Free Markets

In a recent comment, Meet wrote:

I really liked how you found the market to be a key factor for welfare in the setup of the current world. My question is whether free markets did exist at some point of time? And as rather free (different degrees of free) markets exist, should regulation (an apparent contradiction to free markets) be required to protect the participants from manipulation or loopholes in the system?

Markets are where exchanges take place. Free markets are where there are no barriers to entry for buyers and sellers, and there are no exit barriers either. One can easily imagine that free markets do exist somewhere in somethings, and that these have a long history going back to thousands of years.

One can imagine that there have been changes in the degree of freedom in various markets. Examples of restrictions and outright prohibitions are common enough. You cannot, for example, buy and sell human organs for transplantation. Whether a market for, say, kidneys is a good idea or not is  a different matter though.

Should markets be regulated? Depends. Libertarians generally don’t favor interference in markets and oppose regulation of markets as a matter of principle. There are good utilitarian arguments why regulating markets is bad because regulations prevent gains from trade. But the more persuasive reason for not having regulations is that it is an infringement of individual rights and freedom.

But what about fraud or breach of contract? Those can be handled by laws that punish the use of force or fraud.

Free markets make society well off. Everyone gains if individuals have the freedom to say “No, thank you.” An example of where that freedom to refuse an offer is lacking is the fictional story of Don Corleone, the godfather in Mario Puzo’s 1969 novel, “The Godfather.” The Don makes a movie producer “an offer he cannot refuse.”

Free markets are central to human prosperity. Without free markets, most of the marvels of the modern world would not exist at all. It’s worth our time to learn what free markets are and why they matter.

I have written many pieces on the subject. Here’s one from October 2019, titled “Competition in Free Markets” which I quote in its entirety below:

**** Begin quote ****

Production

The primary purpose of production is consumption. Economic activity is by definition the production and consumption of goods and services. Except for the special case of the so-called “Robinson Crusoe” economy (an economy in which there is only one person who has to necessarily be self-sufficient) every real economy involves exchange or trade. The ability to trade what one has produced for things that one wants to consume generates wealth and increases welfare.

You can of course restrict your consumption to only those things you produce, but you will have a Hobbesian existence: “solitary, poor, nasty, brutish, and short.”

Exchange

Exchange makes possible the creation of wealth through division of labor and specialization, two intimately connected concepts. Surgeons operate, bakers bake, brewers brew, carpenters build, architects design, programmers code, … ad infinitum. The ability to exchange decouples production and consumption. Crusoe’s production and consumption are rigidly linked. In our case, we don’t produce any of the things we consume, and don’t consume what we produce.

Specialization is not optional in any even moderately advanced society; it is mandatory. People have to specialize. To become a specialist in any field, you have to forego learning other fields. The opportunity to exchange and trade allows the division of knowledge because trade makes possible the division of labor.

Markets

The importance of exchange or trade in human society cannot be overestimated. Exchanges happen in what we call “markets.” If you own something that others value and are willing to trade for something you value, you can do the exchange in the appropriate market. In nearly all cases, one side of the trade involves money. We don’t trade stuff directly; we trade money for goods and services.

Money is anything that is universally accepted in trade. You can exchange money for whatever you want from the store because the store can exchange money for whatever it wants from others.

Free Markets

Markets are where buyers and sellers do their trade. Markets that do not have barriers to entry or exit are called “free markets.” In a free market, you are free to offer to sell your stuff, and are also free to refuse to sell your stuff. No one prevents you from being a buyer or a seller in a free market. So also no one forces you to be a buyer or a seller in a free market. The freedom that buyers and sellers have to enter or exit the market is what makes the market free.

Consider the labor market. If I am willing to work for you for $10 an hour, and you offer to pay me $10 an hour, then we have a voluntary trade in a free market. But if the law puts the minimum wage at $15 an hour, it prevents that $10 trade. The market for labor with a minimum wage is not a free market.

Competition

In free markets, because there are no barriers to entry or exit, for every good or service there will normally be numerous sellers and sellers. This leads to competition. Note that the competition is not between buyers and sellers, but instead is between sellers on the one hand, and between buyers on the other hand. Sellers compete with other sellers, and buyers compete with other buyers. Thus the sellers of potatoes, say, will compete with other sellers of potatoes for buyers of potatoes, who would be competing with other buyers of potatoes.

This is called “competition in the market.” Everyone likes competition in the market, except for the market participants. The sellers of potatoes don’t like having other sellers of potatoes in the market because it lowers the price of potatoes; and the buyers of potatoes don’t like having other buyers of potatoes in the market because that raises the price of potatoes.

Markets Discipline

Competition in free markets lowers prices. Because buyers will not buy at a higher price if another seller is offering a lower price. A seller does not get to charge an arbitrarily chosen high price; he is prevented from doing so because there other sellers can enter the market at a lower price. Free markets impose discipline on market participants because of competition. Competition is a given state of affairs in a free market.

But what if there is something that has only one supplier? In that case, even in a free market, because the supplier does not have competitors, would not that supplier be able to charge an arbitrarily high price to maximize his profits? Yes. That is the case when the supplier is a monopolist. As the monopolist, you are the only supplier and buyers don’t have a choice of suppliers.

Monopolies

Even in free markets, monopolists can make big profits. But only for a while; monopolies eventually end. The high profits that monopolists make in the market attracts other suppliers to provide whatever the monopolist sells, or produce substitutes to it. Not immediately but eventually, other suppliers remove the monopoly from dominating the market if there are no barriers to entry.

In the natural course of events, monopolies don’t last forever (nothing lasts forever, anyway.) But that natural course can be prevented by force, and monopolies can be imposed. The agency that has the ability to that is the government.

Remember that monopolies don’t last because other suppliers eventually enter the free market. But the government can restrict entry, and thus favor the monopolist. Why would the government do so? Because the government itself can profit from the monopoly.

Market for Widgets

Let’s concoct an example. Suppose there is a market for widgets (which are things that exist only in the imagination of economists, and which they imagine people want to buy.) Suppose further it is a free market for widgets: anyone who wishes to can buy or sell widgets. Because of competition among widget sellers, and the competition among widget buyers, the price of widgets will be determined by the usual forces of demand and supply.

If the supply of widgets increases without a corresponding increase in demand for widgets, the price of widgets will fall; if the demand increases without a corresponding increase in supply, the price will rise. The price will reflect the relative changes in the demand and supply of widgets.

Prices Emerge

The market price is not determined by any particular buyer or seller. The market price emerges out of the myriad interactions of all the buyers and sellers. Nobody has a privileged position in a free market to determine prices. Nobody gets to dictate prices. Every participant wants to increase his own position as best as he can, and the resulting price is not anyone’s choosing. The market is a process and out of this process, prices emerge.

An analogy would be helpful. In game of football, each team tries to score as many goals as it can. Each team “maximizes” the goals they score. The result of the game (say Team A scores 4 goals, Team B scores 3 goals) emerges from the process which is the playing of the game. In no way are the two teams jointly trying to maximize the total number of goals. The two teams participate in the process but cannot directly determine the result that emerges. In markets, prices emerge out of the process of competition. The important words are process and emergence.

Super-normal Profits

In the market for widgets, the suppliers make normal profits, not super-normal profits because of competitive free entry. As noted before, the suppliers would rather not face competition. Suppose the typical widget supplier makes only $10 in profits, or normal profit. Suppose a monopoly supplier of widgets to the market could make $100 in profits, or super-normal profit. It could then work out a deal with the government. It could get the government to restrict entry into the market, and in exchange pay the government anywhere up to $90 for the privilege (the difference between the normal and super-normal profit.)

The government would then use any of the many options. It could grant outright monopoly rights to one of the many widget suppliers. But to which one? The supplier that bids the highest amount for the monopoly rights. Thus you have another kind of competition. Where there used to be a competition in the market, you now have a competition for the market.

Limiting Competition in the Market

In the competition in the market, the consumers win because of price and quality competition. By shifting the competition from within the market to competition outside the market, the winning supplier gains and the government gains, but the consumers lose. The consumers lose because the supplier can choose the quantity/price combination that maximizes his profits (out of which he pays the government.)

So that’s the end of this little bit of simple economic reasoning. Free markets are good for the economy because of competition. Competition is good for the economy but bad for suppliers. To limit competition in the market, suppliers have an incentive to bribe the government.

The government uses various mechanisms such as license, quotas, and permits. By getting into the economic game, the government becomes a participant in the game, instead of being an impartial referee. By limiting competition in the market, the government hurts the economy and enriches itself and its cronies at the expense of the consumers.

Crony Capitalism

This is what is called “crony capitalism” — the government and its friends extract wealth from the people. That is why those in government are so fond of interfering in markets. And when that is allowed to happen, the economy cannot prosper. That is why countries like India are poor. The government prevents the creation of wealth that markets are so good at.

I like to quote Adam Smith from one of his lectures from 1775 (before the publication of his book An Inquiry into the Nature and Causes of the Wealth of Nations in 1776). Read it carefully.

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

It is the highest folly to disregard Adam Smith’s insights. The post-script to that post was —

Only in markets that the government restricts entry into is it profitable for suppliers to exploit consumers. Firms will naturally want to limit competition but they cannot do anything other than bribe the government to do the dirty work of screwing the consumers. It’s not the “0.1% lobby” but rather the “0.0001% lobby” that constitute the politicians and bureaucrats in any economy. Putting the blame on lobbyists is misplaced; the fault lies in the government. That is why the constitution should prohibit the government from interfering and distorting free markets.

***** End quote ****

In another piece that deals with the matter of markets, here’s what I wrote:

The defining characteristic of a free market is the buyers and sellers are free to enter and exit at will without any third party forcing them to enter or exit the market. The operative word is force. When force enters the picture, the market is not free.

Here are some examples of markets that are not free. Consider the slave labor market. The enslaved person is forced to “sell” his labor; he cannot refuse to work for the “master.” The enslaved cannot exit the labor market.

Consider the market for labor with a minimum wage law. Bob wants to employ Jim at $10 an hour and Jim is willing to work for Bob at that wage, but the state (the third part) imposes a $15 minimum wage, a wage that Jim is not willing to pay. That means Jim is not free to sell his labor below the minimum wage. Jim is being prevented from entering the market as a seller, and Bob is being prevented from entering the market as a seller.

Free Trades are 2-Party

Exchange or trade in free markets is always between two parties — the buyer and the seller. There is no third party. If there’s a third party which intervenes in any trade between those two parties, it ceases to be a free market. The third party imposes entry or exit barriers and by doing so prevents free trade. The third party is usually the government or the state. The instrument that the third party uses to intervene in the market is physical force, usually involving guns and other lethal weapons.

The state imposes its will on voluntary exchanges through legislation that require permits, and permissions, and licenses and quotas. All of them prevent the market from operating by preventing voluntary trades between two parties. As a result, wealth which could have been generated does not obtain.

You may ask, are there any instances anywhere in the world where markets are truly free? The answer is no. All markets to varying degrees are not free in all parts of the world, rich or poor. When you pay sales tax, or an income tax, or an import duty, or a license fee, … the list goes on, you are not in a free market. If you don’t pay the sales tax, you cannot buy, for example. It’s not a free market.

But those parts of the world where the markets are relatively free are more prosperous than where markets are less free. Poor countries are made — and kept poor — by the state’s interference in free markets. A major cause of the poverty of nations is government  intervention in markets.

The positive analysis of markets shows that free markets are the engines of economic prosperity. The normative analysis follows from that — to increase economic prosperity, the state should remove all barriers to entry and exit from markets.

Free markets and free people are conjoined twins. You cannot have one without the other. How can any people be considered free if they are not free to engage in trade?  Note that I did not write, “free to engage in voluntary trade” because the word “voluntary” is implied in trade. If an activity is coerced, it is by definition not trade. It’s the imposition of one person’s will on another.

Why don’t states allow free markets when it is clear that free markets lead to prosperity? Because of a basic asymmetry between costs and benefits: the people suffer the losses and the functionaries of the state enjoy the benefits. The state’s functionaries are able to extract bribes and other legal and illegal payments for licenses, quotas, permits and permission.

The more extractive and exploitative the state, the less free are the markets. The less free the markets, the less prosperous the people, and the more prosperous the politicians and bureaucrats.

Black Markets

There are many trades that are prohibited by the state. These are illegal and consequently the market does not legally exist for those trades. But humans are inventive. The trades don’t stop but only go underground. Those markets are pejoratively labeled “black markets”. Black markets are good in the sense that they circumvent the state-imposed barriers to trade and mitigate some of the harm that a lack of legal markets entail.

Examples abound. Prostitution is one such. Another is trade in illegal substances. Smuggling of goods. Employing unlicensed labor. All illegal occupations generate income which cannot be revealed to the state, and therefore the state is unable to tax that income. That income becomes “black money.”

Struggle for Freedom

The focus in this part was on markets because without exchange, we would all be not just poor but in fact dead. We couldn’t survive if we could not exchange. The most efficient mechanism for exchanges is a free market. Free people trade in free markets, and to the extent the market is not free, the people are not free. And if the people are not free, they are not prosperous.

In the next bit, I will focus on a necessary condition for trade: private property. Without private property there can be no exchange. And no exchange, once again, means no creation of wealth, and therefore poverty.

India, like all other poor countries, severely restricts markets, The US and other advanced, industrialized, rich nations have relatively freer markets. India can become richer but the government being what it is will not allow that. The politicians and bureaucrats have too much to lose if Indians are allowed to be free.

This is not surprising. The British exploited and extracted wealth from Indians during their rule. They created all the institutions, the rules and laws necessary for them to profit at the expense of the Indians. After the British left, the new rulers absolutely loved the opportunity to do their own exploitation and extraction. So they kept the controls the British had established and imposed some new ones — to better extract and exploit.

It’s a sad but little known story. That’s why Indians should educate themselves and seek to free themselves from their rapacious government if they are to stop being poor.

Go read the entire piece. There’s some repetition but repetition is good when trying to learn stuff.

 

 

Author: Atanu Dey

Economist.

2 thoughts on “Free Markets”

  1. How do we understand the role of regulators such as Securities Exchange Board of India (the Indian equivalent of SEC), Competition Commission of India among others in enhancing ( or degrading) free markets? The justification of their existence is an additional criteria to “free markets” that are referred to as “fairer markets”. Is that mere rhetoric or is there merit to their existence?

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