A FIRST LOOK AT MARKETS AND POLICY
To foster the economic prosperity of a society of 330 million people, the US relies on both a market system and different levels of representative government. Often public policy questions center on the proper role of government in complementing market activity, and when to let the market self-regulate. Contemporary headliner examples include whether to control or end the use of fossil fuels; or to regulate health insurance markets or nationalize that service; or to subsidize higher education tuition versus enabling students to finance their education through long-term borrowing. Questions of this type are inherently political questions, often accompanied by great polarization, angst, and concern over election outcomes.
Advancement of public discourse about economics requires a common "language," i.e., an understanding of what people mean when they use key economic terms and concepts. Of particular concern is the frequent use of the misunderstood term: "free markets," a term at odds with core economic analysis of markets.
The powerful forces of markets can be used to complement the regulation of utilities such as electricity, natural gas, and cable TV; to guide the construction and operation of infrastructure projects such as streets, roads, bridges, and airline flight paths; and to modulate climate change. Examples such as these, and many more, show the importance of economic understanding in the development of public policy and in the evaluation of politicians at election time.
Although every societal problem has a significant economic component, Democrats seem disinclined to use economics in their policy development and public discourse, preferring to frame issues with vague references to fairness and justice. Meanwhile, self-branded conservatives invoke with gusto the verisimilitude of economics, confidently asserting that economic goals of growth and prosperity can be met within a robust market system that is free of government intervention. In their telling, "free markets" are self-regulating, serving the public better than if the government were to intervene.
Model-Building in Economic Education
In contrast to contemporary liberals and conservatives, economists are more cautiously analytical in determining whether and how markets can serve the public interest. Economists introduce economics through the "competitive market model," a composite of principles describing the conditions required for a market to help society improve its economic well-being despite Nature's scarce resources.
Profit and Loss
The process of competition coordinates myriad choices. When buyers can choose among a large number of sellers, those sellers are incentivized to provide goods and services of reliable quality, durability and price. Price is determined by the interplay between sellers’ supply and the buyers’ demand for goods and services. Investors enter an industry when profits can be expected, and exit to avoid expected losses. Price is forced down by entry or up by exit, until a "Goldilocks" price level is reached at which shortages and surpluses are eliminated: at that price the amount buyers want to buy equals the amount sellers want to sell.
The most surprising and counter-intuitive result from this model is that each of the competitors intends to improve their own profit but the process of competition transforms that intent into a greater quantity and lower price for the benefit of buyers. This was first proposed by Adam Smith: self-interested profit-seekers guided by the process of competition – – "as if by an invisible hand" -- to serve the public interest "even though that is no part of their intent." Smith referred to this as a “system of natural liberty.”
This competitive market outcome requires key preconditions, including a large number of independent sellers as well as well-informed buyers. Economists beginning with Smith have warned against over-reliance on the beneficent outcome of competitive markets without regard to these preconditions. He emphasized the incentive for individual sellers to attempt anti-competitive efforts: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." For example, if firms obstruct the process of competition by forming cartels -- i.e., agreements among competitors to reduce total output to force prices up -- consumers are denied the benefits of competition, such as reasonable prices for drugs or gasoline or meat.
Further Toward Realism: Competitive Markets Require Rules Set by Government
Markets cannot function free of government. Instead, they require certain foundations provided by government, including rule of contract law, property rights law, ownership rights law, and other sectors of the law that form the “rules of the game.” Because mutually beneficial exchange is central to the functioning of the competitive market, tradable ownership rights must be created and protected. Although these legal systems are prerequisites for markets to function, they are a public responsibility; markets cannot provide them.
Another implication of the model that becomes explicit in practice: for the competitive process to serve the public interest, exchanges must be mutually beneficial to all parties affected by the transaction. Consequently, all costs must be borne by buyers or sellers or shared between them, not shed to "third parties" external to the market's buyer-seller transactions. An example of such external costs would be an agreement between buyers and sellers that imposes noise, or danger, or the sight of ghastly architecture onto people who are not parties to the arrangement.
"Free Markets" versus Economics
The term "free market" is used very frequently in public discourse, particularly by people who brand themselves "conservative," and whose all-purpose policy prescription is tax cuts and deregulation. When the word "free" is affixed to "market" it conveys a market that is free of government involvement in its operation.
Because the economics profession has devoted a great deal of attention to the benefits of competition, "free markets" are often conflated with "competitive markets." This is a mistake; they are very different concepts. Economists frame economic problems as seeking ways to improve economic well-being by overcoming some of Nature's constraints on resources -- land, labor, capital equipment, and time. In that conception, economic freedom rises or falls depending upon whether the society's access to resources increases or decreases, whether that involves government or not.
Fossil Fuel Freedom?
The competitive market model not only lays out the preconditions for market efficiency, but it also pinpoints possible remedies when those preconditions are not met. That is, if those missing pieces can be provided through regulation, then economic freedom rises even though the market is less free from government. For instance, as the competitive model shows, the market will tend to ignore external costs of the use of fossil fuels (i.e., pollution, emission of heat-trapping gas), and consequently underprice and, thereby, encourage overuse of those fuels. To correct for the too-low price of fossil fuels, economists recommend implementation of a carbon tax to force buyers and sellers to factor in the external costs to their decision-making. With that correction, economic efficiency rises because of, not in spite of, increased government involvement. While the market will be less free, economic performance and economic freedom improve. This example and many more show the inherent contradiction between free-market concepts and the peer-reviewed findings of the economics profession.
William L. Holahan is Emeritus Professor and former Chair of Economics at the University of Wisconsin-Milwaukee.
 This is the first of several articles on markets and public policy, written with the conviction that misunderstanding of this concept, deepened by dis-information from economic opportunists, is central to the polarization facing the nation.