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24 October 2008

I <3 the Free Market Part 2

The first part of this article can be found here. The truth of the matter, which I will repeat throughout this blog, is that I am not a good writer. Anyways, my first post comes off as some sort of odd fiscally conservative diatribe.

I'd like to reexplain my "vote" concept. This is not something I was taught. It's just an image I use to help me understand the signals by which manufacturers know how much to produce. By vote of course I do not mean anything political. I mean it as a mechanism that alerts producers of goods and services. In communism this would be accomplished by making a government post and telling that person to efficiently allocate said good. People make mistakes, don't do their job, need to get paid, etc. In the free market this is accomplished with the exchange of money. Consumers have a finite amount of money, so you can safely assume that they'd like to spend it wisely. In this way goods get made that people want (sometimes stupid ones; read: spinners, grills, bling, etc.). Another beautiful part of this mechanism is that it produces the most goods at the cheapest price based on this need. This is an inherent function of perfect competition (which rarely if ever really exists).

Okay, now the bad stuff. The free market is currently the most efficient way to allocate resources, but it says nothing about the distribution of income. Basically fairness. In the 19th century the spoils mostly went to the factory owners. This was also, one could argue, probably the closest our markets ever were to "free", so basically right now I'm arguing for the rich white men. Markets today are taxed more heavily and broadly, and there is much more oversight by government and private organizations such as the EPA, OSHA, etc. There are a few mechanisms by which economists can affect distribution of income. However, these questions probably shouldn't be left to economists. The job of an economist is the efficient allocation of resources. Fairness is the job of political scientists, sociology, psychology, or maybe even philosophy. If these academics find some way that they think could be more fair then let them give that idea to economists so that they can work out the details. This brings me to an interesting aside.

Economists have all these little scenarios that are essentially psychological experiments that involve just a few people. They are played a lot in intro economics classes. The name of this game is the ultimatum game, and it contradicts one of Adam Smith's great assumptions. That people are rational. The ultimate game is played like this. Two people are involved. You give one of them some amount of money, say $10. The job of person #1 is to divide the money. The job of person #2 is to either accept the deal in which case they both walk away with whatever split person #1 came up with, or person #2 can reject the offer and they walk away with nothing. Rationally person #2 should accept any split as rejecting it guarantees that they receive nothing. However, this almost never happens. In real life person #2 almost always rejects any offer that isn't close to 50/50. Psychologists think this means that people have some sort of fairness mechanism inherent to us. Studies have shown that revolutions and social upheaval tend to occur when there is a large disproportion in the distribution of income. This is currently measured by the Gini coefficient. The US ranks pretty poorly... #40 something in the world, and our score keeps going up (that means less equality).

The next problem with the free market is one that I personally don't have a problem with (which of course is easier to say when you're an affluent white male), but many do and for good reason. The free market uses competition as its driving force. Without it we would all be winners and we would live in some magical world where people inherently knew how to best invest their money and time without any errors. In reality, competition produces winners and losers. Thus, for the free market to work there must be losers. This is a bit saddening. How could one promote a system where this is the known outcome? Easy, rationalize it!

Say you start a business and after 5 years you are still losing money. At this point you are essentially subsidizing your customers. Economic reality will point you in the right direction. If you continue to lose money you will be forced to close your doors. Either you had the wrong idea or you poorly executed a viable idea. Of course this is unfortunate, but the business wasn't viable. A good example of this is what happened in the USSR after it collapsed. There was a long period when all these government factories and apartment blocks were converted to a capitalist system, but there was a large problem. They weren't viable. There were apartment blocks in the countryside no where near any places of work. Who could afford that? There were steel mills that were too far from quarries to make a profit and compete on an international level. The infrastructure existed, but it was in all the wrong places. The point of the story is that sometimes things need to fail in order for the whole to be better. In all fairness this can also be a bad way of thinking. This is how many economists thought during the Great Depression. Essentially, let the weak fail, but they were wrong. The problems facing businesses during this period were far beyond that.

Of course this is still a downside to the free market. It's inefficient, although better than its alternatives. It hurts people. It pits people in competition. I could go on for a while. Karl Marx actually does a really good job in critiquing capitalism. I think this point is often missed and people focus instead on his communist theories. Which is really quite ironic as he said very little about how communism would actually work.

The free market, at least in my mind, mimics natural selection. It is a bizare and effective mechanism that doesn't need human intervention to work. However, I am not entirely against government intervention in the free market. We just have to be careful not to stifle incentive. In reality the free market has its flaws and through the study of these flaws we can learn how to better deal with economic crisis in the future.

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