In a free market there are converging and diverging forces which may increase or reduce economic inequality. We discuss the pros and cons of free market economy and whether allocative efficiency justifies growing inequality.
Sir Charles Bean is Professor of Economics and member of the Office for Budget Responsibility. Before joining the Department of Economics at the LSE, he was Deputy Governor of the Bank of England. Charles Bean is an expert in monetary policy and macroeconomics.
Should we privilege allocative efficiency and accept the resulting inequality?
Market prices play an important role in signalling scarcity and providing people and businesses with the right incentives. Voluntary exchanges undertaken in competitive markets may produce efficient outcomes in terms of allocation of resources. Free markets may nevertheless sometimes result in unsatisfactory outcomes too. Income inequality is one of these side effects pointed at by some economists. Government intervention in the market may therefore be justified if we seek to reduce inequality or address other problems associated with free markets. Interventions that work with the grain of markets rather than against them is a current practice in most market economies. Managing this trade-off between promoting market efficiency and curbing income inequality has become one of the most important conundrums for policy-makers and economists in the 21st century.
Economists are sometimes divided into two camps. On the one hand, those who follow the ideas of Friedrich Hayek and Milton Friedman, defending the free market and opposing government intervention. On other hand, there are economists, like John Maynard Keynes, who emphasize the role of governments and regulation and warn us of some of the problems associated with complete free market capitalism.
Allocative efficiency is an economic term which refers to the optimal distribution of goods and services, once consumer preferences are taken into consideration. Market efficiency theory predicts that in perfectly competitive markets, a price equilibrium is reached when the the marginal cost of producing a good or service is equal to the marginal benefit consumers receive from them. Market efficiency is one of the main arguments in defence of unleashing markets. Free competition and voluntary adjustment of prices are requisites for achieving allocative and productive efficiency in a market. This is one of the reasons why economists tend to criticize government regulation of prices.
Prices set the terms of trade for exchange and play three major functions:
- Transmit information about the value to the buyer (demand) and the cost to the seller (supply).
- Provide an incentive to substitute from high-price goods to similar low-price goods and from activities with a low return to activities with a high return (i.e. to act on the information about demand/supply).
- Determine the distribution of income and so provide appropriate incentives for the acquisition of suitable skills and the accumulation of capital.
Overall, a competitive market economy produces an efficient outcome, in the sense that nobody can be made better off without making someone else worse off (“Pareto efficiency”). The efficient market hypothesis formalizes Adam Smith’s metaphor of an “invisible hand” that leads self-interested individual behaviour to result in socially beneficial outcomes.
Inequality and the forces of divergence
Neo-classical economists have traditionally defended the idea of convergence in free markets. This notion of convergence refers to a catch-up effect which makes poorer economies grow at a faster pace than richer countries due to difussion of knowledge and skills and the lower cost of production. However, convergence theory is becoming increasingly criticized. Free market is considered by many economists as one of the major causes of income inequality and economic disparity. Moses Abramovitz argues that developing countries need "social capabilities" in order to activate this catch-up mechanism and take advantage of their lower production costs and the technological advances introduced by richer countries. Robert Lucas showed that capital does not always flow from developed to developing countries ("Lucas Paradox").
The French economist, Thomas Piketty argues that the diffusion of knowledge and skills is the key to productivity growth and to inequality reduction. The forces of convergence, such as the law of supply and demand and the mobility of labor and capital, are not strong enough to compensate the effect of the forces of divergence which are pushing toward greater inequality. Under "market efficiency" conditions, top earners can quickly separate themselves in terms of income and wealth. For instance, top executives have the capacity to set their own salaries. Moreover, inequality increases because often the return on capital is higher than rate of economic growth (r >g). Private wealth derived from real estate, financial assess and professional capital has grown steadily since the 1950s. Wealth puts people, and countries, in a situation of structural advantage compared to others. The wealth and income gap increases. Finally, the forces of convergence, are not completely spontaneous. For instance government intervention is key to the the education policies necessary for the diffusion of knowledge.
Do you think governments should intervene to make sure that these forces of divergence are controlled? Should they rather abstain to facilitate market efficiency? Is "inequality a necessary evil"?
Watch Prof. Thomas Piketty's lecture at the LSE as well as the discussion on whether markets are efficient between Prof. Eugene Fama and Prof. Richard Thaler (Chicago Booth)
Free market pros and cons
Critics and advocates of market liberalization have produced many arguments for and against "free market." These are some of the most commonly cited advantages and disadvantages:
Free market pros
- A competitive free market economy produces an efficient outcome. The allocation of resources and productive capacities are optimized.
- Free markets have historically contributed to an increase in trade and economic growth, and to the emergence of liberal democracies.
- Globalization, which to a great extent was driven by free market ideals, has also helped to multiply and enrich cultural and social exchanges.
- Free markets drive investment and innovation. Investment and innovation are inherently uncertain; free markets offer incentives to companies to undertake risks.
- Similarly, free market leads to diversity and experimentation.
- Free market facilitates productive entrepreneurial behavior.
- Governments often lack the sufficient knowledge or resources to steer the complex machine of the economy in its entirety. Sometimes government intervention fails. Therefore, market "self-regulation" is usually more effective.
- Governments can be corrupt or subject to special interest (rent-seeking behavior and government capture).
Cons of free market
- In free markets, there are forces of divergence that contribute to income and wealth inequality.
- Markets need to be supported by rules and institutions which only government can guarantee. For instance, governments secure property rights, enforce contracts and supply money.
- Externalities. Individuals may ignore the impact of their actions on others, either positive or negative externalities.
- The insufficient allocation of public goods (e.g. defence, health, education) due to their non excludable nature and free-riding is another limitation of free market theory.
- Market power may be abused. There are many examples of monopolistic and cartelistic behavior of companies disrupting allocative and productive efficiency, as well as generating a welfare loss.
- Economic crises are often amplified by the lack proper regulation. They provide evidence of market malfunctioning.
- Competitive markets and globalization produce both winners and losers. For instance we have witnessed a booming global elite while middle-classes were in decline.
- The perceived failure of free market economies is one of the reasons for the emergence of populist and xenophobic leaders in many countries.
- Friedman,M. and Friedman,R.D (1980), "Chapter 1 The Power of the Market," in Free To Choose: A Personal Statement. New York: Harcourt
- Irwin, D.A. (2015), Free Trade Under Fire. Princeton University Press
- Piketty, T. (2014), Capital in the Twenty-First Century. Cambridge, Massachusetts : The Belknap Press of Harvard University Press.
- Rodrik, D. (2015) ‘Economics Rules: the rights and wrongs of the dismal science’. LSE Podcast, 7 October 2015. Listen to minutes 3-30. Full Audio available online
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Free market pros and cons - Should we privilege allocative efficiency and accept the resulting inequality?
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