So, if the free market is so great at allocating resources and meeting the needs of consumers, why doesn’t the government simply stand back and let it rip? Well, to begin with there are some things, such as “defense” or a highway that you and I, the consumer, are not going to buy directly. If we want those things we have to get together and buy them. That requires taxes and government spending. But the main reason we can’t stand back and let an ideal free market rip is because the conditions we’ve imposed on describing it simply don’t, and can’t, exist in the real world.

Some requirements for an ideal free market for both a single product and the market in general include:

• Many producers and consumers
• No anti-competitive behavior
• Perfect information
• Homogeneous products
• Perfect factor mobility (factors are explained later, but think labor)
• Moral behavior by all parties
• No tariffs^[1]
• No increasing returns to scale
• No transaction costs.
• Rational buyers and profit maximizing sellers.
• A number of other conditions

In addition to these conditions for an ideal free market, there are also things that simply fall outside the market unless the government is involved. We’ve already mentioned defense and roads which are examples of “public goods”, but there are other “externalities” to the market. For example, a factory that releases toxic waste into a river may cause costly health and environmental damage downstream, but these costs are “external” to the market since the factory doesn’t pay them.

When the conditions of an ideal free market aren’t met, and when there are externalities and a need for public goods, there will be less than optimal resource allocation without government involvement.

We might ask then, if an ideal free market doesn’t exist anywhere, why should we bother to study it? First because the broad outlines of how an ideal free market operates apply to imperfect markets. Secondly, by considering an ideal market we can find ways to make imperfect markets operate more like the ideal perfect one.

Market Imperfections – A Brief Discussion

Among the many possible “market failures” that can occur in a real market, we’ll mention just a few. First is the need for information: in order to pick products and services we need information about them. For resource allocation to be ideal, consumers not only have to know about a product but also be able to figure out which is the best one for the price. The Internet, with its reviews and easy returns, has greatly increased our ability to find products and services and compare them. However, there are some services for which information is still lacking. In the United States health care pricing is usually hidden and certainly not subject to individual price shopping. Price for a blood test range from $22 to $37 in Baltimore, Maryland, but in El Paso, Texas, the range is $144 to $952^[2].  This indicates not only a lack of information but other market failures such as a limited number of suppliers in any geographic area, and the fact that insurance makes consumers insensitive to the costs of specific services. These market failures lead to an inefficient use of resources.

As the healthcare example shows, the requirement that there be many suppliers for a product or service is also not always met. The most extreme cases are “natural monopolies” such as the utilities that supply electricity, gas, and water to homes. It makes no sense to have multiple competing electrical grids or water pipes to the home since there are “economies of scale” such that costs go down as the number of subscribers goes up. Because of these economies of scale, a single winning company can emerge naturally or be given exclusive rights by a government.   In order to prevent price gouging the natural monopolies mentioned are regulated by, or provided by, government at one level or another^[3].

There are less extreme forms of limiting the number of suppliers. When we discuss labor, we’ll see that licensing requirements such as for plumbers, electricians and doctors can limit supply thus increase prices. In manufacturing, high barriers to entry such as the need to build an expensive factory can limit the number of suppliers, although with economies of scale and several suppliers that doesn’t necessarily mean supplies will be limited or prices suboptimal. Supply can also be limited by collusion. An example is OPEC, the oil cartel, which was set up to coordinate oil production and so control pricing. Many countries have laws barring collusion “in restraint of trade” to prevent companies from getting together to limit supply or take other anti-competitive actions. Supply is also limited through the use of patents which give companies a time limited monopoly on specific “inventions” such as pharmaceuticals.

Finally, the ideal free market requirement of moral behavior is unrealistic. Here are some of the conditions in the Chicago meat packing plants that Upton Sinclair recorded prior to the passage of the Food and Drug Act of 1906: “diseased, rotten and contaminated meat products were processed and labeled for sale, workers with tuberculosis spit up blood, coughed on meat, meat for canning was piled on floors covered in human urine, spit, rat dung and dead rats.” Markets favor the cheapest product and in the absence of regulations such as standardizing sanitary conditions and requiring accurate labeling, the unscrupulous will flourish. Company size is certainly no guarantee of moral behavior, Armour and Company was the biggest meat packing company in Chicago at the time Sinclair visited, and there have been plenty of recent cheating behavior by some of the world’s largest firms. A final example of immoral behavior are all the fake reviews on the internet. It is estimated that about a third of all reviews are fake, making it more difficult to get accurate information about products and services.

Externalities and the Free Market

The ideal free market only works with goods and services which are sold, but there are things of value “external” to the market. Take, for example, a factory that belches forth polluting smoke which adversely affects the health of residents for miles around and contributes to acid rain which reduces timber harvests in other states. There are real quantifiable costs to this smoke, but they are “external” to the market and the factory’s products do not reflect these real costs to society. Since the costs of production don’t include these “external” costs, resource allocation through supply and demand pricing is no longer optimal.  Governments may attempt to address these externalities in various ways. For example, by creating regulations that require that the smoke be cleaned up, or by taxing the pollutants at a level that reflects the cost of the damage done. While water, air and sound pollution are common negative externalities, there are many others. There are even some positive ones, such as the benefit of education not just to the individual but to society. Keep reading 🙂

Making Markets More “Ideal”

You’ve probably heard the term “laissez-faire economics”. The basic idea is that leaving the market alone is the best way to achieve ideal resource utilization and growth. Hopefully our discussion of market imperfections and externalities gives you some skepticism about this assertion. The free market is indeed excellent at meeting the desires of consumers and allocating resources efficiently. It is also excellent at encouraging innovation and the introduction of new products and services. But the market of “laissez-faire” economics is not an ideal free market due to the market failures we’ve just discussed, and certainly doesn’t address the issue of externalities.

Many laws and regulations have been created to bring the market more in line with the ideal, and hence to make it more efficient, to address externalities, and to address the fallibility of human nature^[5]. Does this mean that all such laws and regulations are perfect or even needed? Of course not. But the market left alone would be about as perfect as a football game with no rules or referees to enforce them.

At the most basic level, governments provide the “infrastructure” on which markets depend such as standardized weights and measures and currency. These come down to us from ancient times. Governments also create rules relating to property and stable laws and courts to deal with contracts and trade disputes.

In more recent times, as we’ve seen above, governments have sought to address other problems to bring the functioning of the market more in line with the ideal and hence more efficient in the allocation of resources to meet consumer desires. Far from being government interference in a perfectly functioning market, experience has led to government intervention to keep the market functioning well and in accordance with moral principles. We’ve seen that governments have had to create and enforce requirements related to truth in labeling, mandating that foods and drugs be safe and effective, that professionals be licensed, that consumer products not contain hidden dangers, that interest rates be published and accurate, that buildings meet engineering standards to ensure safety, and so on. Governments have also had to ensure that competition remains robust by enacting legislation to outlaw anti-competitive collusion, break up monopolies where possible and regulate them when not. Finally, governments have had to address externalities by requiring that air and water not be polluted among other things.

The efficiency of the free market would suggest that where possible regulations should mandate ends and not specific engineering means to those ends. For example, a carbon tax raises the cost of emitting carbon dioxide to address the enormous potential costs of global warming. That leaves the decision on how to lower costs by reducing emissions to individual businesses, and how to rebalance the mix of products and services to the market through the mechanism of supply and demand equilibrium^[6].

While there are laws and regulations that could be better designed or are no longer needed, an equal or worse danger is posed by what is called “regulatory capture” where an agency (or legislators) responsible for regulation are themselves from the industry or beholden to it. Wealthy interests can also get legislation passed which favors them economically. An example is the depletion allowance which has provided the oil industry with an enormous tax break relative to other businesses. Differential taxation of industries distorts the market, in this case to favor the oil industry.

One final government intervention in the market we should mention is actions taken to counter market crashes. When left alone, markets show an unfortunate tendency to go through boom-and-bust cycles. In a downturn, demand falls which causes some to lose their jobs and others to spend less because they’re afraid of losing their jobs, and this in turn causes demand to fall even further precipitating a crash. During and since the great depression, governments have countered this cycle by pumping up demand through deficit spending during downturns, and slowing demand in various ways when the market overheats. This “Keynesian”^[7] intervention has proven highly effective in ameliorating market swings. 

Making Markets Less “Ideal”

As in the case of the Oil Depletion Allowance, there are times when government actions make markets less “ideal”. A couple of examples include tariffs and patents.

Tariffs on foreign goods will be discussed in the section on trade, but it is clear that, by adding a tax on imported goods, tariffs interfere with the market by increasing the cost of those goods on which the tariff is applied. This is usually done with the intent of protecting domestic producers from competition.

Patents also influence supply and demand by intent. A patent is a form of property right that gives the holder exclusive rights to use an invention for a period of time, say 20 years. Patent laws are quite ancient, the first codified ones dating back to 15th century Venice. The purpose of patents is to provide inventors an incentive to spend the time and money necessary to come up with new and useful products and machines which benefit society, and they do that by allowing the holder of the patent to either exclusively commercialize the invention themselves or charge others to use it. In this way a patent is like other property, and we’ll be looking into that in the section on factors of production. It is probably not fair to say that patents and copyrights make markets less ideal, rather they allow an intangible right to be traded in the market for positive purposes such as increased long run productivity.  But clearly in some cases, such as some essential medications, they have been subject to misuse. It is interesting to note that property rights in general, like patents, are created by governments, they are no more “divine” than the rights of kings. What gets patented is determined by the patent office.

Other government interference that makes markets less “ideal”, like the oil depletion allowance, are often the result of lobbying by industry, or in some cases badly constructed mandates or incentive programs.

Finally, we should note that government taxation and spending influence the demand for goods and services by raising costs through a sales or value added tax. The taxes collected are spent for various purposes and this spending is not directly dictated by consumer preferences. Instead, those preferences are expressed through voting in democratic countries, but that is outside the market mechanism (which gives a clue why there are so many lobbyists and so much spending on elections). A sales tax will raise the prices of all taxed goods and services, reducing demand for the taxed items. An income tax doesn’t affect prices directly but reduces overall consumer demand while increasing demand from the government. 

^[1] High tariffs separate a domestic market from the global one. So, the “no tariffs” condition for a free market only applies when considering a global market.

^[2] Nunn, Ryan, Jana Parsons, and Jay Shambaugh. n.d. “A Dozen Facts about the Economics of the US Health-Care System.” Accessed July 18, 2021. https://www.brookings.edu/research/a-dozen-facts-about-the-economics-of-the-u-s-health-care-system/.

^[3] Over time technology can change. So, for example AT&T was given a monopoly on telephone service until cable and other technologies allowed for competition. Facebook and eBay are de facto unregulated monopolies not because they have high capital barriers to entry but because they were able to get a lot of users early on and the user base itself provides much of the utility of the service. That is called a “network effect”.

^[4] https://en.m.wikipedia.org/wiki/War_of_the_currents#

^[5] Regulations have the force of law. Laws are created by legislative bodies, but in some cases the legislative bodies will leave the details of implementation to agencies. The agencies issue regulations which have the force of law. Imagine the legislature trying to create a law for every road speed limit.

^[6] Many “conservative” economists, and even some daring Republican Congressmen (in the past) have proposed a carbon tax because it is a market solution. Cap and trade also makes use of market forces but requires a bureaucracy and is easier to game.

^[7] After economist John Maynard Keynes (1883-1946)