Sucking All The Air Out of the Room

I'm curious what this notion of a free market that doesn't work means to people who say that.

Let me explain the concept of a free market from the perspective of an economist, and explore some of its ramifications for a bit.

The very basics: if there's a market for a good or service, that means there are people who want to purchase it at some price or other and people who are willing to supply it at some price or other, and they can get together to make a deal. If it's a free market, that means the buyers and sellers all get to pick the best deal on offer, at any price they like, in any quantity they like, without being forced to buy or sell if they don't want to. That means that sellers can try for the highest price that someone will pay, and that buyers can buy for the lowest price that someone will sell at. But the buyers are all in competition to get that best deal, so any seller will raise his price to just under the price at which it wouldn't sell at all and can still find a buyer. Yet at the same time, the sellers are all in competition to make that sale, so they must drop their price to match the lowest available price to make any sale. If they are unwilling to sell at the price that these two effects converge on, (known as the equilibrium price) then they take their goods and go home. If a buyer isn't willing to pay that price, she packs up and heads home empty-handed, money still in pocket. Everyone else makes a deal. The buyers that were willing to pay more get what they want out of the market for less than they'd feared, and the sellers who were willing to sell for less find themselves richer than they'd hoped. A free market matches people up and makes them wealthier - everyone who comes and makes an exchange gets more value in return than they bring. Everyone else has what they started with. They all made a free choice and no one was coerced into paying more or selling for less than they were willing.

There, that's the long and the short of a free market. Maybe other people are talking about something else when they use the term.

Well, how do free markets work? We've been talking about the market for healthcare, but that seems fraught with connotations that I don't want to deal with. Instead, for the purposes of illustration, I'm going to discuss a theoretical community that lives on the deep ocean floor, and trades in a market of compressed air bottles. In this case, the buyers all have a strong motivation to find a deal, since their alternatives are to die a painful death of suffocation or a painful death of the bends, the common factor being a painful death. The sellers, however, are limited in their ability to take advantage of this market by whoever among them is willing to sell for the least amount that will sell all her air bottles. They can't sell a single bottle for more until her supply is all gone. If she can supply as many bottles as buyers want at that price, she'll get a de facto private monopoly, until other sellers lower their price to match, or if they can't, get out of the business.

(For the curious, private monopolies, also known as efficiency monopolies, arise in a competitive market when one seller has a cost advantage over all other sellers and can supply the entire market. A statutory or legal monopoly is one where some government fiat prevents other sellers from entering a market, such as when a product is patented or the field is regulated. A natural monopoly is one where the costs to supply a market go down when there are fewer suppliers, as in, say, roadways or sewer lines. Given the way newspapers have tended to go to one per community, they may be a natural monopoly. Natural monopolies are usually persistent and thus are the most likely to be regulated to prevent abuse of market power; private monopolies tend to be temporary and are occasionally brought to task for abuse of market power through antitrust law, but are unlikely to be regulated.)

So what if there is a monopoly on the air bottle supply? Won't a profit maximizing monopolist restrict the supply and jack up the price? Well, sure, if that actually brings in more profit. Those are some ridiculously motivated buyers, after all. However, if raising the price to a certain point will bring some new sellers into the air bottle business, the monopolist is likely to try to stop just short of that price, lest she wind up attracting competitors, selling fewer bottles and losing out on those profits. That price point in turn will be something under the price at which that new seller could make any money, or just about where their costs of producing and selling the air bottles would be exceeded by the price they could get. In other words, a private monopoly will still be limited in what it can get away with charging for very long, as long as there are no barriers (other than startup costs) to new sellers entering the business, even if they never actually do. The monopolist can hold on to that position as long as she has costs lower than any new seller would, and she can supply all the bottles people want to buy at her price.

However, another factor in the pricing equation is, how many more bottles might the monopolist sell if she lowered the price? If the number sold goes up enough that the reduced profit per bottle times the new number sold is bigger than the old profit per bottle times the old number sold, then the monopolist is better off selling for less. When the buyers' quantity demanded is very sensitive to price, this can easily happen. On the other hand, air bottles aren't really that kind of good - the buyers only need so much of it, really, without much use for excess, but the amount they do need is fairly rigid and they're willing to pay quite a bit for it, since the alternative is a painful death.

What if the monopolist can produce more air bottles than people want to buy at the profit-maximizing price? An enterprising monopolist might see that there are some people who can't or won't pay the full price, maybe because they're poor, or getting good at holding their breath, or mooching off neighbors or something. As long as the monopolist could still make some profit selling to the rest of the market at a lower price, there's an incentive to do so, as long as it doesn't undercut the main market. Perhaps she could sell discount air bottles only to people with AARP cards, for instance. Or maybe add a bad smell to the cheaper bottles. The smart seller will try to maximize the value extracted out of what buyers are willing to pay by segmenting the market this way. As long as no senior citizens start up an air bottle reselling business, and most buyers aren't willing to put up with the smell for the discount, things are good for the seller. The seller may continue to find ways to sell air bottles until the price made from selling the cheapest bottle no longer exceeds the cost of producing and selling it. (In economics-speak, that's when marginal revenue equals marginal cost.)

Let's take the other side of the market. Say that after enduring high prices for entirely too long, the community of air bottle users agrees "We're tired of being held over a barrel for our oxygen. Let's form a collective buyer's association and reverse the market power situation." They pool their funds and stop buying the air bottles individually, instead putting out a single bid request saying "We want this number of air bottles, and this is what we will pay. Any takers?" The sellers are now in a position of either supplying at the bid price, or not at all. Some may choose to take their air bottles and go home, but a few may figure it's the only deal in town and they can still make some money, so they'll sell. As long as the buyers' club can get all the bottles they request, all is good. If they can't, they may request a few more bottles offering a higher price, and repeat until they've got all they need. This turns around the market segmentation case for the buyers' benefit. They pay a lower net price for their air bottles because their monopsony power is extracting a bigger share of the value of the exchange from the sellers.

Conventional economics considers a market failure to be the result of inefficiency of some kind, as when a monopolist or monopsonist uses its market power to extract more value from exchange in a way that constrains the amount of surplus value that its trading partners can get from the market. The amount of value gained by the one is less than the value denied to the other, and the difference is known as a deadweight loss. This is the potential value that is lost to market participants in comparison to a market that is at a competitive equilibrium. (Other sources of a deadweight loss and attendant market failure include when a price floor or ceiling is applied to the market, or the quantity supplied is constrained or rationed, or production or purchase is subsidized or taxed, or informational asymmetry is pronounced between buyers and sellers. These subjects involve lots of math and graphs and are beyond the scope of this already way to long exposition.)

By a strict definition then, in the real world, every market is a failure to some extent, because there is always some conglomeration of taxation and subsidy and information asymmetry and uncompensated externality and market distorting transaction cost going on and causing inefficiency, but it's a question of degree. It's like calling an A-minus student a failure for only getting a 95% score. If a market is at an equilibrium that is reasonably close to its theoretical ideal, despite its inherent practical inefficiencies, the costs of market intervention by a government can easily outstrip the potential gains in improved efficiency. If we consider the cost of market intervention as a potential deadweight loss and compare it to the actual deadweight loss of existing market inefficiency, then we can say that any market where the actual loss is less than the potential loss is real-world optimal and (at least on economic grounds) should not be intervened in. On the other hand, when the existing market is likely to have its efficiency improved by more than the cost of intervention, then intervention is economically justified.

Unfortunately, economic justification does not address issues of social justification, which may for instance require constitutional limits on intervention in the service of non-economic ideals of individuals' freedom of action or freedom from coercion. But if we go back to our undersea world of air bottle buyers and sellers, we also see other areas of social concern that our economics do not directly address. That is, what about those poor buyers who can't even afford the AARP rate or the smelly air bottles? You can only hold your breath so long, after all. Really enterprising sellers might extend credit to someone who was temporarily experiencing a cash flow crisis, but probably not to someone who was just plain poor and likely to remain so. For the sellers of air bottles, there's some incentive not to let potential customers die off, but the only incentive regarding those who will never be able to pay is a humanitarian one, not a financial one. Unless they could capture more business by saying "buy from us, we're good people who provide air to the down and out" there's not much profit incentive to give the stuff away. Maybe there's a branch of the Sisters of Jacques Cousteau who solicit donations and supply air toots for free to the indigent, but if there are more in need than they can supply, somebody's looking at a painful death, and soon. Even so, this does not represent a market failure. The free market in air bottles is working just fine, supplying all the air they can breathe to everyone who can pay. That said, if people are dying, there may well be a social policy failure.

But what should social policy be? In some strict calculus of human economic value, it may be best to let the elderly poor turn blue instead of taxing others to purchase air bottles for them or coercing bottle sellers to give them away. Subsidizing that air supply for them would cost more than they could ever again return to society. However, if everyone instead agrees that they are willing to pay now while they can, in return for assistance in the future if and when they become aged and decrepit and penniless, in essence paying in advance, it makes more sense. They have created a social contract, where the cost of care, or rather air, for those in need who cannot pay is socialized. And that's fine.

Whether it's better to purchase the air bottles for the social insurance in the market or to create a captive producer for them is another question, one that I'll leave for another day. Suffice it to say for now that you cannot escape the cost of production, no matter who is doing it.