Tuesday, December 30, 2008

Why Does Government Interfere With Markets?

Since I wrote my blog post on big vs. small business I have been thinking a fair amount about the role of commerce in society as a whole and our view of commerce in the United States.

This story has to do with the cultural narrative about economics and choice. In some of the circles in which I run it seems that people have a simplistic notion of economics. The basic story is that the free market, unencumbered by government intervention, is an ideal condition and that deviation from this ideal is a distortion that is bound to backfire. I do not put this argument forward as a straw man. I hear the simplistic point of view expressed and I think it influences public debate and policy in the United States. Since the financial meltdowns and obvious abuses of 2008, the argument has lost some power, but it is still seems to be a bedrock view for many people.

The argument starts off with free market economics. In a free market buyers and sellers negotiate with each other to establish prices. Goods that better satisfy a need are more popular in the marketplace and command a higher price and perhaps higher profit. Higher profit draws competition which tends to reduce price and profit. This in turn spurs innovation in both production (lower production costs at a fixed price increases profit) and the good itself (better satisfaction of the consumer need leads to higher price and profit).

The second step is laissez-faire economics. If a free market leads to better satisfaction of self stated needs (ever cheaper and better products), then any interference with the operation of a free market is a distortion that will lead to less than optimal results. In this view, government intervention in markets should be restricted to ensuring that they are free. Any discussion of government intervention centers around whether the market has ceased to be free and what the corrective mechanism should be. For example, intervention to break up monopolies may be considered to be a restoration of a free market. If there is a single supplier of a good and that supplier can prevent the emergence of competitors the free market ceases to operate and government may intervene to restore the free market.

In outline this seems sensible and, I believe, is the basic narrative for economic discussion in the United States. There are some hidden simplifications in this basic narrative. Serious discussions of economics and society should at least acknowledge some of the additional complexities. I will go through a some of these in what I consider to be reverse order of importance. As I move toward the more important considerations the discussion moves farther from strictly economic concerns.


Hidden in the free market explanation is the assumption that the important parties in an economic transaction are the buyer and seller. This is often untrue. The classic case is pollution. A mine or factory may produce a good but as a side effect pollute air, water or land. The people downwind or downriver may pay a price for additional health care or reduced utility of their property, but this cost is not reflected in the transaction between buyer and seller. These are called externalities because they are costs or benefits that are external to the buyer and seller in the transaction. When the externality is a cost, the price paid for a good is artificially low, so the good tends to be overproduced relative to the overall benefit. While we normally discuss externalities in terms of costs there can be external benefits as well.

Externalities are sometimes time-based. This brings up a second shortcoming of the simple free market story. Transactions are based on immediate needs and products. It is true that each actor may be planning for the future, but the transaction is today and the evaluation of price takes only the immediate situation into account. This is easy to see in the exploitation of natural resources. The cost of tropical hardwood is based on the immediate supply of tropical trees. As long as there are large stands of forest, the cost of the hardwood basically reflects the cost of cutting and transport. As the forests decline, the wood will become more scarce and the price will increase. But that will only occur after the native utility of tropical forest is lost, essentially forever. The immediate cost and profit available from the trees is taken into consideration, but future utility of the rainforest is not.

For future externalities some of the problems are often simplified as the "tragedy of the unregulated commons". For situations like logging and fishing, the resource is not controlled, so there is no immediate incentive for anyone to restrict their activity. Each individual has an incentive to exploit the resource until it is gone.

In the United States the predominant reaction to the tragedy of the unregulated commons is to privatize the resource. For example, pollution can be addressed by capping and trading emissions. Resources like fisheries can be sold to individuals. This gives the owner a greater incentive to consider the long term in managing the resource. There is another solution. The basic problem is the tragedy of the unregulated commons. Resources can be regulated instead of owned. For example, Balinese rice farmers traditionally handled allocation of water by setting irrigation schedules. The water was controlled by the community instead of individuals and a water board arranged irrigation schedules to grant use to the farmers in the community. Once we agree on a problem, the solution may depend on both the physical and social situation. For example, for preserving fisheries a combination of protected reserves around the most productive areas and owned fishing rights in other areas seems to be most effective.


To the extent they can, businesses will always externalize costs. A cost not paid is direct profit to the business. A simple example can be seen in the retail market. In many stores there is no one who actually understands the products being sold. The job of understanding the products and their fitness for the task is left completely to the consumer. This allows the store to hire fewer, less skilled, and cheaper workers. On the whole, consumers seem to prefer this model. There has always been a conflict of interest between the salesman as a purveyor of information and the salesman as someone trying to sell the products on the floor. Another example, is "big box" stores like Sam's Club or Home Depot. These are essentially warehouses open to the public. The selection and price make it likely that the consumer will find something close to what they need at a relatively low price. The externalized costs include transportation. The larger store draws customers from a larger area, so rather than have to reship to more, smaller, local stores the company can stock a single warehouse and let the consumer transport goods the final miles.

For many businesses the largest cost is labor. Lowering labor costs can be done in a number of ways. Typical techniques include automation, de-skilling work, and externalizing labor costs. Automation typically reduces the amount of human input needed in a process. On the whole, this tends to increase the quality and reduce the cost of goods and services. Skill implies experience and training. Skilled workers get higher pay because it is cheaper for the business to pay a higher wage to a known skilled worker than to risk the time, energy and lost productivity of training an unskilled worker. Externalizing labor costs can be done in a couple of ways. Pushing needed work outside the boundaries of the business decreases labor costs. So does forcing labor costs outside the business.

The contemporary supermarket shows all these trends. The supermarket itself was an innovation that reduced labor costs by having the consumer choose products directly off the shelf (externalize work). Two generations ago, supermarket prices were marked on each object. Stockers had to both put items on the shelf and mark the prices. The advent of the bar code and scanner eliminated the need for marking prices on individual items (automation). It also eliminated the need for checkers to know produce prices or how to work a cash register (de-skilling). The checker's job today is sufficiently deskilled that customers now check themselves out (externalize work). This does two things, it reduces the number of employees needed and it reduces the wages of those who are left because they can be replaced easily.

Forcing labor costs outside the business is an interesting development. Businesses do this on both a short term and a long term scale. When there are jobs, highly skilled workers are largely exempt from these processes because they can demand and receive higher wages. In the short term, unskilled labor always commands a lower price. The floor of this price is somewhere near the minimum amount of pay it takes for a single person to live. The existence of a public safety net reduces this number. For example, if a low income person can have food subsidized through government food stamps, and medical care through Medicaid, then the business hiring low skill workers can effectively subtract that amount from the wages paid to low skilled workers. In one idealized labor market, workers move completely freely between employers and employers pay for exactly the work done while the person is working. Unfortunately, people sometimes get sick and always, if they are lucky, get old. The most fortunate among us spend about a quarter of our lives under the care of others and unable to gainfully work. The society as a whole must pay for this downtime. For a brief period of time in the United States, many employers took long term responsibility for workers in the form of pensions. These defined benefit plans have essentially disappeared and it is the responsibility of employees to make provisions for old age in the form of defined contribution plans (e.g. 401K plans). Employers may provide such retirement plans, but are not compelled to. Employers may contribute to these plans, but are not compelled to. The net effect is to push the long term care of those who cannot work, particularly low wage earners, onto the government.


In a true free market, both buyer and seller freely enter into an agreement and choose to make the trade. In fact, this ideal rarely holds. When we add to that the almost limitless capacity for cruelty in our species, abuse and exploitation become almost inevitable.

Asymmetry in trading power only matters if one party or the other is effectively forced to trade. It is unimportant for non-essential goods. For example, manufacturers of television sets can conspire on price. This will raise their relative prices, but if the price becomes too high, buyers will simply withdraw from the market. Essential goods include employment, food, and shelter. Employment is probably the most important of these and the root cause of much abuse.

First let me say that employment is a squishy concept because individuals do not have to trade their labor for money. Anyone who has skills or goods can become self employed. That said, the ability of people to become self employed also depends on macro economic conditions. The level of self-employment has varied tremendously over time. In the United States, self employment probably reached its zenith in the early Eighteenth Century when vast tracts of land were opened to ordinary people and the ideal of a country of yeoman farmers seemed within reach. Right now, no more than 10% of the population is self employed http://www.smallbusinessnotes.com/aboutsb/rs243.html.

When there are more people than jobs, pay decreases and conditions become more miserable. To understand the necessity of government intervention, the words "triangle shirtwaist factory" should be sufficient. The height of abuse can be seen in company towns, where the employer controls not just employment, but food and shelter as well. Prices for necessary commodities can be set slightly higher than wages resulting in virtual slavery. As the Merle Travis song says:
You load sixteen tons and what do you get?
Another day older and deeper in debt.
Saint Peter, don't you call me 'cause I can't go,
I owe my soul to the company store.


I certainly feel best when I can freely make my own choices. I like to think I make good decisions and I suspect others feel the same way. It seems to be an article of faith in the U.S. that these sorts of personal and local decisions lead to an optimum (whatever that means) for the society as a whole. Or if individual decisions do not lead to a global optimum, they are still better than any other decision making regime. This fits well into laissez-faire, free market economics. If each of us is left alone in the economic sphere things will work out as well as they can.

We can take this a step further and say that the definition of global optimum is the result of completely free economic choice. Let us avoid that tautology. In social situations, where each person has his or her own views, it is hard to make any decisions about "best" or "optimal". However, there are situations that we can agree are "not best". As a society we have some agreements about unacceptable situations. Check the papers after someone has been denied medical care and died as a result (http://www.msnbc.msn.com/id/25475759/, http://www.bookrags.com/news/911-dispatchers-denied-dying-woman-moc/).

The notion that laissez-faire economics leads to any kind of global optimum in the real world is vacuous. As any physicist will tell you, there are local optimums that are difficult to escape, but are far from a global optimum. In the economic sphere the parties to a transaction often cannot make free and rational choices; there are almost always inherent asymmetries in power and information. Given this, it takes blind faith, unsupported by fact, to assume that a reasonable, sustainable society can be built strictly on economic choices.

Some government interventions are aimed at creating a better global situation than simple economic transactions can provide. Public funding for education is one example. Everyone, particularly property owners, is charged for public education whether or not they have children. The same is true of child nutrition programs. The benefits of these programs cannot be seriously questioned. The quality of childhood education and nutrition drastically affect the quality of life and the productivity of the adults these children become. By making education and nutrition artificially cheap, we encourage "overuse" of these "products". The benefits may be clear, but the distance in time and space between investment in the child and the payoff in the improved quality of life of the adult is too large to be handled by ordinary transactions.


In most societies, only about half the population directly get income. The other half are too young, too old, too infirm, or participate in direct unpaid work caring for those people. That means that on average, each wage earner supports a non-wage earner. The largest part of this income transfer is within families as family members take care of each other.

It often happens that those who cannot work do not have families to take care of them. Sometimes the most economically ruthless among us seem to take the attitude Oscar Wilde parodied. "To lose one parent Mr. Worthing may be considered misfortunate, to lose both looks simply careless". In all industrialized nations there are welfare programs that take the place of family income transfer where that is not available. We have these programs because, as a society, we have decided we do not want people starving and dying on the streets.

Even when people are gainfully employed, it often happens that there are catastrophic events that can bankrupt them. These are typically medical emergencies, but there are other emergencies like fire, tornadoes, hurricanes and global economic collapses. All industrial countries have a mix of private insurance and government aid for these events. In the United States, there is a large reliance on private insurance and personal bankruptcy. The government does step in for national disasters with a combination of direct aid, grants, and loans. For medical expenses, the government provides a floor on care with Medicaid and Medicare. To smooth temporary job dislocations, unemployment insurance is mandated.

Where there are welfare (including Social Security in the United States) and emergency aid programs, they must be paid for. In the United States these programs consume roughly half of the federal budget. That means overall taxes must be set high enough to cover these costs. These taxes are straight, necessary, income redistribution.


My basic objection to the simple laissez-faire free market story is much more basic. In the simple story, monetary value is essentially equated with human value. This view cheapens us all.

We live in a money economy. The economy puts a value on goods and services. The tendency to confuse monetary value with personal value is natural. As I look at my life, the falseness of this becomes clear. Many of the things that make my life worth living have no monetary value and I would be insulted if anyone tried to put one on them. For example, the chance glance of a beautiful woman, a sunset, a musical passage that I happen to play well. I could pay a beautiful woman to smile, but the mere existence of payment cheapens the experience. Things I purchase often have a personal value far in excess of the monetary value. My filing cabinet and my cordless power drill are two inexpensive items. They are inexpensive because production and intellectual property costs are low. They have improved my life immeasurably and I value them greatly. Although their manufacturers would be delighted if they could charge me in proportion to the personal value I place on them, this would be unfair and artificial.

Human value is distinct from monetary value. Sometimes it is practical to pretend that human and monetary value are interchangeable (creating markets for clean air) but let us acknowledge that this is a pretense. We are economic animals, but that does not mean we can be explained, or our actions should be based, strictly on economics. This simplistic view makes no more sense than insisting that because we are sexual animals, all our behavior and decisions are based on sex.

Because I have gotten to sex, I feel I can end this little essay.


sf said...

Black market barter baby!

Anonymous said...

So Colin, where do you think interest rates are headed?