Some people take as an article of faith that “free markets” are a magic elixir that make society prosperous and fair. Certainly, economies based on principles of capitalism and allowing markets freely to direct choice making have generally outperformed economies based upon other principles.
But, as in all things, there are no panaceas. Free markets are no exception. “A free market usually does not produce the optimal quantity of goods with externalities present.” This is from Microeconomics, 3rd ed., Goolsbee, Levitt, and Syverson, a popular college economics text. The authors continue to say externalities are a pernicious form of market failure. In markets where there are significant market failures, unregulated, they fail to produce the efficient or equitable outcomes they are thought to yield. Well-designed regulation corrects for market failures.
For practical purposes nearly all markets fail in one way or the other. Therefore, if all markets operated without constraint, society would be burdened with several undesirable outcomes. They included, but are not limited to, inadequate protection of the environment, tendency toward monopolization and subversion of competition, under provision of public goods and tilting distributions of income and wealth toward the top.
Perhaps the most compelling reason to regulate market activity was cleverly expressed by the late psychologist, Amos Tversky, who once said, “My colleagues, they study artificial intelligence. Me, I study natural stupidity.” Tversky would have shared the Nobel Prize in Economics with Daniel Kahneman had he lived. More recent research by economist Richard Thaler, also a Nobel laureate, and others built upon the foundation laid by Tversky and Kahneman to create the study of behavioral economics.
Behavioral economists recognize we are humans not homo economicus. And humans consistently make cognitive mistakes such that our choices systematically violate the economist’s assumption of rationality. We are, to borrow Duke University psychologist/behavioral economist Dan Ariely’s phrase, “predictably irrational.”
The upshot is our decisions are often affected by supposedly irrelevant factors. Some of them are; the order and manner in which choices are presented, incomplete or inaccurate information, and the influences on us of choices others make. These are only a few of the factors leading us to make “irrational” choices.
In a market economy producers and consumers are guided by prices. Unaddressed market failures distort prices and choices. Therefore, free markets cannot be expected to produce the combinations of goods and services that maximize social wellbeing.
The right policy response to market failures is not throwing out the baby with the bath water. Rather, the right response is to design policy that attenuates market failures but minimizes restrictions of individual freedoms. Congress has a long record of doing that badly.
Patrick Taylor lives in Ridgeland.