Webster’s Dictionary defines a “conservative” as someone who adheres to established beliefs and practices, adopting new ideas for long-held views only if rigorous examination compels that change. Consequently, the dictionary definition of the word “conservative” suggests a principled approach to thinking about public policy. By comparison, if you ask a self-described conservative what the word means, you are likely to get a response that includes slogans like: individualism; personal responsibility, smaller government, limited government, liberty, freedom, and fiscal responsibility. Moreover, there is a headliner attribute -- "free markets" -- that they confidently claim assures that all these goals can be met within a robust economic system where self-regulating markets can better serve the public than if the government intervened.
Economists refer to markets favorably too; they conclude that under certain preconditions, markets expand individual access to resources, contributing to greater economic freedom from Nature's scarcity. But, this "pro-market" preference comes with a warning: for markets to function in the public interest, certain prerequisites must be met.
The Free Market Model
To understand complex systems like markets it is common to build "models." These are detailed descriptions of an idealized version of a real thing. Building models is a centuries-old art; Archimedes (287BC - 212BC) taught engineering by explaining frictionless "natural machines," including pulleys, levers, inclined planes, etc. Although there is no such thing as a frictionless machine, engineering students from Archimedes' time to the present begin their study of real machines by first studying imaginary frictionless machines. Economists do the same thing with "the free market model," a set of principles describing how a market would function under idealized conditions.
The Free-Market Model
In the free-market model, business and private investors base their decisions on their expectation of profits and losses. They invest, invent, innovate, buy equipment and hire people, all free of government direction or interference. Firms seek profit by selling to buyers. The process of competition among profit-seeking firms establishes market prices that eliminate shortages and surpluses: the amount buyers want to buy equals the amount sellers want to sell.
The model describes how markets adjust to change; for example, if demand for an industry’s goods and services increases, price and the expected profits will rise, encouraging the expansion of supply via the participation of more profit-seeking investors. This inflow of new competitors increases the choices available to consumers, driving down prices until it is no longer attractive for additional profit-seeking suppliers to flow in. This process of entry and exit transforms the original profit potential into a benefit to consumers, reducing price to the level that covers production and distribution costs including a "fair rate of return to investors."
If demand decreases, the system works in reverse; price falls, threatening losses and encouraging some firms to leave the market. This outflow of some firms reduces supplies of goods, causing prices to rise for the remaining firms until once again price covers cost including a fair rate of return to investors. Through this process of profit and loss, prices are determined not by the individual firm but by the interplay of all market buyers and sellers. The final results of these competitive pressures are lower prices, improved products, innovative ways to produce products, and control costs, ultimately for the benefit of consumers.
This model reflects the keen insight of Adam Smith, the Founder of Modern Economics: in competition, profit-seeking firms serve the public interest even though the firms do not have public interest in mind as they seek profits; that “is no part of their intent.” Because there is no coercion, these are called "free markets." Investors are free to add or withdraw their investment and free to expand or contract their offerings of products and services to buyers. Firms are free to innovate, i.e., to change those products or the way they are made, sold, warranted, or financed. Meanwhile, buyers are free to buy the quantity they prefer, provided they have the ability to pay. They earn the ability to pay in another free market: the market for their uncoerced labor. All of this operates without government interference. Smith referred to this description as a “system of natural liberty.”
Product warning: If the preconditions for competition do not exist in a particular sector of the economy, the beneficent outcome ascribed to the free-market model cannot be expected. For example, the pre-conditions for competition are not present if firms collude, i.e., obstruct the process of competition by forming agreements to reduce total output to force prices up. The anti-trust laws are designed to protect the competitive process by criminalizing such collusion.
Contradiction: Markets cannot exist without government.
Real markets cannot function without 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.” There are no investor returns to these laws or their enforcement. Although they are prerequisites for markets, markets cannot provide these laws. Those who favor market allocations over central planning allocation of resources must still favor complementary government activity.
Strictly speaking, there is no such thing as a free market. However, the free-market model has broad applicability not only as a preliminary tool of analysis and critique but also as a guide to public policy. The model captures the role of competition and the role of the price system in the coordination of the economic affairs of independent-minded people in a free society.
Future essays in this series on Econ4Voters for Grassroots North Shore will explain the compatibility of regulated markets with representative government; how the powerful forces of markets can be used to address climate change; regulate utilities such as electricity, natural gas, cable TV; and guide the construction and operation of infrastructure such as streets, roads, bridges and airline flight-paths. Examples such as these, and more, will show the importance of economic understanding in the development of public policy and in the evaluation of politicians at election time.
William L. Holahan is Emeritus Professor and former Chair of Economics at the University of Wisconsin-Milwaukee.