One of the most annoying oxymorons bandied about in discussions at all levels is the term "free market" and its derivatives. There is no such thing.
"Free-marketers" argue that, for an economy to operate at optimum efficiency, resources need to be optimally allocated. Resources will be optimally allocated if the goods and services produced with these resources are correctly priced, as an incorrect price leads to an inefficient allocation of resources.
The correct price in turn – being the price that leads to the most efficient allocation of resources – will most reliably result from a balance of supply and demand. The mechanism that allows a price to be established through the balancing of supply and demand is a market, and it is free so long as there are no extraneous forces acting on either supply, demand or price.
That is the definition of the IDEAL free market. "Ideal" is epistemological code for saying: This construct BY NECESSITY AND DEFINITION cannot exist in the REAL world. To make it work even approximately in the REAL world, regulation is a definitional requirement. Regulation is not a contradiction to the principle of markets, but an existential necessity.
- The "Free Market" Oxymoron
There are two objections to the term "free market", one theoretical and one practical.
- The theoretical objection is in this definition of "market" as it omits two essential corollaries: The (market) price will reflect the balance of supply and demand under the assumption of (i) total information and (ii) zero transaction costs. The complete definition describes an ideal market; an ideal market by definition does not and cannot exist.
- The practical objections come from the fact that the discussion on "free markets" completely ignores the practical relevance of the corollaries; "regulation" and "market" are seen as antagonistic terms, when it is obvious that regulation is essential for the existence of any market. Where there is no regulation there cannot be a market.
These two corollaries are sufficient to define "market"; to ensure that the market price actually (in theory) results in and reflects an efficient allocation of resources across an economy, a further corollary is required: That the price faithfully captures all resources used in the production of a good or service, so that the cost of all resources use is internalised.
To take a closer look at the first two corollaries:
- "Total information" means that buyer and seller both have the same level of information and both have all the information that exists with respect to the thing being traded, the market, the supply situation, the demand situation, etc. – the market information needs to be transparent.
That total information does not exist is obvious to anyone – programs such as "Antiques Roadshow" would not exist if buyers and sellers had total information. Even where an object is bought at auction (auctions being in theory one of the clearest mechanism for establishing a price based on supply and demand), there can still be an enormous disparity in the level of information the parties have.
- "Zero transaction costs" implies that, if I have a choice of buying an item 10% cheaper in a town two hours’ drive away as compared to buying it in my home town, then I will buy the 10% cheaper item. Of course, no sensible person will ignore the cost in time, fuel, depreciation etc. implied in driving four hours to save 10%. If that item is a car, I may invest those transaction costs, as the savings might exceed the cost of driving there. If it is a can of soup, I’d be crazy to do that.
Market theoreticians deal with this by saying that the definition suggests that over time, prices tend toward equilibrium (i.e., even for a can of soup, there are people who live close enough to the store selling the soup 10% cheaper that demand for the soup will grow, thus pushing up price, while my home town store will feel pressure to lower the price of soup, and eventually, prices will even out). This fixes the theoretical problem, but also makes the definition less useful in practice; more importantly, it ignores hard-won regulations that reduce transaction costs.
- Ideal Market and Real Market
Long before there was any theory of markets, our ancestors understood the value of trade in satisfying the needs of a society and the advantage of specialising: Instead of every household being self-sufficient in everything and doing a tedious, mediocre job of it, there was an advantage to some households specialising in a particular service or product and producing it in a skilled and efficient manner. This meant that the specialising household gave up producing its subsistence needs; instead, it was dependent on being able to sell its product and buy its subsistence needs.
For a household to give up its assured subsistence in return for the uncertainty of being able to purchase it, society had to provide some mechanism to protect the specialist whose specialisation benefited society as a whole. One solution was for the authority to guarantee the specialist’s subsistence (a planned economy). The other was to guarantee the specialist an opportunity to sell the result of his or her skills and – just as importantly – the opportunity to purchase the subsistence needs (market economy).
The sophisticated societies of antiquity and the Middle Ages were at an advanced stage of market economy: A high degree of specialisation and a functioning monetary system.
Achieving that sophistication took a level of effort that today is largely forgotten. The elements that produced that sophistication all focus on the two corollaries; so successful were our forebears that these elements are today accepted as matter-of-course. They aren’t. To consider some:
(a) Weights and measures: Consistent and true weights and measures both operate on the "information" as well as the "transaction cost" level. If I as a buyer can rely on the market authorities enforcing weights and measures, then I can reliably compare prices between different merchants (information) and I don’t have to carry around my own scales and weights (transaction costs). In Antiquity and Medieval times, supervision of weights and measures was a prime function of the authority, and falsifying weights and measures among the most serious crimes.
(b) Quality: This can be considered under several aspects:
(i) Implied warranties – though the principle "caveat emptor" is part of Roman law, it marks a recognition that the buyer can never be fully protected; it emphatically did not mean that Roman law was philosophically opposed to "interfering in the autonomy of buyer and seller". The aediles developed the principles of implied warranties that still apply today (when sellers are not permitted to disclaim them). "Implied warranty" has two aspects: Fitness for purpose and absence of defects. If I buy a pitchfork, I should be able to use it to pitch hay. If I buy a sheep, I should be able to rely on it not being ill.
Implied warranties equalise the information level – in the case of the pitchfork, I should not have to ask the seller whether the pitchfork can be used to pitch hay. Pitching hay is the sole reasonable purpose of a pitchfork, and if it can’t be used for pitching hay, the seller has to tell me.
Implied warranties also aid in reducing transaction costs – in the case of the sheep, I could hire a veterinary to inspect it or keep the sheep in quarantine until all possible illnesses should have manifested themselves. In exceptional cases, that is appropriate, but not in mass transactions.
(ii) Explicit warranties – if a seller advertises a property, the goods should have that property. Again, this aids information and reduces transaction costs.
(iii) Inspection of goods – the market authorities may publish quality standards and allow merchants that comply with the quality standards to mark their wares accordingly. Hallmarking is a case in point: As it is easy to cheat on the silver content of an object, authorities introduced an obligation to submit pieces to assay; an object that passed the assay could be hallmarked. Again, this aids information (the hallmark tells me what the silver content is) and reduces transaction costs (I don’t have to take assay chemicals with me when I buy a silver object).
(iv) Inspection of producers and merchants – the Medieval guild system was a system to ensure reliable skill and expertise in the practitioners of a craft. Only a master baker, member of the guild, could sell bread; the guild ensured that each baker’s bread was made from uncontaminated ingredients (so as not to cause illness) and that he operated his ovens in a safe manner (so as not to cause fire).
(c) Currency – the authorities provided a unitary form of payment. In the Roman empire, the coinage was imperial. In Medieval times, a merchant would bring his "foreign" coins to the local mint, which would assay the bullion and re-coin it into local coinage for a fee remarkably similar to the present day foreign exchange conversion spread (for tourist exchanges).
(d) Physical infrastructure – more basic than the already evolved details of market management are the physical infrastructure: Roads, bridges, harbours, wharves, canals, sometimes also the physical market infrastructure like halls and squares, with running water – all these operate on the transaction cost corollary. In first world economies, this is so obvious that the enormous government effort needed to ensure their continuous operation, in terms of cost and technological expertise of construction, operation and maintenance, are simply taken for granted.
(e) Organisational infrastructure – history shows that it took a long time for societies to accumulate the organisational expertise that is required to operate and maintain a functional market. The society needs individuals who have the skill and experience to monitor weights and measures as well as the quality guidelines applicable to the market. Transactions in which a price is established are contracts like sale and purchase, rent or lease, or service. There needs to be a legal system which defines the transactions, a court system which resolves conflicts, an enforcement system that enforces judgements, experts who understand the legal and court system and can operate it (judges, lawyers). The legal system thus has to deal with the issue of property rights, in the resources, the products, the means of production, the know-how required to effect the production, and so on. Accountants need to keep track of how resources are valued, for without this effort there is no transparency. There also has to be a staff that ensures the security of market participants and protects property rights. None of these functions are intrinsic to the definition of market – they are, on one hand, a pure service to society. On the other hand, a society that was not able to efficiently organise these services failed to gain legitimacy in the eyes of its neighbours – it did not have effective government.
The roads, bridges etc. are the physical infrastructure of a market economy; the rest represent the regulatory infrastructure. The ideal market assumes that the perfect infrastructure is somehow there and costs nothing. The real market does not have that luxury; as the ideal market does not deal with the infrastructure, we cannot look to the definition for guidance, but have to use our own judgement to decide which aspect of market regulation renders the market more efficient (in terms of contributing to the achievement of society’s aims).
An essential element of the market infrastructure, both regulatory and physical, is that all market participants are treated equally; society must provide a "level playing field" for all market players.
However, one thing is very clear: A certain level of physical and regulatory infrastructure is implied by the definition of the ideal market and is essential for the existence of a real market. No regulation, no physical infrastructure equals no market.
- The Argument for a Market Economy
The argument for a market economy instead of a planned economy is that a market economy is beneficial to society because it is more likely to result in an efficient allocation of resources. The market economy is therefore not a good in and of itself; it is good because it is an effective tool in achieving the good, which is the efficient allocation of resources, which we have taken as a proxy for a successful, happy society. The market economy is also only good so long as it is an effective tool.
An efficient allocation of resources is not intrinsic to the definition of "market". Also, the definition of market does not necessarily lead to an efficient allocation of resources; it does so only if the consumption of all resources used for the production of the traded goods or services is in fact reflected in the price. There are two ways of internalising the usage of resources: Granting private ownership over it, or by allocating ownership to society as a whole and taxing its usage.
The decisions whether to require the internalisation of all resource usage, and if so, whether to put the resource in private or public ownership, are all decisions that have to be taken on a political level. The fundamental decision to have a market economy is no guide to these implementing decisions as the market economy is merely the tool used to achieve the goal chosen by society.
It is true that, if the resource is placed in private ownership, then the price for using that resource can be established through a market mechanism, which in turn will ensure the most efficient allocation.
However, it is not even clear whether a society wants to have market mechanisms to apply to all aspects of a society’s needs. Should the market mechanism apply to health care – if you can’t afford an operation, you die. Should the market mechanism apply to justice – if you can’t afford to defend yourself, you go to jail. Should the market mechanism apply to fire protection or personal safety – if you can’t pay for a fire engine or a body-guard, you take your lumps. Should the market mechanism apply to voting – he who can pay most for votes gets elected. Should the market mechanism apply to education – you only get an education if you can pay for it.
It is clear from this list that a market mechanism can be applied to all of these. But most of us would be shocked at a pure market approach. The reason for this is that a pure market approach would not produce a society any of us want to live in. This once again emphasises that the market is not a good in its own right. It is a tool which society uses in order to achieve a certain goal. However, which goal is to be achieved, is a decision for society to take. In reality, societies pursue a mixture of goals – from general prosperity to personal freedom of choice to societal peace.
- Economical System and Political System
How a society sets its goals is a political process. In a constitutional democracy, the majority decides on the goals. The most fundamental decisions are typically made in the constitution, and the constitution then limits the ability of the majority or its (sometimes putative) representatives in their decision-making on specific, second-order issues.
However, there is nothing in the definition of market or market economy that requires this goal-setting decision-making to be made by democratic means. The definition of market only requires that goals be set and that at least a rudimentary infrastructure (physical and regulatory) be offered.
History does not offer any convincing judgement, either. Both authoritarian-governed societies as well as democratically governed societies have done well with market economies, both in ancient history as well as modern history. It is fair to say, though, that the market economy in a democracy looks different from the market economy under an authoritarian government.
Historically, the market economy of a democratic society will feature a multitude of small participants. The market economy of an autocratic society will feature larger actors. Democratic societies tend to fracture both political and economic decision-making. Authoritarian-governed societies tend in the opposite direction.
- The "Free Market" Slogan
The term "free market" therefore has no intrinsic meaning; from its common usage, it is set opposite "regulation", seeking to imply that as regulation is reduced, the market becomes "freer", i.e. works better. The implication is, of course, wrong both in theory and practice – as regulation is reduced, the market vanishes.
Nevertheless, the discussion on regulation is legitimate. As the definition of the ideal market offers no (very little) guidance as to the concrete shape of the appropriate regulation, this must form part of the political discussion. Bad regulation will result in an inefficient allocation of resources and cause market forces to work against the achievement of society’s goals.
One term often mentioned in the context of "deregulation" is "market failure". "Market failure", too, is an inaccurate term. "Market" simply describes a mechanism; it cannot fail. "Market failure" typically describes two phenomena: That the market mechanism is pushing society to consequences not desired by society; and that one market player has gained so much power in the market that the price mechanism no longer works (monopoly or monopsony - in other words, a planned economy). Neither, really, is "market failure"; both are regulatory failure.
There are some examples of misregulation that are obviously suspect, and are easiest to show in international trade. If country A has high import duties and country B low import duties, then the exporters of country A will have no trouble exporting to country B, whereas the exporters of country B will be locked out of country A.
Tariffs are not the only barrier – a country’s regulation may be crafted to make distinctions which are fundamentally irrelevant, but happen to provide an advantage to one party. Is it reasonable to require all market participants to sell their wares in e.g. a specific size or colour which one market participant happens to manufacture, but others would have to retool to achieve? Probably not.
As another example, assume two factories, A and B. Both need water to manufacture their product, and there is no difference in technology. However, A is charged twice as much per unit of water as B. Is that fair? A is obviously at a disadvantage, the playing field is not level. What if, though, A has located its factory in a desert, and B along a river in a temperate zone? Should society artificially level the playing field?
Unequal treatment in the marketplace is unavoidable because all situations will include aspects in which two players are the same, which suggests equal treatment, and at least one aspect in which they are different . Our aim therefore cannot be to achieve perfectly equal treatment, but to be conscious of and open about the judgements we make in shaping the regulation which defines the market.
To the extent that "deregulation" and "free market" are only meant to urge society to consider the nature and effect of its regulation, the terms are harmless. However, that is not the flavour the terms have in the political discussion.
To lay the ground for the further discussion, I will take a step back: The market economy is not the only option for a society to run its economy; a society can also choose to operate planned economy. Historically, planned economies have been associated with communist regimes; a centrally planned economy is the only economic system compatible with communist ideology. However, the notion of planned economy does not necessarily imply communism.
There are good arguments for a planned economy: A real market economy tends to have huge inefficiencies; achieving the right regulation is difficult, and the multitude of market participants makes information dissemination well-nigh impossible. It can imply high transaction costs (which either have to be factored into prices or internalised through general taxation). Far better to delegate resource allocation to scientifically trained technical and management specialists, who will so allocate the resources to achieve the goals defined by society without the inefficiencies and high transaction costs incurred by running a market economy.
There is nothing inherently wrong with the argument, except that history shows that getting a planned economy right is as difficult as getting market-adequate regulation right.
If, however, "deregulation" is taken literally as the removal of all (or substantially all) regulation, which by definition causes the disappearance of the market, then the alternatives are either a subsistence economy or a planned economy. Advocates of deregulation do not appear to be keen to revert to a subsistence economy, so their objective can only be a planned economy.