When people use the phrase “free markets” they seem to be doing so in the belief markets, left to their own devices, unburdened by regulation, will make us all better off. If most markets met stringent, necessary conditions, they might work their magic and maximize social welfare. However, many markets don’t come close to meeting those conditions.
What are the conditions necessary for free markets to perform as advertised? Individuals as either buyers or sellers must be free to pursue their self-interest, meaning market participation is voluntary. Individuals must make reliably rational choices. Here rationality refers only to how we make choices in market settings, choosing only what is in our best interest. Every market participant must be fully informed about all aspects of the market. Furthermore, no market participant may have outsized power to influence prices or other facets of the market. This condition requires competition between and among buyers and sellers be effective, thereby preventing the accumulation of excessive market power. Critically, all benefits and costs associated with market activity must be bestowed upon or borne by market participants. That is, there must be no externalities due to market activity.
When these conditions are met, at least approximately, free market prices are presumed to be fair, innovation incentivized, resources efficiently allocated, income and wealth equitably distributed, and the economy grows. Therefore, free markets are deemed to be the engine of maximum social benefits. Unfortunately, most markets fail to meet many of these conditions and therefore do not produce the benefits ascribed to free markets. Even Adam Smith recognized, when the necessary conditions are absent, the invisible hand requires a bit of hand holding.
Two of the more important conditions free markets nearly always fail to meet are the assumptions of human rationality and balanced power between buyers and sellers, in other words, no monopoly power. Free marketers bear the burden of demonstrating how markets populated by individuals whose rationality is faulty and where sellers have monopoly power can deliver the promised benefits.
About the rationality assumption, if your choices are sometimes irrational, don’t be too hard on yourself. The Nobel laureate, behavioral economist, Richard Thaler, says, “People aren’t dumb. Life is hard.” For instances when humans are systematically irrational, see the books, Nudge by Thaler and Cass Sunstein and Predictably Irrational by Dan Ariely. Many irrational choices occur when humans are influenced by what Thaler calls “supposedly irrelevant factors,” context being one of those factors. Indeed, when context matters, Smith’s assumption that we are driven by strict self-interest is called into question. Consumption choices influenced by context are not likely to be in our best interest.
Problems on sellers’ sides of markets also distort market outcomes. When markets are served by only one or very few sellers, prices are higher while quantities, quality, and service levels are all lower. Sellers not facing effective competition, earn excess profits, fail to innovate and tilt upward distributions of income and wealth, all to the detriment of society at large.
In advanced economies, many markets are controlled by sellers with substantial market power. In the U.S., markets for event tickets, eyeglasses, appliances, bedding, financial services, pharmaceuticals, especially, and many others are riddled with monopoly power. In industries in which firms earn abnormally high profits you can bet those firms exercise significant monopoly power. Speaking of betting, the gambling market is one of them.
Broken markets, left to their own devices, will not fix themselves. Solving market failures requires appropriately designed public policy. Congress has several potential policy fixes from which to choose. The best ones achieve desired results most efficiently. Unfortunately, Congress, a duopoly dominated market itself, has a very poor track record in making efficient policy, especially to correct market failures.
When you are prone to question the efficacy of existing or proposed market interventions, please stop to think whether the market in question meets the conditions of a free market. If not, intervention is called for but we must hold Congress accountable for implementing policy that is likely to work and is efficient. We know what happens when Congress is left to its own devices!
Patrick Taylor lives in Ridgeland.
