The Problem with Completely Free Markets

The Problem with Completely Free Markets

REUTERS/Jessica Rinaldi

The Supreme Court’s decision last week saved Obamacare from the Republican’s latest attempt to get government out of health care. But if Republicans can find another way to attack the Affordable Care Act, they surely will. 

Healthcare is not, of course, the only place where Republicans object to government intervention in private markets. They believe that markets free of government rules and regulations almost always outperform markets where the government is involved. So it’s a good time to review why this faith in free markets is sometimes misplaced, and how government involvement in some markets can improve their performance. 

When a market works well, when it approaches the competitive ideal found in economics textbooks, there is no need for the government to intervene. The market will do better if the government stays away. But we shouldn’t confuse free markets with competitive markets. When there are significant departures from pure competition, what economists call market failures, markets are “free” to perform very badly, and sometimes a market will collapse entirely. In these cases, government intervention can help. 

Related: How to Make Government Regulation Less Burdensome 

The conditions for textbook competitive markets are fairly strict. To begin, there must be numerous participants on both sides of the market. When, for example, there are only a small number of sellers the price will be too high and the quantity too low relative to the competitive outcome. If the good is a necessity – suppose a single firm has a monopoly on the supply of water – the price could be very high indeed. To combat this problem, the government tries to prevent firms from pursuing strategies to monopolize markets, and regulators break up markets that become monopolized anyway. 

When a monopoly is unavoidable as with public utilities, the government regulates the price that can be charged and the customers that must be served. We can debate where to draw the line – when the government should and shouldn’t be concerned about monopoly power (e.g. how dominant does one firm have to become before the government takes action to break it up?), but I doubt that any of us wants to live in a world where most of our markets are monopolized. 

All participants must also have perfect information about the market. If the buyer does not know the exact quality of art, wine, or health care services, if a home-buyer is unaware of a big problem with a house, if a seller misrepresents the quality of a good (a fake watch instead of a real one, or a tipped scale), if a service provider does not have the credentials that are claimed, and so on, then the market will be distorted – people will pay more than they would have if they had been informed. 

Despite free market rhetoric, we want government to intervene to ensure that weights and measures are accurate, there is no fraud, people are truthful about their credentials, and known defects in a product are disclosed to buyers. In some cases, as with wine or art quality, there is little government can do beyond ensuring that that the type of grape or the artist is accurately represented, etc., but when government can intervene and prevent information problems, it improves market outcomes. 

Related: SCOTUS Deals a Blow to Obama’s Environmental Agenda 

Competitive markets are free of externalities. If a firm can pollute the air and water when producing a good without having to pay the costs, then the firm will produce more of that good than is socially desirable. It improves the market outcome when the government uses taxes or other means to ensure that firms pay the full cost of the goods and services they produce, something that seems difficult for those who deny global warming to understand. 

Principle agent problems, which occur when one person is making economic choices on behalf of another, can also cause non-competitive outcomes. For example, when a manager of a firm makes decisions on behalf of shareholders, he or she may do what’s best for their own income rather than what’s best for shareholders. Certainly we want government to have regulations in place that require stockbrokers, bank managers, CEOs, and so on to operate in the best interest of those they represent instead of lining their own pockets. 

A competitive market must also be free of moral hazard and adverse selection problems.  Moral hazard occurs when insurance alters your behavior. For example, if you have health insurance you might pursue riskier behavior, if you believe society will provide for you in old age you may not provide retirement insurance for yourself, and if you have insurance on your car you may drive carelessly. 

The private sector can sometimes solve these problems on its own, e.g. high deductibles reduce risky behavior by making it more costly, and government rules and regulations can also help. But in some cases, as with Social Security and Medicare, the private sector fails to provide adequate insurance and the government must step in and fill the void. 

Related: How Volcker Would Overhaul Wall Street Watchdogs 

Adverse selection is also a problem in many insurance and financial markets. This problem occurs when some customers are more costly to serve than others are, and for one reason or another – usually an inability to distinguish the high and low cost customers – the firm cannot vary the price with the cost of serving a particular person. Under these conditions, if a firm posts a price for its service and customers know their own cost-type (e.g. a customer has a pre-existing health condition the insurance company does not know about) only those customers who expect to pay less than it costs to serve them will show up. The result is that the firm will lose money, go out of business, and the service will not be provided. 

One solution to this problem is what we’ve seen in Obamacare--mandates that all be covered to prevent some people from dropping out (in return for no exclusion for pre-existing conditions). In any case, this problem is not limited to health care markets. It can also occur, for example, in the market for loans (too many risky borrowers show up in some cases), and there is a role for government to play in making these markets work better. The success Obamacare has enjoyed to date is an example of this. 

Finally, there are some goods society desires such as national defense that the private sector will not provide. If a private firm asked you to pay for national defense, why would you say yes? If everyone else pays, you will still be protected, so why pay yourself? If everyone thinks this way – or if enough people do – then there will be no way to pay for the defense that is needed. The solution is for government to provide the good itself, and then mandate that everyone help to pay through taxes. 

The role that government should play in the economy is sure to be a centerpiece of the debate surrounding the upcoming presidential election. Those on the right will champion the idea that markets should be free, while those on the left will hold a more interventionist point of view. I believe in markets as much as anyone. But for markets to work well the conditions for perfect competition must be approximated. In many important markets such as healthcare, retirement security, energy, and finance, that means the government must be involved. 

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