The Failures of Markets: Capitalism’s Original Sin
Going Beyond Incentives and Signals
In the last post, we looked at the system of incentives (firm’s profit motive and consumer’s utility maximization) and signals (prices) that allow capitalism to indirectly coordinate production between firms and consumers. The issue I began to delve into in the last topic was that capitalism’s incentive structure and signals actually disincentivize it from acheiving the greatest good. And as explained in the last post, acheiving the greatest good was the core motivation behind capitalism as presented by Adam Smith and others. I presented one example that demonstrated that the interaction between elasticity and inequality can generate these perverse disincentives.
In this post, I aim to go further. It is not only the incentive structure and signals of capitalism that is broken: the mechanism that implements those incentives, the market, is broken as well. I will break this down in two manners:
If we assume that pareto-efficiency (the theoretical end result of a “free” market) is ideal, markets rarely if ever reach this point:
- The assumptions underlying the notion of the free market are unrealistic and fail
- Externalities are inevitable and cannot truly be fully internalized
Pareto-efficiency isn’t even ideal in the first place!
- The Liberal Paradox demonstrates pareto-efficiency is logically incompatible with the Individualist ideals that the market needs to even exist in the first place
- Pareto-efficiency is no guarantee of any kind of social good
- The “firm as transaction cost mediator” theory that attempts to defuse the notion of “market failures” therefore fails, as it ultimately relies on pareto-efficiency as being optimal
From these two, it is clear capitalism’s incentives+signals+market structure undermines capitalism’s own promises to such an extent that the only way to resolve its failures is to allow for a degree of State power (and therefore State surveillance) I find unacceptable.
The Inevitability of Market Failures
Free Market Assumptions are completely unrealistic.
- “Perfect Information” (or something approximating it)
Why you would ever assume this would hold is beyond me. Not only is it apparently clear that we don’t have anything close to perfect information in our economic activities (every “scandal” about any given company is yet more confirmation of this), it is actually disincentivized by market mechanisms itself. It is in the best interest of firms to not provide full information regarding their products to consumers, in order to push the price upwards and increase profit. The market actively incentivizes undermining itself!
2. All individuals make “rational” decisions
Most models of “rational” decision making tend to constrain the signal for individual decision making to the price mechanism itself (because, well, thats how capitalism functions…in theory). It is patently obvious that prices are not the only determinant of people’s decision making, but that can be readily incorporated into any given theory of decision making by just having prices as one of the determinants of decision making. A signal, instead of the signal. There are coherent models that use this more minimal assumption. The issue remains in that agents are heterogeneous, have nosy preferences, and cannot be aggregated using mere composition. In other words, the “microfoundations” of modern mainstream economic theory are largely bunk.
Ah yes, just “start a company.” How simple.
4. Large number of firms selling a homogeneous product
One, if everyone sold the same product, people would just end up selecting the highest quality one they could afford. You’d see consolidation of firms, not differentation. It is in fact differentiation in products that is required for there to be a large number of firms. And, do we really want to live in a world of homogeneous products? What good is “choice” then?
5. The actions of any particular firm have little to no effect on price
Yeah, sure. Once you have a sufficiently small number of firms (which can still be a pretty high number of firms), this assumption also fails. A cursory glance at the actions of Walmart or Amazon is enough to make this obvious. You don’t need the government to do anything here. The profit motive actively incentivizes firms to find ways to affect prices so that they can maximize their own profit. And they do.
Externalities are Inevitable
Look, I don’t need to be the one to tell you that “free market” assumptions fail. There’s plenty of scholarship out there on it already (I cited a bunch in the section above). The very concept of “externalities” (instances where the cost of production and/or consumption of some good or service is not constrained to just those involved in the transaction but affects everyone else) dominates large swaths of scholarship.
I should not have to tell anyone that externalities (in both the economic and political sense) are actually completely inevitable, yet here I am doing so. And no, they do not necessarily have anything to do with government intervention. The very nature of social exchange and the incentives and mechanisms of capitalism drive the production of externalities. “Wahhhhh but big bad government distorts the market which is perfect” is not a real argument. In fact, it doesn’t even make sense. Why? Because…….
Market Efficiency Isn’t Even Ideal in the First Place!
The Liberal Paradox
- be committed to a minimal sense of freedom,
- always result in Pareto Efficiency (a state in which you cannot make person better off without making another worse off), and
- be capable of functioning in any society whatsoever
What does this mean? To put it simply:
giving each individual the freedom to choose…has led to an inefficient (“not pareto-efficienct”) outcome — one that is inferior to another outcome where neither is free to choose
Amartya Sen constructed the first example of this paradox, but (in my opinion) Allan Gibbard constructs a far clearer example and demonstrates why it is Pareto-inferior:
Suppose there are two individuals Alice and Bob who live next door to each other. Alice loves the color blue and hates red. Bob loves the color green and hates yellow. If each were free to choose the color of their house independently of the other, they would choose their favorite colors. But Alice hates Bob with a passion, and she would gladly endure a red house if it meant that Bob would have to endure his house being yellow. Bob similarly hates Alice, and would gladly endure a yellow house if that meant that Alice would live in a red house.
If each individual is free to choose their own house color, independently of the other, Alice would choose a blue house and Bob would choose a green one. But, this outcome is not Pareto efficient, because both Alice and Bob would prefer the outcome where Alice’s house is red and Bob’s is yellow.
There are potential ways to defuse the Liberal Paradox but only one truly works if we wish to accept the importance of individual’s choices. Let’s examine the failed ones and then identify the successful one:
- “Preferences are not Nosy” (i.e. people’s preferences no longer depend on the choices of others)
Anyone who actually believes the choices/preferences of others do not affect our own preferences is an idiot. Enough said.
No. I (and others) have already discussed earlier in this piece why contracts are not a way out (hell the concept isn’t even coherent).
Not only is this not guaranteed to actually defuse the problem (uncertainty over the decision making of the other person may cloud judgment), it seems incredibly unlikely that this is going to correspond to the reality of any sufficiently complicated economic system. Human beings aren’t mind-readers.
And now the successful one: Abandon pareto-efficiency as a guiding principle. This is the only way out of the paradox that respects the choices of individuals. In other words, we see yet another reason why the very notions of “libertarianism” cut its own legs off.
Pareto-Efficiency isn’t Necessarily Good in the First Place!
Pareto-efficiency, by definition, is not equal to what is socially optimal. Considering, as we have discussed, that all economic systems are embedded in a moral framework (who deserves what, etc), Pareto-efficiency fails as a guiding metric.
Pareto-efficiency can be reached at almost any distribution of income, including ones where one person has everything and no one else has anything. And again, since all economic systems must be based on an ethical principle, pareto-efficiency is as nonsensical a concept in economics as the concept of “liberty” is in politics.
Abolishing slavery was a Pareto-inefficient move. If we were to follow pareto efficiency, the abolition of slavery would not have been justified.
“Slavery was widely seen in the North as being unethical from a deontological perspective, but a policy alternative of ending slavery would make slave owners worse off than under the status quo, and thus would have failed the Pareto efficiency criterion” (Hackett, 2001: 26)
Pareto-efficiency is internally contradictory: to fulfill the goals of capitalism, it must largely reject the notion of diminishing marginal utility, which it needs in order to function in the first place.
Is the “Transaction Costs” Notion a Way Out for Market Apologists?
Now our question might be: “what does the failure of free market assumptions mean?” A simple answer would be “market failure” but this doesn’t tell us enough. We need to be very particular about what we mean by “market failure.” Just because “what we wanted” didn’t happen, doesn’t mean the market has necessarily failed.
In the vein of the theory that firms emerged to solve transaction costs (aka “the costs of finding trade partners and negotiating and enforcing the terms of a trade”), Carl Dahman argues for a theory of market failures that demonstrates there is only one situation in relation to transaction costs that can be argued to be a market failure:
where the parties incorrectly anticipated the benefits were too low and failed to negotiate
He distinguishes this from situations in which parties correctly anticipated the benefits would be greater than the cost and effectively negotiated (perfect world), where one or both parties correctly anticipated benefits<costs and so didn’t negotiate, and where one or both parties incorrectly anticipated benefits>costs but didn’t actually benefit from the negotation.
But the fundamental problem with all of Dahman’s assumptions and his argumentation is that: they rely on assumption that pareto-efficiency is ideal. Which, as we have seen, is nonsense. I could go into more depth on the failure of contracts to do what they’re supposed to do, or Dahman’s very odd implicit assumptions about equality in bargaining power, but the fact that his argument relies on pareto-efficiency is sufficient to discount it.
Conclusion: “Fixing” Markets Requires Too Much Centralized Power. So What do we Do?
This is more of an ethical/philosophical guiding principle of mine. I remain deeply distrustful of centralized, concentrated power. There will always be a central government, yes, but the question of the concentration of power is not the question of “who has the final say” (someone, somewhere, always has the final say), but rather a question of the extent of surveillance. Power needs information and thus demands surveillance. Concentrated power in a centralized government means lots of surveillance in order to acquire said information, especially because the Central Government is displaced by both time and space from where economic transactions actually occur. This is something I cannot accept as just.
The issue we are presented with is that “fixing” markets would require regulations and procedures that would demand massive central government surveillance. Even if we assume the regulations worked perfectly (a dubious assumption at best), I would disagree that this position is justifiable. Rather than attempting to jury-rig ever more complex solutions to an inherently broken system of incentives, signals, and market mechanisms, we need to move to a new one. Because, it seems, that deep down, capitalism is utterly dysfunctional. It functions and yet it builds incentives that act to undermine itself. At risk of sounding too much like Karl Marx, there are intrinsic contradictions within Capitalism and its functioning. And the only way to solve these, while maintaining the capitalist system, is to allow for (at least to me) an unacceptable concentration of power (and thus surveillance) within centralized bodies.
Make no mistake, I want a system that works. I want a system that incentivizes innovation and rewards hard work; however, I want such a system that also doesn’t possess the internal contradictions of capitalism. Ultimately, I aim to build a system of incentives and signals that can indirectly coordinate individuals in such a manner as to actually accomplish the greatest good that Adam Smith wanted to acheive while also respecting and rewarding the contributions of individuals and giving people what they deserve. I want a fuctional system built on a more robust ethical foundation and with systems of incentives, signals, and economic mechanisms that actually acheive the goals of the system, instead of undercutting them. And I believe all of this is possible. So, stay tuned.