The Problem with Completely Free Markets

As in most areas of life, extremism is not desirable.

http://www.thefiscaltimes.com/Columns/2015/06/30/Problem-Completely-Free-Markets?utm_campaign=548f5168cb03a93709042da0&utm_source=boomtrain&utm_medium=email&bt_alias=eyJ1c2VySWQiOiIyOWU2MDRjZS1jNmY3LTQzNTYtOTFhOC1mMjU5ZjNmMjAzOWUifQ%3D%3D

By Mark Thoma
June 30, 2015

The Supreme Court’s decision last week saved Obamacare from the Republican’s latest attempt to get government out of health care. But if Republicans can find another way to attack the Affordable Care Act, they surely will.

Healthcare is not, of course, the only place where Republicans object to government intervention in private markets. They believe that markets free of government rules and regulations almost always outperform markets where the government is involved. So it’s a good time to review why this faith in free markets is sometimes misplaced, and how government involvement in some markets can improve their performance.

When a market works well, when it approaches the competitive ideal found in economics textbooks, there is no need for the government to intervene. The market will do better if the government stays away. But we shouldn’t confuse free markets with competitive markets. When there are significant departures from pure competition, what economists call market failures, markets are “free” to perform very badly, and sometimes a market will collapse entirely. In these cases, government intervention can help.

The conditions for textbook competitive markets are fairly strict. To begin, there must be numerous participants on both sides of the market. When, for example, there are only a small number of sellers the price will be too high and the quantity too low relative to the competitive outcome. If the good is a necessity – suppose a single firm has a monopoly on the supply of water – the price could be very high indeed. To combat this problem, the government tries to prevent firms from pursuing strategies to monopolize markets, and regulators break up markets that become monopolized anyway.

When a monopoly is unavoidable as with public utilities, the government regulates the price that can be charged and the customers that must be served. We can debate where to draw the line – when the government should and shouldn’t be concerned about monopoly power (e.g. how dominant does one firm have to become before the government takes action to break it up?), but I doubt that any of us wants to live in a world where most of our markets are monopolized.

All participants must also have perfect information about the market. If the buyer does not know the exact quality of art, wine, or health care services, if a home-buyer is unaware of a big problem with a house, if a seller misrepresents the quality of a good (a fake watch instead of a real one, or a tipped scale), if a service provider does not have the credentials that are claimed, and so on, then the market will be distorted – people will pay more than they would have if they had been informed.

Despite free market rhetoric, we want government to intervene to ensure that weights and measures are accurate, there is no fraud, people are truthful about their credentials, and known defects in a product are disclosed to buyers.

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Competitive markets are free of externalities. If a firm can pollute the air and water when producing a good without having to pay the costs, then the firm will produce more of that good than is socially desirable.

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Principle agent problems, which occur when one person is making economic choices on behalf of another, can also cause non-competitive outcomes. For example, when a manager of a firm makes decisions on behalf of shareholders, he or she may do what’s best for their own income rather than what’s best for shareholders.

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Finally, there are some goods society desires such as national defense that the private sector will not provide. If a private firm asked you to pay for national defense, why would you say yes? If everyone else pays, you will still be protected, so why pay yourself? If everyone thinks this way – or if enough people do – then there will be no way to pay for the defense that is needed. The solution is for government to provide the good itself, and then mandate that everyone help to pay through taxes.
[Same for paying for food inspectors, etc.]

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