Government's role in a free-market economy

Standard-Examiner: Government's role in a free-market economy  Vijay K. Mathur

Among many people, politicians and media pundits, there seems to be confusion about the operation of free markets. Sometimes the word capitalism is used to propagate the notion of free markets. However the word capitalism came into use almost one hundred years after the publication of The Wealth of Nations in 1776 by Adam Smith, the most ardent supporter of free markets. Capitalism should not be confused with the system of free markets. Like markets, capitalism is evolutionary, however it encompasses not only economic organization but also political and social organization.

According to Adam Smith, self-interest (not selfishness), property rights and division of labor are three important interrelated pillars of economic growth. Property rights, if clearly defined and enforced, ensure that people are free to transact their goods and services at positive prices. Self-interest of sellers to make profits and of buyers to obtain products they prefer at the lowest prices brings sellers and buyers together in a market transaction. Self-interest in competitive markets maximizes economic welfare of the society. If free and competitive markets work, they efficiently allocate products among consumers according to their preferences, allocate inputs among producers, and enable producers to obtain the maximum output with given amounts of inputs. Division of labor facilitates scale economies to bring down costs.

However, there are circumstances when markets do not perform their function efficiently. Economists refer those states of the markets as market failure, a point missed by many who blindly promote virtues of free markets.

Market failure occurs due to many reasons. Let me discuss five of those reasons. First is monopoly power, where one or few producers and/or sellers gain control of the market. ...

The second reason for market failure is when producers do not fully bear total costs of products or are unable to capture all benefits of producing products. ...

Third, market fails when there is a common property resource. ...

... The fourth reason is lack of information, misinformation or asymmetry of information. ...

Finally, risk and/or uncertainty may be an impediment for free markets to provide products, which may be welfare-maximizing for the society in the future. ...

There are a host of other areas where free markets will not work efficiently and promote public welfare as envisioned by Adam Smith without some government intervention: for example, areas of product safety, workplace safety, airwaves allocation, oil and gas exploration. Therefore government intervention is essential for the working of free and competitive markets. I do recognize that government intervention in markets should be measured for efficient operation of markets. But indiscriminately diluting regulations, taxes, subsidies and user fees, which are essential parts of a vibrant free-market competitive economy, may result in undesirable consequences which no one would value.

Great summary. I think I agree with most of what he says here. The challenge is distinguishing between "regulating" an economy and "managing" an economy. Regulating an economy is mostly about equalizing  anti-competitive advantages in the marketplace. Managing an economy is about deciding what strategies companies/industries should take (or not take), privileging  one company/industry over another, or deciding for consumers which products they should should use. Two analogies.

Urban transportation network versus an airport. Urban designers provide some infrastructure, and they establish basic enforced rules. But the nature of traffic movement is individuals deciding when and where they want to go, and what route they will take to get there, sometimes deviating on a whim. They observe formal and informal rules of the road to reach their goal. The airport is managed by air traffic controllers. No one moves without permission. Decisions about destinations and routes must receive approval and alterations require permission.

NFL referee versus NFL coach. Referees make sure the game is played fairly according to the rules. They sometimes must make judgment calls and determine what is fair in a competitive environment. Coaches direct the play of the players, deciding who will be on the field and what plays will be called in which context. Referees regulate a game and coaches manage a game.

My position is that government has the role more similar to a regulator than a manager. Regulation is absolutely essential to the functioning of a free market economy. That has been the traditional understanding of "free market" from the beginning. I think the concept has frequently been abused in two important ways.

Free market champions rightly resist attempts by governments to manage economies but then extend this opposition into the arena of what I'm calling regulation, opposing it as well. Converesly, free market detractors rightly uphold the need for regulation but extend this concept into the realm of managing the economy. Then, each side condemns the other (respectively) as socialists or anti-government anarchists. The line between regulating and managing can sometimes be unclear and reasonable people can disagree. But conservation would be radically improved if people were clearer about what they mean by "regulation."

Comments

[Dan Anderson-Little]

Mike,
Good question about regulation vs. management. I think you are right about liberals and conservatives. As a way to see how we think about this, let me know which category you think these examples fall into:

Air pollution standards
Water pollution standards
Nutritional labeling
Banning Happy Meals
Putting warning signs on cigarettes
OSHA rules
NLRB (essentially protecting union rights)
Affirmative action and set asides for racial minorities
Criminalization of marijuana
Capping punitive damages for medical malpractice
Recalls on cars
Recalls on baby cribs

The devil, it seems to me, is in the details. I suspect that most people (except staunch libertarians) would favor some of those regulations/managements enumerated above, but not all of them. I also suspect that most people would finally have to admit that their preferences have to do with how these regulations/managements affect them directly. (Sort of like the people who want the government out of health care EXCEPT for their Medicare).

Can we develop a template or philosophy of regulation that would apply in most cases? Or is much or all of this driven by self-interest? I would be interested in your thoughts on this.

Dan

[Michael W. Kruse]

Dan this is a collection that would require some significant breakdown. For instance, pollution is the quintessential example of #2 in the article. Polluting the air or water imposes a substantial cost to those who most weren't a party the selling and buying of the polluting companies product. From a property rights standpoint, it can frequently be argued that your pollution is an uncompensated appropriation of my property (land and air) ... a type of theft and therefore not very free market. So regulation makes sure that potential polluters play fair. Depending on the issue, it could mean banning/limiting some production, taxing production, or other alternatives.

Warnings on cigarettes might meet #4. Consumers need to know the full costs they could encounter for purchasing the product.

NLRB and Affirmative Action could be seen as addressing anti-competitive behavior of businesses against labor or specific minority groups. The goal is not to privilege these groups but equalize competitive factors in the economy.

As you say, the devil is in the details. First it has to be established that something anti-competitive has emerged. Second, a strategy must be adopted to change the status quo. Frequently, there are unintended secondary consequences. A common example is imposing rent controls to make housing affordable. But rent controls mean landlords can't raise prices to capture what the market price is for their units. Meanwhile, tenants hang on to units subletting them to others, getting a profit above the rent control price. Landlords can't make enough money and let buildings deteriorate. In some extreme cases (Ex. Brooklyn, Detroit, Chicago), landlords resort to arson to destroy their buildings and collect the insurance. Developers cease building new units because they can't get the income. In short, the real cost of renting rises and the number of units decline under rent control. There is correlation between rent control measures and increased homelessness. Sometimes working with the market to develop solutions is better than working against the market with regulation. Does that make sense?

There are also some things government needs to do (or are at least preferable or them to do.) No one individual is going to build their own tornado early warning system, where they put out all the money but the whole neighborhood gets the benefit. It is better to have everyone contribute a small amount and have government provide such services.

Also, each of us benefits by everyone else being able to read and do math at a basic functional level. There are positive spillovers to all of society beyond the benefit received by individuals. If for no other reason, it facilitates our ability to engage in commerce with each other and vote about public policy. Therefore, investing in everyone receiving a basic education and requiring it has positive spillover that would not be achieved it were simply left optional. You might say some similar things about some aspects of health care. But again, I go back to the rent control example, it is critical to more prudent and less ideological about how to accomplish much of this.