It's Not as Intuitive as You'd Think

Boy, if you want to see free markets (and Milton Friedman) get libeled, you couldn’t do better than this. If I were to diss on Milton Friedman, it would be because he invented income tax withholding, not because the Chileans 'disappeared' thousands of people.

Give me some time and I'll write up why unemployment and shuttered factories are often a good thing for society as a whole, and why it would generally be better for everyone if, say, travel and trade in goods were as easy between countries as they are between the US states. Folks get up in arms about a trade imbalance between the US and China, while nobody is concerned about the trade imbalance between Nevada and California. Wonder why?

One thing to remember about free markets is that they don’t exist in a vacuum. A whole lot of social context is required before you can have lots of random people getting together to buy and sell successfully. For instance, being free to make and sell something presupposes a property right which is protected somehow from thievery and thuggery. The buyer needs that same assurance so that he can take his purchase home and make use of it. A buyer is able to shop for the best prices in the market only when there is a common means of exchange, with a reasonably constant value that isn’t subject to radical swings due to it being based on some fickle commodity, or raging hyperinflation. And there needs to be some recourse for fraud and misrepresentation. The social background level of honesty and integrity makes a difference in the emergence of markets. In an ideal market, information spreads about those participants who try to cheat, and lie, and steal, and their transactions get discounted appropriately, if they can make any at all. Real markets suffer from information flow problems, and then everyone pays extra when some bad actors appear. The social costs of creating and enforcing the conditions that allow reasonably free markets to exist must be paid somehow, through fees or taxes, however indirect. Economists are well aware that the free market of microeconomics is a simplification and model of how real markets work, and that the reality is far more complex and nuanced. Kind of like how a physicist might model an internal combustion engine, fully aware that what takes place under the hood of his Toyota is an entirely other kettle of fish. The model is useful and instructive and gives insight into what’s going on, but it’s no substitute for the real thing.

That said, economists are also fully aware of things like environmental side effects and social ill effects. The word used for something that happens indirectly as a result of a market exchange is "externality," which means that someone gets a benefit they haven’t paid for, or faces a cost they haven’t been compensated for, because of that activity.

Let’s say that Ann sells Bob some firewood in the firewood market. Ann cut down some trees on her property to make the firewood. Bob goes and burns it in his fireplace. As a simple exchange, Ann and Bob are both better off, because Ann wanted to trade her trees for some money, and Bob wanted to trade some of his money for firewood. But Ann and Bob are not the only people affected. Charlie lives near Ann and Bob. He used to enjoy the view of Ann’s trees out his window, and now they are gone. And the air is now all smoky because Bob’s badly ventilated chimney sends all that sooty air Charlie’s way. Charlie was previously enjoying a view provided by Ann, but he didn’t pay anything for it, and now it’s gone but no one paid him any compensation. Charlie also had gotten used to some clean air, which he enjoyed for free, but now it’s all smelly and irritating his eyes, and no one has paid him to make up for it. These are externalities with respect to the firewood market.

One way to deal with an externality is to make paying for it part of the cost of a transaction in the relevant market. In the case of the firewood market, for instance, buyers of firewood might have to pay extra, and that money might go to paying for filter masks for people like Charlie, or to a fund for subsidizing clean-burning wood stoves for polluters like Bob. This isn’t something that the participants in the firewood market are necessarily going to come up with on their own; it’s a social cost and usually requires the coercive presence of an enforcer like a government to implement some kind of consensus fix. And the cost of administering the fix is usually high, the fix itself is often less than ideal, and it is usually subject to the vagaries of the political and regulatory process. But with luck, it’s better for Charlie than no fix at all.

Most of the objections of the free market being awful to workers and the environment are either cases of externalities becoming apparent or cases of sharp imbalances in market power. When a market has many players in both the buyer and seller roles, and information on the price of the goods is easily shared, it turns into a commodity market, where no one has pricing power and all must accept the going rate or go home without making a trade. In this case, we call the participants price takers because they take the price set by the market. When there are only a few buyers and lots of sellers, or a few sellers and lots of buyers, or information on pricing is difficult to come by, then those few, or the ones with the information, can be price makers, dictating the price through the quantities they are willing to purchase or provide. Say a town full of people looking for a job with few available skills meets up with a mill that will employ a town's worth of people if they'll work twelve hours a day six days a week for a pittance a day and put up with some awful smog. The mill is a price maker, and the townsfolk can work on those terms or not at all. As long as there are lots of towns full of people who a desperate for jobs, and the mill can pack up and move to whatever town they can employ the cheapest, there will be no change in the terms on offer. It’s not until the folks in each town are already well enough off that they can turn down an offer like that, that you will see any significant change. Since any given worker has very little market power, if they turn down a job they have little recourse when there are few employers. Forming a union will help, but like any cartel, a union faces the problem of defectors, those who find the incentive to take a job at a lower rate personally compelling even if it undermines the chance for everyone in the group to do better. Adopting a local ordinance to set the rates of pay will work as long as the mill can’t pack up and move to another town without such an ordinance. And larger governments have traditionally been very conservative about adopting such measures, basically only doing so when the market realities are already mostly changed to match, and only catching a few laggards out. That’s because politics is generally tied to money rather than votes once the legislature is in session, and returns its attention to votes only once in a while. And voters start caring about, say, the environment more when they have already dealt with more pressing issues of being fed and housed and have a little leisure time to enjoy it in.