Ideal Free Markets: Exploring Alternatives

[mXSCNT]

Ideal "Free Market"

In an ideal economic system, if Joe knows of some job he can do that will benefit a group of other people by a total of $X, and the cost to Joe in time and materials of doing that job is $Y < $X, then Joe should receive at least $Y (but not more than $X) if he performs that job. That would reimburse him for the cost of performing the job, and allow and incentivize him to increase the total public utility.

A free market works great if the job Joe is doing is selling a consumable product such as cheese. If he sells the cheese, he gets paid something between what it cost to produce and what it's worth to the customer (what they're willing to pay). This works because Joe is selling cheese to one person at a time, and the cheese can only benefit a single person, so the selfish evaluation made by Joe's customer of the cheese value to that customer, accurately describes the total utility of the cheese.

A free market does not work well if the job Joe is doing benefits many people. Suppose Joe wants to install a revolutionary air filtering plant to reduce smog in a densely populated, but unregulated area. Joe can't bargain with any single individual in the area because the cost of the plant is much greater than the value to that specific individual, even though the overall benefit of the plant to everyone does outweigh the cost.

Additionally, Joe can't enter into a simple collective contract with everyone in the area that says for each person "I will pay Joe my fraction of the cost when the plant is built." The reason is that if someone chooses not to enter into this contract but the plant still gets built, then they receive the benefit of increased air quality without having to pay the cost. So no customers would enter into the contract. (We're assuming that everyone is selfishly motivated).

Government regulation is the usual solution to this problem. But government regulation is prone to all sorts of corruption from lobbying that runs contrary to the true public interest. Politicians have only a weak incentive to try to maximize the true public utility. So for this exercise let's ignore conventional government regulation as a solution and look for alternate ones.

Is there some other kind of contract that Joe could devise, so that it would be in each person's best interests to join the contract if and only if they personally would benefit more from the plant than their share of its cost to build?

I'm open to some kind of government or taxation device related to this contract, as long as it doesn't primarily rely on some corruptible government official making the right decisions. For example, a tax whose amount is mandated for everyone, but where the individual decides which organization receives it, would be an acceptable device. Although that specific proposal would probably not provide the results we want.

 

[ektrules]

Instead of incentives, governments could just directly fund the project. Like they do with highways, military, research, etc...

In regards to some kind of contract where each person would benefit more than the share they pay, I'm not sure how you would assign a monetary value to clean air to make that assessment. I guess the monetary value could be assigned based on projected healthcare costs and lifespan, but still, it's hard to assign a value to life.

If there was a tax where everyone decided what organization it would go to, I would bet almost everyone would start their own "non-profit," and pay themselves :) If that was outlawed, they'd enter into informal agreements with their friends to pay each other. If that was outlawed, then they'd pay organizations that only directly benefit them, but may not benefit others, or may even cause harm to others. So that's probably not a good way to structure a society.

I also think it's worth noting that with a "free market" and perfect competition, Joe would be selling his cheese for exactly the cost of making it ($Y in your example). A free market where no profit is made is considered to be optimally efficient.

 

[talk2glenn]

A free market works great if the job Joe is doing is selling a consumable product such as cheese. If he sells the cheese, he gets paid something between what it cost to produce and what it's worth to the customer (what they're willing to pay). This works because Joe is selling cheese to one person at a time, and the cheese can only benefit a single person, so the selfish evaluation made by Joe's customer of the cheese value to that customer, accurately describes the total utility of the cheese.

Not quite. In a perfectly competitive market (what is generally understood to be meant by the "free market" language), Joe's economic profit would be zero - the marginal product would equal the price which would equal the marginal cost.

A free market does not work well if the job Joe is doing benefits many people. Suppose Joe wants to install a revolutionary air filtering plant to reduce smog in a densely populated, but unregulated area. Joe can't bargain with any single individual in the area because the cost of the plant is much greater than the value to that specific individual, even though the overall benefit of the plant to everyone does outweigh the cost.

You're describing the classic problem of market externalities. In this case, there is an external benefit, and society has an interest in internalizing this benefit to maximize social efficiency.

The solution is to have the government pay for so-called public goods: classically, national defense, but also "clean air", "clean water", etcetera.

Is there some other kind of contract that Joe could devise, so that it would be in each person's best interests to join the contract if and only if they personally would benefit more from the plant than their share of its cost to build?

We are looking at a combined free-rider and hostage-taker problem. The plant is of varying, declining value to members of the population, while Joe's cost of entry is fixed. At the point where marginal values equals this entry cost, Joe will enter the market, paid for by those with highest plant value. Those with lower (but still positive) value will not invest, hence the free rider problem. Once Joe has entered, he (and those who value the project relatively highly) will be held hostage by the city (and those who value the plant relatively little). They will use this leverage to exert price controls, and to pass off the costs.

The end result is that the plant is not built.

Joe can use contracts to correct for the hostage-taker problem, but there is no perfect, generally applicable contractual solution to the free-rider problem. Such solutions (defined as all beneficiaries paying according to their relative value, as in a marketplace) tend to only work when the competitors value the good in question equally between them, and if it is commonly known that the good will not be provided without their agreement. We do find "unanimous consent" clauses in many contracts for public goods, as a mechanism for dealing with this. An oil company, for example, will condition an offer to a landowner on the unanimous consent of his neighbors to the same terms. This is called a Coasian Solution. We also have threshold clauses - contracts which only take affect if a certain threshold (in terms of investment, eg) is met. The bidders are assumed to bid simultaneously, without the knowledge of their compatriots decisions or their preferences. This gives everyone an incentive to bid, regardless of the mechanism for dealing with excess (pro-rated refunds or the provision of additional public good) - you want the good (however little), you don't know whether the threshold has been met, ergo you bid where Pi=Vi (P being the bid, V the value). This is called an Assurance Contract.

The remaining solution - Privileged Group - is probably the most common mechanism by which most externally beneficial goods are provided, but the least desirable from a social perspective (absent intervention). This occurs when one party values the good more than the cost of production and the rest of society, such that he is willing to buy it individually, and society at large benefits (think Education as the classic example). The problem with this is that the price, relative to society, is too high and the quantity supplied too low. Governments often intervene in these markets with subsidies, as a corrective mechanism. A real-life example of this is subsidies for home owner energy efficiency upgrades, or the installation of solar panels.

 

[mXSCNT]

Instead of incentives, governments could just directly fund the project. Like they do with highways, military, research, etc...

In practice, trusting corruptible politicians to act in everyone's best interests has certain advantages (and disadvantages) but again, it's just not on topic in this thread. The purpose of this thread is to explore alternate solutions that don't require direct government planning.

I also think it's worth noting that with a "free market" and perfect competition, Joe would be selling his cheese for exactly the cost of making it ($Y in your example). A free market where no profit is made is considered to be optimally efficient.

Not quite. In a perfectly competitive market (what is generally understood to be meant by the "free market" language), Joe's economic profit would be zero - the marginal product would equal the price which would equal the marginal cost.

In the cheese scenario, Joe's marginal profit is 0 but his total profit is greater than 0 due to the law of diminishing returns. The total profit is the area between the price and cost curves. The curves eventually meet, but in perfect competition there is profit on all the units up to the point when the curves meet.

An oil company, for example, will condition an offer to a landowner on the unanimous consent of his neighbors to the same terms. This is called a Coasian Solution.

The Coasian solution is very good and theoretically solves the problem, the only trouble is that it doesn't work as well for cases where the number of people is very large. If Joe overestimates the value to even one of the customers of his air filtration plant, then that customer won't sign and the plant won't get built. But it's the best so far.Another potential solution could be if there were a law that enabled signees to Joe's contract who offer to pay their share, to somehow punish people who do not sign. Or without a specific law, they could still punish non-signees by refusing to do business with the non-signees. They could agree to this as a provision of the contract, once a quorum is met. The question is, does such punishment result in an economically beneficial solution?

 

[ektrules]

Another potential solution could be if there were a law that enabled signees to Joe's contract who offer to pay their share, to somehow punish people who do not sign. Or without a specific law, they could still punish non-signees by refusing to do business with the non-signees. They could agree to this as a provision of the contract, once a quorum is met. The question is, does such punishment result in an economically beneficial solution?

Hmm. That's kind of how labor unions, or maybe even Amish communities work. It's kind of like a directly democratic government itself. Seems to work ok in some circumstances.

I could see a few special-case problems arising though. Consider a small town, with only one store; let's say a Wal-Mart :) Wal-Mart would have much more bargaining power than one of many yard workers. If most of the town doesn't agree with Wal-Mart on something, they can't really refuse to do business with their only store. I suppose someone in town could build a new store (if anyone had the capital), but the new store likely wouldn't have the lucrative business deals, or supply chain, that the monolithic company that is Wal-Mart has, and the cost of goods would be greater. This is mostly just a problem with monopolies though.

Another scenario that I could imagine would be a large power plant that serves a large region, but causes a lot of local pollution. Let's say the people close to the power plant wanted wind turbines to replace the dirty power plant which is causing them to get ill, but it costs slightly more. If the pollution doesn't effect the vast majority of the region, and the vast majority of the region would have little to lose by refusing to do business with the small amount of people living close to the power plant. The dirty plant would probably stay open.

I could also see the most powerful corporations/people banding together on issues to fight the majority. Then you can complicate the matters more when the most powerful start using marketing, propaganda, and disinformation to further sway the majority in their favor. Starting to sound like real-life now :)

Again, it's hard to say what's economically beneficial, because certain things are hard to assign values to. In the above example, some might think that it's the greater good to let a small amount of people suffer from pollution, so that the majority of people can get cheaper energy.

 

[talk2glenn]

In the cheese scenario, Joe's marginal profit is 0 but his total profit is greater than 0 due to the law of diminishing returns. The total profit is the area between the price and cost curves. The curves eventually meet, but in perfect competition there is profit on all the units up to the point when the curves meet.

Not quite. The area between the marginal cost and price curves is producer surplus (which is passed on as wages, rents, and interest), not economic profit. The vertical point difference between the TOTAL cost curve and the market price at the firms equilibrium quantity is the per-unit economic profit. In a competitive market, this distance is zero for any optimal quantity supplied.

Economic profit is always zero in perfectly competitive markets.

The Coasian solution is very good and theoretically solves the problem, the only trouble is that it doesn't work as well for cases where the number of people is very large. If Joe overestimates the value to even one of the customers of his air filtration plant, then that customer won't sign and the plant won't get built. But it's the best so far.

This is true. None of the mechanisms work well as population size goes up. That's why we have governments, and the concepts of public space (the ocean and the atmosphere).

Another potential solution could be if there were a law that enabled signees to Joe's contract who offer to pay their share, to somehow punish people who do not sign. Or without a specific law, they could still punish non-signees by refusing to do business with the non-signees. They could agree to this as a provision of the contract, once a quorum is met. The question is, does such punishment result in an economically beneficial solution?

This kind of behavior is broadly contrary to the principles of efficient markets. Generally, to be efficient, outcomes have to be voluntary and consensual. If you have to force somebody to do something, it isn't in his rational interest, more or less by definition. Besides, under the law, only governments would have the authority to do this (otherwise its collusion). Not practical as a private-party solution.

 

[mXSCNT]

This kind of behavior is broadly contrary to the principles of efficient markets. Generally, to be efficient, outcomes have to be voluntary and consensual. If you have to force somebody to do something, it isn't in his rational interest, more or less by definition. Besides, under the law, only governments would have the authority to do this (otherwise its collusion). Not practical as a private-party solution.

In practice, refusing to do business with people as a retaliation method, perhaps because they refused to buy into some social contract, is extremely widespread (near universal).

1. Boycotts: If a corporation doesn't care about the environment at all, people will refuse to buy from it.
2. Strikes: If a corporation makes decisions contrary to the collective good, people will refuse to work for it.
3. People don't make friends easily with people who buy into opposing political movements, denying all the economic benefits of friendship.
4. If a person fails to be altruistic and other people find out, then he may be excluded or suffer a loss in status.

In fact, the very notion of owning property is grounded in the ability to defend what you own - in the idea that a person will be punished if they take what you own. Without punishment there is almost no ownership.

So punishment is certainly not unusual, and it may not necessarily be undesirable. The real question is not whether including a contract clause that punishes non-signees is wrong purely on principle (it's not), it's whether the clause accomplishes the desired result.

The specific punishment clause I proposed probably would not accomplish the desired result. Either the punishment threatened by non-signees would be too great, in which case everyone would sign regardless of the true utility of Joe's air filtering plant contract, or the punishment threatened would be too small, in which case no one would sign at all. For example, suppose the punishment was 110% of a person's share of the plant's cost if they did sign. Then their cost benefit analysis would go like this:
1. If a quorum is not met, the plant does not get built and it doesn't matter if I sign or not.
2. If a quorum is met and I sign, the plant gets built and it costs me 100% of my share of the cost
3. If a quorum is met and I don't sign, the plant gets built and it costs me 110% of my share of the cost
So in that case, a rational, purely selfish person would always sign - even if the plant were instead a doomsday device set to go off in 10 years!

If the punishment was 90% of the person's share of the plant's cost if they did sign, then the cost benefit analysis would go the other way, and a purely rational, selfish person would never sign, regardless of the public benefit of the plant.

 

[BWV]

Your example proposes a plant that would remove pollution from a communally held property (the air). In any capitalist system you need a rule of law and protection of property rights, including communal property such as air and water resources. Where and at what cost did individuals or firms obtain the right to degrade this communal property? Without government enforcement of these communal property rights there are any number of tragedy of the commons problems, such as air and water pollution or degradation of commercial fisheries

 

[mXSCNT]

Your example proposes a plant that would remove pollution from a communally held property (the air). In any capitalist system you need a rule of law and protection of property rights, including communal property such as air and water resources. Where and at what cost did individuals or firms obtain the right to degrade this communal property? Without government enforcement of these communal property rights there are any number of tragedy of the commons problems, such as air and water pollution or degradation of commercial fisheries

Yes and the topic of this thread is whether the problem can be solved through people acting in their economic best interests (perhaps with a simple law to set the stage) - without the government directly making decisions. Note that the Coasian solution could do exactly that in theory - so the question is are there solutions that could improve on the Coasian one in practice?

 

[BWV]

Well, a Coasian solution might be that Health insurers provide the incentive, either through higher premiums for cities without the plant or even financing the construction themselves if the costs of the plant are less than the marginal healthcare costs from Asthma & other related problems. To the original example, proof of financial support for the plant would qualify for reduced health insurance premiums.

In practice, social pressures are quite effective. Why do people not dump their trash on the highway to the extent they did 40 years ago? Why do most people not park in handicap spaces? These things might be illegal, but the chances of being caught are slim. The social stigma is the real motivator here. Some mechanism of signalling that one has or has not paid his or her share of the plant costs could be effective

 

[mXSCNT]

The insurance company method is interesting, but does it hold water - does an insurance company really have a long term incentive to improve the health of a population?

In the short/medium term if an insurance company reduces pollution in an area, then they have to pay out fewer claims. But also, the people living in the area now have less demand for health insurance because they get sick less often. So they either wouldn't buy insurance or wouldn't pay as much for it. Wouldn't it balance out eventually if people are allowed to switch insurance carriers freely, and act rationally and selfishly?

But we can talk about adding a law to prevent people from switching insurance carriers or not buying insurance. We could designate mandatory insurance companies for geographic regions. If we add that law then the government must also fix the price of insurance somehow, otherwise the insurance companies would take advantage of their monopoly and raise the price. The question is then, what policy could the government use to set the price of insurance so that insurance companies are efficiently motivated to improve the long term general health of their subscribers?

The price setting policy must be firm and mathematical, not based on fuzzy dealmaking, otherwise lobbyists could influence it (and anyway, we couldn't analyze it). And if the policy allows for a reduction in the price of insurance when the cost of healthcare goes down, we must assume that insurance companies will consider that as a reason not to improve the health of their subscribers.

One potential solution could be to have multiple insurance companies each responsible for a given district, and set the price of insurance based on the average cost of healthcare across all districts. Each insurance company would then have an incentive to improve the health of its district, because although doing so would bring down the price of insurance, the price would be averaged among all their competitors. So if their district has a lower cost of healthcare than surrounding districts, the insurance company turns a profit.

The obvious disadvantage with that solution is the fact that different districts have different demographics. If one district is a college town and the other is a retirement community, the insurance company responsible for the retirement community would go out of business.

So, you could have some government demographer set an insurance price multiplier based on the demographics of the community. Insurance companies would be rewarded if their communities had lower health care costs than demographically comparable communities. But this is now getting into the government directly making decisions; the demographer doesn't have a clear incentive to be accurate or fair.

So instead of a demographer, suppose we set the insurance prices using a predictions market. The number we would like to predict for each district is the cost of healthcare over the next 10 years, if the insurance company took no corrective action to reduce that cost. That would be used to set the price of insurance ahead of time, and then if the population needed less healthcare, the insurance company would turn a profit.

One way to set up the rules for such a predictions market would be by flipping a coin - heads, the government does not regulate insurance at all for the district, and the investors into the market are rewarded or punished based on the outcome of the bets they placed earlier. Tails, the government does set up an artificial monopoly for one insurance company in that district, and all transactions in the predictions market are reversed as if they never happened.

The obvious problem with this method is, if the coin comes up heads, thousands of people might die as a result of not having the insurance company to help them.

Can this be fixed?