Free Market Economics: Problems and Solutions

Free Market Economics: Problems and Solutions

Rick Olson
September 13, 2018, revised June 29, 2019

The private enterprise/free market/capitalism model of economies has been highly successful. Not only is it perceived to be optimal in theory, but the performance of the U.S. and European countries vs. USSR and Communist China (before some loosening up) should be convincing. The surge in China began with some relaxing of private ownership/incentives in agriculture and allowing locally owned enterprises to flourish.

Even President Obama has said, ". . . it is important to remember that capitalism has been the greatest driver of prosperity and opportunity the world has ever known." "The Way Ahead", October 8, 2016,

Free market economic theory, also known as capitalism is based on a set of assumptions: i.e.:
·  capital assets are owned
·  prices are the signals that allocate resources among uses
·  exchanges are voluntary and mutually beneficial
·  many small competitive producers
·  many small buyers 
·  perfect information
·  mobile resources; zero transaction costs, no constraints at borders; people, products, money and resources can move to the highest valued use
These assumptions are not always met in reality, even in the most free enterprise countries.

Capitalism is not perfect. There are some problems with unfettered private enterprise:

·         Business cycles - Booms and busts cause many recessions. Market economies have a long history of booms where optimism reigned, business boomed and employment was high and then busts when businesses failed, people lost their jobs (and fortunes) and the economy shrank. Current monetary policy of raising and lowering interest rates by the Federal Reserve Board, fiscal policy of deficits (and theoretical surpluses) and “automatic stabilizers” (such as progressive income taxes and unemployment insurance) are governmental attempts to tame the business cycles. The Great Depression lingered for many years without any significant free market correction and the economy didn’t really get going again until World War II.

Most economists promote the use of governmental fiscal and monetary policy to stabilize the economy, to “take the punch bowl away from the party” when the economy is heating up to avoid too much of an expansion that may result in a severe retraction, and to create demand by government spending and to lower interest rates to encourage buying and investing in capital assets when the economy is slowing.

·         Bubbles – Closely related to business cycles but tend to be more industry or commodity focused, where irrational exuberance prevails as prices rise and greed is the motivating factor, then when the bubble bursts and prices fall precipitously, fear rules the market. In the 2007-2008 housing crisis, this affected the entire economy because housing financing was so tightly connected with the entire financial system. Those who worked to control the crisis saw that the banks and AIG that were “bailed out” were not “too big to fail”, but rather “too connected to fail”.

Unfortunately, no one has devised a method to detect when a bubble is occurring in contrast to a natural real positive change in conditions - until it is too late.

·         Monopolies and oligopolies – Excessive market power distorts the allocation of resources and production/consumption such that the optimal production and consumption is not achieved. We normally think about excessive market power on the production side, but excessive market power can also be on the buying side, also known as monopsony.

The policies aimed at curing excessive market power is to replace it with competition wherever possible. Years ago, the U.S. telephone company AT and T was broken up into separate companies. Excessive concentration of market power prompted the “trust busting” for which Teddy Roosevelt was known for in the early 1900’s, as the oil and railroad companies had grown enormously powerful. Where a “natural monopoly” exists, the government typically resorts to regulation of the prices charged by the monopoly. Rumblings about the “excessive power” of Facebook, Google, Microsoft and Apple today can be heard.

·         Externalities - An externality is a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost (or benefits) of the goods or services involved, such as the pollination of surrounding crops by bees kept for honey (a positive externality) or pollution by a manufacturer (a negative externality). Another example is called “the tragedy of the commons”, where a public resource is overused by people, because each can benefit from using the resource but all bear the costs of the degradation of the resource by overuse, yet no one restricts their use because if they did, the situation would not improve his or her own welfare, only the ones who continued to use the resource. Overuse of the early colonial Boston Commons for grazing and traffic congestion are two specific examples of this concept. Regulations have been the primary means to governments dealing with externalities.
The release of carbon dioxide 
into the atmosphere by the burning of fossil fuels is another example of an externality.  As the concentration of carbon dioxide in the atmosphere increases and causes climate to change, people other than the fossil fuel burners suffer the consequences. Thus the fossil fuel burners do not bear the entire cost of their production of the carbon dioxide. 
The key to redressing an externality is to internalize the costs by the producers which would otherwise spill over to others. Examples of such attempts are pollution taxes and tradeable pollution credits. In the case of releases of carbon dioxide, economists generally prefer carbon taxes.

·         Imperfect information, also known as “asymmetrical information”, where one party to a transaction has much better information than the other party – examples include:

  •    extended product warranties for new products purchased (why would the extended warranty be offered if the manufacturer knew repairs would be needed to the extent and often enough for the warranty to be worth the price paid?), 
  •    state run lotteries (the pay off odds are horrible for the purchasers of lottery tickets, etc.) and 
  •    sales of used cars (the owner knows the problems, but the buyer is buying a “pig in a poke”).

Warranties are one way to give buyers greater confidence in the quality of the products they are buying. In the 2007-2009 housing crisis, imperfect information was a significant factor in the seizing up of the financial markets, because many of the financial products being bought and sold among the big financial players were of uncertain value. Securities that had been used as sources of payment or as collateral became “toxic”. Once the financial institutions realized that the ratings by the rating agencies (Standard and Poors, Moody’s and Fitch) were useless, they had no way of knowing what the mortgage backed securities were worth. What quality mortgages were in the “tranche” they owned? How many of them would be foreclosed on? What percentage of the loan amount would be recovered in foreclosure? To what extent would the mortgage insurance cover the remainder of the loan? To the extent that the security would lose value, how much of the loss would be covered by the credit default swap? Would the insurance company that sold the credit default swap (e.g., AIG) be able to pay according to the agreement to indemnify the loser? Fear reigned, and the markets crashed.

·         Public goods – Public goods exist where (1) consumption of the goods or services by one person does not leave less for any other consumer and (2) the costs of excluding nonpaying beneficiaries who consume the good or service are so high that no private profit-maximizing firm is willing to supply the good or service. Many services governments provide are best, or perhaps soley, provided by governments, due to the problem of “free riders”. National defense is the obvious example, but the concept can be extended to highways, water and sewer systems, etc. That is, if everyone did not collectively pay for the service, those who voluntarily chose to pay would bear all of the costs, but those who did not pay would be “free riders”.

The issues with public goods are usually dealt with in one of two ways: (1) subsidize the good or service either directly (or indirectly through the tax system) or (2) provide the public good itself and pay for it through taxation. Just what are public goods as compared with goods that might be provided by private companies is the source of contention among “liberals” and conservatives. Examples include public education, public libraries, public parks, support for the arts and sciences, etc.

·         “Creative destruction” - New products and new businesses absorb resources to increase total production (and therefore consumption) but leave behind the labor and capital from those industries and businesses that can no longer compete. Creative destruction, a term coined by Joseph Schumpeter in "Capitalism, Socialism and Democracy" in 1942, describes the "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." This occurs when innovation deconstructs long-standing arrangements and frees resources to be deployed elsewhere to the new “highest and best valued use”. By using the word “destruction,” Schumpeter directly implies the process results in losses alongside profits and there are losers in the creative destruction. Entrepreneurs and technologies actively create disequilibrium and highlight new profit opportunities that did not previously exist. This evolutionary process rewards profitable adaptations and innovations and punishes less efficient ways of organizing resources. The resources (inputs, such as labor, management and capital) move to those businesses and industries where the resources have higher values. The process can be bumpy and unpleasant for some, but the result is progress, growth and higher standards of living. One of the problems is that the benefits (e.g., lower prices due to innovation) are often spread out among many people, while the costs are concentrated among a smaller identified group. Those who benefit a small amount barely notice but those who bear the costs can feel sorely aggrieved and attempt to exert political pressure on policy makers to redress the situation. The very real problems encountered by “those left behind” are some of the causes for the populist movements in many countries, but most notably capitalized on by Donald Trump in the 2016 U.S presidential election.

Should we better address the problem of creative destruction of capitalism, especially in light of massive job losses due to innovation, technology change and globalism? Should we have massive education benefits for those adversely affected? What about relocation assistance so people can move to where the jobs are? 

          Wealth and income inequalities – Despite the dramatic reduction in the percentage of people around the world who are truly impoverished, we have seen in the past few decades a widening of the gap between the highest and lowest income earners and between he wealthiest and the poorest people. This is a prime weakness in a pure democracy, as envy encourages the taking from the rich and giving to the poor (without the consent of the rich). This creates a possible source of instability.
Behavioral economists have found that the vast majority of people have a sense of fairness. When there gets to be excessive income and wealth gaps, that is perceived as unfair, perhaps by some evolutionary mechanism or perhaps simply by what we learned in kindergarten (although the researchers have found this to be true across multiple cultures, genders and age levels). The buildup of sentiment about the “unfairness” of wealth and income distribution led to the anti-trust movement in the early 1900’s in the US, and perhaps contributed to Trump’s election as the President of the U.S.
The concentration of wealth is a problem, not only because some people have more wealth than others and the envy that results, but because of the political influence wealth has.

Walter Scheidel, a Stanford professor, in his book “The Great Leveler”, posits that throughout history, economic inequality has only been rectified by one of the following: warfare, revolution, state collapse and plague. One hopes that we can find a better way to either live with the problem or cure it without the major disruptions he sees as the past solutions. Incidentally, this gap between the rich and the poor was what Karl Marx was noticing, but his prescriptions for the cure proved to be unsound. The abolition of private property also destroyed the incentives upon which a thriving economy depends.

·         Anti-commons – modern society involves actions or decisions that need to be made to allow modern advances and innovation to occur that completely free markets do not facilitate. An example is the building of an airport. This involves the assembly of extensive property that is currently owned by private individuals or companies. Another example is the construction or widening of a road that requires property owned by private parties. So how does the public acquire this property? Of course, the government may purchase the property from the owners who voluntarily choose to sell at a negotiated price. The issue is how to deal with people who seek to “hold out” and refuse to sell except at extraordinary high prices.

In the United States, a system of eminent domain has been created by which the government can purchase the property through condemnation court proceedings in which the owner is paid the fair market value (as determined by the court). There are issues, however, when the property is “taken” by the government for a private use, or when the property is not physically taken but its use is so restricted as to significantly reduce its value.

·         Nation states – The economists assume the free movement of people, products and money, i.e., mobile resources. In reality, resources are not completely mobile due to transportation costs, transaction costs, etc. The existence of borders of nation states creates barriers to the movement of people through immigration policies, and barriers to the movement of products due to trade barriers. The movement of money can also be restricted. The states combined into the United States solves many of those problems, but there still is “friction” due to transportation and transaction costs. The European Union and its related agreements are another grand experiment in the lowering of restrictions of movement of people (Schengen Agreement), products (EU common market) and money (Eurozone).

     Conclusions - Despite these problems or deficiencies of pure capitalism, the sheer success of capitalism through the ages should give one pause before one tampers with the system which allocates resources via voluntary price signals. When one steps back and thinks about it, isn't it amazing that the city of New York each day has enough bread, shoes, cars and every other product needed, without anyone commanding what amount of each product should be there? Adam Smith's "unseen hand" remains truly amazing.


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