3 – CLASSICAL BEAUTY AND THE BEAST
The free market! The concept is a wonderful and satisfying idea. It brings clarity to economic exchanges and shows how freedom and prosperity are related. It is a great achievement. With its simplicity and scope it has captured hearts and minds for over two hundred years. It shows how everyone can benefit when independent buyers and sellers interact in a free market, all looking for the best bargains and the most profits, each pursuing their own purposes. Everyone is satisfied with their bargains, the entire society benefits and, best of all, no one is trying to make it happen. As Adam Smith put it in his book The Wealth of Nations: [1]
“. . . he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
Such a simple idea has amazing consequences. Prices find a level where buyers and sellers agree. No supervision is needed. The free market, lovingly described and explained by its enthusiasts, is at the heart of so-called classical economics. Smith’s invisible hand seems so convincing that it surely must be true and apply throughout the economy. Whenever you buy or sell in your own interest it will have a good effect. How soothing to bad consciences! Smith gave commerce, from the nineteenth-century onward, a creed. British economist Joan Robinson called it “the ideology to end ideologies, for it. . . abolished the moral problem. It was only necessary for each individual to act egotistically for the good of all to be attained.” [2] It was a religious metaphor translated into the sphere of money and commerce. Free-market advocates easily adopted the belief that self-interested actions would benefit society as a whole.
I found that Adam Smith was, however, a much more wise and subtle thinker. His Wealth of Nations went far beyond his remarks above on markets. He wrote that a free market could not operate without the restraints on individual behavior provided by law and religion. He also noted that businessmen could hardly ever gather together without plotting to restrain trade. But the creed was his popular legacy. It is the foundation of the introductory course Economics 101 as it’s taught today.
Another free market concept is that the supply, demand, and prices for goods are all related. Adam Smith knew that an increase in an item’s price would decrease consumer demand whereas a fall in price would increase demand. Producers, on the other hand, would increase output and raise prices if demand strengthened. Prices would find a level where balance is achieved. The French economist Antoine Augustin Cournot first proposed this in 1838 but his work was forgotten for more than 100 years. The great English economist Alfred Marshall produced a fully developed mathematical theory of supply and demand in 1890.
The Law of Demand takes the consumer’s point of view. It is an intuitive, easily understood idea. People accept it without difficulty because it fits with their own everyday experience; it’s just plain common sense. It’s described to students of economics this way: When a graph is plotted with the price of a good shown on the vertical axis and its quantity demanded on the horizontal axis, their relation appears as a downward-sloping curve from left to right, called the demand curve. At the left side, the price of a good is high and consumer demand is small. If the price decreases demand will increase, so the curve slopes down and to the right. Demand is highest and price is lowest at the lower-right side of the graph.
There is also a Law of Supply which applies to producers. Since they can sell more of their products when demand is high they will increase supply and also raise prices to increase their revenue. On the other hand, if demand is low they will decrease supply and lower prices in order to maintain revenue. This makes sense from the producer’s point of view. The supply curve for a product is a graph showing price on the vertical axis vs. the quantity that producers will supply at a given price. It slopes upward from left to right, from a low price and low amount supplied to higher prices as higher amounts are supplied. If consumers are not willing to buy, producers will supply less and reduce prices. However, if demand rises, producers will increase output and raise prices for greater profits. The supply curve goes up to the right as supply goes up and prices increase.
This tug of war between producer’s profitability and consumer’s frugality stops when the price rises to the point where demand levels off, and supply increases no further. At this particular price, the number of units consumers are willing to buy equals the number of units producers are willing to supply. Economists call it the ‘clearing price’ and say that the market clears at this price. The supply and demand curves intersect at this price. This balancing of consumer and producer motivations is called the Law of Supply and Demand. It is a property of a free market, because it results from the decisions of many independent consumers and producers and is not dictated by anyone. The law of supply and demand is elegant. It is self-adjusting, automatic, and eliminates any need for interventions like subsidies and administered prices. It’s a key concept of classical economics.
Adam Smith and other early economists didn’t spell out details of how supply and demand operate in a real free market. Later economists pondered about the conditions needed for them to actually work. The actual way that prices were arrived at was hard to pin down and remained vague. Unsatisfactory gimmicks like an ‘invisible auctioneer’ were put forward, wherein a buyer and seller could arrive at a price in a market without doing face-to-face negotiations. How did they actually arrive at their bargain? More questions seem to hang in the air. Was it legitimate? Was it fair? Did one party have no choice or only bad choices? Was there money under the table? Would it matter if there were? What if the seller knew the goods were defective or stolen? How many prospective buyers and sellers were involved in a free market; were there one-on-one, one-on-many, or many-on-one?
It was recognized that real markets could not be free, in Adam Smith’s sense, unless some pre-conditions were met. For example, both parties had to buy and sell willingly and negotiate in good faith. Of course, you may say, that’s elementary, but this postulate had to be presumed without question though the real world is full of cheats and scoundrels. The butcher must keep his thumb off the scale and the antique dealer has to pay a fair price for grandma’s Chippendale. Furthermore, the ability to bargain means more than merely a desire to do so. Both buyer and seller must be “free to choose” in Milton Friedman’s immortal phrase. They must negotiate on nearly equal terms with each other. A hungry man dealing with a grocer is not in that position, nor is a sick person and a doctor. Also, both parties must have the power to break off negotiations and decide not to buy or sell. It goes without saying, and usually does, that there is no hint of pressure or favoritism on either side. That’s part of dealing in good faith.
I often read of the parable of the buyer and the seller, one on one, the village shopkeeper and a likely customer, illustrating price-setting in the marketplace. They haggle over features, quality, suitability, cachet, and yes, price. “Tell you what I’m going to do.” “You’re trying to squeeze blood out of me!” It’s all very personal, not arms-length dealing. If they finally agree a price is set, a deal is done, and they’re both satisfied. Perhaps not happy, but satisfied. A price has been discovered, as an economist would say. However, the price may be different if the customer and proprietor know each other well. Although they treat each other openly and honestly their social relationship may change the price agreed upon. Neither party is trying to cheat the other but new factors are being considered. What is an economist to make of this? Which price is the “true” one? The economist can’t possibly understand all the thoughts, motivations, and haggling going on. The participants probably don’t either. This is an enigma, a black hole, at the heart of economic theory. But all is not lost. Economic theory strikes back! This complicated situation is simplified by introducing the ‘rational economic man’ homo economicus. This fictional person is presumed to ignore all those messy things and consider only the properties and the price of what he wants to buy. Social influences and unconscious motivations are wiped away by this masterstroke. Discovered prices collapse into a small range. If the hagglers can’t agree on a price they’ll break it off; no goods for the customer and no profit for the shopkeeper. But there is still no guarantee that negotiations with different customers will arrive at a single ‘true’ price. Something more needs to be added. Customers need some extra leverage. They should be able to try another shop that sells the same thing. That’s it! Competition! That’s the crucial idea. Now the consumer is king. He can pick and choose between retailers, comparing only their prices. He can pit one vendor against another and beat prices down. But this is still, not yet, really and truly, a free market because it is now a single buyer vs. multiple sellers.
A single buyer can force prices down against all sellers but they can’t force prices up against him without colluding with each other. If they did so a many-seller single-buyer relationship would exist, called a monopsony. The reverse situation, with a single seller and many buyers, called a monopoly, wouldn’t work either for the same reason. A genuine competitive free market requires many independent buyers and sellers for each good.
So, let’s summarize the rules needed to create a free market out of the confusion of ills that commerce is heir to. Where do we stand thus far? We know that buyers and sellers should:
- Enter into negotiations willingly;
- Be honest and negotiate in good faith;
- Be able and free to choose alternatives, or to quit buying and selling;
- Negotiate on nearly equal terms of power, status, and information;
- Consider the prices and qualities of products but not other factors;
- Compete, with multiple buyers and sellers for any product.
These requirements permit a free market to operate once it exists. But if the law of supply and demand is to operate too, even more conditions have to be added:
- Many transactions between many buyers and sellers are needed.
- Buyers always know the properties of the goods sold and their current prices in the market.
- Transactions are independent of one another. The result of one negotiation does not directly affect the outcome of others. (For example, people don’t buy something just because its price is rising, as in a speculative bubble.)
- Prices are free to rise or fall as needed to equalize supply and demand at all times. Prices are not “sticky,” as might be caused by long-term contracts or government regulations.
- The supply and demand of goods can always accommodate each other.
- There are never excessive shortages or oversupplies. That is, there are never buyer’s or seller’s markets.
- There aren’t any goods available, in the mind of the buyer, which will directly substitute for the good desired. The buyer must compare vendors with each other for only the good sought. Such goods are called non-substitutable.
- A good sold must be consumed by only a single user. That is, its consumption prevents use by other possible consumers. These are called rival goods. Examples are a tankful of gasoline or an ice cream cone. (Non-rival goods, like movies, can be used simultaneously by many consumers.)
- Transactions are risk free and executed without fees or other extraneous costs. Cash on the barrelhead. No bounced checks or waiting until payday.
- Transactions do not substantially help or harm other parties. There are no free riders or externalized costs paid by others.
And finally, there some necessary boundary conditions which are usually taken for granted:
- The value of money is stable – inflation and deflation are absent;
- The government properly and uniformly enforces the laws, particularly those of property and contract;
- The economy is normal, that is, it’s not in a state of rapid change. Inflows and outflows are steady, profits are good, and jobs are stable. An economist would say the economy is near equilibrium.
When all of these conditions are in place, a free market can exist and the law of supply and demand can function. The invisible hand can go to work. If consumers demand more, prices rise and producers increase supply. Production increases until demand is satiated and prices level off. If too much is being supplied, prices drop as producers get rid of inventory and consumers can afford to buy more. As a result, supply and demand meet each other. Trading and pricing become steady, or nearly so. Expectations are for more of the same. Any changes bring about forces which act to restore the status quo. This wonderfully balanced situation is what classical economists call ‘equilibrium.’
It should be obvious that in the real world these rules and conditions are much too restrictive. It’s nearly impossible to find any true free markets today. They are always being tinkered with. Governments support favored industries with subsidies and tax breaks. Businesses buy up their competitors. Conservatives are right when they complain, “let the markets alone so they can do their magic!” But free markets are merciless as well as magical. If a company provides a good or service that no one wants, it goes out of business. Workers lose their jobs and owners lose their capital. That’s all to the good, say the free market theorists. It’s Joseph Schumpeter’s creative destruction in action, weeding out the losers. Disturbances work their way painfully through the system and gradually, in the ‘long run,’ the economy settles into a new equilibrium. Prices, supply, and demand have all changed but everything is quiet again. Some have benefited and others have been hurt, but that’s the way the free market operates. Problem is, it doesn’t really work that way. Those with political or market power can protect themselves with tax loopholes, price supports, and so forth.
Real-world markets also have recurring “crises” of speculation, inflation, depression and unemployment which cause great distress. Unemployment has been a persistent curse since early industrial times. Classical economists acknowledge these faults but their theories do not, and they certainly can’t explain them. Why do they happen? Where do they come from? Did they happen in the markets Adam Smith wrote about? Yes, they did. He didn’t mention the Dutch tulip mania of 1637 or the South Seas bubble of 1729 which occurred prior to his book of 1776. Further, as had been noted in the 1800s by economists Sismondi and David Ricardo, and later by J. S. Mill and Karl Marx, wealth tended to flow from bottom to top in capitalist societies: from the tenant to the landlord, from the worker to the capitalist, and to concentrate in the hands of the rich. Marx believed this was the cause of capitalism’s crises and predicted a revolution of the lower classes.
In his memoirs, President Hoover said he got the following advice from multi-millionaire Andrew Mellon during the 1931 depression: [3]
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”
That was easy for him to say. Mellon was a self-made man, a powerful banker who financed companies in oil, aluminum and steel. Tycoons like him made grand plans that went far beyond making money. They created big things and broke rules to do it. The steel and railroad barons of the 1890s overwhelmed all competition with ruthless power. Empire and growth triumphed over mere profits. James J. Hill bought, bullied and built the Great Northern railroad. He named its premier passenger train The Empire Builder.
In the Great Depression many banks failed, large numbers of businesses went bankrupt, and unemployment rose to more than twenty percent. How could so much capital vanish and so many people be thrown into poverty? How did free market theory explain such a catastrophe? It could not. The economy was not normal. It was rapidly changing, violating one of the rules above. Could theory describe how the economy slid from normalcy into a crash? Neither Andrew Mellon nor any economist of the time saw the disaster coming or could explain it afterward. It was beyond accepted theory and notions of how the world worked. No wonder rich people gave such bad advice and ordinary people believed the rug had been pulled from under them. Instead of correcting itself, the economy had toppled over like a stack of bricks. There was no denying it had happened, but why? Where did the appealing simplicity of Adam Smith’s butcher and baker, acting in their self-interest but somehow creating benevolence, go awry?
There was something conspicuously missing from the pretty picture of a free market. There was truly an elephant in the room: there was no mention of loaning money at interest. No mention of credit at all. Free market transactions had no delays between purchase and delivery. Therefore transactions were actually barter using money as an intermediary. Credit was something new: I get the goods now and you get the money later. Handing over goods for a promise to pay is taking a risk – which free market theory does not contemplate. If a borrower defaults on a loan the lender’s money is gone, vanished. In years gone by the scoundrel might go to a debtor’s prison since failure to pay was considered a kind of robbery. Today, in our enlightened awareness, bankruptcy laws smooth out such failures. In either case, normal commerce is disrupted. Supply, demand, and price lose their tight connections.
If actual free markets don’t exist, does that mean all markets are merely illusions? No, we have many markets around us that are alive and well. There are seller’s markets for airline tickets, buyer’s markets at yard sales, competitive auction markets for valuable paintings, brokered auction markets for stocks and bonds, regulated markets for liquor, unregulated black markets for scalped tickets. There are subsidized markets for ethanol made from corn and heavily taxed markets for gasoline and tobacco. Why don’t economists explore buying and selling in more than the simple version seen in the textbooks? Maybe it’s too hard for beginning students. Maybe it’s unorthodox. In 1970 economist George Akerlof published a paper titled The Market for Lemons [4] exploring the marketing of used cars, where a salesman knows all about a car’s defects and uses this information to advantage over an ignorant customer. Akerlof found that unscrupulous dealers tended to drive honest ones from the market – a kind of Gresham’s law. His paper was of great interest and has been referenced many times. But it took until 1970 (!), almost two hundred years after Adam Smith, for academic economists to inquire into markets having information asymmetry. That’s terribly late; used cars are not novelties.
I think a broader model of negotiation in markets would help us understand how things actually work in the circumstances all around us. Isolated independent workers take the offered wage or leave it but unionized workers don’t. Independent small businessmen pay the going wage or hire undocumented immigrants. Shoppers at the supermarket pay the listed price at checkout but they haggle with the fruit stand owner. Small customers pay more than big customers. Department stores give big discounts from posted prices without asking. These markets all behave differently. It seems their structures must be partly responsible but how, exactly? Economies can oscillate between boom and bust. There are “animal spirits” and “irrational exuberance.” Then, sometimes, it’s “over the cliff.” Businesses and governments act unexpectedly or do too much, or too little, or too late. When there’s real uncertainty no one knows what to do. If everyone sells stocks at the same time there’s blood in the streets, as they say in Wall Street. Free-market rules go out the window. That’s nowhere near a free market as classical economists think of it. It may seem like chaos but it’s more likely operating by new rules which no one has figured out. Move along folks, no free markets here.