Changing the Paradigm of Being, Part 5: Limitations of markets
Posted by TCW
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Libertarians, and others who believe that a truly free market could solve virtually any problem, are generally in favor of laissez-faire capitalism. Merriam-Webster dictionary defines laissez-faire as “a doctrine opposing governmental interference in economic affairs beyond the minimum necessary for the maintenance of peace and property rights.”
The idea is that “demand and supply” principle of a free market is better at allocating resources and satisfying human needs than any other alternative, such as centrally-planned economy.
In a free market, individuals have an incentive to find a way to satisfy the needs of others, because they will be rewarded for that, while competition ensures that the needs of consumers are satisfied in the cheapest way possible. The price mechanism balances demand and supply: when a particular good is in high demand, a producer can charge more and therefore make a higher profit. Higher prices will attract more production, until eventually the supply matches the demand again. At that point the price will go down and a new equilibrium will be found. The free market also leads to efficient division of labor, because it rewards producers who have specialized and can compete better in a niche market.
Market mechanisms are basically collective trial-and-error processes that ensure that production is matched to the needs of consumers, even though no single person involved in this process might know how to do this. Market system itself will produce the solution, even though all participants are only following their narrow self-interest and have limited knowledge about the workings of the system. That’s why market is usually far superior to planned economy.
This is the theory of the free market in a nutshell. It looks great on paper and even works in practice quite well, but it also leads to all sorts of problems when confronted with complexities of the real world.
In his book Evolution’s arrow* John Stewart offers conclusive arguments that a free market is not always the best option. Chapter 16 of this book, titled “Limitations of Markets”, is a brilliant summary of problems with a free market. The following text will explore some of the ideas presented in that chapter, together with my commentary.
The most important thing that Stewart points out in his study of markets is the observation that markets will work properly only to the extent that individuals and corporations capture full effects of their actions on others. In his words:
“If individuals are not rewarded for all the beneficial effects of a particular action, the action will not be as profitable as other actions that are less beneficial, […] and if individuals do not bear the full cost of their harmful actions, they will not be deterred from doing things that harm others.”
In situations where this is the case, a free market produces detrimental outcomes for the society as a whole. Let’s explore now this argument in greater detail.
Goods such as home appliances, clothes and cars are normally used solely by the purchaser and cannot be enjoyed for free by anyone else. The same goes for services such as air travel, tickets for concerts and mowing your lawn. In all of these cases the full benefits of goods and services go exclusively to the purchaser, and as a result producers can obtain payment for all the benefits they create for others. In these cases a free market will provide the products and satisfy the demand.
However, a number of products are different in one important aspect:
“Some goods and services have collective effects that cannot be targeted only at those who pay for them. They have effects on many others, and it is impossible to prevent people from enjoying these effects even though they have not paid for them. It will be in the interests of individuals to free ride on these goods and services by taking them without paying. As a result, the producer will not be able to capture payment for all the beneficial effects on others of his goods or services. Goods and services that would have been profitable if all their effects were captured will not be profitable, and will not be produced in a society that relies only on markets.”
Stewart lists defense of a country as a classical example of a service with collective effects, as territory can only be defended on a continuum. Since free market would be unable to provide an adequate defense system, a government is needed to impose taxes and fund defense.
Another example of a service that free market will not provide to a satisfactory level is education. This is because good education doesn’t benefit only those people who got it, but has broader social implications. Stewart writes that specific professional education doesn’t benefit only the individual who can do his work better because of it, but also his co-workers who will be more productive, simply because they are working with and learning from someone with better skills. (Of course, it is usually much better to learn a particular skill from a professional teacher). More importantly, the society as a whole will function much better if everybody – no matter of financial status – is well educated about the common issues and can participate in democratic process.
Some other examples of services that are not handled well by a free market are “policing, the provision of safe and well-planned public areas such as parks and streets, and programs that reduce crime by rehabilitating drug addicts or by providing satisfying activities for teenagers.” All of these programs and services have “beneficial collective effects that cannot be targeted only at those who are willing to pay for them. No matter how beneficial these sorts of programs may be to a community, a free market will not provide them.”
When confronted with this failure of markets to solve certain social issues, libertarians usually invoke charity and voluntary work. Charitable contributions certainly can make a big difference in the world, but in my opinion this is not an adequate solution. And it doesn’t solve the free rider problem described above – some people will always choose to contribute disproportionately less to charity than others (or not at all), even though they could afford to be more generous, and even though they may benefit indirectly from charitable actions of others. Of course, the essence of charity is that it’s voluntary, so you cannot do anything about this.
Failure of a free market to address certain social problems and inadequacy of relying on charity makes a good case for having a public sector in some parts of the economy.
Unregulated markets will also lead to poor outcomes when individuals or corporations do not capture all the harmful effects of their actions. Generally, this would happen when the production and/or the use of goods and services have collective effects that go beyond the producer and the consumer – for example, the production may pollute the environment, and consequently be harmful to people in general. If neither the producer nor the consumer pays the price for these harmful effects on others, the market will give them no incentive to change anything. In fact, if the producer wants to stay in business he actually cannot even afford to use more expensive technologies that pollute less, as he would have to charge higher prices and lose competitive advantage of his product. As Stewart puts it:
“The competition that ensures that consumers get goods and services at the cheapest price is a two-edged sword. It destructively ensures that individuals and firms cannot take into account the factors that the market does not, even where it would advantage the community or society greatly if they did so.”
Free market advocates would probably say that consumers have the power to correct this destructive force of markets. They are on the demand side of the equation, so if they started to demand environmentally friendly products, the supply would follow. To some extent this is correct, but I think this seriously underestimates the power of public relations spin and greenwashing. A company that would only appear to be environmentally conscious would be able to outcompete other producers who would make genuine effort to pollute less.
But there are even bigger problems than greenwashing. Some people simply don’t care enough about the environment as they have other priorities, so in a laissez-faire system you would have to accept certain levels of pollution. Then there are people that like to live in a nice and clean local environment, but don’t care much about the environment on the other side of the planet. This is actually much more common and shouldn’t even be judged too much, because it is understandable to a certain degree: if you don’t observe pollution by yourself, you can have hard time comprehending the scope of the problem. Add globalization to the mix and it becomes extremely difficult to force companies to pollute less with market mechanisms: corporations can produce (and pollute) on one continent and ship the goods elsewhere. Consumers don’t see the pollution and people that are most affected by it are not in a position to influence the market.
It’s easy to say that consumers should educate themselves about products they buy and the impact they make on the environment by consuming this or that good or service. While I support the idea of personal responsibility, it is absolutely impossible to educate yourself about everything. Fields of science and technology have become so complex and enormous in scope in the last hundred of years that you have to study them for years to understand even the basics. It is completely unreasonable to expect from the average consumer to research every product he intends to purchase and understand every ramification of his decision.
Because of all these reasons mentioned above, I’m a strong supporter of environmental regulations imposed by the government.
The important conclusion that Stewart reaches in his chapter on the limitations of markets is that a market system doesn’t make government redundant:
“Markets are unable to ensure that citizens capture all the effects of actions that have collective effects. So ungoverned markets fail to reward and organize activities that have collective social benefits such as defense, education, and programs that build better communities. And they fail to deter pollution and other activities that cause collective harm […] Where markets fail, government action is necessary to ensure participants capture the full effects on others of their actions, and to ensure participants do not capture greater benefits than they should. Government can use taxes, laws, subsidies and other payments to try to organize the behavior and activities that would have arisen if the market was not deficient.”
Stewart makes no idealization of governments, though. He is fully aware that a government has very limited ability to perform its function effectively. Government has to rely on often incompetent and inefficient bureaucracy, and the interests of government officials will never be completely aligned with those of the general public – even in a democratic society.
What’s even worse: special interest groups can capture the government and use its powers for their own benefit. I have already written about that in my previous post (Part 4: Capitalism – A Love Story). When this happens you can kiss free market goodbye.
So, here is our catch-22: to carry out its duties government must be very powerful; it cannot be a paper tiger. But the more power the government has, the greater threat it becomes to society, if and when special interest groups capture its power.
To limit the risk of abuse, government should have no more power than what is strictly necessary to correct market deficiencies and provide services that the market could not. It seems to me that changing society for the better depends on finding this delicate balance between free market and government intervention. As well as between private ownership and collective ownership.
This series of articles will continue with the quest of finding a way toward that balance.
Continue to Part 6: Principles of balanced governance
*Evolution’s arrow: The Direction of Evolution and the Future of Humanity – I really enjoyed reading this book, yet I remain skeptical of some of its conclusions. Still, I would recommend this book to anyone – if nothing else – for Stewart’s outside-the-box way of thinking that will challenge your existing views on life, evolution, humanity and social systems.
Posted on October 23, 2013, in Social change and tagged capitalism, collective effects, competition, demand and supply, division of labor, economy, free market, globalization, government, incentive, John Stewart, laissez-faire, market failure, price mechanism. Bookmark the permalink. Leave a comment.