The tiresome second best
'How does this happen?" wondered Jay Leno on the Tonight Show recently, referring to the current shortage of flu vaccine. "How come we never run out of crack?" A fair question--and worth pondering a bit. To start with, the crack trade comes pretty close to meeting the economist's requirements for open competition. True, having all those narcs trying to shut it down pushes prices far above the actual cost of producing the stuff. Still, the outsize profits garnered by those willing to risk jail ensure an ample supply of dealers. So, setting social costs aside, the crack market is, as Leno notes, pretty efficient.
Why can't the vaccine market do likewise? First off, most of us aren't willing to set those "social costs" aside when it comes to vaccines. And unlike the average crack addict, we rightly expect both guaranteed purity and efficacy in our injectables--and an army of tort lawyers stands ready to back up those demands. This, however, drives up the cost of making vaccines --especially in the case of the flu virus, whose fast mutations require producers to constantly update their research. That also means that, unlike the typical blockbuster drug, a particular batch of vaccine has a limited sales life during which producers can recoup their investments. So, left to itself, the free market would very likely produce a limited quantity of any specific blend and sell it at top prices to those who could afford it. That's an outcome few would find acceptable. Even if we could personally afford the vaccine, we recognize that all of us have a stake in the public health. And that's the sort of interest that only collective action can address--which is why societies long ago formed governments. In other words, in this case the unfettered private marketplace will not meet legitimate consumer demands. Economists have a label for this sort of situation; they call it "second best."
Messy. The world of the second best is often a tiresome place. But, like it or not, most people spend a good deal of time in it. Not just when languishing in line for a flu shot but, for another example, while vegetating in O'Hare airport, hoping that some deregulated-but-now-bankrupt airline will finally supply the connecting flight to your desired destination. What distinguishes these messy markets from those of the first-year economics textbooks is that they are severely deficient in one or more prerequisites for pure competition, such as easy entrance for new suppliers, a relatively homogeneous product, and ample information so consumers can make the best buy.
Take the airline market. Here the big stumbling blocks are: (1) limited airports and hence landing slots, (2) customer demands for carrier investment in equipment safety and passenger screening that most likely far exceed what strict cost-benefit analysis would dictate. Other times, constraints are physical (like airports, you can't have railroads or even roads just anywhere); sometimes they're financial (the huge upfront costs of laying cable discouraged competitors from entering the cable TV market without guaranteed returns). In the case of vaccines or utilities, limits arise from public demand for nonmarket goods, such as safety, standby capability for emergencies, or service compatibility (would you want a dozen phone lines coming into your home?). Or, when it comes to things like sophisticated medical treatment, the problem is that only trained specialists can evaluate choices.
Rare, of course, is the perfect market. But when the defects are severe, the theory of the second best (first enunciated by economists Richard Lipsey and Kelvin Lancaster in 1956) tells us that the normal prescriptions dispensed by practitioners of the dismal science--namely, more deregulation and competition--don't apply. In fact, where the second best is firmly entrenched, it's impossible even to predict whether a move to less regulation or--gasp!--to more regulation will improve efficiency. You simply have to study the specifics of the situation. Worse yet, the right next move may change as the market mutates in response to altered conditions or to the policy itself.
This is a bitter pill for dyed-in-the-wool free marketers to swallow. That's especially so when it comes to punditry: It's a lot easier to prescribe another dose of free-market medicine than to deal with the intricacies of the second best. Which brings us back to vaccines and airlines. Clearly, neither market is working well now. But the right policy choices will take hard thinking. How many competitors do we want in each field? How much will we pay for broad availability and a high degree of safety? Who should foot the bill? Unfortunately, the demonstrated ability of Washington policymakers to deal with this tough sort of question is all too often, well, second best, at best.
This story appears in the November 1, 2004 print edition of U.S. News & World Report.