Fallacy of the Free Market - Greed Is Good?

The title of this article is taken from the 1987 film Wall Street, whose lasting legacy is a speech given by Michael Douglas' character, Gordon Gekko, at the shareholder meeting for a company he is trying to take over. Here is the crescendo of that speech:

“Teldar Paper, Mr. Cromwell, Teldar Paper has 33 different vice presidents each earning over 200 thousand dollars a year. Now, I have spent the last two months analyzing what all these guys do, and I still can’t figure it out. One thing I do know is that our paper company lost 110 million dollars last year, and I’ll bet that half of that was spent in all the paperwork going back and forth between all these vice presidents. The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated. In the last seven deals that I’ve been involved with, there were 2.5 million stockholders who have made a pretax profit of 12 billion dollars. Thank you. I am not a destroyer of companies. I am a liberator of them! The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA. Thank you very much.”

Some people have used this speech as a sort of moral justification for all acts of greed, “Greed, in all of its forms” he says, and particularly greed in business as it, if you believe Mr Gekko anyway, produces the best outcomes overall, not just for one person but all parties engaged in economic activity. And not only that, but those principles should also be used in governance, he implies, though it's not exactly clear how that would be applied. But fear not, people, we have the solution: Greed Works!

This is very much in line with the central tenets of capitalism, that individuals acting in their own self-interests produces the best outcomes. The theory is that all these competing interests will collectively form a market and an equilibrium between supplier and consumer interests will dictate a market price for goods and services which is the most efficient economic outcome. And it works because all the market participants act in their own greedy self-interests. This isn't wrong exactly, but it isn't the whole story.

It turns out that greed is more complicated than that. In one form, greed can make a person work hard to develop a new product which people find useful, make a fortune, and everyone -- the hardworking person and consumers alike – is happy. However, greed can also make a person lobby lawmakers and provide financial contributions in exchange for helping put rules in place which benefit their business, makes it harder for other business to compete which and hurts consumers and makes only one person happy. Both are legitimate cases of greed, but with very different results. So greed can lead to good outcomes but it's far from a guarantee. Competition in business, as I will demonstrate, is actually the more important element to producing good economic outcomes.

In the first couple of weeks taking an Intro to Microeconomics class one will learn about the different forms of market competition: the idealistic but rarely seen in real life perfect competition, imperfect competition (e.g. oligopoly and monopolistic competition), and outright monopoly. You, acting as a supplier in the industry, learn how to maximize profits in each of these types of markets based on the cost inputs which form the supply curve and demand from consumers. You can determine quite easily that that things being equal about a market, same product, same demand curve, prices change depending on how many suppliers exist. A clear trend emerges which can be expressed like this: The more competition among suppliers, the lower the prices. The less competition, the higher the prices.

I will say, this isn't just about keeping prices low. Prices depend on many different conditions and high prices can be perfectly appropriate for certain markets. But high prices caused by collusion, corruption, or stifled competition through supply manipulation guarantees that the utility (the total benefit, essentially) from the market transactions are heavily concentrated with the suppliers, and overall economic efficiency is reduced. The following table, which I will explain below, illustrates the utility division between suppliers and consumers in a perfect competition model vs a monopoly:

Image stolen from BYU Idaho

This will probably bore the shit out of you if you're not into economics. But if you're not into economics then you probably haven't made it this far. So for everyone who's still here, let's go for it! These are standard supply and demand graphs for the same market. On both graphs you see the Demand line and the Marginal Cost (MC) line and the price (vertical axis) and quantity (horizontal axis) outputs for both scenarios. Notice that in the Pure Competition (as BYU refers to it) graph producers have to produce and sell at the intersection of MC and Demand. If they try to increase the price, customers will go to a competitor with the lower price. So in order to maximize their surplus, the producer takes the industry price (P_pc) where MC is equal to Demand and produces as much quantity as demand will purchase at that price.

Meanwhile, due to a lack of competition, the Monopolist produces a quantity (Q_m) where MC intersects Marginal Revenue (MR) – which maximizes their profit – and charges the price where that quantity meets the demand curve (P_m). Overall, there is less quantity sold but at a higher price. The monopolist can only get away with this because there isn't a competitor for the customers to turn to. Due to the higher prices several consumers get priced out of the market, and the ones who stay in have to pay more. But the monopolist keeps the price high knowing they will sell less in quantity, but also knowing they will make a greater profit.

The total benefit of the market transactions to each of the parties is expressed in the shaded areas, the blue being consumer surplus (the total benefit all the consumers collectively receive), and the pink is the producer surplus (e.g. profit). Notice the increase of the pink area in the Monopolies graph and the shrinking of the blue. That is the benefit of being able to dominate a market which, of course, comes at the expense of the consumers. There is also a yellow area labelled “DWL” which stands for dead weight loss. This is total market efficiency (or surplus) lost due to lack of competition. I'll note that the price and quantity points in the monopolistic competition and oligopoly competition models typically end up somewhere between these two. Not as much dead weight loss as a monopoly, but still loss.

These graphs illustrate what happens when greed exists with and without adequate competition. It doesn't take a genius to work out, probably even without these graphs, that suppliers benefit from reduced competition, while consumers are hurt by it. So it follows that (greedy!) suppliers have a financial incentive to reduce or control competition within their market.

So, there is the potential to benefit financially from reducing market competition, but does that mean that businesses actually strive to do this? Yes, of course they do. There are many ways that suppliers attempt to control competition but the major ones which spring to mind are collusion (which is illegal), corruption (which is illegal), lobbying and providing election funding for beneficial legislation votes (a form of corruption which is generally perfectly legal), and corporate consolidation (which is illegal in some cases, legal in others, and whose rules are poorly enforced because the regulators have been awful at doing their job, probably because of corruption). I will provide a more in-depth look on that last one in my next post.*

*I'll note that the segment on corporate consolidation was originally intended to be included in this post, but, you see, the post grew too big and began to dominate the entire blog so I had to split it into a separate post. This is a metaphor. Unlike the typical capitalist, I am self-regulating.

Now, for some reason, the free-market ride or dies either believe that collusion, corruption, lobbying, and corporate consolidation either do not exist, that they are not harmful, or most likely just haven't really thought this through completely (which is why I've written this post). But to clarify: yes, these practices exist and they can be extremely harmful to the operation of our markets. We've already proven that monopolies are worse than perfect competition both for consumers in the market and for overall economic efficiency. Just imagine what happens over time to economic efficiency and wealth inequality if all markets started looking more like the monopoly graph, fiscal quarter after quarter for many years. Wealth flows in the direction of the large suppliers and gets even more consolidated, and the cycle repeats. And I think pretty much everyone agrees that this is happening. I'm just helping to explain why.

The notion that free markets are entirely self-regulating is a complete fallacy. Just because a market in a textbook can determine merit, determine who works the hardest and innovates the most and produces the most value for customers doesn't mean that is how it plays out in real life. In real life, greed for money exists, so it is the natural extension of this greed that individuals running these companies would try to use their accumulated wealth or any market leverage available to reduce competition and game the system in order to get the additional profit which is available (that alluring pink rectangle from the graph). That is what businesses do in real life and there is almost no limit to their creativity – which on one level I completely admire – in how they do this. I have listed a few notable historical examples in sidebar.

So how do we stop it? First of all, I agree that there is typically more competition in capitalism than most incarnations we’ve seen of socialism, namely communism, making it the superior economic model for most, but definitely not all, markets. Also, every market is different, and natural monopolies do exist, so we can't make a broad rule on how to regulate every market and industry. But aside from convincing everyone to restrain their greed (this is larger social issue and may eventually be corrected over a long enough timeline) to only situations where it also benefits the rest of society, the solution is of course government regulation.

Now, I feel those same free-market ride or dies and Ronald Reagan parrots rolling their eyes at my suggestion of regulation and saying something like, “government regulation is the problem.” In response I say that this isn't a new socialist position. The Sherman Antitrust Act was passed in goddamn 1890(!!) in an attempt to prevent suppliers from forming monopolies because they hurt the public interest. It's only due to government regulation that corruption and collusion are illegal.

I will concede that governments have created laws, rules, taxes etc. which are detrimental to competition – and all our various governments, federal, state, and local, are guilty of this. But the reason those bad rules exist is usually because the big suppliers lobbied and legally (or not) bribed them to. So, the solution is not to leave those current rules in place and it is also not to pack up the government and remove all rules. The solution is... fix the fucking rules!

What rule changes would fix this? Well, we could change campaign finance rules so that elections are publicly funded and wealthy corporations or wealthy individuals who run corporations can't outbid everyone else for the ear and favor of our representatives. We could enforce regulations on corporate mergers and set tighter standards on what levels of competition are acceptable, and stop making exceptions for when merging companies say it will benefit consumers because the company says it will result in lower prices, which the company is under no obligation to follow once the merger has gone through and instead, of course, we just allow them to fire a bunch of redundant staff, raise prices because there is less competition, and pocket the now fatter margins as executive bonuses. We could make it a requirement that every elected politician at all levels show their finances and tax filings publicly so we know if they are receiving assets they shouldn't be, and know if they are benefiting from their own legislation. This should be extended to 10 years after they leave office as well so we know they aren't on a deferred payment plan (wink, wink). We should eliminate most if not all forms of corporate and business welfare, and stop bailing out large companies that have wandered into insolvency. We should also change intellectual property rules to better reflect public interest in how patents and copy rights are awarded and how much benefit they can provide. We can also break up companies that have grown so large that they dominate multiple industries, or that repeatedly violate antitrust law.

So we've seen that greed, if unregulated, will lead to market domination because there is a financial incentive to dominate, and that market domination, hurts consumers and public interest overall. While that helps the individual it hurts the rest of the country. But that is where greed takes you, Mr Gekko. Competition is the engine which drives good economic outcomes in markets. Greed is a minor player. Somehow this message has been lost on some.

I guess it's similar to how it should have been more obvious to viewers that Mr Gekko's philosophies and business practices were not, as the writer believes, the solution to fix all things, the USA included. Because (Spoiler Alert!!) At the end of the film Mr Gekko ends up arrested by the FBI on charges of insider trading and securities fraud, and somehow people still come away with the total misinterpretation of that Mr Gekko is morally just. Really? The villain of the film receiving a 20-year prison sentence is how you know he's right? That's your takeaway? OK.

But anyway, here, I fixed that for you Mr Gekko:

“Greed Competition, for lack of a better word, is good.”

Idiot.