29 August 2017

There’s no such thing as a free market


As we all know, or at least should by now, there’s no such thing as a free market. There’s nothing which comes close to the model of perfect competition that economics textbooks describe: perfect information, absolutely no market power accruing to anyone, infinite numbers of perfectly rational consumers and producers and so on. Seven billion humans is less than an infinity so those beloved perfectly free markets simply do not exist.

We could, at this point, therefore throw out the entire idea and let Nicolas Maduro decide the price of everything, not those markets which simply don’t work as the books say they’re supposed to. We’ve tried this and it appears to work less than well. We could also be a little more sophisticated and, like the economist Steve Keen, agree that the perfect competition model doesn’t exist therefore we should use models of imperfect competition, or oligopoly (where a few firms do have some market power) or monopoly (where one has a lot).

It is undoubtedly true that such models, based upon other principles, are useful in the examination of certain sectors of the economy. But what we’d like to know is how useful that model of perfect competition really is. How closely does it describe our reality, even if it’s not an, er, perfect portrait?

At this point it is worth pointing out something I take to be axiomatic about classical liberals, distinguishing us from the libertarians on one side and the various dogmas of socialism and Marxism on the other. We are, at heart, utilitarians, not philosophes. Some will define the world by the exploitation of the labourer not gaining the entirety of the value of their labour and attempt to build a system from that. Others might insist that any form of compulsion is immoral and that therefore tax is theft. While we classical liberals certainly have moral principles, we are primarily interested in what works.

We are therefore interested in how the world works and how humans interact, rather than any lofty discussions of how it all should work or, as happens when theorising is taken even further, how it would work better if only humans were different.

Thus our question about those free markets isn’t whether they exist or not. They don’t. Rather, the question is: “how good is the model at getting close to a decent description of what does happen?” The answer: pretty good.

Something we can learn by coming at it crab wise, as in a paper brought to my attention by Tyler Cowen. Entry and Competition in Concentrated Markets starts by assuming that the perfect market isn’t there and uses the standard models of monopoly and oligopoly to look at the markets for dentists, plumbers, tyre dealers and the like across geographic markets. These are things you need to be close to to gain access, therefore geography creates many small markets across the country, some of which will have only one provider, some two and so on. We are thus starting by insisting that the state of affairs is a long way from market perfection.

But something that looks like market forces arrives pretty quickly. Monopoly, just the one supplier, changes significantly with the arrival of the second and third, moving us to where theories about oligopoly explain matters best. But, according to the paper, by the time there are three to five producers in the mix, the arrival of more doesn’t seem to change matters much.

In other words, while those perfect markets by definition cannot exist in the real world, if we’ve got thousands of producers and thousands of consumers then reality has asymptotically approached that ideal. The interesting question, then, is how many players do we need to get close enough to the market ideal? According to the paper, four to five producers is enough. Which means the perfectly free market is a useful model of the world after all. Even if it is not a complete description of it.

For us classical liberals that’s good enough. That textbook model works at this point and that’s all we’re after: something that works.

Tim Worstall is senior fellow at the Adam Smith Institute