The world can be divided into two groups, the kind of people who think a rainbow is a beautiful and wondrous miracle of nature, the closer inspection of which destroys the illusion, and those who find it even more wondrous when understood as a very special property of sunlight; chromatic dispersion through water droplets. I count myself amongst the latter, and being trained in economics find I am most curious about economic systems and institutions. The central concept in modern in economics is of course the market system, the conception and functioning of which rivals the beauty of the rainbow in my mind. Much like that optical delight, there is much more to real-world markets than meets the eye, and I argue that it is this complexity that should give free-market fundamentalists some cause to be circumspect.
The difference between physics and economics – one that is the subject of heated debate – is that economics cannot claim to be an exact science. Of course when physics delved deeper into the sub-atomic world and we discovered that Newtonian laws, which govern our world, do not apply in this strange quantum reality, the scientific community was both ‘shaken’ and ‘stirred’, to borrow from the vocabulary of the famous fictional British super-agent. However it would be fair to say that economics has some distance to go, before it can be uttered in the same breath as any of the natural sciences. And yet theorists and practitioners alike continue to put their faith in certain immutable economic laws. Perhaps the most fundamental belief shared by mainstream economists, is in the existence of the ‘invisible hand’, first introduced in Adam Smith’s seminal book. The idea is that when every agent in the economy strives to maximize his or her own utility, the economy as a whole achieves the highest possible level of collective or ‘social’ utility. This is the simple and yet very powerful idea that supports the notion that free markets must not be tampered with because any deviation will lead to a sub-optimal or less beneficial result for society as whole.
Much like the rainbow, the market system is both beautiful and wondrous when it functions perfectly. Well-functioning markets lead to efficient resource allocation and economic growth. Perhaps the best and most readable account of how and why markets are so good at resource allocation was given by Friedrich A Hayek in 1945 in an essay published by the American Economic Review. He argues that the market system aggregates and transmits relevant information to producers of goods and services, telling them what and how much to produce, and likewise to consumers informing them what to buy and from whom. All of this is done instantly and relatively costlessly through the operation of the price mechanism, whereby producers decide what to supply depending prevailing price, and consumers informed by their individual preferences choose the basket of goods and services that will afford them the greatest utility given their limited budget.
The problem is that price does not always communicate everything there is to be known about a product to the consumer, such as the quality of the product. In the presence of an asymmetry of information between buyer and seller, markets don’t function as efficiently because the seller can pass off a low quality good at the price of a high quality good, without the buyer being any the wiser. The specific problem of adverse selection where buyers don’t have complete information about products or service is discussed in a highly engaging, neat little paper by George Akerlof.
Another problem that free markets do not handle very well is the problem of externalities. Let us take the case of a leather-tanning factory, which uses a nearby river to wash the tanned leather in, and sells the finished leather upstream. The river is also the primary water source for people living downstream that are now forced to use contaminated water. The factory would have no incentive to stop polluting the river, since it would be costly to use a different source of water and the externality does not affect its consumers. Here we have a sub-optimal result for society if we include the community living downstream in our analysis. For those interested in a detailed discussion on externalities I would recommend Ronald Coase’s paper on the problem of social cost.
I am going to move away from the metaphor of the rainbow, and introduce another somewhat more whimsical likeness; between a Formula 1 car and a perfectly functioning market system. In one sense, the race-car is the quickest way to get from point A to point B, but for it to perform optimally, requires a team of engineers, precision in the pits, the right track conditions and of course a skillful driver. One gets the feeling that an F1 car may not perform as well on a pot-holed Indian village road. Much like a race-car, the perfectly competitive market structure produces optimal results under very stringent conditions, such as perfectly rational agents, perfect information, homogeneity of goods, perfectly mobile factors of production, zero barriers to entry and an infinite number of buyers and sellers. Relaxing even one of these assumptions moves us to a sub-optimal result, and in reality there are no markets in existence where all or indeed any of these conditions are met.
As I said at the beginning of this post, economics is not an exact science, which is why economists have failed to prevent or indeed predict financial crises, and we are still struggling to understand the development process, and how to solve the problems inherent in the third world. Free market ideology does not seem to hold the key, however adamant the voices, either in theory or indeed in practice, as we should learn from the Latin American experience. This does not mean that the market paradigm is not the best we’ve got, it is. However it is time we accept that it is not a ‘magic’ solution. Economics has its work cut out, and the sooner we face up to these home truths, the sooner we can begin to look in earnest for real answers.