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A central tenet of libertarianism is the notion of free association–being able to socialise and enter into contracts with people of your choosing, with the corollary of being able to refuse to do those things too. The obvious criticism of this would be that one could then refuse to sell to people based on their skin colour, sex, orientation, etc., which has a historical precedent pretty much all over the globe. Does this make economic sense, though, or does it represent a market failure?

To my non-economist eyes it looks pretty cut and dry. Say Alice has a widget store and decides to only sell to people in group A. Bob also has a widget store and sells to both groups A & B. Surely Bob should have a significant economic advantage here, allowing him to lower prices and stay competitive with Alice? Even if some group A customers would refuse to shop at Bob's, presumably more would be attracted to Bob's store for its lower prices?1

Even if social or legal pressures meant everyone had to segregate, would this not present a gap in the market to be filled by group B store-owners, who would then sell to the underserved group Bs, with prices presumably more in line with group B incomes (if they are also economically disadvantaged compared to group A), and with the profits more likely to be redistributed amongst other group B businesses?

It's a cliche that the libertarian answer to everything is that 'the market will fix it', but this does seem like a sitation where that should happen, unless government pressure countered market forces (e.g. if it was made illegal for group Bs to even open their own stores or buy stock from wholesalers willing to sell to them). Would the libertarian counter-claim be, then, that the existence of economic segregation can only occur when backed by state force?

1 However, this paper does suggest that '[d]iscriminators are on average willing to forego 8 percent of their earnings to avoid a coworker of the other ethnic type'.

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  • $\begingroup$ @Ubiquitous Not sure if this is price discrimination. It does not seem like the segregationist would have several stores, one for each segregated type. This seems more like refusal to deal/serve. (Gender based discrimination in insurance markets is different, there your tag is valid.) $\endgroup$ – Giskard May 22 '19 at 7:13
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    $\begingroup$ @Giskard you are right. I removed the tag. $\endgroup$ – Ubiquitous May 22 '19 at 8:01
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In many models, we assume that firms simply want to maximize profits, and there are no externalities. If these assumptions are true, then a free market will be racism-free, gender-blind etc, etc. However, this is not the case in the real world. People that own and operate firms not only want to maximize profits, often they also have all kinds of biases, including social biases like racism, sexism, etc; as well as cognitive biases, for example when they want to make the firm as big as possible even if that is not profitable. In all cases, this biases necessarily mean forgoing profits. For example the paper you cite. Ross Levine has other papers on the topic.

However, the question of segregation is broader than this. For some type of relationships, "segregation" can make economic sense. For example, if you have a common resource, like a lake that provides some fishes, limiting who has access to such lake to only people who take care of the lake and does not overfish it, can have clear advantages, and be socially efficient.

In short, segregation can be the result of a friction, like cognitive or social biases. This is not a market failure, properly speaking, but it entails some inefficiencies, so in that sense, it does not make "economic sense". But you can also have segregation, being the optimal response to a situation that involves externalities (like in the example of the lake). This segregation can make "economic sense" in that it is individually rational, and it may or may not be socially efficient.

Consider an example where it is likely not socially efficient. Suppose there is a big proportion of people who are racist, and you own a restaurant. Let's assume you are not racist and you only care about maximizing profits. It is perfectly reasonable to think that you will deny service to people based on race if that will make your racist costumers more likely to visit your restaurant. This segregation makes "economic sense" even though it might not be socially efficient in some way or desirable (the social welfare can be measured in many ways). Notice that I needed to assume that your other customers somehow have negative externalities from you selling to racial minorities.

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  • $\begingroup$ That all makes sense. I suppose I thought that, whilst individual people/firms would have different externalities on top of their profit motive, in aggregate the profit motive would be the most powerful driver as it would be the only one shared by all (or almost all, as there may be a handful of people who are happy to just break even), so overall the situation would gradually tend towards being 'racism-free, gender-blind etc, etc.' That said, I imagine this would only happen above a certain size threshold, which is unlikely to happen in, say, a small rural township in the Deep South. $\endgroup$ – Rumps Apr 24 '19 at 10:02
  • $\begingroup$ Yes, this non-monetary incentives can be very prevalent. Studies have shown, however that people do respond to economic incentives, for example when it gets too expensive to be racist, say it’s hard to find workers except those from a racial minority, people do start hiring more minorities, etc. So the monetary incentives are still present, and markets can help get us close to a more equalitarian society. $\endgroup$ – Regio Apr 25 '19 at 5:11
  • $\begingroup$ "In many models, we assume that firms simply want to maximize profits, and there are no externalities. If these assumptions are true, then a free market will be racism-free, gender-blind etc, etc." (emphasis by me) So there is no price discrimination for non-transferable goods like health insurance? $\endgroup$ – Giskard May 22 '19 at 7:15
  • $\begingroup$ Some papers: Strategic Price Discrimination in Compulsory Insurance Markets, Unisex Insurance Pricing $\endgroup$ – Giskard May 22 '19 at 7:21
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    $\begingroup$ @Giskard ah yes I suppose, my apologies didn't think that one through. One could though then take your argument a step further and make a similar case for say age or race provided of course that different age groups or races have different risk profiles and those can be observed. Quite a slippery slope that but I guess that makes the answer then: seggregation may make sense if it's a near perfect predictor of another unobservable characteristic (such as risk profile) $\endgroup$ – Maarten Punt May 23 '19 at 17:44
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Models have been constructed that show, at least, how discrimination can rationally self-perpetuate. For instance, in The Illusive Quest for Growth, William Easterly describes a model in which employers maintain discrimination through rational expectations, implying that government policy is needed to disturb the perverse equilibrium (paraphrased from "Increasing Returns: Leaks, Matches and Traps"):

Easterly extends this idea of traps to explain variation in income by geography and race purely on the basis of a difference of initial conditions, because under increasing returns variation tends to be self-reinforcing. He proposes a race model in which whites begin as high-skill and blacks low-skill. If there is any segregation in economic enterprise between the races then it may be rational for whites to seek education and blacks to not. Furthermore, if there are costs associated with uncovering the true educational level of a particular worker, it may be rational for a white employer to only select whites rather than pay to discover the true educational level, on the basis that the probability that a white is high-skill is high, and for a black, it is low. If white employers are known to use this policy, then it will be rational for whites to pursue education and for blacks not to: even without a legal or geographical divide, the perpetuation of a racial income disparity can be rationally self-reinforcing.

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