Economics

Is the free market the best form of mechanism to achieve goals in economics?

Ideas matter, in particular a great idea such as liberty, in all its facets – economics, individual, political, philosophical and historical. However, there remain many challenges to liberty, ever-present under our governments. Therefore, today we must retell the lessons of the past Austrian economists and thinkers and look to writers to understand what is happening. In doing so this paper reviews the free market as a mechanism and whether it is the best mechanism to achieve goals (efficiency and equity) in economics. As many economists had believed: Adam Smith, Ludwig von Mises, Friedrich von Hayek, Milton Friedman, Frederic Bastiat, and many others. While, also exploring the struggle between the free market versus government control, and if any limits to the free market.

The free market distributes resources with its allocation being the most efficient mechanism, guided by the philosophy of individual responsibility. A disadvantage of equity can be differences in living standards, despite Margaret Thatcher in 1990 gave a timeless explanation of the difference, “[they would rather] the poor poorer [provided the rich were less rich]” (Massey, 2011, p.9). Because as living standards are increased, the wealth will also increase portionately. Competition and cooperation enhances efficiency, as people try to do better, people always look for incentives. “Cheaper production methods enable them to cut costs, lower prices, and attract more consumers, again raising profits.” (Grawue, 2017, p.64) These market dynamics led Adam Smith to write “[The rich] consume little more than the poor, […] led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, […]”. (Smith, 1759, pp.184-185)

Centralised economies and decisions by governments included two issues (i) lack of technological innovation and (ii) government managed economies failed to create material prosperity. Even though India is a growing export economy, India is held back by these destructive government regulations, entrepreneurial activity is at the ‘street level’, because of the lack of property rights. “Extension of property rights [and regulation] may effectively internalize [externalities]” (Cheung, 1973). Property rights allow people to remain secure ownership and authority over the resources and capital they own. In observation there are creative and hard working people, trading, exchanging with markets, still without wealth. Whereas, property rights provide the security for secure investment and saving, which in turn lead to increases in capital accumulation.

Unclear property rights can also result in the free rider problem, allowing individuals to avoid associated marginal costs. For instance, A creates theorem which B uses without charge. “According to the Coase theorem, if private parties can bargain over the allocation of resources at no cost, then the private market will always solve the problem of externalities and allocate resources efficiently.” (Mankiw, 2015) Best understood from the classical parable called the Tragedy of the Commons “that illustrates why common resources are used more than is desirable from the standpoint of society as a whole.” (Mankiw, 2015) Private markets overuse the resource, while governments regulate behaviour and impose fees to combat overuse. Technology property rights, such as patents and assigned contracts between parties, lower transaction costs and encourage entrepreneurial incentives. (Katz, 1992) Equally, private suppliers would devote few resources with high transaction costs and absent public policy. Whereas, determining the goods’ beneficiaries, can exclude free riders. As a private good, it would internalise the benefits providing private suppliers proper incentives. (Frischmann and Lemley, 2007)

Alternatively, market efficiency allocates goods to the consumers’ willingness to pay. Efficiency is when a resource allocation maximises the total surplus received by all members of society. To allocate the demand for goods to the sellers who can produce them at least cost. Produce the quantity of goods that maximises the sum of consumer and producer surplus. The equilibrium of demand and supply via the invisible hand of the market maximises the sum of consumer and producer surplus. Adam Smith in his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, produced a detailed analysis of trade and economic interdependence, which economists still adhere to today. Interdependence is the norm because people are better off when they specialise and trade with each other. Patterns of production and trade are based upon differences in opportunity costs. Without trade economic gains are diminished. Everyone would be better off if they specialise in producing the product that they are more suited to produce and trade, represented in the Production Possibilities Frontier.

Social planners (policymakers) might also care about equity the fairness of the distribution of wellbeing among the various buyers and sellers. Government agencies often use command-and-control policies that regulate behaviour directly or market-based policies to provide private suppliers incentives to act. Governments often use a subsidization policy to increase consumption. (Azam, n.d., p.3) When appropriating funds an ideal corrective subsidy should equal the external benefit and consider quantity and quality. In economic theory, values are subjective cannot be measurable; therefore the social value is often compared to the opportunity cost, represented as consumers’ willingness to pay minus the actual payment. Valuation is measured by buyer’s willingness to pay, as such those who demand a generator in a power outage might be better use in a hospital in need of electricity for patients rather than a house without electricity for the lighting of their home. As free goods have no price signals distribution of resources results in the socialist calculation problem.

Welfare economics is the study of how the allocation of resources affects economic well-being. Participation in market leads to buyers receiving benefit consumer surplus and sellers receiving benefit producer surplus. Equilibrium maximises total welfare. Willingness to pay measures the buyers’ value of a good or service as the maximum amount that a buyer will pay for a good. Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Every buyer has a different willingness to pay. The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Consumer surplus, equals the amount buyers are willing to pay for a good minus the amount they actually pay for it. It measures the buyer’s perceived benefit from the good. It is measured as the area below the demand curve and above the price in the market. Represented in the demand schedule and the demand curve. Producer surplus is the amount a seller is paid for a good minus its cost. It measures the benefit to sellers participating in a market. Producer surplus is closely related to the supply curve. The producer surplus equals the area below the price and above the supply curve. Represented in the supply schedule.

The economist and philosopher John Stuart Mill, said that infant industries should only be protected if they can mature and then become viable without protection. Charles Francis Bastable, added a simple condition, that the cumulative net benefits provided by the protected industry must exceed the cumulative costs of protecting the industry. Despite, such a government system would fail because: decisions should be based on information, government can’t know how much value people give, failed by lack of information. A clear contrast between the market economy and central planning, would be north and south Korea split after the Korean War in the 1950s, both being equally poor, then the per capita GDP in the 1970s exploded in South Korea, and stagnated in the North. (Grawue, 2017, p.59)

In fact, in a mixed economy, it is now found necessary to indirectly alter interest rates to find additional policy stimulus. Resorting to credit expansion through quantitative easing policy, is tempting to inflate away debt and raise seigniorage revenues. (Bassetto & Messer, 2013) This, however, distorts market price signals in the market for loanable funds in a similar fashion to the effect price controls have in markets for capital goods and services. Monetary equilibrium might be an ideal policy goal for such central planners, but there exist knowledge and incentive problems that may make it an uncommon practice. The demand curve does not represent present nor future effects, and increases in productivity only increase revenue in the short-run. (Rothbard, 2009) There is not time materially available to equal the amount of goods (deficient or excessively supplied and imperfectly employed) to the supply of credit expansion. (Tooke in Marshall, 1920) The supplied capital goods and services would not have changed in response to credit expansion, as they are reliant on the unaltered physical capital, human capital, natural resources, and technological knowledge. The total quantity of money can be unknown and contain many meanings. (Hayek, 1985) Met with animosity by governments, capital contraction increases interest rates along with capital purchasing power. To prevent miss-calculation investors compute for inflation increases in prices using the real interest rate, “[the] return to saving and the cost of borrowing after adjustment for inflation.” (Mankiw, 2010) A depression according to the Austrian economists is when the interest rate is not the real rate, the business cycle is caused by distortions in the interest rates, because of government intervention.

A government banking system can create collective rationality, for example in the Global Financial Crisis bankers took extra risks and became reckless. With weak regulation distributing loan criteria became trivial, banks took risky loan investments. A current an example would be the recent commission on Australian major banks compliance following the loan contract law change, the corporate regulator became concerned that Australia’s major banks were not doing enough to bring contracts into compliance.^1 Australia can have plenty of laws and regulations but the laws are not enforced and history tends to repeat itself.

In contrast, when there is no government support it would be difficult for financial institutions to survive during a bank run, with no government guarantee or bailouts. Yet this precise market coordination ensures for better currency and banking practices without moral hazard with risky incentives. “On the whole it seems cryptocurrencies (compared with fiat currencies) do well as a medium of exchange but leave much to be desired as a unit of account and as storage of value.” (Bhatt, P., 2014, p.568) A pure free market, meaning having no Reserve Bank, market price signals would communicate and reveal the subjective valuations of all market participants, including time preference toward present goods over future goods. Market price signals represent scarcity and important information, such as market interest rates, and are relied on to direct factors of production and provide incentives to save.

Internal limits of the market, for people who care about fair income distribution, intrinsic motivation, and cooperation, this leads to a lack of fulfilment. An example would be whether to work an extra three hours or spend time with family, now financial incentives usually are preferred within a free market. A market outcome that affects individuals outside buyers and sellers in that market creates an externality. Hence welfare in that markets isn’t just the value to the buyers and costs of the sellers. If buyers and sellers ignore externalities in their plans, an inefficient market equilibrium can result. Therefore, without government intervention, some groups in society maybe left out, such as those with illness and disability. Rather than government support, the free market can allow for charities, individuals and institutions through corporate social responsibility to offer solutions that help to substitute for government support. The free market assumption that people are rational can become incorrect when in behavioural economics speaks of herd behaviour, with two systems of the brain: (i) emotion (fear, panic, ect.) and rational (calculation). Capitalism only fails when it becomes individual rationality versus the collective rationality, pollution leads to negative externalities, and incentives are less.

External limits of capitalism would be (i) the environment, for example global warming, and deforestation. The identification and measurement of public and private goods, presents challenges for government agencies and private suppliers to overcome the tragedy of the commons and discourage negative externalities. Individual rationality however can create collective irrationality, for instance an iceberg melts equals more landmass, or market failure equals mass loss. Whereas, practical reason asserts that an increase in the population would bring more thinkers, scientists, and others interested to develop ecosystems. While, negative externalities multiply rapidly in urban, industrialised societies, therefore pollution can never be stopped entirely. A society must grow in order to innovate sustainable practices. The abstraction called the ‘ecosystem’ barely includes mankind or civilization. While, the oil industry, factories, planes, trains, and automobiles have contributed greatly to human development. Namely, contributing to the supply of products (food, water and timber) and regulating services that impact climate (floods, disease, wastes and water quality). Along with providing cultural services (recreational, aesthetic and spiritual) and supporting services (soil formation and nutrient cycling). Individuals protect and develop their land, whether to increase yields or land value. Even neighbouring tourism-oriented regions are invested in sustaining and developing their private environmental assets produce positive spill-over effects. (Villanueva et al., 2015, p.2126)

For example, a government petition that calls for a fishing free zone – can have good intentions but can have bad results – it contradicts with vested interests while favouring the majority. It is wrong for an act to be in contradiction, to favour one group at the expense of the other group, since both parties would be impacted. Therefore, the petition alone cannot make an absolute case just from a majority in agreement. A weakness to deontology could cause negative outcomes for third-parties, had one not considered the unintended consequences before acting, yet acted on a good maxim. Such as, ‘to prevent fishing’, this action is good to an extent it protects marine life, however had it became universal law it could either been viewed as good or bad, depending on one’s perspective. However, in economic fact the unintended consequence is that it would cause a black market, while increasing expenses and crime. “[While, a] weight of empirical evidence now [shows] that fertilizer [subsidies, taxes or prohibition] are likely to be inefficient, costly, and fiscally unsustainable, […]” (Morris, Kelly & Kopicki, 2007, p.103) Government agencies pay far less attention to information and incentive problems facing pollution reduction policies. The Endangered Species Act is a case in point. The intention of the act is to enable endangered species to flourish, however the unintended consequence causes many endangered species to be killed off more quickly than otherwise. For instance, a landowner finds an endangered species on their property, now the environmental protection agency as a result of the finding, impose restrictions on the land. Reducing the value of the land. Therefore, land owners would kill any species found on the land that could be on the list. Clearly, that is not the goal of the act. Therefore, people ought to judge a policy by the incentives that the policy will likely give to the people it impacts.

The free market is free to be applied to many different economic goals, even if they are for the benefit of the collective. “[Pembient], a startup based in San Francisco, plans to flood the Chinese market with the synthetic horns which carry the same genetic fingerprint as the real thing.” (Ward, 2015) A 3D printed ivory works as a substitute good to wild ivory, competing on low-cost and better quality to thwart the black-market supply of wild ivory. “Just as there is faux fur, there should be a rhino horn alternative” (Corbyn, 2015) As the animal population numbers of rhinos and elephants decrease and the threat of extinction is present the importance of 3D printed substitutes are demanded for the protection of the many animals with highly valued skins, ivory, shells, or furs. “It is starting with rhino horn but has plans for more complex materials such as elephant tusk.” (Corbyn, 2015) “Our goal is to replace the illegal wildlife trade, a $20B black market, the fourth largest after drug, arms, and human trafficking, with sustainable commerce,” Pembient [announced] on its Web site.” (Maynard, 2015) Flooding the market would ensure increased supply while protecting against the number of poaching, as the synthetic ivory is cheaper and higher quality it decreases the black-market supply and demand of real ivory. “According to Matthew Markus, CEO of Pembient, the company will sell the horns at a fraction of the price of real horns, undercutting poachers to force them out of the market.” (Ward, 2015) Along with consumer awareness around endangered species, there is a present gap in the market for such private market competition against black-market products. “Conservation groups have also voiced concern over the plans, saying that although Pembient may have good intentions, there is a danger that flooding the market with fake rhino horns could increase demand for real ones.” (Ward, 2015) However, there is still controversy as to whether the supply of 3D printed ivory would decrease or even increase the supply and demand for the real ivory. Though, it follows that if credit expansion devalues the currency, ivory expansion should devalue the ivory.

In conclusion, the free market can be in most instances the best form of mechanism to achieve goals in economics. However, such goals in equity would preferably be protected by government regulations, such as well defined property rights. It is about advancing good ideas, furthering the conversation, promoting engagement and encouraging people to rethink ideologies of central governments.

 

Reference List

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Bassetto, M., & Messer, T. (2013). Fiscal consequences of paying interest on reserves. Fiscal Studies, 34(4), 413-436. doi: 10.1111/j.1475-5890.2013.12014.x

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Cheung, S. (1973). The fable of the bees an economic Investigation, Journal of Law and Economics. 16(1). ISSN: 0022-2186. University of Chicago Press.

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Mankiw, G. (2015). Principles of economics, 7th ed. United States: Cengage Learning.

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Marshall, A. 1890 (1920). Principles of economics, (8th ed.). London: Macmillan and Co., Ltd.

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Maynard, J. (2015). Incredibly realistic 3D-printed horns could put an end to rhino poaching. Tech Times. Retrieved [02/04/2016] from <http://www.techtimes.com/articles/60656/20150615/engineered-rhino-horns-spell-end-poaching.htm&gt;.

Morris, M., Kelly, V. A., & Kopicki, Bon J. (2007). Fertilizer use in african agriculture: Lessons learned and good practice guidelines. Washington, DC: World Bank. doi:10.1596/978-0-8213-6880-0

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Ward, A. (2015). Synthetic rhino horns are being 3D printed in an effort to defeat poachers. The Independent. Retrieved [02/04/2016] from <http://www.independent.co.uk/life-style/gadgets-and-tech/news/synthetic-rhino-horns-are-being-3d-printed-in-an-effort-to-defeat-poachers-10334751.html&gt;.

Footnotes

ASIC. Unfair Contract Terms and Small Business Loans. (2018). <http://download.asic.gov.au/media/4676255/rep565-published-15-march-2018.pdf>.

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