Among many people, politicians and media pundits, there seems to be confusion about the operation of free markets. Sometimes the word capitalism is used to propagate the notion of free markets. However the word capitalism came into use almost one hundred years after the publication of The Wealth of Nations in 1776 by Adam Smith, the most ardent supporter of free markets. Capitalism should not be confused with the system of free markets. Like markets, capitalism is evolutionary, however it encompasses not only economic organization but also political and social organization.
According to Adam Smith, self-interest (not selfishness), property rights and division of labor are three important interrelated pillars of economic growth. Property rights, if clearly defined and enforced, ensure that people are free to transact their goods and services at positive prices. Self-interest of sellers to make profits and of buyers to obtain products they prefer at the lowest prices brings sellers and buyers together in a market transaction. Self-interest in competitive markets maximizes economic welfare of the society. If free and competitive markets work, they efficiently allocate products among consumers according to their preferences, allocate inputs among producers, and enable producers to obtain the maximum output with given amounts of inputs. Division of labor facilitates scale economies to bring down costs.
However, there are circumstances when markets do not perform their function efficiently. Economists refer those states of the markets as market failure, a point missed by many who blindly promote virtues of free markets.
Market failure occurs due to many reasons. Let me discuss five of those reasons. First is monopoly power, where one or few producers and/or sellers gain control of the market. Monopolists restrict output and charge prices higher than the competitive market prices. That is the reason we have antitrust laws. The first major statute was The Sherman Act of 1890, enacted in response to the widespread growth of combinations or trusts in 1880s. Since the Sherman Act, other statutes have been enacted to deal with other anticompetitive behavior of businesses. Proper functioning of free competitive markets requires either to break-up monopolies, cease and desist monopolistic practices or regulate them. For example, in 1911 the Supreme Court broke up the Standard Oil Company into 33 geographically separate companies. Monopolies of electric and gas utilities are regulated to promote public interest.
The second reason for market failure is when producers do not fully bear total costs of products or are unable to capture all benefits of producing products. For example, oil and gas producers in Utah do not bear the full cost of health hazards their pollution imposes on population in the Uintah basin as well as in the Salt Lake valley. Many of the benefits of basic research and development and education pass on to others who do not pay the total price for inventions and knowledge production. Another example is when uninsured people seek health care in emergency clinics, thus causing higher premium costs to insured people. All such cases require government regulation or taxes or subsidies to improve efficiency of markets. A British economist A.C. Pigou, presented the earliest and most cogent discussion on market failure in 1920 in his book, The Economics of Welfare.
Third, market fails when there is a common property resource. Common property is nobody's property, hence the property is misused. For example, Great Lakes, Amazon Rainforest, Yellowstone National Park, national parks in Utah, Great Salt Lake are common property resources. Such resources cannot be privatized; the government has to intervene to preserve common property. The fourth reason is lack of information, misinformation or asymmetry of information. For example, the recent mortgage crisis was partly the result of asymmetry of information and/or misinformation to the participants, especially the borrowers. Health insurance also faces the problem of asymmetry of information. Therefore there is a need for regulations in such markets.
Finally, risk and/or uncertainty may be an impediment for free markets to provide products, which may be welfare-maximizing for the society in the future. For example, production of renewable energy and construction of transmission lines are very risky ventures at early stages of development, hence this sector will require government assistance to grow, just like railroads and system of canals did in the 19th century.
There are a host of other areas where free markets will not work efficiently and promote public welfare as envisioned by Adam Smith without some government intervention: for example, areas of product safety, workplace safety, airwaves allocation, oil and gas exploration. Therefore government intervention is essential for the working of free and competitive markets. I do recognize that government intervention in markets should be measured for efficient operation of markets. But indiscriminately diluting regulations, taxes, subsidies and user fees, which are essential parts of a vibrant free-market competitive economy, may result in undesirable consequences which no one would value.
Mathur is former chair of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden. His articles also appear in vijaykmathur.blogspot.com. He offers original blog posts for the Standard-Examiner at http://blogs.standard.net/economics-etc/.