What's Wrong With Markets?

Originally published at: https://participatoryeconomy.org/whats-wrong-with-markets/

The text below is from a virtual talk given by Robin Hanhel about the problems with Markets to Noam Chomsky’s class at University of Arizona in Tucson AZ on the 26 January 2021.

There are four reasons to reject markets if you want to build a desirable economy:

  • Contrary to what most economists will tell you, markets do not allocate scarce productive resources efficiently.
  • Markets distribute the burdens and benefits of economic cooperation unfairly.
  • Markets undermine solidarity and promote egotistical attitudes and behavior.
  • Markets fail to provide economic democracy and subvert political democracy as well.

1. Why Markets Allocate Resources Inefficiently

As a well-published professional economist who has taught economic theory at the highest levels in economic doctoral programs for over forty years, I want to be called as an “expert witness” so I can testsify:

The conclusion that markets can be relied on to yield efficient outcomes is completely unwarranted.

It is well known among professional economists that markets allocate resources inefficiently when they are out of equilibrium, when they are noncompetitive, and when there are external effects. As a matter of fact, what economists call “the fundamental theorem of welfare economics says as much” when read carefully. But despite clear warnings in our most sacred theorems about “necessary conditions,” market enthusiasts continue to insist that if left alone, or perhaps with a little assistance, markets generally allocate resources very efficiently. This could only be true if dis-equilibrating forces were weak, if noncompetitive market structures were uncommon, and most importantly, if externalities were the exception rather than the rule. Unfortunately, there are good reasons to believe that exactly the opposite is true in all three cases, and that policy correctives will prove very inadequate.

A. Externalities Are Pervasive

At the risk of boring you with more economics than you bargained for when you decided to come to class today, I want to take the time to explain this particular failing of markets because it is terribly important. Markets do permit people to interact in ways that are convenient and mutually beneficial for buyers and sellers. But convenience and benefits for buyer and seller do not imply efficiency. Ironically, the very features that render markets convenient and beneficial for buyers and sellers also render them inefficient.

Increasing the value of goods and services produced and decreasing the unpleasantness of what we have to do to produce them are two ways producers can increase their profits in a market economy—and competitive pressures will drive producers to do both. But maneuvering to appropriate a greater share of the goods and services produced by externalizing costs onto others and internalizing benefits without compensation are also ways to increase profits. Moreover, competitive pressures will drive producers to pursue this route to greater profitability just as assiduously. Of course, the problem is that while the first kind of behavior serves the social interest as well as the private interests of producers, the second kind of behavior serves the private interests of producers at the expense of the social interest. All economists agree that when sellers or buyers promote their private interest by externalizing costs onto those not a party to the market exchange, or by appropriating benefits from other parties without compensation, their behavior introduces inefficiencies that lead to a misallocation of productive resources, and consequently a decrease in welfare.

When car manufacturers fail to take into account the damage their sulphur dioxide emissions impose on those damaged by acid rain, they offer to supply more cars than is efficient from society’s perspective. When consumers of cars have no incentive to take into account the damage their emissions of greenhouse gases inflict on victims of climate change, they offer to buy more cars than is socially efficient. Because negative external effects associated with both car production and consumption go ignored in the market decision making process in which buyers and sellers weigh the consequences of their choices only on themselves, we are led to produce and consume many more cars than is efficient. In general, it is well known that markets will underprice and overproduce goods and services when there are negative external effects associated with either their production or consumption, and overprice and under produce goods and services when there are positive external effects associated with either their production or consumption.

The positive side of market incentives has received great attention and praise dating back to Adam Smith who coined the term “invisible hand” to describe it. The darker side of market incentives has been relatively neglected and grossly under estimated. A notable exception was E. K. Hunt who coined the less famous, but equally appropriate term, “invisible foot” to describe the socially counterproductive behavior markets drive participants to engage in.

Market enthusiasts seldom ask: Where are firms most likely to find the easiest opportunities to expand their profits? How easy is it usually to increase the size or quality of the economic pie? How easy is it to reduce the time or discomfort it takes to bake the pie? Alternatively, how easy is it to enlarge one’s slice of the pie by externalizing a cost, or by appropriating a benefit without payment? Why should we assume that in market economies it is infinitely easier to expand private benefits through socially productive behavior than through socially counterproductive behavior? Yet this implicit assumption is what lies behind the view of markets as guided by a beneficent invisible hand rather than a malevolent invisible foot.

Market admirers fail to notice that the same feature of market exchanges primarily responsible for their convenience—excluding all affected parties other than the buyer and seller from the transaction—is also a major source of potential gain for the buyer and seller. When the buyer and seller of an automobile strike their convenient deal, the size of the benefit they have to divide between them is greatly enlarged by externalizing the costs onto others of the acid rain produced by car production, and the costs of urban smog, noise pollution, traffic congestion, and greenhouse gas emissions caused by car consumption. Those who pay for these costs, and thereby enlarge automobile manufacturer profits and car consumer benefits, are easy marks for car sellers and buyers for two reasons. They are dispersed geographically and chronologically, and the magnitude of the effect on each negatively affected, external party is small, yet not equal. Consequently, individually external parties have little incentive to insist on being party to the transaction. The external effect on a single party is seldom large enough to make it worthwhile for one person to try to insert herself into the negotiations. But there are formidable obstacles to forming a coalition to represent the collective interests of all external parties as well.

Organizing a large number of people who may be dispersed geographically and chronologically, when each has different, small amounts at stake, is a difficult task. Who will bear the transaction costs of approaching members when each has little to benefit? When approached, who will report truthfully how much they are affected when it is to their advantage to either over or under exaggerate? In sum, when there are multiple victims they face formidable transaction costs, and what we economists call free rider and hold out incentive problems to acting collectively.

One way to see the problem is that markets reduce the transaction costs for buyers and sellers but do nothing to reduce the transaction cost of participation in decision making by externally affected parties. It is this inequality in transaction costs that makes external parties easy prey to rent seeking behavior on the part of buyers and sellers. Even if we could organize a market economy so that buyers and sellers never face a more or less powerful opponent in a market exchange, this would not change the fact that each of us has smaller interests at stake in many transactions in which we are neither buyer nor seller. Yet the sum total interest of all external parties is often considerable compared to the interests of the buyer and the seller. It is the transaction cost and free rider incentive problems of those with lesser interests that create an unavoidable inequality in power between those who make an exchange and those who are neither buyer nor seller but are affected by the exchange nonetheless. This is the power imbalance that allows buyers and sellers to benefit at the expense of disenfranchised external parties in ways that cause inefficiencies. Since this opportunity to increase private benefits is readily available in market economies there is every reason to believe those who must maximize profits or be competed out of business will take advantage of it—leading to significant inefficiencies.

B. Markets Are Generally Not Competitive

It is well-known among economists that when markets are not competitive they lead to inefficient allocations of resources. When sellers are few it is in their interest to produce an output that is, collectively, less than the amount that is socially efficient. In other words, just as it is often easier to make profits at the expense of disenfranchised external parties than through socially productive behavior, it is also often easier for a small group of sellers to make profits by restricting supply than producing the socially efficient amount of their product. All empirical evidence indicates that most goods today are sold in noncompetitive markets and that market structures are growing less, not more competitive. This means that noncompetitive market structures are a serious and growing source of inefficiencies in market economies.

C. Markets Often Fail to Equilibrate

Professional economists all agree that when markets are out of equilibrium inefficiency results. Moreover, real markets do not always equilibrate quickly, much less instantaneously. The famous “laws” of supply and demand, which predict that when market price rises quantity supplied will increase and quantity demanded will decrease, leading markets toward their equilibria, are based on a highly questionable assumption about how market participants interpret price changes. Standard analysis implicitly assumes that sellers and buyers believe that when the market price rises the new higher price will be the new stable price. If this is truly the case, then it is sensible when market price rises for sellers to offer to sell more than before and for buyers to offer to buy less than before, thereby reducing excess demand—as the “laws” of supply and demand say they will. However, sometimes buyers and sellers quite sensibly interpret price changes as indications of further price movements in the same direction. In this case, it is rational for buyers to respond to an increase in price by increasing the quantity they demand before the price rises even higher, and for sellers to reduce the quantity they offer to sell waiting for even higher prices to come.

When buyers and sellers behave in this way they create greater excess demand and drive the price even higher, leading to a market “bubble.” When buyers and sellers interpret a decrease in price as an indication that the price is headed down, it is rational for buyers to decrease the quantity they demand, waiting for even lower prices, and for sellers to increase the quantity they offer to sell before the price goes even lower. In this case their behavior creates even greater excess supply and drives the price even lower, leading to a market “crash.” In other words, if market participants interpret changes in price as signals about the likely direction of further price changes, and if they behave “rationally,” they will not only fail to behave in the way the “laws” of supply and demand would lead us to expect, they will behave in exactly the opposite way from what these “laws” predict. When this occurs and markets move away from, not toward their equilibria economic inefficiency increases.

Those who argue that bubbles and crashes only occur in a few markets where many players are speculators should remember their own explanation for why all units of a good tend to sell at a uniform market price. Only when people are free to engage in arbitrage do we get “well ordered” markets and uniform prices in the first place. This means mainstream economists must expect and welcome players who are motivated purely by hopes of profiting from trading rather than because they have any use for the particular good being bought and sold. Since those who engage in arbitrage have no interest in the usefulness of the good in question, it seems likely that they would be particularly sensitive to the implications of a change in price on the likely direction of further price changes, and therefore on their profits from trading. In other words, market bubbles and crashes, which all economists agree cause efficiency losses, are generally the result of rational not irrational behavior, and much more likely to occur than mainstream economists would have us believe.

D. Practical Problems with Policy Correctives

When faced with reasons to believe that externalities, noncompetitive market structures, and disequilibrium dynamics are neither rare nor trivial problems, supporters of the market system respond in different ways. There is a clear divide between “free market fundamentalists” whose influence has grown significantly over the past four decades, and more pragmatic supporters of the market system who favor market interventions to create what some of them call “socialized markets.”

The ideologues’ enthusiasm for a laissez-faire market system literally knows no bounds as they brush aside qualifying assumptions as if they did not exist. Market pragmatists, in contrast, concede that we must sometimes intervene in markets with policies to internalize external effects, curb monopolistic practices, and counter dis-equilibrating forces. However, those who give qualified support to market intervention conveniently ignore practical problems that inevitably arise whenever we attempt to “socialize” markets.

  • The job of correcting for external effects is daunting, because there is every reason to believe they are the rule rather than the exception—as market enthusiasts simply assume without providing any evidence whatsoever.
  • Alfred Pigou proved long ago that when there are negative external effects in a market a corrective tax is required to eliminate the inefficiency, and when there are positive externalities a corrective subsidy is indicated. But how are we to know what the size of the external effect is, and therefore how high to set the tax or subsidy? The market offers no assistance whatsoever in this regard, forcing us to resort to very imperfect measures. Stop-gap procedures for trying to estimate the magnitude of external effects like contingent valuation surveys (where economists survey a random sample of those affected and ask them how much they would be willing to pay not to be damaged) and hedonic regression studies (where economists try to deduce how much people are adversely affected by their purchase of related goods that are sold in markets) are notoriously unreliable and therefore highly subject to manipulation by interested parties.
  • Because they are unevenly dispersed throughout the economic matrix the task of correcting the entire price system for the direct and indirect effects of externalities is even more daunting. Even if the negative external effects of producing or consuming a particular good could be estimated accurately and the corrective tax were applied, if the external effects of producing or consuming goods that enter into the production of the good in question are not also accurately corrected for, the theory of the second best warns us that the Pigovian tax we place on the good in question may move us farther away from an efficient use of our productive resources rather than closer.
  • In the real world, where private interests and power take precedence over economic efficiency, the beneficiaries of accurate corrective taxes are all too often dispersed and powerless compared to those who would be harmed by an accurate corrective tax. As Mancur Olsen explained long ago in The Logic of Collective Action, this makes it very unlikely that full correctives would be enacted even if they could be accurately calculated.
  • People also learn to adjust to the biases created by external effects in the market price system. Consumers will increase their preference and demand for goods whose production and/or consumption entails negative external effects but whose market prices fail to reflect these costs and are therefore too low; and consumers will decrease their preference and demand for goods whose production and/or consumption entails positive external effects but whose market prices fail to reflect these benefits and are therefore too high. While this reaction, or adjustment, is individually rational it is socially counterproductive since it leads to even greater demand for the goods that market systems already over produce, and even less demand for the goods that market systems already under produce. As people have greater opportunities to adjust over longer periods of time, the degree of inefficiency in the economy will grow or “snowball.”
  • In theory, inefficiencies due to noncompetitive market structures can be solved by breaking up large firms, i.e. through antitrust policy. But true economies of scale provide good reasons for sometimes not doing so, and corporate power provide bad reasons for seldom doing so. Noncompetitive market structures are routinely tolerated simply because large firms are politically powerful and successfully pressure the political system to permit them to continue their profitable but socially inefficient practices. An alternative to antitrust action is to regulate large firms in noncompetitive industries. But this practice is also, regrettably, in decline, as regulatory agencies are increasingly “captured” by the companies they are supposed to regulate and turned into vehicles for promoting industry objectives.
  • There are well known policies to ameliorate inefficiencies due to market disequilibria. Both fiscal and monetary policies can be used to stabilize business cycles. Indicative planning and industrial policies can be used to eliminate disequilibria between sectors of an economy. Regulation of foreign exchange and financial markets particularly prone to bubbles and crashes are almost always an improvement over ex post damage control consisting mostly of bailouts for powerful economic interests most responsible for creating problems in these markets in the first place. Unfortunately, neoliberal ideologues and the corporate interests they serve have waged a relentless campaign against these policies over the past four decades, and both national economies and the global economy have experienced huge losses in economic efficiency as a result.

In sum, contrary to both popular and professional opinion, free markets lead to a very inefficient use of our scarce productive resources, and even when “socialized” by policy correctives, a great deal of inefficiency inevitably remains.

2. Why Capital and Labor Markets are Unfair

When capitalists hire workers, the profits capitalists receive for no work on their part are testimony to the fact that collectively their employees were not paid wages equal to the market value of what their work produced. But beside the fact that capitalist income is unfair because those who do all the work receive too little as a whole, what should we make of differences in wage rates for different categories of workers?

If the last hour of welding labor hired raises output and therefore revenue by more than the last hour of floor sweeping does, when employers compete with one another in labor markets for welders and sweepers they will bid the wage rate for welders up higher than the wage rate for sweepers. This means that when labor is hired in labor markets those who have more human capital, and therefore contribute more to enterprise output and revenues, will receive higher wages than those with less human capital.

Why is this a problem? Suppose our welder and sweeper work equally hard in equally unpleasant circumstances. In a market economy they will not be rewarded equally even though they make what we might call equal “sacrifices.” In a market economy those with more human capital will receive more, even if they work no harder and make no greater sacrifices, and those with less human capital will receive less, even if they work just as hard and sacrifice just as much.

Moreover, for all of us who understand this is unfair there is no way to fix the problem in a market system without creating a great deal of inefficiency. If we intervene in the labor market and legislate wage rates we consider to be fair, but allow markets to determine how resources are allocated, not only will different kinds of labor be allocated inefficiently, the entire price structure of the economy will fail to reflect the opportunity costs of producing different goods and services leading to further inefficiencies. There is no getting around the dilemma: In a market economy we must either allow the market system to reward people unfairly, or, if we try to correct for inequities we must tolerate even greater inefficiencies.

3. Why Markets Undermine the Ties that Bind Us

Disgust with the commercialization of human relationships is as old as commerce itself. The spread of markets in eighteenth-century England led Edmund Burke to reflect: The age of chivalry is gone. The age of sophists, economists, and calculators is upon us; and the glory of Europe is extinguished forever.” Thomas Carlyle prophesized: “Never on this Earth, was the relation of man to man long carried on by cash-payment alone. If, at any time, a philosophy of laissez-faire, competition, and supply-and-demand start up as the exponent of human relations, expect that it will end soon.” And of course running through all his critiques of capitalism, Karl Marx complained that markets gradually turn everything into a commodity and, in the process, corrode social values and undermine community:

“With the spread of markets] there came a time when everything that people had considered as inalienable became an object of exchange, of traffic, and could be alienated. This is the time when the very things which till then had been communicated, but never exchanged, given, but never sold, acquired, but never bought—virtue, love, conviction, knowledge, conscience, etc.—when everything, in short passed into commerce. It is the time of general corruption, of universal venality….It has left remaining no other nexus between man and man other than naked self-interest and callous cash payment.”

The Poverty of Philosophy [Progress Publishers, 1955], chapter 1, section 1

In my view what the oldest critique of markets amounts to is an objection to the organization of economic cooperation in a way that is personally distasteful and demeaning, and unnecessarily sours human relations. It is a plea to others to come to their senses and join the search for a different way to organize economic cooperation. The forms of interaction that are encouraged by markets are mean spirited and hostile, the forms of cooperation that markets discourage are respectful and empathetic, and the detrimental effects on human relations are far from trivial.

In effect, markets say to us: You humans cannot consciously coordinate your interrelated economic activities efficiently, so do not even try. You cannot come to equitable agreements among yourselves, so do not even try. Just thank your lucky stars that even such a hopelessly socially challenged species such as yourselves can still benefit from a productive division of labor, thanks to the miracle of the market system. In effect, markets are a no-confidence vote on the social capabilities of the human species.

If that daily message were not sufficient discouragement, markets harness our creative capacities and energies by arranging for other people to threaten our livelihoods. Markets bribe us with the lure of luxury beyond what others can have and beyond what we know we deserve. Markets reward those who are the most efficient at taking advantage of his or her fellow man or woman, and penalize those who insist, illogically, on pursuing the golden rule—do unto others, as you would have them do unto you. Of course, we are told we can personally benefit in a market system by being of service to others. But we also know we can often benefit more easily by taking advantage of others. Mutual concern, empathy, and solidarity are the appendices of human capacities and emotions in market economies—and like the appendix, they continue to atrophy.

But there is no need to take the word of pre-capitalist romantics like Burke and Carlyle, or the word of the greatest critic of capitalism, Karl Marx, or the word of an avowed market abolitionist such as myself on this matter. Samuel Bowles, an economist who strongly supports a “socialized” market system, provides eloquent testimony regarding this failure of markets in an article titled “What Markets Can and Cannot Do” published in Challenge Magazine in 1991. Bowles said:

“Markets not only allocate resources and distribute income, they also shape our culture, foster or thwart desirable forms of human development, and support a well defined structure of power. Markets are as much political and cultural institutions as they are economic. For this reason, the standard efficiency analysis is insufficient to tell us when and where markets should allocate goods and services and where other institutions should be used. Even if market allocations did yield efficient results, and even if the resulting income distribution was thought to be fair (two very big “ifs”), the market would still fail if it supported an undemocratic structure of power or if it rewarded greed, opportunism, political passivity, and indifference toward others…. As anthropologists have long stressed, how we regulate our exchanges and coordinate our disparate economic activities influences what kind of people we become. Markets may be considered to be social settings that foster specific types of personal development and penalize others. The beauty of the market, some would say, is precisely this: It works well even if people are indifferent toward one another. And it does not require complex communication or even trust among its participants. But that is also the problem. The economy—its markets, workplaces and other sites—is a gigantic school. Its rewards encourage the development of particular skills and attitudes while other potentials lay fallow or atrophy. We learn to function in these environments, and in so doing become someone we might not have become in a different setting. By economizing on valuable traits—feelings of solidarity with others, the ability to empathize, the capacity for complex communication and collective decision making, for example—markets are said to cope with the scarcity of these worthy traits. But in the long run markets contribute to their erosion and even disappearance. What looks like a hard headed adaptation to the infirmity of human nature may in fact be part of the problem.”

4. Why Markets Subvert Democracy

Confusing the cause of free markets with the cause of democracy is astounding given the overwhelming evidence that the latest free market jubilee has disenfranchised ever larger segments of the world body politic. The cause of economic democracy is not being served when thirty-year-olds with an MBA degree working for multinational financial companies trading foreign currencies, bonds, and stocks in their New York and London offices affect the economic livelihoods of billions of ordinary people who toil in third world economies more than their own elected political leaders.

First, markets undermine rather than promote the kinds of human traits critical to the democratic process. As Bowles explained in the essay quoted previously:

“If democratic governance is a value, it seems reasonable to favor institutions that foster the development of people likely to support democratic institutions and able to function effectively in a democratic environment. Among the traits most students of the subject consider essential are the ability to process and communicate complex information, to make collective decisions, and the capacity to feel empathy and solidarity with others. As we have seen, markets may provide a hostile environment for the cultivation of these traits. Feelings of solidarity are more likely to flourish where economic relationships are ongoing and personal, rather than fleeting and anonymous; and where a concern for the needs of others is an integral part of the institutions governing economic life. The complex decision-making and information processing skills required of the modern democratic citizen are not likely to be fostered in markets.”

Second, those who are more wealthy generally benefit more than those who are less wealthy from market exchanges. As long as capital is scarce—that is, as long as more capital could make someone’s labor more productive than it is currently—it is predictable that those with more capital will capture the lion’s share of any efficiency gains from exchanges not only in labor and credit markets, but in goods markets as well. Moreover, this is not only true in noncompetitive markets but even when market structures are competitive. In other words, economic liberalization breeds concentration of economic wealth, and in political systems where money confers advantages it leads indirectly to the concentration of political power as well. Those who deceive themselves and others that markets nurture democracy ignore the simple truth that markets tend to aggravate disparities in wealth and economic power.

It is true that the spread of markets can undermine the power of traditional elites, but this does not imply that markets will cause power to be more equally dispersed and democracy enhanced. If old obstacles to economic democracy like kings and nobles are being replaced by new, more powerful obstacles in the persons of chief executive officers of multinational corporations and multinational banks, the new global mandarins at the World Bank and International Monetary Fund, and if these new elites are more effectively insulated from popular pressure than their predecessors, it is not the cause of democracy that is served.

Support for the theory that markets promote democracy stems from the dominant interpretation of modern European history in which the simultaneous spread of markets and political democracy is assumed to be because the former caused the latter. It is hardly surprising that perhaps the most intrusive social institution in human history would have disrupted old, pre-capitalist obstacles to democratic rule in pre-capitalist Europe. The question, however, is not whether markets undermine old structures of domination—which they clearly do—but, if the new patterns of economic power that markets create are supportive or detrimental to democratic aspirations. I am skeptical that markets deserve nearly as much credit as mainstream interpretations award them for the emergence of European political democracy. I suspect this interpretation robs Europeans who fought against the rule of monarchy and feudal lord in the seventeenth, eighteenth, and nineteenth centuries, Europeans who fought for universal popular suffrage in the nineteenth and twentieth centuries, and all who fought against fascism in the twentieth century of much of the credit they deserve. But a worthy rebuttal to the thesis that we owe whatever advances political democracy has made to the rise of the market system would require much more time than we have here today, and require more historical knowledge than I pretend to have.

Conclusion

In sum, inefficiency due to external effects is significant. Hope for reasonably accurate Pigovian correctives is a pipe dream. Market prices diverge ever more widely from true social opportunity costs as individuals have every reason to adjust their desires to accommodate significant institutional biases in the market system. Efficiency losses also mount as real markets become less competitive, with no sign of meaningful antitrust or regulatory correctives in sight. And, as financial regulation, stabilization policies, and industrial policies all fall out of vogue, efficiency losses due to market disequilibria escalate even further.

In short, the invisible foot is gaining strength on the invisible hand every day! Meanwhile, market exchanges continue to empower those who are better off relative to those who are worse off—undermining economic and political democracy—and the antisocial biases and incentives inherent in the market system continue to tear away at the tenuous bonds that bind us. To avoid all this we must find an alternative way to plan and coordinate the interrelated economic affairs of workers and consumers.

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This is a great summary. Thanks for posting it!

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