Misunderstanding the Free Market

It is radical liberal orthodoxy that capitalism is bad, an unrestrained free market is evil, and the machinations of enterprise are undilutedly unfit for mankind. Often the targets of criticism for defending the free market are academics whose thought-out views don't comply with the politics of left-leaning radicals. Take, for instance, neo-Keynesian economist Paul Krugman. A renowned critic of George W. Bush and his administration, he was taking flak not too long ago for defending the existence of sweatshops in developing countries. (Never the mind the fact that he was right in that the market did produce the best possible solution to the problem of poverty - it created factories where people could eke out a better living than on the farm, even if by Western standards, wages were meagre.)

However, in failing to understand the economic theory behind free markets, anti-globalisation advocates and protectionist protestors have not grasped the fact that the market is still the best solution we have to the basic economic questions - who produces how much of what for who - despite its imperfections. At the same time, those conservatives whose habitual kneejerk reaction to any government role in the marketplace is to cite the free market are doing an injustice to the market by assuming it is perfect. It is not. There is a reason whole chapters in economics textbooks are devoted to the subject of market failure.

It is market failure that causes much of the privation and pollution we see in the world today. Liberals are absolutely right in blaming the market for the problems we see with our economies today. The problem is that instead of reforming and rehabilitating it, harnessing the price mechanism of free market economics to address the problems at hand, they seek to invent a whole new system altogether that obviates the need for the market to answer the basic economic questions. Whether by quotas, price controls, or what other barriers to trade you may have, they undermine the foundation of modern economics by focusing on its flaws instead of utilising its strengths to fill the flaws.

Now, even the reformed market is not going to be a perfect solution. But whoever expects a human system to perfectly address human problems is not living in a human world. The market, despite its imperfections, is the best thing we currently have, and until a new system - perhaps participatory economics or a gift economy - proves itself, we will have to settle for the market.

However, some of the market-based solutions offered here are not going to be palatable for die-hard conservatives, libertarians, minarchists or anarchists who decry any government intervention whatsoever in the market. The government does have a role to play in the economy - its job is to maximise social welfare. The only reason we have the market is that it has proven itself to be the best way we currently have to maximise - as economists put it - utility. Or, as one man of wit once said, the vice of capitalism is the unequal sharing of blessings, while the virtue of communism is the equal sharing of misery.

Let us first look at one key and absolutely undeniable failure of the market. Minarchists and anarchists can talk all they like about how ideally mankind will be able to work out our problems without government intervention here, but the fact is that the market simply canot act to provide public goods. I would say that the most key aspect of a public good is its non-excludability. You cannot exclude someone from enjoying the benefits of a public good. What this means is that you can take my property and my labour without providing me with anything in return.

An obvious example would be national defence. The free-rider problem exists here, because even if a mercenary army charged the populace it protects for its protection, without a government to levy taxes, it would be impossible to meet the fee demanded. Each fellow would reason that "Well, everyone else is going to pay for it, and I am not going to be harmed if I don't pay because they can't exclude me from the benefits of not having my house burned, my wife raped, and my children sold into slavery. So why don't I just...not pay?" The end result is that few, if any, would take the individual initiative to pay, and the mercenary army would either leave, or take it upon themselves to burn houses, rape wives, and sell children into slavery. Sure, perhaps the community might have learnt its lesson...but that's if there's a community left at all. And even then, people are notorious failures at remembering the lessons of history (case in point: the 2004 US presidential election).

We are thus left with a void the market cannot fill. No private initiative would be able to establish a standing army, a police force, or provide any other public good. This is the void governments fill for us. This is something indisputable, and I am not about to bother with the intellectually intriguing but pragmatically preposterous conjectures of minarchists and anarchists who would suggest otherwise.

A more controversial subject would be merit goods and demerit goods - goods that would benefit society if consumed at higher (or lower) levels than set by the market system. Obviously, what merit goods there are, if any, would be decided rather normatively (economic jargon for subjectively and questionably). Conservatives and liberals would have obvious disagreements about what constitutes a merit or demerit good, and some (probably libertarians) would argue that merit and demerit goods don't exist.

This is where the economic concept of externalities comes in. Externalities are where the market produces a situation that is less than desirable for society. However, this definition is a simplification of the economic theory behind externalities. Externalities are generally determined on an objective basis. The only thing subjective is the assumptions used to determine what constitutes an externality, and more importantly, the assumptions used to calculate the costs and benefits to society of a particular good or service.

Now, the fact that economists use assumptions to determine externalities is certainly something very debatable. However, it reflects the fact that we have imperfect information about our preferences and society's preferences. There's also the fact that it's extremely difficult to debate the existence of an externality.

Here, we have public goods to thank. Let's look at two examples of externalities: pollution and traffic congestion. Pollution exists because a clean environment is a public good. Nobody owns clean air or water. Nobody owns the sound of a bubbling brook or the sky on a sunny day. As a result, everyone is free to do what they like with these resources, regardless of the costs imposed on others. It is this that represents a key attribute of externalities - they either constitute a cost or benefit to someone not party in a transaction. Take a polluting factory near a river. It creates a cost for those who would like to use the river and the surrounding area, but this is a cost not reflected in its bottom line. This cost is not paid by the owners of the factory or their clients. It is a burden suffered by those who would like to enjoy a cleaner river and a greener view - it is an externalised cost.

The same applies to the problem of traffic congestion. It costs practically nothing to get on the road - perhaps on some highways there is a toll to pay, but otherwise, all you need is a hunk of steel on wheels with a combustion engine and a tank of petroleum, and you're set. The problem that arises is that same old free-rider problem. Everyone wants to attain the benefits of using the road. However, some people would gain more utility (benefit more) from the road than others. Someone in a hurry for a meeting to seal a deal would clearly pay those joyriding buggers clogging up the road to get off it. Because there is no market here, an externality arises - just as when there was no market for a clean environment.

The solution in both cases is to establish a market. What can be done in the case of pollution is to establish a market for pollution through the use of pollution permits. The key word here is a market. The government ought not to set a price on pollution, or absolutely mandate that people or enterprises do this or do that. The goal is to provide an incentive for them to do this or do that, and this is achieved by the market for pollution. What is done is that the government determines the maximum level of pollution they would like to see (something not too hard to do objectively), and then require that all polluters own a permit for every X quantity of pollution they emit. The government, being the sole distributor of permits, would then be able to limit pollution as much as desired within practical constraints. The operative bit here is that companies may buy or sell permits as they like. The price mechanism would then set the price of a pollution permit, and thereby internalise the costs of pollution by incorporating it into the costs of production. Those who find it cheaper not to pollute can then sell their permits on the market to those who can't afford not to pollute. The eventual result is that pollution goes down - this has been demonstrated both in the United States and the European Union, where such schemes were tremendously successful.

Although a similar system has not been implemented for traffic congestion yet, we are seeing the rise of traffic congestion fees in many cities around the world. In this case, the government requires all cars in a certain area of the city at a certain time of the day (e.g. office hours) to own a permit. Those who can't afford to pay the price of the permit (which is in this case government-set; trading is illegal) will simply have to get around by another form of transport or not enter this area of the city at all. (If you think this is unfair, it might be a good idea to review how the price mechanism and the concept of utility in economics work - simply put, if the cost to the traveller is too high to warrant entering the area by car, then the traveller does not benefit enough to warrant paying the price, and can maximise his individual benefit by spending the price of the permit on other goods.)

Even some aspects of the socialist platform, such as subsidised education, can be incorporated into capitalism by means of internalising externalities. Many economists have suggested that education is a positive externality, because it benefits the public at large. It is not just the student or the education institution who benefits if she gets a degree - it is her future spouse, her future employer, her future colleagues, and so forth. As a result, the argument goes, education ought to be considered a merit good and thus be at least partially government-funded. And of course, the market system has also been brought to bear on this problem through schemes such as school vouchers.

The last area of discussion for today is the touchy subject of monopolies. Conservatives justify the existence of monopolies as a natural end result of the free market, and that should the monopoly not act in accordance with the will of the consumer, other firms will spring up and gain market share. Liberals, on the other hand, are all too well aware of the dangers of monopolies, and generally have the right idea - some government regulation is inevitable in this area.

A monopoly harms the market and consumers in a number of ways. One is by raising barriers to entry - it blocks access to the market by other firms. One example of this was covered in the September 4th issue of Fortune which discussed how Intel used threats and predatory pricing to get consumers not to buy from rival chip-maker AMD. (Predatory pricing is when a firm intentionally underprices its goods - effectively accepting a loss on them - so as to gain an unfair edge over rival competitors, who may offer better quality, but lose out simply because the monopoly has vast resources to amass at its behest.) Other controversial tactics may include collusion, whereby many companies secretly carve up a market amongst themselves at an artificially high price instead of competing to drive prices down. Those old enough to remember the oil crises of the 1970s caused by OPEC should note that this was an example of collusion by OPEC's members to split the global oil market amongst themselves.

Of course, there are a number of objections to the economic theory about monopolies. Predatory pricing is untenable for long periods of time because a firm will eventually go out of business if it prices its goods below the costs of production. However, this argument fails to account for the huge cash reserves any longstanding monopoly would be wont to amass - Microsoft is drowning in money it doesn't know what to do with. A company does not have to run predatory price campaigns forever - just long enough to drive the nascent competition out of business, and to discourage potential competitors from joining the fray. Collusion is also a definitely untenable tactic, as demonstrated by game theory - thanks to the free-rider problem, each member will try to gain an edge by subtly under-pricing their products, and eventually the cartel will compete itself to death. The OPEC cartel eventually collapsed, after all.

Nevertheless, despite what many may say, monopolies do exist. Certainly, there are natural monopolies in some areas - perhaps not public utilities (although this would likely apply only to huge countries such as the United States), but in other areas - postal service, for instance. Government regulation and intervention is needed to some degree in order to maintain the basic requirements of a free market, such as low barriers to entry. Allowing monopolies to become a government unto themselves would be tantamount to government intervention in the market, except on the behalf of a company instead of the public.

Notably, I have not discussed the famous abuses of government officials of their authority to favour particular business interests in this article. The reason for this is that it is so absurdly clear that this runs contrary to the norms of a free market that there is no need to discuss such government intervention. Subsidies and other protectionist measures are rarely, if ever, justifiable. A government that supports the free market should not necessarily be a "pro-business" government.

The free market, as any economics text can tell you, is an imperfect beast. It can't help being that way - after all, humans run it. However, it is the best mechanism we have to run the economy. The key thing to keep our eyes on is the basic goal of any economic system - to maximise social welfare (or utility, in the parlance of economists). Properly regulated and adapted, the free market can work to address many of the problems facing the global economy today.