Free Markets and External Costs

A market is a way to distribute goods and resources that does not require a central authority to make decisions about prices, or about quantities and quality of goods being traded. An ideal market does this in a way that is “fair” to all the parties involved – in fact, it makes all the parties better off. This is Adam Smith’s “Invisible Hand.”

Can a market really be “free?” Only if all participants have the same information about goods and their availability, have the same influence on prices in the market, and if participants don’t cheat. Many markets in the modern world are highly asymmetric – a few large sellers have the power to set prices, and buyers have little or no influence. In the case of agricultural products, many markets are exactly the opposite – a few large buyers have the power to set prices for many small producers.

Without rules and enforcement, there are many ways to cheat – to subvert the intent of a market. They range from simple thuggery — preventing competitors from participating — to fraud and collusion. The original idea behind standardized weights and measures back in the middle ages was to prevent fraud. The ultimate in collusion is to buy up competitors and gain monopoly power. Much “white-collar” crime involves some sort of cheating in a market.

Another way to cheat is to externalize costs, which simply means that someone else pays for the goods you sell. Obvious examples are simple theft — stealing the gold your competitor has mined and selling it, or slavery — stealing labor from people who lack the power to resist and using it to undercut competitors.

Lacking rules and enforcement, theft of one type or another can make it impossible for an honest market participant to compete. A very common example of theft that happens every day is environmental degradation, which amounts to stealing from neighbors and from our children and grandchildren. Obvious examples are pollution, large-scale deforestation, and overfishing.

Some resources are “free for the taking,” like fish in the ocean. In other words, they are not “owned” by an individual or institution who can demand payment. The result is a kind of external cost called the Tragedy of the Commons. For example, individual commercial fishing enterprises have no incentive to preserve the stocks, because that would cut their incomes without protecting the fish. The only way to preserve the fish stocks is if everyone agrees on limits, and nobody cheats. This is why we have licenses and bag limits for recreational hunting and fishing, and why it takes international treaties and enforcement to manage ocean fish stocks. In the short term, of course, this raises the price of fish.