Radical Reform

The Market: An Introduction

Most of the policies I shall propose herein are based on market mechanisms. They are, as is the fashionable name amongst many scholars for anything they dislike, neoliberal. It is, therefore, useful to start by quickly outlining the case for the market allocation of resources. Otherwise, I would be repeating myself, ad nauseam, throughout. My apologies to those who are familiar with the typical arguments for the free market: There is little original in the next chapter.

What is the Market

For a roughly dictionary definition: The market is the interaction of willing and, typically, profit-seeking or utility-maximising individuals (and firms, being collections of individuals) in the exchange of limited resources. In a typical product market this looks like producers attempting to meet consumer demands at the lowest possible cost. Generally, in a monetary economy like ours, what the ‘demands’ of consumers and the costs facing producers are is expressed in terms of prices.

Prices are the core element of a modern market. They are expressions of relative scarcity. Prices increase when, holding the amount producers are willing or able to provide constant, consumers want more of the product. They decrease when producers are willing or able to make more of them. They also decrease when consumers want less of them and increase when producers become less willing or able to make them. In economic terms, they are determined by the supply and demand for the product.

But why do they work? Higher prices suggest that there is demand for the product. If those prices exceed the cost of producing the product [1], entrepreneurs will enter to earn the difference – profit. Why? Because that profit increases their own purchasing power to purchase more of what they want. And if the price is below the cost of producing the product, they will exit the market – it is no longer profitable. And if the price of inputs change, this can change behaviour. For instance, when the price of oil increases – because there is more scarcity in the market, airlines both increase prices (driving people away, and reducing demand for oil in a time when it is scarce – reallocating it only to its highest value uses) and invest in fuel-saving technology (moving away from the newly scarce resource). The price of any given thing is “a signal wrapped up in an incentive” (Tabarrok, 2015). The function of the price system is for the community to, as Adam Smith – the father of modern economics – said, “interest the self-love” (1977, p. 30) of the entrepreneur in doing what they require. After all, “it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” (Smith, 1977, p. 30)

Note, however, the use of prices to incentivise useful behaviour necessarily creates inequality. This is inescapable: If we were all materially equal, no matter our contribution – why would we contribute? We would receive the same reward if we did or didn’t. And even if we did decide to contribute, if there is no incentive to make the most valuable use of our time, instead we might waste our potential in a less useful path. Thus naturally, a world without inequality is a world of tremendous waste[2]. This need for material inequality does not, of course, justify abject poverty. In a rich country such as ours, we must collectively insure each other against the scourge of poverty. A well-designed welfare state – as I propose in the later section on taxation and welfare – can do so without destroying the incentive to contribute to the maximum of one’s potential.

The Moral Dimension [3]

The simple moral argument for the market was best said by Milton Friedman: “[In] a free market…no exchange takes place unless both parties benefit” (Friedman, 2000). This, in and of itself, should justify most market transactions. There are, really, only three reasonable objections to market transactions conducted in this manner:

1) The transaction affects innocent third-parties negatively (externalities),

Clearly, it is not within the scope of any person’s freedom to harm another without their consent[4]. However, it is not inherently impossible for a private negotiation to reach an adequate settlement for such issues. In Coase (1960)’s masterful paper on bargaining of this sort, he suggests that it is, often, quite possible. His example, of a cattle ranch next to a crop farm, remains the most famous: The rancher’s cows regularly trespass onto the neighbour’s farm and destroy crops. It could be efficient for the farmer to pay rancher to move, the rancher to pay the farmer for the lost crops, or they both to pay for a fence in the middle. Which is the best option depends on the relative prices of the cows, the crops, and the mitigation method. Coase showed that private negotiation would find the most efficient way to resolve this externality problem.

He also proposed two common issues which make reaching efficient solutions difficult: 1) the presence of significant transaction costs; and 2) the lack of clearly defined property rights. These first of these problems often come up when the external costs (or benefits) of a given transaction are dispersed between many people. For instance, the cost to each individual of the pollution of a factory which might cause acid rain are relatively negligible, but the total costs are significant. This means that, while it would be efficient to make the polluter to compensate its neighbours for the pollution, it will not occur because the costs of coordinating them all and providing them with legal representation (the transaction costs) outweigh the possible benefit to the neighbours. Government action is justified here. The second problem is rarer. It emerges when it not clear who has the right to do what they will – the person who experiences the negative externality or the person contributing it. For instance, do smokers have the right to smoke or others the right to smoke free air? The answer to that question decides who pays whom (but not what is the efficient outcome). Typically, however, governments (and courts) settle to whom these property rights belong very early on.

2) The transaction was conducted fraudulently, under duress, or by an incompetent party.

Part of the assumption of the morality of the free market is that it is conducted by people considered competent to deal with their own affairs. Children, some of the mentally-ill, those being deceived or held prisoner (or under blackmail) cannot be considered competent to conduct (some or all) transactions. Government must prohibit such transactions.

3) The transaction was unfairly structured, so that one party got a worse deal that he should have.

The archetypal example of this scenario is monopolism. When the producer is the only provider of a certain good or service and no competitor is able to emerge, he can take advantage of this situation and produce at a higher price and lower quantity that he otherwise would in a free market. Here, government might have a case to intervene. However, it is possible that government action could have more deleterious long-term effects. For instance, poor price-setting could worsen the monopoly situation or reduce the incentive for the monopoly to invest in research and development. Badly-planned intervention in the market, like nationalization or compulsory divestment of certain parts of a business, could led to more inefficiency and could deter foreign investment, because investors could be afraid for the safety of their own investments.

Another example of this is monopsonic labour markets. Here, one predominant employer dominates the labour market for a certain class of employee or for a certain location and uses this power to set wages at lower-than-free-market rates and hire fewer workers than they otherwise would. Government intervention here, for instance, in providing additional power to unions (to create a monopoly to counter the monopsony) or setting a minimum wage can be useful – however, again, possibly seriously deleterious if poorly done.

There are other moral arguments against the free market which I believe are quite flawed. For instance, the view that people regularly make poor decisions and require paternalistic governments to ensure their decision-making is proper. My principal moral objection to this is that it requires a belief that others have ownership over the individual. Surely, excluding the cases where they are literally incapable of rational decision making, the individual is the whole and exclusive owner of himself and therefore, should be permitted to do what he pleases with himself. The view that his life is the property of others or that he owes duties, inherently, to others is slavish[5].

The Economic Argument

Leaving aside empirical evidence (of which there is much in favour of the free market and little in favour of the opposite; however, it is probably best to leave a survey of such data to others, it is not all that useful in this case), there are three principal economic arguments for the free market system: incentives, decentralization, and information.

Incentives

As laid out above, the price system incentivises individuals – who, above all, serve their own self-interest – to generally work for the wider benefit of society. Compare this to the incentives operating on a central planner. His notional duty is to best serve the interests of the community, but, as the entire field of public choice economics can attest to [6], this is often in fundamental conflict with his natural instinct to serve his own. At best, the entire planning staff will be comprised of entirely self-sacrificing individuals who have no consideration for their own interest – a wonderful, if entirely unrealistic, vision. More realistically, they might be reasonably-public minded people, who still cannot escape occasionally temptations to prefer their own interests to that of the public-at-large – the example of the public service unions occurs. Worse, they could be like Sir Humphrey Appleby in Yes Minister: Broadly competent but entirely uncommitted to the public interest. At worst, they could be corrupt – siphoning public funds or handing out cushy government contracts, not merely in violation of the public interest but in direct violation of the law.

Democratic accountability is meant to provide a bulwark against this. The threat of losing office is thought to ensure politicians are competent and benevolent and ensure the same behaviour from their underlings. Unfortunately, as lovely as it sounds, democratic accountability is woefully weak, compared to the harsh accountability of the market. For one, it is not in the interest of most voters to consider their votes, because the cost of becoming informed is high and the possible benefit is small – it is very unlikely that one’s vote would change the result, even in a small country such as ours. Public choice economists call this rational ignorance. Secondly, in a political market of constrained choice (there are 13 registered parties in New Zealand (Electoral Commission, 2018), of which only seven had a reasonable chance of making it into Parliament in the 2017 election), accountability is unlikely to be exercised by most voters, who are committed to a certain ideological position, except in the most serious of cases. Thirdly, there exists an exit-option, but it is severely limited. It is far from costless to simply shift countries to avoid bad policies [7]. By contrast, in most markets, there are competitors to a consumer’s incumbent provider who is easy enough to access. It is also in the consumer’s interest to exercise this accountability: Even if their move does not change the position of their former provider, it does allow them to access better service immediately.

Milton Friedman made the simplest statement of why government planning is inherently suboptimal, first in his book Free to Choose, later in a television interview:

There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present[8], but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. (Friedman, 2004)

Decentralisation and Competition

The very chance of the planner being a Sir Humphrey Appleby-type or worse speaks to one of the core problems of planning, when compared to market-based interactions: The lack of choice inherent in government. An incompetent or even malfeasant administrator is obviously suboptimal, but when choice exists, it need not be disastrous. Consumers will simply, in their own self-interest, move away from the bad provider. When enough do so, the poor provider will collapse.

The existence of competitors in the marketplace is crucial [9]. It alters the power dynamics of the market in favour of consumers. When multiple firms compete for a consumer’s business, the consumer becomes sovereign: He can demand higher quality, lower prices, and goods which better match his needs – because he can move providers. It also encourages what Schumpeter called ‘creative destruction’. He proposed that competition is a process whereby the less productive firms are “incessantly destroy[ed]” to make way and free up resources for newer, more productive firms, which better match consumer desires (1942, p. 83). By contrast, planners – and government – are almost always monopolies. The consumer is not sovereign, the planner is.

Information

The best (and probably, original) statement of this argument for the free market comes from Hayek in his ingenious essay, The Use of Knowledge in Society (1945). There, Hayek sings the praises of the market as a coordinative agent, principally by comparing the information available to a board of central planners with that available to the market.

No central planner can possibly have the information available to him that each individual has. Individuals are the ones directly aware of their own circumstances. Just as when you zoom out of a map you lose clarity on any one point, when you make decisions at an aggregated level you cannot possibly account for all the individual concerns of every New Zealand household[10]. Sure, consumers might not be entirely rational in all of their decision making all the time, but on big decisions, generally individuals consider their own value system adequately and make boundedly-rational decisions far better than a civil servant, who knew little of their unique circumstances, could.

In addition, Hayek (2002) in a later lecture argued competition between firms in the market is a ‘discovery procedure’, allowing individuals to discover how to best serve one another. This discovery occurs by the creation of ideas or the expression of disperse knowledge, which is incentivised by the search for profit. There is then competition between operators of those ideas or that knowledge on the marketplace for consumers. Eventually, operators will converge, either through poor performers atrophying or moving to the better model, around the best ideas. In the absence of competition, knowledge that may prove useful in, for instance, improving quality, lowering costs, or better matching consumer demand will remain unknown because no incentive exists to invent or discover it, or no system exists to test it against other ideas or knowledge. This, really, is at the heart of the outperformance of the market: It incentivises invention.