(Mis)Understanding Free Markets

A surprising number of people who think they are advocates of free markets are thoroughly misguided about what free markets are about.

Prepare for a shocking notion… Free markets are not about maximizing profit.

Let’s repeat that because it seems so wrong to some people: Free markets are not about maximizing profit.

On the contrary, free markets are about achieving the maximum production of goods and services at the lowest prices.

Consider the consequences if we really are talking about maximizing profit as the end goal.

We surely would not choose free markets to achieve that goal. Monopolies and criminal enterprise maximize profits much more effectively.

A free market yields the highest possible production of a good or service because the exchange of information among buyers and sellers leads to an equilibrium that will be high enough for sellers to produce that quantity; at that price which is low enough for consumers to be willing to buy that quantity. This is called the “equilibrium price” because it is the perfect balance that achieves the highest production. Any higher price results in lower production because consumers are unwilling to purchase that quantity at that higher price. Lower prices will result in lower production because sellers will be unwilling to produce that quantity at the lower price. Thus a free market with price transparency and true price discovery always leads to the greatest possible production.

So we can see that the theory of a free market is dependent on the free flow of information: potential buyers and sellers have perfect knowledge of prices, so that there is “price transparency,” and that this information flows directly and quickly enough for “price discovery” to occur. Price discovery is essentially a process of bid and offer by which the true equilibrium price of a product or service is “discovered.” It is “discovered” because theoretically potential buyers are able to obtain information about competing suppliers product qualities, quantities available, and price. Potential sellers are able to obtain information about competing consumers’ demand, tastes, and willingness to pay. As each side learns this information, they “discover” the lowest price at which the product can be obtained.

If one or the other side of the buy-sell balance does not have open access to the necessary information, then the market is not in fact a free one. For example, if farmers could hide half their wheat production, so that buyers could not know that there is a large amount available, while magically preventing potential buyers from identifying any possible substitute for wheat in peoples’ diets, then the price of wheat would jump dramatically. Of course there is no such shortage of information for wheat buyers. But in some crops, like lentils, there is a surprising and probably market-distorting shortage of information for lentil farmers.

Free markets also depend on the assumption that no group can exercise non-market power to advantage their side. That is to say, for example, that sellers will not have the power to influence governments in a way that forces prices up and buyers will not cause government to intervene to force prices down.

Monopolistic power is to be resisted at all turns, as it is the very antithesis of a free market. Price discrimination schemes supported by non-market factors are strong evidence of the absence of a free market. (Market factors that would cause price variability would be things like transportation costs and these would not represent price discrimination.)

But remember, businesses are properly not interested in achieving the highest possible production. They are, and must be, interested in maximizing profit. The existence of the profit motive, while it is vitally necessary to a free market, must also be regulated to ensure it does not overwhelm free markets. Thus the need for laws to prohibit monopolies and to prevent anti-competitive behaviour.

Real world experience, as opposed to theory or philosophical thinking, has taught us that the best way to ensure the benefits of free markets is to maximize competition in the economy.

In recent history we have experienced some remarkable examples of the transformative power of governments acting to enhance competition. For many decades telephone and telecommunications services were operated by monopolies or oligopolies. There was relatively little innovation and prices remained high — by today’s standards outrageously high. The U.S. government eventually intervened to break up the monopolies, including ordering open access to the physical infrastructure of long distance telephone lines. The result was a rapid decline in prices and an explosion in telecommunications innovation.

Now note this experience carefully. Competition to deliver the benefits of a free market was achieved by government intervention.

Those who think that any government intervention is by definition contrary to the operation of a free market, need heed the historical facts.

When an economic sector or industry becomes characterized by one or a few players exerting  market power to the extent that they effectively prevent genuine competition, government must intervene or the free market becomes a myth.

Today most governments have become so overwhelmed by the persuasive siren song of powerful players that new ways of eroding free markets are being blessed. Yet there remains a core impulse in democratic countries for those same governments to at least advertise belief in free markets. So we have the spectacle of an entire anti-competitive infrastructure being constructed on pronouncements of free market gospel.

This is exemplified by the systematic application of proprietary hardware solutions to prevent consumers from accessing competing products. Governments have taken the shallow position that “no one is forced to buy the hardware.” Willfully or out of ignorance they fail to recognize that if the entire market is characterized by such “innovations” as locked cell phones or DRM-restricted televisions, then it will become impossible to produce any hardware that does not conform to the pattern. An “open device” will have no competitive functionality. So while it is abstractly possible for a willing seller to offer a competing product to an abstractly imagined willing consumer, just as in the days of monopoly phone service, the competition will all be equally abstract. In reality we will live in controlled market, possibly even a command economy. Consider that a command economy is still a command economy whether those issuing the commands are governments or corporate officers.

Of course we have lived with inherently anti-competitive infrastructure for some time in the form of rail lines. Governments have been unwilling to either force open access rights (exactly as was done with long distance telecommunications infrastructure, ie. the actual telephone wires) and equally unwilling to regulate the physical monopolies as has been historically done with things like electric utilities. For rail they get it both ways, no competitive access to the physical monopoly and little or no regulation of price and service.

Governments have also seriously failed in disregarding of the importance of the free flow of market information among all participants.

The injuries range from the seemingly trivial deceptions of “the second one is free — just pay additional processing” to the more sinister schemes that create product bundles or complex feature mixes such that competitive information comparison is impossible.

Understand that the problem is not the purpose of sellers to develop unique feature sets to address unique customer segments. Rather the problem is cleverly creating feature sets that are difficult or impossible to compare with competing products or services or manipulating communications and packaging to hide true pricing. When advertising becomes a higher value than the product purported to be advertised, the market is not working.

How much government can or should do about the resulting distortions in information flow is a matter for serious thought and frankly a conundrum.

Those who invoke “Buyer beware” are probably not aware that the quote predates free markets by a thousand years, and it has no more validity than mouthing “seller beware” as cover for not enforcing contracts. But those who would have government regulate every aspect of marketing failed to learn from the object lessons soundly delivered by the fall of the Soviet Union.

What should be clear is that genuine free market thinkers should be considering these issues and exploring opportunities to reduce the anti-competitive effects of modern practices.