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Free Markets Are Ruthless Regulators

Markets have a marketing problem. A big part of the problem is the widespread belief that markets facilitate self-interested, even selfish, behavior. Today a growing number of conservatives, like Senators Marco Rubio and Josh Hawley and others, join in the left’s traditional criticism of markets for encouraging individual selfishness. As a result, many think of markets only as the object of regulation: markets need to be regulated to limit the pernicious effects of human selfishness. The irony is that this gets the central feature of markets exactly backwards. Far from indulging self-interest, markets exploit self-interested behavior; markets actually frustrate self-interested behavior even as they harness it to serve the public good. Rather than being opposites, markets are a superlative form of regulation. A false dichotomy between markets and regulation invites overlooking this central feature of markets. The means by which markets regulate economic activity is hardly new. Even Adam Smith, in his Lectures on Jurisprudence, discussed markets in the subsection on government police powers. 

Markets produce profound regulatory effects because their central feature is the incentive structure of the prisoner’s dilemma. The reason the incentive structure is called a “dilemma” is because, while the players pursue self-interest in the game, that pursuit results in their achieving a suboptimal, “lose-lose” outcome for themselves.

Importantly, though, even though the outcome is “lose-lose” for the players in the game, prisoner’s dilemmas (PD) can leave the broader society better off. (Although, to be sure, sometimes prisoner’s dilemmas can leave broader society worse off as well, depending on the context of the game.)

An example of how PD games can leave society better off even though the players are worse off is provided by the canonical story that gave the name to the “prisoner’s dilemma.” In the story, a prosecutor constructs a plea bargain for each of two criminal partners. The incentive structure the prosecutor develops in the plea bargain is such that each partner chooses to rat out the other partner. (The canonical story is described here for those who don’t already know it.)  The result of the game—the “equilibrium” outcome—is that both criminals are worse off than if they didn’t rat out the other. Nonetheless, because of the incentive structure the prosecutor developed, each criminal is individually always better off ratting than not ratting. Individually rational behavior on the part of each criminal leads to a suboptimal outcome for them.

Yet while both criminals are worse off as a result of the prisoner’s dilemma, society as a whole is better off. The criminals rat each other out, and provide the prosecutor the testimony needed to convict each of the worst crime they committed. The incentive structure of the prisoner’s dilemma allows the prosecutor (and society) to exploit the self-interest of each of the criminals for the benefit of society. (It is worth repeating that some prisoner’s dilemmas can be suboptimal for society as well, as with negative externalities like pollution. The only point here is that some prisoner’s dilemma situations serve the public good even though the players are left worse off as a result of playing the game.)

The crazy genius of markets is that they democratize, or socialize, the benefits of production rather than socialize the means of production.

Market competition creates a prisoner’s dilemma for businesses. To be sure, owners are pursuing their self-interest. But, like the canonical prisoner’s dilemma, in creating a competitive market, society exploits the self-interest of business owners to advance the public good. This insight isn’t new. It is because markets frustrate and exploit self-interest that Adam Smith observed, “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.” Businesses want to limit or stop market competition if they can because of the markets’ prisoner’s-dilemma incentive structure.

Of course, the point of using markets to regulate business isn’t to cause frustration, it’s to advance the public good. To understand why markets are often a superlative means by which to regulate business behavior we need to compare them with alternatives. The main alternatives to markets today are socialism and cartelism.

Socialism—social ownership of the means of production—is a well-known alternative to markets. Less known, however, is that, decades ago, socialist economists conceded that an efficient socialist economy would replicate market outcomes. To be sure, the likelihood that a system of centralized planning could replicate market outcomes is another question entirely. The debate is lengthy and is well-known; there’s little need to rehash it here.

While there are indeed examples of socialism in the United States, that is, where the government owns the means of production (public schools, roads, some hospitals, and, until 2001, a cement plant in South Dakota), what today’s American “socialists” mainly advocate is enhanced social insurance and, for businesses, some form of cartelism or enhanced regulation that would have the same effect.

Government-run “cartels” exist when business ownership remains in private hands, but production and pricing decisions are made by government-created planning boards. Cartelization was the centerpiece of the economic program of FDR’s National Industrial Recovery Act during the Great Depression. Yet even today, government organized cartels continue in some markets in the U.S., particularly in agriculture, and there is increasing interest in adopting some form of “managed agricultural supply,” as in Canada. There are some calls to have the government expand cartels broadly throughout the economy. In his book, The New Class War, Michael Lind expressly advocates New Deal-like cartels as a part of the solution to America’s current economic problems. 

The point of government-run cartels is precisely to mute the prisoner’s-dilemma aspect of markets as deleterious to the common good. The irony of cartelization, however, is that, by design, it distributes benefits less broadly than markets do, and cartels impose “deadweight” losses on society relative to markets. 

First, the crazy genius of markets is that they democratize, or socialize, the benefits of production rather than socialize the means of production. It’s easiest to see this with price competition, but it occurs with quality competition also. The prisoner’s-dilemma incentive structure created by markets induces business owners to dissipate their profits (beyond those minimally needed to stay in business) through lower prices. Everybody throughout society has access to these lower prices. Further, as profits are democratized through the market in the form of lowers prices, everybody’s dollar goes further. The same nominal wage for a worker will purchase more goods and services as these profits are dissipated through price competition. Living standards go up even though nominal wages may not.

The economic case for cartels typically revolves around protecting businesses from “ruinous competition” (that is, the market’s prisoner’s dilemma) for the stated purpose of providing higher wages to workers. (While the stated goal is usually to increase wages, truth be told, cartels rarely hurt owner profits as well.) Yet these gains—while they can be real for the workers in the cartelized industry —are distributed far less democratically than the market distributes those same gains. The gains are limited to the workers in the cartelized market rather than distributed to everyone in society.

Like other regulatory tools, markets are not always optimal, just as taxes, or subsidies, or civil or criminal penalties are not always the right regulatory tool for every situation.

The impact of cartelization is not simply a matter of redistributing gains from everyone throughout society to a privileged set of owners and workers in cartelized industries. Added to the redistribution of gains from all to some, cartels also shrink the size of the economic pie that gets distributed.

The problem with cartelization relative to the regulatory effects of market competition is that cartels raise prices and reduce supply. The supply reduction and increased prices, which is the very purpose of cartels, creates a deadweight loss that market pricing does not create. Essentially, the economic pie is smaller with cartels than with markets because cartels stymie the prisoner’s-dilemma aspect of markets. Basically, the democratic pricing systems generated by the regulation of market competition provide more benefits for people than prices under a cartel system.

The point is not that markets are a panacea for whatever economic problems exist. Like other regulatory tools, markets are not always optimal, just as taxes, or subsidies, or civil or criminal penalties are not always the right regulatory tool for every situation. And market failures can arise from externalities, asymmetric information, non-existent or incomplete markets, and more. (Though not all market failures invite a government response. It depends. There is, after all, “government failure” as well as “market failure.”)

Rather, the point is that for those on both the left and the right who aim to promote the public welfare, markets should not be thought of merely as objects of regulation. Markets themselves are powerful regulatory tools. They’re so powerful, in fact, that those subject to their prisoner’s-dilemma like incentive structures recoil from them, and want to be protected from them. But the regulatory effects of markets are powerful not because they indulge self-interest, but because their incentive structures exploit that very same self-interest for the public’s benefit. 

Reader Discussion

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on November 06, 2020 at 13:43:05 pm

Informative essay, and it captures well the difference between socialism and capitalism. But it misses the essential divide between devotees of the virtues of capitalism, those who support free markets and a level competitive playing field that benefit all producers and consumers and the national well-being (common good capitalists) and those who support government intrusion in markets to favor some producers and some consumers, to the detriment of the common good and national well-being (free-renters and crony capitalists.) The "prisoners' dilemma" to which Rogers devotes his essay fails to reflect this existential economic divide. Nor does the "prisoners' dilemma" work as Rogers predicts. It assumes competing, mutually exclusive goals for the cops and the crooks, which is no longer the case. The "prisoners' dilemma" does not work as predicted when the cops and the prisoners collude, which is what has happened 1) with globalism and its the outsourcing of US jobs, 2) with the outsourcing to Red China of US national security and 3) with Big Government legislation and regulation which favors Big Banks, Big tech and Wall Street and the ruling class and the wealthy elite, while harming the middle class, the vast majority of producers, workers and consumers, and the national well-being.

Professor Rogers recognizes these realities with his use of the following language:
"(It is worth repeating that some prisoner’s dilemmas can be suboptimal for society as well, as with negative externalities like pollution.)"
"Businesses want to limit or stop market competition if they can because of the markets’ prisoner’s-dilemma incentive structure."
"Markets themselves are powerful regulatory tools. They’re so powerful, in fact, that those subject to their prisoner’s-dilemma like incentive structures recoil from them, and want to be protected from them."

Yet Rogers fails to address these factors which are decisive for addressing who's right in the ever-growing rift between common good conservatives vs. Establishment Republicans, a rift around which the Trump phenomenon arose and which has now reshaped the Republican Party into the party of the common man and woman, the working class, racial minorities, the entrepreneur, and small business and redefined the Democrat Party into the party of government intervention for the benefit of the wealthy and the ruling class.
Big subject with lots to write about, Perhaps Professor Rogers will do it in a later essay.

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paladin
on November 07, 2020 at 12:04:47 pm

"But the regulatory effects of markets are powerful not because they indulge self-interest, but because their incentive structures exploit that very same self-interest for the public’s benefit. "

Gee, how about the 'incentive structure" to maximize shareholder value?
How is that working out for the "public benefit"?
Let us take our productive capacity, our manufacturing prowess and ship it off tot hose "dumb Asians". We can milk the profits while minimizing investment costs, increase share price, make ourselves rich and those Asians will never presume to try and a) take our technology and b) produce the stuff themselves.

Yep! Grand MARKET strategy, boyos. works well, does it not and it all accrues to the public benefit.
The only Prisoner's Dilemma here worth considering is the dilemma of all those once productively employed manufacturing personnel and associated engineering professionals who are now prisoners to their new jobs at Walmart.

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gabe
on November 07, 2020 at 17:15:45 pm

Discussion of the relative merits of capitalism and socialism are hindered by ambiguities. This is referenced in Professor Rogers's observation regarding the difference between socialism as state ownership of the means of production and socialism as an imprecise misnomer for social insurance. These ambiguities are used both tactically and strategically to advance other political objectives and ideologies, taking advantage of obfuscation, half-truths, and idiomatic double-talk.

All economic systems require capital. The relevant difference between systems is who controls the capital, and consequently, who gets rich from it. As economic systems go, socialism has some inherent and highly relevant limitations:

1. Socialism lacks an optimizing mechanism for determining who is best qualified to direct the use of capital. The traits that are most useful in acquiring the decision-making authority in a socialist system are not, and cannot reasonably be expected to be, the traits that result in the best use of capital.

2. The incentives for decision-makers in socialist systems are contrary to innovation, long-term efficiency, and ultimately improved quality of life. The reason for this is that the incentives of government planners are inherently and unalterably risk-averse. Risk is necessary to progress, and capitalist systems rewards those who are willing to take risks with capital in order to generate economic benefit by allowing the possibility of profit.

3. Regulation is at base a strategy of risk-minimization. This is entirely reasonable when the risks are such things as airplane crashes, carcinogenic pharmaceuticals, or flourishing criminal gangs. It is less reasonable, for the reason stated in paragraph 2, when those risks are investments that do not pay off, loss of market share to more efficient competitors, or loss of political favoritism. Regulation can also be thought of as a tool, and like any tool can be used for a variety of purposes, good and bad, and can produce both intended and unintended consequences. To the extent that regulation is relied upon for protection of favored economic interests, and suppresses others, society has no practical means of avoiding unintended consequences, no matter how disastrous, other than changing the process of regulation.

4. Socialism is much more prone to unintended consequences, because concentrating decision-making authority also concentrates the privilege of prioritization. In a fair market, participants may determine their own priorities. In a regulated market, they are stuck with what is decided by others, using whatever process is most advantageous to those who are most effective at protecting their own interests.

5. One of the greatest weakness of central planning is its relative inability to adapt. Bureaucracies inevitably develop their own interests wholly apart from their professed purposes. The result is the rise of bureaucratic fiefdoms, that are inherently resistant to change. The interest of bureaucratic preservation takes an increasing priority among regulatory considerations and central planning becomes sclerotic, unable to adapt to uncertainty and unexpected events.

6. Socialism and central planning are devastatingly susceptible to the dominant fallacy of modern politics: the notion that there is nothing in this world that cannot be controlled by policy; the weather, climate, coronavirus, the tides, social attitudes, etc. As Chesterton noted, fallacies do not cease being fallacies just because they become fashions.

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z9z99
on November 09, 2020 at 01:05:20 am

Markets themselves are powerful regulatory tools. They’re so powerful, in fact, that those subject to their prisoner’s-dilemma like incentive structures recoil from them, and want to be protected from them.

On the hypocrisy of capitalists:

“With some notable exceptions, businessmen favor free enterprise in general but are opposed to it when it comes to themselves…. The broader and more influential organizations of businessmen have acted to undermine the basic foundation of the free market system they purport to represent and defend.” Milton Friedman’s lecture, "The Suicidal Impulse of the Business Community" (1983)

“Nobody talks more of free enterprise and competition and of the best man winning than the man who inherited his father's store or farm.” C. Wright Mills

“He was a long-limbed farmer, a God-fearing, freedom-loving, law-abiding rugged individualist who held that federal aid to anyone but farmers was creeping socialism.” Joseph Heller, Catch-22 (1961)

On the relative rigor of market forces compared to regulation: Evaluate any industry that went from regulated monopoly/oligopoly to competitor—airlines, trucking, shipping, telecommunications, wholesale electricity, wholesale natural gas, etc. You’ll often see the incumbent firm shed labor (even if rival firms add labor). Moral: Whatever rigor regulators sought to wield to make these firms efficient paled in comparison to the rigor of the market.

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nobody.really

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