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Competitive Markets Don't Just Happen; It's Time to Regulate In the Public Interest

by: Mark Thoma October 13, 2008    

Mark Thoma

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I want to rerun an old post, then add something to it:

Markets Are Not Magic, by Mark Thoma: To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart (WMT) with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic (though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern).

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, if government favors one contractor over another due to political contributions, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic, there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch, say, from TypePad to Blogger. That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from TypePad and import them into Blogger, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principle agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Markets don't work just because we get out of the way. When government contracts are moved to the private sector without ensuring the proper incentives are in place, there will be problems - waste, inefficiency, higher prices than needed, etc. There is nothing special about markets that guarantees that managers or owners of companies will have an incentive to use public funds in a way that maximizes the public rather than their own personal interests. It is only when market incentives direct choices to coincide with the public interest that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of government services by private sector firms, there is no reason to expect the market to deliver an efficient outcome, an outcome free of waste and inefficiency. Why would we think that giving a private sector firm a monopoly in the provision of a public service would yield an efficient outcome? If the projects are of sufficient scale, or require specialized knowledge so that only one or a few private sector firms are large enough or specialized enough to do the job, why would we expect an ideal outcome just because the private sector is involved? If cronyism limits the participants in the marketplace, why would we expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A market can be a monopoly, a market can be perfectly competitive, a market can be lots of things. Markets with bad incentives produce bad outcomes, markets with good incentives do better.

I believe in markets as much as anyone. But the expression "free markets" is often misinterpreted to mean that unregulated markets are all that is required for markets to work their wonders and achieve efficient outcomes. But unregulated is not enough, there are many, many other conditions that must be present. Deregulation or privatization may even move the outcome further from the ideal competitive benchmark rather than closer to it, it depends upon the type of regulation and the characteristics of the market in question.

When competitive conditions are not met but can be regulated, the regulations should be put in place and the private sector left to do its thing (e.g.  mandating that sellers disclose problems with a house to prevent asymmetric information or mandating that government funded projects be subject to competitive bidding and monitoring to ensure contract terms are met). There's no reason for government to do anything except ensure that the incentives to motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are always best, privatization that does not proceed by first ensuring that market incentives are consistent with the public interest, doesn't do us any good. There are lots of free market advocates out there and I am with them so long as we understand that free does not mean the absence of government intervention, regulation, or oversight. Free means that the conditions for perfect competition are approximated as much as possible and sometimes that means the presence - rather than the absence - of government is required.

As we are seeing now, sometimes markets can fail catastrophically, but that doesn't mean that all markets fail, or that we should lose faith in the ability of markets to allocate goods and services.

Most markets work pretty well. Every day, somehow, the needs of hundreds of millions of people are met through our market system. For the most part, when you go to the marketplace, you can find what you want -- somehow, the market anticipates your needs and has the goods and services ready and waiting when you walk through the door of a store.

You won't always find what you are looking for, stores can stock out, oversupply, not have what you want, and so on, but most of the time you do find what you are looking for, or don't have to wait long to get it.

When you think about it, it's actually pretty amazing that we are able to coordinate so many diverse actions of so many individuals into an economic system that does a pretty good job of providing for our needs, responding to changes in our tastes, providing incentives for technological advancement, and so on.

So I don't think the lesson of this crisis is that markets don't work. I think the lesson is that markets don't always work, that we need to be vigilant in our oversight of markets to make sure they really do satisfy, as much as possible, the competitive ideals that are necessary for markets to perform well.

I believe that markets do have lots to offer, and I hope we don't lose faith in the market system. But I do not believe that a competitive marketplace necessarily evolves on its own if we simply get the government out of the way.

What market share did some of these financial firms have? Why were they allowed to get too big and too interconnected to fail? Why didn't we ask more questions about the ability of ratings agencies operating as a duopoly and paid by the firms whose securities they were rating to solve asymmetric information problems?

Shouldn't we have paid more attention to other market failures such as moral hazard and adverse selection issues that seem to plague all types of insurance markets, including those in financial markets? Why didn't agency problems, a common market failure, receive more notice and attention? And so on, and so on.

Government oversight is needed to produce and maintain a competitive marketplace,  Competitive markets don't just happen through self-correction, and in a broad sense the failure to ensure that these conditions were satisfied, and when they couldn't be satisfied to ensure that the markets were subjected to strict oversight to prevent exploitation of market power, systemic breakdown, etc., is one reason we are in the mess we are in.

There's a difference between government imposing conditions on markets that cause distortions, and oversight that maintains a stable and competitive marketplace. Allowing markets to regulate themselves hasn't worked, a competitive market is not an inevitable outcome of government turning its back and saying do whatever you want, and it's time for regulators to reassert the power they have to regulate markets in the public interest. If we fail in our oversight of markets, if we let markets take on non-competitive and unstable structures, then we shouldn't be surprised when markets fail us in return.

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This article has 8 comments:

  •  
    Oct 13 07:01 AM
    The self-contradictions in this piece are mind boggling. The last thing we have here in the US are free markets. They are regulated to the point of no return.

    The author's example of moving from one blog service to another rests on the false presumption that one should be able to make such a move at no cost. This is false in a free market. Every action has a cost. If you want to make such a move, PAY someone to transfer all the data to the new blog. At some price you can make the move.

    The same is true for almost any action you wish to accomplish. At some price you will be able to get things done. The question that is always overlooked by the people who claim free markets don't work is whether the government's "regulation" reduces or adds to that cost.

    (Hint: It never reduces the cost because you now have to pay a bureaucrat to generate and police "the rules" instead of relying on individual negotiation and contracts that aren't so restrained.)

    The author should set aside a few days and read "Human Action" by Ludwig von Mises so as to gain a proper understanding of how free markets work and why they are the best possible means of production.
    Reply
  •  
    Oct 13 11:06 AM
    Unfortunately, free market "principles" are theories, not laws. In theory, free markets are transparent and understood by all participants. In practice, some participants often know more than others because of lack of disclosure. There is a term for this situation: "caveat emptor" (spelling?) or "let the buyer beware". When the lack of disclosure goes to extremes, we can have collapses such as we are now experiencing. Obviously, in the present situation the buyer has been unaware. One might argue that the seller has been ignorant, as well.

    Regulated markets can restrict desired activity as well as prevent undesired activity. They also can add cost, as pointed out by Smarty_Pants. Obviously, regulation can slow economic activity and growth. On the otherhand, proper regulation can insure transparency and reduce systemic risk. If regulations go so far that they protect idiots from making mistakes, they are likely to be counter productive. However, regulations should be sufficient to assure that information is available and unambiguous for all cogent market participants. If a few don't pay attention, there is no systemic problem. If many don't pay attention to the information, there can be systemic risk and there may be a need for more restrictive regulation. This should be needed only occasionally. Such an occasion appears to be what has happened in the past year.

    To use a metaphor, we are all on a sailing ship. There should be rules that specify the necessary actions to keep the ship sailing and these rules should be imposed on all aboard. Beyond that, there should be rules (I'll call them "circuit breaker rules") that will prevent everyone from running to the leeward side of the ship when a wind gust hits.
    Reply
  •  
    Oct 13 01:14 PM
    Years ago I came across a little book by an English and Marxian (not Marxist) economist, Joan Robinson. She explored the concepts of utility and money, and the lure of the perfect competition model for many economists. The underlying assumptions of perfect competition may be questioned. The point is that the model bears little relationship to reality. The work of Friedman and others in the Chicago school of economics were misapplied and adopted as a matter of faith, but what we ended up with is socialism for the rich and capitalism for the rest of us.
    Reply
  •  
    Oct 13 03:38 PM
    We all need to go back to the classics of economics.

    It's interesting to read Adam Smith because he battled against the absurdities of the Mercantile system with simple, common sense examples. We can see a ourselves in a distant mirror too.

    But it's also sobering to realize that Alexander Hamilton, who is often called the father of the American economic system, was a protectionist of the old mercantile model, and rejected the "radical" ideas of Adam Smith. Food for thought.

    All throughout the 19th century, America followed the protectionist ideas of Alexander Hamilton and not the free trade (between countries) arguments of Adam Smith.

    The Austrian School, which had its foundations in the work of the French economist Leon Walras, his Italian counterpart Vilfredo Pareto and the two Viennese economists Carl Menger and Eurgen von Böhm-Bawerk, was to a very large extent, a reaction against the German historical school and socialism of the time which was threatening to come to power everywhere.

    In the 1930's, Marxism, German National Socialism, the American New Deal under Keynesian influence, French socialism under Leon Blum and others were dominant when the Austrian school rose to counter them.

    Friedrich von Hayek, Ludwig von Mises and Joseph Schumpeter were the principle representatives of the Austrian school during this time when socialism was in its ascendancy but the Austrian school were outsiders (It should be added that the Austrian Empire lay in ruins after World War I just as the Soviet Empire does today.) Schumpeter believed that socialism would triumph in the end but he wasn't happy about it. He agreed with Marx that governments (the people) would take over monopolies and that monopolies were the most efficient way to produce goods and services. A Big Mac anyone?)

    The Chicago school started with Frank Knight in the 1930's and was also, for the most part, anti-socialist. The students of Knight, Milton Friedman and George Stigler rose to influence under the Reagan government.

    The principle that markets are self-correcting systems that create their own conditions of equilibrium started with Walras and Böhm-Bawerk in the late 19th century and has grown into the highly sophisticated mathematical models of the early 21st century.

    These mathematical models dominate modern United States economic departments but that doesn't mean they are necessarily correct. Many people argue that these mathematical systems are crude simplifications of necessarily messy human processes and therefore can lead to serious unintended financial consequences.

    We need to (re)read the classics to reopen the discussion!

    To assume that the final, correct economic model has been determined for all time is a dangerous illusion.
    Reply
  •  
    Oct 15 07:33 AM
    Indeed, the assumptions of all Economic Schools of Thought have and are being challenged with each unique set of economic circumstances that does not behave according to theory. I think most economists agree that some component of free-market action must be part of an economy, but we see increasingly the need for "interventionist capitalism". It could be argued this is not necessary, but the natural corrections of a self-correcting system (if it is indeed actually self-correcting?) can be quite severe and prolonged.

    The Chinese have found a model that is fitting their unique situation of mass and concentrated population, culture, and slow change, that allows for very free markets at a lower level, with macro policy controls by the government. But what we also see is that a lack of regulation means that the entrepreneurs are very much like those of the Industrial Revolution: cutting corners at all costs. The normal self-correction is that scrutiny and reputation factors will step in, but today's massively globalized and largely free market brings with it an equally massive supply chain. Do you know the chain of products and sources in your cereal? My point is: we have a new type of economy, and it demands a new school of thought.

    What this likely suggests is that there are models that apply to certain levels of development and culture within a particular country. If you try to implement free-market policies without proper market mechanisms or basic security, it simply doesn't work. Somalia is not the place for an Austrian-school economy right now: its already so dysfunctional and controlled by violence that no transactions have any basis of security. Counterparty risk there is mitigated by how many guys with AK-47's you have behind you.

    This is not a failure of capitalism, but in our Western and developed countries, we face other fundamental problems as a result of policy such as the condensation of wealth and of counterparties that removes a diversification of opinions, strategies, and investment-horizons from the market. We've seen a copy-cat strategy amongst what were supposedly the smartest and most-respected managers of wealth, and without capital being withheld or invested in contrarian or more conservative ways, there becomes no counterparties of last resort when those copy-cats go wrong. Thus the government becomes that lender, rather than what in theory should happen: that private capital should at least be flowing to *some* extent. Instead schools assume rational actors, and even these largest of institutions, who ultimately make a single collective decision for the massive amount of wealth they have condensed, are paralyzed by fear. In other words, Minsky certainly had something to his point.

    Right now all I hear are battles between existing schools of thought, and polarizing characterizations of economic systems. Is China a 'socialist' economy? Not in the same way Cuba is. Is France a capitalist economy in the same way the US is? Nope, it has some nationalized industries. So there are a vast spectrum of systems *in-practice* that span the spectrum between the dozen or less, highly idealistic, economic grand theories. What is needed is a real study of what works for a given society/culture/govern... Pragmatism should be the rule of the day, not this theoretical and idealized arguments, and empirical and historical data should support these theories, rather than elaborate word-arguments. If you want to call economics a science, at least *try* to treat it like one.
    Reply
  •  
    Oct 16 01:52 AM
    WHAT AN IDIOT!!!

    All you have to do is get rid of the federal reserve, its fiat currency and fractional reserve banking and POOF!! the market will be self correcting again.

    Don't you get it?? As long as people are gambling with someone else's money - including credit that spends like money - they will not be super careful about how it gets spent. And the ones who are foolish with their money will soon be parted from it by the market.

    No more regulation, LESS regulation, LESS gov't BUT (and this is a big BUT) only if you have honest money of some sort like a true gold backed dollar, etc. and some trusted way to ensure that dollars will number grow larger than associated gold stockpile.

    So many people ignore the real problem and then go crazy with bandaids trying to patch up the symptoms!! Cure the cancer and you can stop the drugs to control pain, nausea, and weakness.

    GET IT???
    Reply
  •  
    Oct 16 01:58 AM
    correction: will >NOT< grow larger than the gold stockpile...

    We already have a trusted mechanism for dollars growing larger than the gold stock pile (even though the dollar is no longer tied to gold): We call the system for dollar growth 'Congress and the Fed'.
    Reply
  •  
    Oct 16 08:50 PM
    This is a very interesting and well informed conversation with good points on both sides of the regulation question. I don't think a true free market has ever existed anywhere. The large hairy caveman with the big stick can extort a pretty lopsided bargain out of you, so we can't look to primitive times for a pure market.

    In 1776 when Adam Smith published his Inquiry into the nature and causes of the wealth of nations England's economy was largely barter, work was mainly done in and around the home, and pretty much every living person 2 years old and up was an economically active participant. Everybody worked, and everybody needed to work to survive. There were no "equity" issues like unemployment insurance: you don't work, you don't get paid, period. We can't do that today.

    Unlike today's breakfast cereals with inputs from god knows where, in Smith's England the entire production and marketing cycle of most goods was local so that everyone had all the information they needed to determine "fair market" exchange values. Goods were mainly simple necessities of life that pretty much anybody was capable of producing. In modern times none of us can personally produce something as "simple" as a lead pencil, as the famous story shows us.

    Even if one subscribes to incomprehensibilities like Marx's labor theory of value, it is impossible in the practical technical sense to objectively determine the 'true' value of anything because of the enormous complexities involved, so competitive markets, imperfect though they be, are our best means of establishing prices even though information asymmetries are probably the rule rather than the exception. A few years ago someone from the Chicago School demonstrated the common sense truism that sellers almost always have more information about the item being bargained on than do prospective buyers, which is why caveat emptor applies, though merely "being wary" is no match for possessing information.

    We all know that government-provided security such as the pax Romana is essential to economic progress (remember what happens when exchange values are determined by he who holds the stick), so government at the very least has a necessary role as guarantor of basic security (though libertarians argue that private security can be had contractually).

    Ayn Rand argues cogently that early 20th century antitrust laws were motivated by envy rather than the public good, so even capitalist monopoly/oligopoly has its defenders.

    Also unlike Smith's time, today the "peasants" have political and other "rights". The oligarchs of old at least had been educated and had some understanding of the mechanics of the issues they were addressing. They had at least a basic understanding of the political economy they were ruling over. Most voters today do not have even a rudimentary understanding of how their national economy works. They vote for whoever promises to feed them better at the public trough. But the public trough is filled up by their neighbor. If they understood, would they vote for the politician who promised to rob the neighbor's house and deliver the goods in person?

    Maybe they would. The politics of envy is alive and well. It was less than a century ago that economics became separated from political economy, but it's a false separation. Another Chicago School economist recently exposed the illusion of the economically "rational actor". People behave for all kinds of psychological motives, many of which we would consider perverse, which makes their behavior "appear" irrational but which, once you discover what is motivating them, is actually perfectly rational but perversely motivated. Economics assumes all values can be priced, but many emotional values are difficult if not impossible to objectively evaluate. And personal values are notoriously divergent. One rational actor can't wait to get rid of the very thing the next rational actor can't wait to possess at high price: think of the person who married your ex. The political aspects of political economy are at least as important as the more purely economic aspects. Economic activity, unless you're a hermit, involves working with the polis. So you can't take the political out of the economic and think you're going to have an economic free market unencumbered by political factors.

    Moralists historically identified 7 common human psychological/characte... failings that, from our perspective, can be said to perversely affect their rational choices. These are the 7 deadly sins of greed, sloth, gluttony, envy, vanity, anger and lust. These are "common" motivating influences in human psychology: that's why they were identified in the first place and attempts made to teach people to recognize and suppress them. A political economy must accomodate the people who have these features as well as those virtuous people who act from nobler motives.

    So I think there isn't and never was a "free" market, though we'll get a lot closer to realizing its beneficial ideals by striving for it than we will by accepting regulation without a fight.
    Reply
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