The Fallacy of the Free Market

The free market is a brilliant idea. It, and many ideas stemming from it, have garnered countless Nobel Prizes and helped earn fortunes a million times over. Basic supply and demand curves which you read about in your Intro to Economics class in high school paint a simple, pretty picture which shows how a free market through many individuals acting in their own interests can find a price and quantity output efficiency point for any good or service. Based on cost to supply and the demand to purchase prices and quantities will naturally negotiate through the actions of the buyers and sellers and arrive at the efficiency point. The free market has been essential in my understanding of the world as I use it, often daily, in decisions and conversations about business, politics, international relations, poverty, you name it.

The issue is that today the free market frequently becomes something associated with political parties, with one claiming to believe in the virtues of the free market and therefore against any sort of government regulation, while an opposing party will propose some sort of regulation and in turn be labelled a non-believer in free markets that hates capitalism.

While I personally advocate the power of knowledge and many principles which have evolved from the social science known as economics, I don’t feel that it is mutually exclusive to believe in the free market as well as regulation or oversight. This is because the notion of the ‘perfect competition’ free market as we observe it in economic text books rarely occurs in real life because those models are built on a series of assumptions which don’t practically exist and this often results in levels of market failure or interference.

The most frequent market failure I see is caused by imperfect information. Market models assume that all buyers and sellers know the same things so they can each make informed decisions to act within their own self interests. But in most cases sellers know significantly more information about what they are selling than the buyer does. Sellers know about defects in their products, they know about the materials and conditions it was made under and they have a better understanding of its limitations. Sometimes information is hidden in small legal fine print of contracts, which the seller knows about, but is often not considered by the buyer. Some buyers might simply not have sufficient education to properly understand the full implications of the purchase. A mainstream example is predatory lending which last decade featured mortgage lenders in the US making loans to people who didn’t understand the terms of the arrangement and didn’t understand the real risk of having a variable interest rate on their home loan leading to a very large number of mortgage defaults.

Those claiming to be in the pro-business/free market camp would argue that an attempt to put restrictions on mortgage lenders would be anti-competitive, anti-capitalist bureaucratic behavior. But the truth is that the predatory lending scenario is not an example of a free market working simply because both parties signed the mortgage documents, it is one party taking advantage of the advanced information it possesses. The result of these situations of significant information inequity is a broken market where the less informed make self-destructive decisions they likely wouldn’t have made if they had all the information, and in turn, economic efficiency is not achieved.

Of course anyone with an information edge will lobby to keep regulations out of the way, because having an information advantage can make a person or a company quite wealthy, and that is where the free market/anti-regulation arguments come from. But at the end of the day, broken markets should be fixed if one truly wants to support the principles of the free market.

The most obvious way to correct a market with imperfect information is to inform the person who is missing information. And that’s where ideas like more transparent disclosures of terms in a mortgage or even labelling ingredients and origins of foods come into play. Consumers will then have the knowledge to decide if they should sign the mortgage or purchase that food product. Many businesses will protest in the name of costly overregulation by the government. However I see it as simply fixing a market failure and closing up a way that market participants with better information take advantage of their position.

This brings us to a philosophical crossroads and the crux of the issue. When there is a difference in information between market players, should the party which knows more be allowed to take advantage of that knowledge? It goes against the basic principles of entrepreneurism and innovation to say that one is forbidden to take advantage of it, but morally fraudulent behavior should also be discouraged. So where exactly is the line between legitimate profit based on innovation and defrauding someone because of a knowledge difference? When is opportunism good and when is it bad? The only practical answer is ‘somewhere in the middle’ as both serial killers and Nobel Peace Prize winners could be considered opportunists depending on how you look at it. But there is at least some portion of this spectrum that needs intervention.

Free markets also fail to achieve maximum efficiency when they create externalities, by-products of some economic process that is incidental to the intended product or service. Externalities come in positive and negative forms. Properly functioning markets naturally take care of positive externalities as entrepreneurs seize the advantage of the positive ones. For example, when one homeowner in the neighborhood fixes his house and repaints it resulting in the neighborhood being viewed as more affluent, the neighbors sell their houses for more money due to increased property values (this increase in value is the positive externality of the homeowner painting his house). Nobody complains.

The negative externalities, however, are the ones that often go unregulated and result in overproduction. The most common, but still quite relevant example of an externality is air pollution. When a power plant burns coal while producing electricity the result is that carbon dioxide and other toxins are put into the air which have known (though perhaps sometimes difficult to directly quantify) negative effects the environment, agriculture, and health. If these costs are not levied against the power plant the truth is that this is a market failure because third parties not participating in this economic market suffer. When companies producing negative externalities claim that regulation is not in the spirit of the free market, it is a false statement. Regulation and determining the societal costs of their externality should be part of the price of doing business, and will actually help the market function more efficiently.

Since nobody owns the airspace per se, it is difficult to charge the power plant for the costs it should be incurring. So in these cases, where there is no practical method for society to work this out, that is when a government should step in. The amazing thing is that in cases such as this one with air pollution, the government can actually use markets (in cap and trade programs for example) to determine what additional societal cost the power plant should be paying.

So in the future when someone claims a policy change does not support the free market you should do two things. First, decide if the market is in fact broken from either an information disparity or a failure to account for negative externalities. And second, figure out how you can actually use the free market to solve the problem.