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07 October 2010

The Free Market Doesn't Always Work

So far, at least, the free-market has proven itself to be the most effective economic system known to industrial society - most effective in the sense of being able to deliver the most material benefit to the most people. And the reason for that is no secret - market-determined pricing is able to communicate the relative preferences of buyers and the scarcity of supply better than any other approach yet devised while the profit-motive provides the best long-term incentive for people to produce things.

But the market doesn't always work. One such situation is where the fixed costs of production exceed any possible profit generating capability of marginal-cost pricing. Normally, such a situation is not a problem as it simply means that the good (or service) won't be produced. But where that good is considered necessary by society, then the only way to produce that good is via a non-market mechanism. The typical way these needs are satisfied is via a publicly-granted and tightly-regulated monopoly business enterprise (such as an electric or water utility), though sometimes the public itself produces the good or provides the service.

Another exception to free-market exceptionalism is fractional-reserve banking. Sure, banks do compete against each other, but because they have been endowed with a sacred trust (the ability to create money) they must be tightly regulated so that they don't grossly violate this trust (which could lead to civil disturbance). Our recent financial disaster can be traced to abuses of this sacred trust (excessive leverage, reckless lending).

A third type of problem area for markets - though it's not really a flaw in markets themselves - is where society has made judgments on the value of certain goods such that the use of prices and profit-motive are considered immoral measures of worth. The most obvious example in our recent public debates is health care - we'd rather people not be forced to make critical health decisions based on price nor do we want the delivery of health services to be primarily based on profit potential - though in America market forces are still predominant. But education is a more traditional example of a market curtailed by the intrinsic value society places on its product, as public schools have for over a century dominated primary and secondary education. Even the post-secondary market is dominated by non-profits, and is in general a grossly-distorted market (though not necessarily distorted in favor of the consumer).

Markets, as efficient as they are in communicating value, are not good at communicating critical information about a transaction when that information cannot possibly be known until the transaction in question has become irreversible. When this inadequacy threatens public safety, society must step in to fill the breach. The most common mechanism is licensing - thus we license doctors since it's too late to find out that the doctor is incompetent once he provides his service. We do the same with plumbers and electricians so that you don't have to wait for your home or business to fall apart or burn to the ground before finding out that they had no idea what they were doing.

And finally, society places a great deal of value on the quality of life where people live. As a result, very stringent limits are placed on markets via local zoning laws which aim to keep businesses separated from residential neighborhoods as well as to segregate businesses by type of business performed. Land-use regulations as well as old-fashioned nuisance torts keep business activities in check beyond already strict zoning, as well.

In all the above, the actual approach society takes to remedy the market's shortcomings may be done well or poorly; it may lead to corruption or rent-seeking or other abuses; it may lead to gross inefficiencies or out-and-out injustices. But in no case - in spite of any drawbacks - would simply leaving it to the market be acceptable to the society at-large.

The above are basically some musings of mine that I find convenient to think-aloud, as it were, on the blog. It's a reminder also that strict libertarianism is an alien, non-traditional ideology that America's founders, for example, would not have recognized. And also how Republicans and Tea-Partiers can overreach in reacting to the anti-business policies of the Democrats.


Anonymous Roach said...

All well said. One major difference of conservatives and libertarians is that conservatives look to the good of the nation as a whole, broadly understood, whereas libertarians because of their radical indivdualism are indifferent as between the good of one community or another, and will embrace things like free trade even when it's harmful to a particular community and their collective (aggregate) good, economic or otherwise.

October 07, 2010 10:56 PM  
Blogger ziel said...

Chris, very true about libertarians - look at Econlog - Caplan, Kling and Henderson - they act like the United States is just some political division and find our borders inhumane in and of themselves.

And they believe it's a gross violation of property rights to tell a man he can't put a pig farm on his property but perfectly fine for a man to ruin the value of others' property by putting a pig farm next to their homes.

October 08, 2010 7:01 AM  
Anonymous Laurent said...

Clear explanation.

October 08, 2010 7:23 AM  
Anonymous Polichinello said...

As Sailer has noted, the distortion in post-secondary education has its roots in government interference through disparate impact litigation. Government interference also plays a role in the problems we experience in health care. You can't, for example, buy insurance across state lines, so you don't really have a free market. In fact, going with an NHS style program will still create the same cost problems for us, because it will still carry the same 3rd-party payer dilemma. Now, though, it won't be an insurance company deciding what to cover and not cover, but the government itself.

Otherwise, I tend to agree. Zoning laws are a good example. Workplace safety is another good example, as well employment laws.

October 11, 2010 5:05 PM  

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