In that case then I think it worth explaining just why I find free market economics so frustrating. Fundamentally this is because of the absurd assumptions that underpin the logic of those who adhere to these beliefs. Saying that, many of those who do so will, I am sure, say that what follows represents beliefs they do not personally recognise. I hate to disillusion them, because the reality is that all this will reveal is that they are the unwitting slaves of some far from defunct economists because what I will describe are the assumptions that underpin the vast majority of economics journal papers in the UK, including those that result in the policy prescriptions of almost all free marketeers (including, depressingly, on tax).
So what are these assumptions? You can give and take a little on these, because once you get above about eight there is some overlap or substituitability between them, but each is common and worth noting. I should, in fairness, add I started with a list from here, but expanded a little as I thought appropriate. Free markets to work require that there be:
Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price.
Many individual buyers, none has any control over the market price
Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run.
Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.
Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors.
Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives.
No externalities arising from production and/or consumption.
Markets that clear, which requires that for all sellers there is a buyer.
Markets that reach a state of equilibrium i.e. there is an optimal outcome to economic activity.
Rational expectations, which means that people accurately forecast statistical expectations and all errors are random.
Well, we might argue about a few of these. Rational expectations for example really doesn’t mean that. Only that people are not systematically biased in what they think the future might bring. And the point is not so much to insist that markets only work if they do think this way as to examine whether the point it true or not. Also worth noting that this is the basis of Keynes’ ideas on the origins of the business cycle too. It’s not a new or “free market” idea.
Coase in part won the Nobel for pointing out that externalities can, but only in certain circumstances, be dealt with in a purely free market with the appropriate property rights. And everyone else, from Marshall through Pigou onwards has pointed out that the right thing to do about them when this isn’t possible is to incorporate them into market prices. This is the argument both for a carbon tax (negative externalities) and public subsidy of basic research (positive externality of a public good).
Which brings us to his complete misunderstanding of markets that clear. This doesn’t mean that there is a buyer for every seller. It means that prices change so that markets clear: at £10 each there’s not a buyer for every seller of lovely fresh pears, at 1 pence each there’s too many buyers for willing sellers and at some number inbetween the market clears as the willing supply and willing demand becomes equal. Our biggest problem being that we’ve no way at all of determining what that market clearing price is without using the market as a whole as our model. Which is why, when we’ve those externalities, we’ve got to change the price through either tax or subsidy and then let the market deal with it, find that market clearing number. This is why Stern concentrated on working out the damage from emissions: once we know that (whatever you think of the answer he came up with) then we can tax at that rate and then the market clears giving us the correct amount of emissions.
At a slightly less detailed level he’s describing the simplifications that we make to build a model. The vast majority of what happens next is relaxing one of more of those simplifications and seeing what happens to the model. There’s reams and reams of papers on oligopolistic competition, imperfect information, bounded rationality and all the rest.
Which brings us to the next point at again a higher level of abstraction:
As I have said, you can argue that one or two extra conditions can be added to this list and that a couple may overlap. It does not make a lot of difference to the outcome because the fact is that all these conditions need to exist simultaneously if markets are to provide optimal outcomes for the economic organisation of society. If any one of them fails then because of the simple application of chaos theory and the power of small numbers the outcome from leaving markets to themselves are wholly unpredictable.
Dunno what the hell that chaos theory and small numbers stuff is about. But he’s not getting the real meaning of “optimal” here. The real meaning being “as perfectly perfect as anything can be”. And there’s not a single economist out there who wouldn’t agree that there are times when a pure market solution, only a pure free market solution, might be in this sense sub-optimal.
It’s at exactly that point that the argument then gets interesting. When we bring in things like public choice economics (essentially, the people who make, enforce and administer laws are greedy thieving bastards like the rest of us), bounded rationality (the people who make, enforce and administer laws are just as ignorant as the rest of us) and so on and so on then we want to ask the extremely important question. OK, so a pure free market outcome is sub-optimal. And is whatever we get from the ignorant musings of a retired accountant from Wandsworth optimal? Or sub-sub-optimal?