayek.