Fallacies of Free Markets

3p is proud to partner with the Presidio Graduate School’s Macroeconomics course on a blogging series about the economics of sustainability. This post is part of that series. 

By Justin Semion

The concept of the “invisible hand of the market” underlies classical and neoclassical economic theories advocating for a free market economy, one with no government regulation.  In summary, free market theory proposes that supply and demand in the unregulated marketplace naturally reach a state of equilibrium where the maximum possible social good is achieved. 

Many economists over the past half century have developed complex mathematical models to demonstrate how this basic concept works, and these proofs have led to substantial deregulation, principally of financial markets, over the past quarter century. Many criticisms have also been made of free market theory.  The most well known criticism is that a free market economy does not account for externalities, side effects such as pollution that are borne by society at large and not by the individual supplier or consumer. 

However, there are more significant flaws to this theory that are rooted in the assumptions underlying its basis, the economic concept of “perfect competition”.  Perfect competition is the ideal state in classical and neoclassical economics, and functions properly only when held to certain assumptions.  These assumptions are necessary for a pure free market economy to function efficiently.  

A brief examination of each of these assumptions can show some fallacies in arguments for a pure free market economy.

1.  That the flow of information regarding the prices and quality of goods and services is perfect; that is, free and accessible to everybody in the market.

In an unregulated free market it is in the best interest of a firm or group of firms to maintain an imbalance of information.  Viewed in this way, the assumption of perfect information is self-defeating when applied to free market theory.  A recent and influential example of this is the sale of mortgage derivatives that played a large part in the current financial crisis. 

Complex derivatives comprised of individual mortgages carrying varying levels of risk were bundled and sold under a single risk classification.  Information regarding the individual mortgages within these packages was not readily divulged, and not free and accessible to everybody in the market.  It was in the best interest of the firms brokering these derivatives to maintain a lack of information regarding the structure of these instruments because it made them easier to sell at volume.  Buyers were eager to cash in on the bubble and so did not ask the right questions.  This lack of perfect information contributed heavily to the devastating effects of the mortgage bubble.  

2.  Consumers and producers always make rational decisions when purchasing or producing goods and services (i.e., buy at the optimal price and produce at optimal levels).

Some failures of this concept are described in Richard Olsen’s writing The Fallacy of the Invisible Hand.  In that article, differences in time horizons of different investors are used to examine the problem of heterogeneous agents.  In other words, investors do not make decisions based solely on price, but also depending on the length of time they expect for a return. 

The assumption of rationality also ignores interpersonal aspects of consumers and producers, such as emotional purchases or production decisions, and decisions made based on social preferences and priorities.  For this assumption to hold true, the flow of information would also need to be perfect, which as described above, is not often in the best interest of a profit-maximizing firm.

3.  Entry to and exit from the marketplace is easy (low “barriers to entry”). In short, barriers to entry are advantages held by established firms over firms entering the market, such as up-front capital costs, reputation, and revenue to support operating costs.  In modern times, this assumption holds true only in a very limited number of industries, such as some consulting services, computer programming, and internet retailing. 

The technological knowledge required to participate in lower barrier to entry industries often requires significant personal investment of time and money, which in itself is a barrier to many.  In addition, low barrier industries are often reliant on higher-barrier industries, such as manufacturing, real estate development, and energy production.  For the majority of industries, a startup competing with established firms requires a huge influx of resources, investments of both time and money, to compete with firms that have established reputations and economies of scale.  The resources required to compete in today’s landscape are available to very few.

4.  There are a large number of firms within a given industry, each selling a homogenous product. A real-world condition that represents this assumption has yet to be found.  Homogenous products are just not good for business (General Motors is one example).  Industries where products are largely homogenous trend in real-world examples towards fewer firms, such as with Coke and Pepsi. 

It is often industries with largely heterogeneous products that trend towards the greatest number of firms.  A world of homogenous choices also raises questions about personal freedom and individual choice, values that are promoted by many free market pundits as benefitting from a free market economy.

5.  The actions of an individual firm have little to no effect on market price. To see the fallacies of this assumption, one only need look to the effects of WalMart on local small businesses.  In today’s economy, large firms have amassed sufficient market power to be able to affect market prices by influencing suppliers, driving down price and margin to levels that competitors cannot maintain.

Capitalism has been a very successful system producing a host of innovations and generally increasing the standard of living around the world.  However, it is not a perfect system.  People make the markets, and people are not perfect.  People do not exist in the abstract and are not controlled by assumptions we choose to place on them for market-based analytical purposes. 

At their core, the invisible hand and free market economy are romantic notions, born from a romantic time.  The conditions necessary for the free market economy to function simply do not exist in today’s world, if they ever did.  A pure free market does not provide for the greatest social good, only the greatest good to those with the means to exploit weaknesses in a free market system. 

This can be seen in the large increases in income disparity that correspond with the deregulation of financial and other markets over the past three decades. To function properly and efficiently, markets need guidance.  The term “invisible hand” first appeared in The Wealth of Nations, where author Adam Smith popularized the notion that the study of market forces was a worthy pursuit, and one that could serve the greater social good, largely establishing economics as an academic discipline. 

The study of economics has been working to guide markets ever since.  In a sense, the notion of a pure free market economy seeks the absence of this guidance, and thus is contrary to the notions that build its foundation.

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