Monthly Archives: October 2008

Reflections on Free Markets

In contemporary debates on economics, the main contentions usually involve how much government intervention is necessary in the economy. On one side of the debate are the socialists, advocating complete government intervention in the economy, and on the other side are the proponents of free markets, advocating the opposite. Where we find ourselves on that spectrum should depend on an honest discussion about the basic nature of markets.

First, what is a market? Basically, it is a collection of exchanges between people. Markets are most commonly associated with exchanges of goods and services, but they can also exist within other frameworks (e.g., immigration as an exchange of cultures, and universities as exchanges of ideas). In particular, a free market is characterized by voluntary transactions between people. Conversely, when transactions between people are forced or hindered by outside actors, be they governments or other individuals, the market is not free.

In my experience, most criticisms levied against free markets are based on faulty premises. Now that we have some idea of what a free market is, let us take time to address a few examples of what it isn’t:

Free markets and capitalism are not exactly synonymous.

While “capitalism” does traditionally denote a system in which the means of production are owned privately by individuals, that definition does not necessarily provide real insight into the nature of common market transactions. To capitalize merely means acting advantageously upon a situation or opportunity; it is an expression of the innate human desire to maximize personal success. This occurs as much within socialism as it does a free-market, but the differences lie in the particular mode of capitalization used: Maximizing personal success will look different in a socialist economy than in a free market. Nevertheless, it is false to assume that the differences between economic systems will cause differences in human nature.

A free market is also not the same as pure capitalism because pure capitalism involves individuals using any means necessary to advance themselves, including coercive acts, usually referred to as crimes, which abridge other peoples’ natural rights. A free market is, by definition, devoid of coercion (transactions must be voluntary), and is therefore incompatible with pure capitalism. Socialism, on the other hand, has no appreciation for individual rights, so pure capitalism actually comports more nicely with socialism than with a free market!

The free market is not fascism.

I’m not exactly sure where this association comes from, so it’s really hard for me to understand its rational. Fascism is a political philosophy on the left of the political spectrum. Proponents of fascism are hyper-nationalistic and seek to use a powerful government to promote their desires. Much like the other leftist philosophies, such as communism, feudalism, totalitarianism, or monarchism, fascism rejects individual natural rights, and therefore cannot allow the operation of a free market–of goods and services, cultures, or ideas.

The failure of a firm does not denote the failure of a market.

This is another common misconception about free markets. Contrary to popular belief, the failure of a firm is an example of when free markets works best. If a firm is unfit to compete in a market, it goes out of business and its assets are liquidated. This way, markets work out inefficiencies in the system, and the surviving, successful firms are those better equipped to serve the needs of society. Think of markets as an ecosystem, inherent to which is the natural selection for and against competing firms. By removing the weak from the market, the economy evolves and progresses. When government steps in to regulate or hinder this process is when the free market truly fails. The most prominent modern example of this is the recent Wall St. bank bailout. The massive economic bailout for these banks prevented their failure, allowing non-competitive banks to stay in business, insinuating major economic collapse down the road, and all at the taxpayers’ expense.

Now that we’ve defined our terms, the issue resolves to whether or not free markets are beneficial. The propriety of an economic system in which people are able to voluntarily trade with others would seem self-evident, but there are a couple of pertinent criticisms of true free markets which should be addressed.

Externalities

Externalities are a real problem for markets. Externalities are the costs which buyers and sellers within a private transaction unintentionally pass on to the rest of society (e.g, pollution, or traffic congestion). Most economists would concede that externalities are mitigated by institutionalizing these social costs—that is, reintroducing these costs into the immediate transaction and forcing the transaction’s assenting parties to incur it themselves–not society.

Unfortunately, leftists then naïvely assume that government is the best agent, or is the only agent capable of performing this task. They believe that government should tax or regulate businesses and consumers. This will transform the social cost of producing or using a particular product into a direct economic cost incurred by the buyer or the seller, which will decrease either the supply or the demand for the product, and will in turn decrease the product’s social cost.

There are other mechanisms, however, for institutionalizing social costs that don’t require government intervention in the form of confiscatory taxes or regulations. The first mechanism that comes to mind is market self-regulation: If consumers become knowledgeable about the social costs imposed by their demand for a product, they may decide that the benefit derived from a low price is not worth the cost they impose upon the outside world. Firms which self-institutionalize social costs, such as coal power companies investing in scrubbers, or car companies investing in better crash safety technology, may have an easier time marketing their products to the public, as the public may enjoy moral gratification from supporting these companies. As Milton Friedman explains in the video below, tort law and social customs also counteract and guard against market failures.

Monopolies

This is probably the most common honest criticism of markets. The argument goes like this: Every once in a while a firm becomes so large and its operations become so efficient, that it is able to out-compete virtually every other firm in the market. Take Walmart as an example. Walmart is often cited as undercutting the prices of its competitors, taking a short term loss merely to drive its competitors out of business. As the evolutionary processes of the market remove the weak and inefficient firms from the economy, one could expect, in the long run, that only one firm would remain. Logically, it would follow that, in the absence of competition, it would be in the best interest of the one remaining firm to jack up its prices as much as possible, bleeding the consumers dry.

But looking empirically at the issue, this logic simply hasn’t panned out. There is, again, a mechanism built into free markets that protects against this type of occurrence. If Walmart became a monopoly and decided to raise its prices over night, it would make the profitability of potential new firms wanting to enter the market near infinite. As a result, very few monopolies have ever arisen as a result of pure, market-driven forces, and endured for long periods of time. As Milton Friedman explains, most monopolies have endured only because government has intervened on their behalf.

The only two notable examples Friedman mentions of monopolies which have endured without government intervention–the New York Stock Exchange from Reconstruction to the Great Depression, and the De Beers diamond company from the early twentieth century until 2000–both lost their monopolistic status due to the introduction of international competitors. If we are to prevent the emergence and endurance of private monopolies, we must ensure that government policies do not make prohibitive the cost of market entry for competitors, which is exactly what did not happen in the television, steel, labor, railroad, and trucking markets.

Conclusion

Free markets are a fact of life–they are not implemented, but rather exist by default. Free markets are imperfect, though, because people are imperfect, and no private or public system comprised of people will ever be without flaw. However, a free market is the most efficient economic system ever known to mankind. Even with the presence of externalities and occasional monopolies, free markets succeed in producing the greatest amount of wealth for the greatest number of people. Most importantly, free markets reflect human nature, and the cause to better oneself. They are an expression of individual natural rights, and they yield a net benefit for society as a whole.

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