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Free market illustration
Often public policy questions center on the division of responsibility between the levels of our government and the market. For example, how extensively should government intervene in the market for the extraction, refinement and sale of fossil fuels; or the market for health insurance; or for higher education? Questions of this type are both economic and political, with “conservatives” urging reliance on markets free of government interference, while “progressives” tend to lean toward government solutions. Resolving these predilections requires a rigorous way to think about markets—and how “free” they should be.
Since 1776 when Adam Smith founded modern economics, peer reviewed research has produced an intensely logical model of how markets would work under idealized preconditions. The result is called the “Free Market Model,” an essential teaching tool in college and advanced high school economics classes. A working knowledge of the model is among the standard prerequisites for study in economics and in business and public policy schools. The model shows how the price system provides incentives for profit-seeking investors and innovators to form enterprises to produce and sell goods and services to the buyers, who, in turn, are described as well-informed about the quality, durability, safety and other characteristics of what they are buying. In this model, all market exchanges—buyer/seller; employer/worker; entrepreneur/banker—are voluntary and “mutually advantageous.”
The conclusions that can be drawn from this model include one of the great insights of Adam Smith: when there is competition among a large number of firms in a market, the profit-seeker promotes the betterment of society as a whole, even though “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.”
The free-market model is deductive; its conclusions are drawn from axioms or preconditions. When some or all of the necessary preconditions of the free market are absent, the societal benefits of efficiency and innovation cannot be expected.
Role of Government
To protect the pre-requisites of market efficiency, government must provide contract law, accident law and criminal law, as well as police, fire and military protection. But the complementarity of government and markets does not end there; Smith further warns that the essential pre-requisite of competition might be undone by the profit-seekers: “People of the same trade seldom meet together, even for merriment and diversion, but [when they do] the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
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Concentration of Economic Activity:
Some of our most important services are sold to us in markets that have too few firms to foster competition. For example, the airline industry has only four major domestic airlines; the meat-packing industry has only four major producers; and the internet only two major search engines. Other important goods and services are sold to us by public utility monopolies, e.g., the distribution of electricity, natural gas, water, cable TV, internet connectivity and sewer services.
Patents
Because inventions are easier to copy than to invent, the government grants inventors temporary protection from competition. During that temporary period, the inventors enjoy monopoly profits as the reward for their inventive and creative activity. When that period is over, the secret behind the invention becomes public knowledge so that competitive markets can bring the benefit of the invention to a broader market. Counter-intuitively, competition must be suppressed temporarily in order to incentivize innovation and to enhance eventual competition.
Public goods
By their nature, some goods and services cannot be owned by individuals; they must be shared. Tradable ownership rights cannot be well defined for such public goods as national defense, as well as public parks, streets, roads, broadband, police stations, ports, communication satellites and railroad rights of way. These are long-lived productive assets in the public sector, provided by the government and paid for with taxes.
This small sample shows the key point raised by Smith and refined to the present day: the economic prosperity of the nation—in America, a society of 330 million people—relies both on a market system and different levels of representative government. The market alone cannot perform the broad range of economic activity the nation needs. Understanding the free market, its limitations, and its role in formulating the right mix of market and government activity, would help move policy makers toward cooperation and away from the ideological polarization that hampers progress today.
