The Free Market – Ideology vs. Reality

January 7, 2011

Politicians often tell us that government regulation (such as consumer protection, mine safety rules etc.) or government intervention (such as the bank bailout) is unnecessary red tape because economic problems will be corrected by the operation of the free market.  Unfortunately, there is no free market. There are many markets and few of them are free, either in the sense that they are free of government regulation or in the sense that they are freely competitive. 

The regulations that govern most markets were not put in place by foresighted politicians who wrote bureaucratic regulations to solve potential problems.  On the contrary, most regulations were written in response to a scandal or a disaster or both.  If we simply do away with regulations, we can expect these calamities to recur. 

There are few industries in which markets are freely competitive in the sense that economists call efficient.  An efficient market would require that

  • There are many firms, not just a handful.
  • All firms are price takers, that is, no firm has any pricing power.  They all take the market price as a given. 
  • Consumers know enough about what they are buying to make rational choices.
  • There are no barriers to entry for firms that want to compete in the market.  That is, would be competitors do not have much trouble gathering the resources, facilities, or skills necessary to produce a competitive product.
  • All the firms are independent.  The market is not a system which ceases to function when one critical part fails.

With the exception of some commodities and perhaps the market for Internet pornography, few of these assumptions hold. 

In Internet pornography (let us call it the IP market), there are so many competitors as to be moderately embarrassing.  But sadly, most other markets are oligopolies. That is, they are dominated by only a few firms. Industry leaders easily coordinate price increases and stifle competition by implicit agreements that they enforced by the threat of tit-for-tat retaliation. 

The IP market has a clear market price for a given level of service.  A big pornographer cannot raise the price and expect other pornographers to follow suit.  They are sleazy pornographers after all. Alas this is not true of steel, or autos, or airlines.  The threat of a price war usually deters other firms from trying to grab market share by sticking with their old price.  The few rare cases where we hear of a price war are exceptions that prove the rule.

In the IP business, we are all equipped by nature to understand exactly what we are getting for our money.  However, in other industries, such as health care, pharmaceuticals, chemicals, and information technology, the goods and services are so complex that few consumers can understand exactly what they are buying.  They must rely on consumer protection regulations to avoid being cheated or being injured by defective products. 

In the IP business, there are notoriously few barriers to entry.   Not so in other industries.  For example, Intel’s new computer chip fabrication facility (Fab 32) in Chandler, Arizona cost $3-billion.  The skills and equipment necessary to make a pornographic video are easy to come by, but the skills required to design and operate Intel’s new microchip plant are not.  There are many more knock out porn stars than there are experts in 45nm process technology.

Finally, in the IP market, if one operator fails because of excessive risk taking or too much leverage, it has no effect on other pornographers.  However, this is not so in industries, such as, banking where all the big players form a single interconnected system.  For example, when Lehman Brothers filed for Chapter 11 bankruptcy protection in 2008 the financial system went into shock like a person who had just had a limb amputated.

Those of us who have followed the IP industry avidly for a number of years (the better to understand the workings of free competition) can attest to the virtues of an efficient market.  Prices have come down and the quality of the product has dramatically improved.  The IP industry is always a leader in technology and in finding truly novel applications for video imaging.

Alas, the same cannot be said for most markets.  Between 1986 and 1995, approximately 1000 thrifts went under in America in what became known as the Savings and Loan crisis.  In 2001 Enron collapsed and set off another financial crisis.  Late 2007 saw the banking and mortgage crisis, which led to The Great Recession that officially ended only in June of 2009.  The American auto industry has lost market share to car makers in Germany and Japan even though government regulation in those countries is more invasive than it is in the U.S.  We could multiply these examples endlessly.  Evidently the free markets only work well when, as the great economist John Maynard Keynes said, they are moved by “animal spirits”.

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