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.