No Market approach

Although I think markets have a place in society, and are a natural outcome of community(econ pages) I think it is worth examining the ideas in this work:

States created markets, markets require states, neither could continue without the other, at least in anything like forms we recognize today…markets are an effect of government administration. David Graeber

The case against markets
by Robin Hahnel

Markets are an efficient way of producing and distributing a very large number of mundane items. Market incentives are a dependable way of getting our bread baked. Markets allow us to make the best use of the information dispersed throughout a society. Markets give their participants a certain kind of freedom–expanding the range of choices and giving each person a variety of partners with whom to deal.

–David Miller and Saul Estrin (1994)–

Rather than efficiency machines, optimal incentive systems, cybernetic miracles, and human liberators, when we examine markets we find institutions that generate increasingly inefficient allocations of resources, unleash socially destructive incentives unnecessarily, bias and obstruct the flow of essential information for economic self-management, substitute trivial for meaningful freedoms, and lead to irremediable inequities in the distribution of goods and power.

–Robin Hahnel and Michael Albert (1990)–

The debate between those who believe that markets are an integral part of a desirable economy and those who believe we must eventually replace the market system with some kind of democratic planning is long standing. By the end of the twentieth century, supporters of markets had the upper hand for obvious reasons. (1) The demise of central planning not only in the Soviet Union and Eastern Europe, but in China, Vietnam, and Cuba (to a lesser degree) casts a pall over any talk of comprehensively planning how best to use productive resources. (2) In Western Europe and the United States, the free market jubilee began in the 1980s when Margaret Thatcher and Helmut Kohl defeated social democracy in Europe and Ronald Reagan put liberals in the United States on the run. (3) When social democrats regained power in Germany and Great Britain, and Democrats won back the White House in the 1990s, instead of reigning in market mania Tony Blair, Gerhard Schroeder, and Bill Clinton routed progressive forces inside their own parties, promoted pro-market, “third way” domestic policies, and directed the IMF (International Monetary Fund), WTO (World Trade Organization), and World Bank to force free market medicine down the throat of one third world country after another. (4) In the aftermath of the East Asian financial crisis even mighty Japan Inc. and other Asian “tigers” like South Korea were forced to bow to the market gods they had long held at bay, and abandon their highly successful “Asian model” of long-run international economic planning.

Consequently, by century’s end, to speak ill of markets narrowed one’s access to ears, and progressive economists quickly learned how to reformulate criticisms as suggestions about improving market performance. Any hint that one considered markets to be part of the problem rather than the key to the solution to any economic problem was sure to blow one’s cover in the economics profession as well as policy circles. Proclaiming oneself a “market abolitionist” at the dawn of the new millennium was tantamount to a plea of insanity.

But, while it is easy to see why the shrinking circle of progressive economists with lingering doubts about markets have been cowed into silence, none of the above “reasons” have any logical bearing on the positive and negative aspects of either markets or democratic planning. Market performance is not enhanced by the collapse of central planning or by an increase in ideological hegemony of those who sing in praise of markets. Nor does the demise of authoritarian planning mean that democratic planning is also a bad idea. As a matter of fact, one reading of the empirical evidence of market performance over the past thirty years is that when constraints on markets are weakened, the damage to human livelihoods and the environment increases dramatically. In any case, having no cover left to blow, I take this opportunity to reiterate the theoretical case against the market system. (1)

The debate between those who favor the market system and those who favor democratic planning has always consisted of two parts: (1) How bad are markets? And, (2) is there a feasible alternative that is any better? I make no attempt to address the second question in this article having done so elsewhere (Albert and Hahnel 1991a; 1991b; 1992a; 1992b; and 2002; and most recently, Hahnel 2005, where I go to great lengths to respond to important concerns others have raised about democratic planning.) In this article, I also make no attempt to explain why markets inevitably reward people unfairly. I refer readers to Hahnel (2004) for the case against markets on equity grounds, and why I do not believe correctives would be forthcoming even in “market socialist” economies. In this article, I confine myself to arguing that contrary to both popular and professional opinion, there is every reason to believe that markets allocate resources very inefficiently and undermine rather than promote democracy. I also reiterate the case that markets are perhaps the most socially destructive institution ever devised by the human species.

Why Markets Are Inefficient

It is well known among professional economists that markets allocate resources inefficiently when they are out of equilibrium, when they are non-competitive, and when there are external effects. When the fundamental theorem of welfare economics is read critically it says as much: Only if there are no external effects, only if all markets are competitive, and only when all markets are in equilibrium is it true that a market economy will yield a Pareto optimal outcome. But despite these clear warnings, market enthusiasts insist that if left alone markets generally allocate resources very efficiently. This conclusion can only be true if: (1) disequilibrating forces are weak, (2) non-competitive market structures are uncommon, and (3) externalities are the exception, rather than the rule. I will offer theoretical reasons to believe exactly the opposite in all three cases. A second line of defense holds that while free markets may be plagued by inefficiencies, it is possible to “socialize” markets through various policy correctives and thereby render them “reasonably” efficient. While I generally support policies to ameliorate market inefficiencies, I will offer practical reasons why it is a pipe dream to believe that such policies could ever render market systems “reasonably” efficient.

Why Externalities Are Likely To Be Pervasive

Markets permit people to interact in ways that are convenient and mutually beneficial for buyers and sellers. Market exchanges are convenient whenever transaction costs of exchanges are low–which is the case when those others than the buyer and seller are excluded from the transaction. And, it is a tautology that any voluntary agreement is mutually beneficial under the assumptions of rationality and perfect knowledge. While knowledge (which includes foresight) and rationality are seldom perfect, I am happy to stipulate that both are often “good enough” so that market exchanges are frequently beneficial to both buyer and seller. But convenience and benefits for buyer and seller do not imply social efficiency. Ironically, the very factors that render markets convenient and beneficial for buyers and sellers also render them socially inefficient.

Increasing the value of goods and services produced and decreasing the unpleasantness of what we have to do to produce them are two ways producers can increase their profits in a market economy, and competitive pressures will drive producers to do both. But maneuvering to appropriate a greater share of the goods and services produced by externalizing costs onto others and internalizing benefits without compensation are also ways to increase profits. Moreover, competitive pressures will drive producers to pursue this route to greater profitability just as assiduously. Of course the problem is, while the first kind of behavior serves the social interest as well as the private interests of producers, the second kind of behavior serves the private interests of producers at the expense of the social interest. When sellers (or buyers) promote their private interests by externalizing costs onto those not party to the market exchange, or by appropriating benefits from other parties without compensation, their behavior introduces inefficiencies that lead to a misallocation of productive resources, and consequently, a decrease in the value of goods and services produced in the economy.

The positive side of market incentives has received great attention and praise, dating back to Adam Smith who coined the term “invisible hand” to describe it. The darker side of market incentives has been relatively neglected and grossly underestimated. Two exceptions are Ralph d’Arge and E.K. Hunt (1971; Hunt and d’Arge 1973; and Hunt 1980), who coined the less famous, but equally appropriate term, “invisible foot” to describe the socially counter productive behavior markets drive participants to engage in.

Market enthusiasts seldom ask: Where are firms most likely to find the easiest opportunities to expand their profits? How easy is it usually to increase the size or quality of the economic pie? How easy is it to reduce the time or discomfort it takes to bake the pie? Alternatively, how easy is it to enlarge one’s slice of the pie by externalizing a cost, or by appropriating a benefit without payment? Why should we assume that in market economies it is infinitely easier to expand private benefits through socially productive behavior than through socially counter productive behavior? Yet this implicit assumption is what lies behind the view of markets as guided by a beneficent invisible hand rather than a malevolent invisible foot.

Market admirers fail to notice that the same feature of market exchanges primarily responsible for small transaction costs–excluding all affected parties other than the buyer and seller from the transaction–is also a major source of potential gain for the buyer and seller. When the buyer and seller of an automobile strike their convenient deal, the size of the benefit they have to divide between them is greatly enlarged by externalizing the costs onto others of the acid rain produced by car production, and the costs of urban smog, noise pollution, traffic congestion, and greenhouse gas emissions caused by car consumption. Those who pay for these costs, and thereby enlarge automobile manufacturer profits and car consumer benefits, are easy marks for car sellers and buyers for two reasons. They are dispersed geographically and chronologically, and, the magnitude of the effect on each negatively affected, external party is small, yet not equal. Consequently, individually, external parties have little incentive to insist on being party to the transaction–the external effect on a single party is seldom large enough to make it worthwhile for one person to try to insert herself into the negotiations. But there are formidable obstacles to forming a coalition to represent the collective interests of all external parties as well.

Organizing a large number of people who may be dispersed geographically and chronologically, when each has little but different amounts at stake is a difficult task. Who will bear the transaction costs of approaching members when each has little to benefit? When approached, who will report truthfully how much they are affected when it is to their advantage to either over or under exaggerate? Ronald Coase (1960) recognized these transaction cost and free rider problems associated with forming a voluntary coalition of pollution victims when he explicitly stipulated that his argument for the efficacy of private negotiations between polluters and pollution victims applied only to situations where there was a single pollution victim and not to situations where there were multiple victims. Nor can we solve the free rider and hold out incentive problems inherent in organizing a coalition of those who are negatively affected by car production and consumption by awarding them the “property right” not to be victimized without their consent. As Coase also demonstrated convincingly, efficiency–or in this case, inefficiency–depends solely on incentives, and is unaffected by whether victims of external effects possess the property right not to be victimized, or those whose behavior negatively affects others have the legal right to do so. Who has the property right merely determines who must approach and bribe whom; it does not change the fact that when there are multiple victims they face formidable transaction costs, and, free rider and hold out incentive problems to acting collectively.

It should be noted that the opportunity for buyers and sellers to benefit at the expense of external parties is not eliminated by making markets perfectly competitive or entry costless, as is commonly assumed. (2) Even if there were countless perfectly informed sellers and buyers in every market, even if the appearance of the slightest differences in average profit rates in different industries induced instantaneous self-correcting entries and exits of firms, even if every buyer were equally powerful as every seller–in other words, even if we embrace the full fantasy of market enthusiasts–as long as there are numerous external parties with small but unequal interests in market transactions, those external parties will face greater transaction cost and free rider obstacles to a full and effective representation of their collective interest than that faced by the buyer and seller in the market exchange.

If we include the free rider and hold out incentive problems faced by external parties as part of their overall transaction costs, one way to see the problem is that markets reduce the transaction costs for buyers and sellers but do nothing to reduce the transaction cost of participation in decision making by externally affected parties. It is this inequality in transaction costs that makes external parties easy prey to rent seeking behavior on the part of buyers and sellers. Even if we could organize a market economy so that buyers and sellers never face a more or less powerful opponent in a market exchange, this would not change the fact that each of us has smaller interests at stake in many transactions in which we are neither buyer nor seller. Yet the sum total interest of all external parties can be considerable compared to the interests of the buyer and the seller. (3) It is the transaction cost and free rider incentive problems of those with lesser interests that create an unavoidable inequality in power between those who make an exchange and those who are neither buyer nor seller but are affected by the exchange nonetheless. This is the power imbalance that allows buyers and sellers to benefit at the expense of disenfranchised external parties in ways that cause social inefficiencies.

In sum, a sufficient condition for buyers and sellers to have the opportunity to profit in socially counter productive ways by shifting costs onto others is that each one of us has diffuse interests that make us affected external parties to many exchanges in which we are neither buyer nor seller. Even if we could make every market perfectly competitive and thereby eliminate any power imbalance between buyers and sellers, this source of market inefficiency would persist.

Not every buyer and seller is equally powerful in real world markets. Many markets are non-competitive, i.e. there are sufficiently few sellers or buyers, so one party to a market exchange has greater bargaining power than the other. It is well known that when sellers are few it is in their individual interest to produce an output that is, collectively, less than is socially optimal. (4) Assuming equal cost structures a rational monopolist will restrict output the most below socially optimal levels. Rational duopolists will jointly produce more than a rational monopolist, but still less than the socially optimal level. A three firm oligopoly will produce more than a duopoly, but less than the socially optimal level nonetheless, etc. In other words, just as it is easier to make profits at the expense of disenfranchised external parties than through socially productive behavior, it is often easier to make profits through noncompetitive behavior than socially productive behavior. When a few large powerful players on one side of a market exchange, face many small powerless players on the other side, it is often more sensible for large players to pursue socially counter productive strategies to take advantage of their weaker market opponents than it is for them to search for ways to increase the size of the economic pie or reduce the time and discomfort necessary to bake it. In the real world there are consumers with little information, time, or means to defend their interests against huge, corporate producers. There are small, capital-poor, innovative firms for giants like IBM and Microsoft to buy up instead of tackling the hard work of innovation themselves. Noncompetitive market structures give rise to highly profitable, but socially counter productive behavior.

In The Transformation of American Capitalism, John Munkirs provides overwhelming evidence to refute the myth that the U.S. market system remotely resembled the fantasy world of perfect competition prior to 1980. By 1980, most U.S. GDP was already produced by firms operating in non-competitive markets. Since then, U.S. business has gone through a prolonged merger mania, which has dramatically increased what Michael Kalecki called “the degree of monopoly” in the economy. Using weighted concentration ratios for the entire economy, Frederick Pryor argued that industrial concentration decreased in the United States from 1960 to the early 1980s but has increased ever since as merger waves more than offset counteracting effects from imports and the growth of information technology in production (Pryor 2001). According to Danaher and Mark (2003, 3) between 1998 and 2000 alone, the U.S. economy witnessed $4 trillion in mergers. According to Hartmann (2002, 37) the largest 1,000 companies account for about 70% of U.S. GDP.

In sum, more markets have become non-competitive, and markets that were already not competitive have become even less so. As anti-trust legal actions declined and regulation of non-competitive industries diminished, it has become ever easier to profit by taking advantage of non-competitive market structures in socially counter productive ways instead of tackling the difficult job of increasing the value of goods produced or reducing the sacrifices necessary to make them.

Why Markets Do Not Always Equilibrate

Real markets do not always equilibrate quickly, much less instantaneously. The famous “laws” of supply and demand, which predict that when market price rises quantity supplied will increase and quantity demanded will decrease, leading markets toward their equilibria, are based on a questionable, implicit assumption about how market participants interpret price changes. Standard analysis implicitly assumes that sellers and buyers believe that when the market price rises the new higher price is the new stable price. Or, more precisely, standard reasoning assumes that when a market price rises, buyers and sellers assume that price is just as likely to fall from this new higher price as it is to rise further. If this is truly the case, then it is sensible when market price rises for sellers to offer to sell more than before and for buyers to offer to buy less than before–as the “laws” of supply and demand say they will. However, sometimes buyers and sellers quite sensibly interpret price changes as indications of further price movements in the same direction.

In this case, it is rational for buyers to respond to an increase in price by increasing the quantity they demand before the price rises even higher, and for sellers to reduce the quantity they offer to sell waiting for even higher prices to come. When buyers and sellers behave in this way they create greater excess demand and drive the price even higher, leading to a market “bubble.” When buyers and sellers interpret a decrease in price as an indication that the price is headed down, it is rational for buyers to decrease the quantity they demand, waiting for even lower prices, and for sellers to increase the quantity they offer to sell before the price goes even lower. In this case their behavior creates even greater excess supply and drives the price even lower, leading to a market “crash.” This means that if market participants interpret changes in price as signals about the likely direction of further price changes, and if they behave “rationally,” they will not only fail to behave in the way the “laws” of supply and demand would lead us to expect, they will behave in exactly the opposite way from what these “laws” predict.

Standard textbook treatments try to salvage the “laws” of supply and demand in face of these seemingly anomalous outcomes by interpreting them as the result of changes in the “expectations” of buyers and sellers that shift the supply and demand curves. In the standard explanation, both before and after the shift, the supply curve slopes upward and the demand curve slopes downward, i.e., at all times they obey the “laws” of supply and demand. It is the shift that causes the seemingly anomalous result that the quantity actually demanded responds positively to changes in price while the quantity actually supplied responds negatively to changes in price. It is certainly true that the anomalous behavior results from changes in expectations, but what textbooks invariably fail to point out is that the standard interpretation renders the “laws” of supply and demand unfalsifiable. In any case, however one chooses to interpret the phenomenon, it is clear that market bubbles and crashes can result from behavior on the part of individual buyers and sellers that is perfectly rational when they interpret a change in price as an indication of the direction the price is headed, and that this behavior leads to movement away from, rather than toward the market equilibrium.

As the East Asian financial crisis reminded us, financial market bubbles that burst can generate great efficiency losses in the “real” sector of their economies when “vicious” disequilibrating dynamics in financial markets overpower “virtuous” equilibrating forces. Moreover, those who believe that bubbles and crashes only occur in a few markets where many players are speculators should remember their own explanation for why all units of a good tend to sell at a uniform market price. Only when people are free to engage in arbitrage do we get “well ordered” markets and uniform prices in the first place. This means mainstream economists must expect and welcome players who are motivated purely by hopes of profiting from trading rather than because they have any use for the particular good being bought and sold. Since those who engage in arbitrage have no interest in the usefulness of the good in question, it seems likely that they would be particularly sensitive to the implications of a change in price on the likely direction of further price changes, and therefore on their profits from trading. In this case, it would appear unlikely we would have well ordered markets, which require actors who engage in arbitrage, without speculative players being present as well. The view that we have many well ordered markets free from speculative players and the kind of problems they bring, and only need worry about problematic disequilibrating forces in a small number of speculative markets may be difficult to justify upon close examination. What we may have instead are some markets that suffer from allocative inefficiencies because the same good often sells for different prices for lack of sufficient players engaged in arbitrage, and other markets immune from this problem because there are enough players engaged in arbitrage, but prone to disequilibrating forces because actors engaged in arbitrage are also prone to price speculation, yielding a different kind of inefficiency. An exciting new area for theoretical research about market dynamics is to use agent based simulation modeling techniques to explore outcomes where some market participants interpret price changes as signals while others assume new prices will remain stable. This research threatens to call into question what it means to say a market is “well-ordered” or a price is consistent with “market fundamentals.”

Even when equilibrating forces outweigh disequilibrating forces in a single, isolated market, when equilibration is not instantaneous–which it seldom is–it is possible for disequilibrating dynamics to operate between two connected markets. Keynes’ greatest insight about self-reinforcing recessionary dynamics can be framed in these terms. (5) Consider a labor market and a goods market. Assume that if either market is out of equilibrium the excess supply or excess demand in that market will eventually lead to wage or price adjustments leading that market to its equilibrium. Now assume that while the goods market is initially in equilibrium, the labor market is not because the wage rate is temporarily higher than the equilibrium wage. While the excess supply in the labor market will generate equilibrating forces pushing the wage rate down toward its equilibrium, suppose it does not reach its equilibrium immediately, and in the meantime labor contracts are struck at a wage rate that is still higher than the equilibrium wage. If the labor demand curve is elastic this will result in lower labor income than would have been the case if the wage rate had reached its equilibrium. But the demand curve in the goods market was premised on the (implicit) assumption that the labor market was in equilibrium, and therefore that labor income was higher than it actually will be. When we reconstruct the demand curve in the goods market based on the actual outcome in the labor market, where labor income is lower than it would have been had the labor market been in equilibrium, we get an actual goods demand curve to the left of the one anticipated. No matter how quickly or slowly the price in the goods market adjusts to the resulting excess supply, we will get a drop in sales and revenues in the goods market.

But lower sales and revenues in the goods market will decrease the demand for labor in the labor market. The demand curve we originally drew in the labor market was premised on the (implicit) assumption that we had reached the equilibrium outcome in the goods market. Now that sales and revenues are lower in the goods market, when we reconstruct the demand for labor curve based on the new, actual outcome in the goods market, we get a new demand for labor curve to the left of the initial one. No matter how quickly or slowly the wage rate adjusts to the new excess supply, employment and labor income will drop, further depressing the actual demand for goods in the goods market. Instead of remaining in equilibrium in the goods market and moving toward the higher, equilibrium level of employment in the labor market, we move out of equilibrium in the goods market and even farther away from equilibrium levels of employment in the labor market. In general when price adjustments are not instantaneous, and “false trading” takes place at non-equilibrium prices, we can easily get disequilibrating dynamics operating between interconnected markets.

Sufficient conditions to give rise to this kind of disequilibrating dynamic between connected markets are: (1) One market must be temporarily out of equilibrium in the first place. (The second market can begin in equilibrium.) (2) The price in the market out of equilibrium can adjust, but must not adjust instantaneously to its equilibrium level so that some “contracting” takes place at a non-equilibrium price. (In the second market price adjustment can be instantaneous.) (3) The demand curve in the market that began out of equilibrium must be elastic. These highly plausible conditions can give rise to disequilibrating dynamics between markets that would not have displayed the kind of disequilibrating dynamics on their own described previously.

In sum, while every economics text book explains how self interested behavior of buyers and sellers leads to equilibrating price adjustments whenever there is excess supply or demand in a market, they devote little if any attention to the study of disequilibrating forces which are also the product of self-interested behavior by market participants, and which frequently overpower the equilibrating forces Adam Smith made famous hundreds of years ago.

Practical Problems with Policy Correctives

When reminded of the important qualifying assumptions that are integral to the fundamental theorem of welfare economics and when faced with theoretical reasons to believe that externalities, non-competitive market structures and disequilibrium dynamics are neither rare nor trivial problems, supporters of the market system respond in different ways. There is an increasingly clear divide between “free market fundamentalists” whose influence has grown significantly over the past few decades, and more pragmatic supporters of the market system who favor what some of them call “socialized markets.” The ideologues’ enthusiasm for a laissez-faire market system literally knows no bounds as they brush aside qualifying assumptions in fundamental welfare theorems and the Coase theorem as if they did not exist. Market pragmatists, on the other hand, concede that we must “socialize” markets with policies not only to reduce inequities but to internalize external effects, curb monopolistic practices, and counter disequilibrating forces as well. Some of these pragmatists are even cognizant of Karl Polanyi’s insight that the market system cannot function without institutional support, which cannot be willed into existence over night, and understand that how well or badly a market system will function depends to a great extent on the social institutions that support it. However, I believe those who give qualified support to “socialized markets” conveniently ignore a number of practical problems that inevitably arise whenever we attempt to “socialize” them.

* The job of correcting for external effects is daunting, because they are the rule rather than the exception. As E.K. Hunt explained:

The Achilles heel of welfare economics is its treatment of externalities…. When reference is made to externalities, one usually takes as a typical example an upwind factory that emits large quantities of sulfur oxides and particulate matter inducing rising probabilities of emphysema, lung cancer, and other respiratory diseases to residents downwind, or a strip-mining operation that leaves an irreparable aesthetic scar on the countryside. The fact is, however, that most of the millions of acts of production and consumption in which we daily engage involve externalities. In a market economy any action of one individual or enterprise which induces pleasure or pain to any other individual or enterprise constitutes an externality. Since the vast majority of productive and consumptive acts are social, i.e., to some degree they involve more than one person, it follows that they will involve externalities. Our table manners in a restaurant, the general appearance of our house, our yard or our person, our personal hygiene, the route we pick for a joy ride, the time of day we mow our lawn, or nearly any one of the thousands of ordinary daily acts, all affect, to some degree, the pleasures or happiness of others. The fact is externalities are totally pervasive. (Hunt 1980)

In the previous section I merely attempted to bolster Hunt’s claim with theoretical arguments explaining why competitive pressures that steer market participants toward the least line of resistance for advancing their personal situations is prone to lead them to frequently take advantage of easily disenfranchised external parties.

* The popular impression that the Coase theorem “proves” that government intervention is unnecessary to correct for inefficiencies due to external effects because once property rights are clear, private negotiations between polluters and pollution victims will lead to efficient outcomes is completely misinformed. Most importantly, Coase (1960) himself explicitly stated that he was only considering situations where there was a single pollution victim. Moreover, Coase recognized that whenever there were multiple pollution victims there would be transaction cost and free rider problems for pollution victims that would in all likelihood preclude them from the kind of negotiation he discussed. Those who cite his “theorem” to argue against government intervention conveniently ignore the critical assumption that there is only a single pollution victim. (6) Furthermore, it turns out on careful examination that the so-called Coase “theorem” hinges on the highly implausible assumption that both parties to the negotiations have what game theorists call “complete information”–i.e., that each party knows not only what her own marginal benefit or marginal damage curve looks like, but what the curve of her opponent looks like as well. Whenever this is not the case it turns out that parties have an incentive to deceive their opponents in ways that will predictably lead to inefficient outcomes. Since it is seldom the case that a polluter will know how much a victim is damaged, or a victim will know how much a polluter benefits from pollution, the conclusion that private negotiations between a polluter and even a single victim will lead to an efficient level of pollution does not follow in general. (7) In other words, when rigorously examined the Coase “theorem” provides overwhelming reasons to believe that most external effects will go uncorrected through private negotiations between affected parties exactly the opposite of what free market environmentalists insist.

* Alfred Pigou proved long ago that when there are negative external effects in a market a corrective tax is required to eliminate the inefficiency, and when there are positive externalities a corrective subsidy is indicated. Moreover, Pigou also taught us that the corrective tax or subsidy should be set equal to the magnitude of the external effect. But how are we to know what the size of the external effect is? It is hard to calculate accurate corrective, or “Pigovian” taxes and subsidies because there are no convenient or reliable procedures in market economies for estimating the magnitudes of external effects. In this crucial regard, the market offers no assistance whatsoever forcing us to resort to what are inevitably very imperfect measures. The most common method of estimating the size of external effects in market economies lies with willingness to pay and willingness to accept damage “contingent valuation” surveys. But unfortunately, contingent valuation surveys have well known biases that can be exploited by special interests, and efforts to reduce “hypothetical bias” necessarily increase “strategic bias,” and attempts to diminish “ignorance bias” necessarily increase “imbedded bias.” Moreover, estimates derived from willingness to accept damage surveys are on average four times higher than estimates derived from willingness to pay surveys, even though, in theory, they should yield roughly similar results. This hardly breeds confidence in the accuracy of contingent valuation surveys in general, and provides interested parties with ample opportunities to object to estimates that disadvantage them and finance alternative studies that give widely different results. While popular among economists, it is well known that hedonic regression studies are inherently incapable of capturing two entire categories of external effects–existence value and option value–rendering them unsuited to providing accurate estimates of the full range of external effects. Moreover, these are only some of the practical problems of estimating external effects. Beneath these practical problems lurk deeper questions of what is invariably lost when we attempt to monetize environmental benefits and when we fail to critically evaluate the origins of the preferences our stop-gap techniques try to estimate. William Kapp and Gregory Hayden are two who have warned of more fundamental problems with standard procedures used to account for external effects (Kapp 1950; Hayden 1983; 1988; 2006; and Eberle and Hayden 1991.).

* Because they are unevenly dispersed throughout the industrial matrix, the task of correcting the entire price system for the direct and indirect effects of externalities is even more daunting. Even if the external effects of producing or consuming a particular good were estimated accurately, if the external effects of producing or consuming goods that enter into the production of the good in question are not also accurate, the theory of the second best warns us that the Pigovian tax we place on the good in question may move us farther away from an efficient use of our productive resources rather than closer.

* In the real world, where private interests and power take precedence over economic efficiency, the beneficiaries of accurate corrective taxes are all too often dispersed and powerless compared to those who would be harmed by an accurate corrective tax. As Mancur Olsen explained long ago in The Logic of Collective Action, this makes it very unlikely that full correctives would be enacted in most cases, even if they could be accurately calculated.

* A central tenant of evolutionary economics is that people’s preferences do not “fall from the sky” but are instead formed and molded by social institutions including our major economic institutions. Thorstein Veblen’s famous caricature of the “hedonic calculus” was intended to drive this point home. The conviction that preferences and values are formed by social processes requiring analysis rather than given, has played a central role in the contributions of luminaries like Gunnar Myrdal, John Kenneth Galbraith, and John Dewey to disparate fields of economic study. More recently, I have argued that if we believe consumer preferences are endogenous, then we should expect the degree of misallocation that results from predictable under correction for external effects to increase or “snowball” over time (Hahnel 2001). To the extent that people’s preferences are endogenous, they will learn to adjust to the biases created by external effects in the market price system. Consumers will increase their preference and demand for goods whose production and/or consumption entails negative external effects but whose market prices fail to reflect these costs and are therefore too low, and will decrease their preference and demand for goods whose production and/or consumption entails positive external effects but whose market prices fail to reflect these benefits and are therefore too high. While this reaction, or adjustment, is individually rational it is socially counter productive and inefficient since it leads to even greater demand for the goods that market systems already over produce, and even less demand for the goods that market systems already under produce. As people have greater opportunities to adjust over longer periods of time, the degree of inefficiency in the economy will grow or “snowball.” (8) A rigorous modeling of endogenous preferences helps clarify the mechanism through which institutional biases affect what preferences people will choose to develop and what preferences they will not choose to develop, and captures the subtle dynamic of individually rational self-warping that I believe forms a crucial part of the core of the evolutionary economics perspective.

* In theory, inefficiencies due to non-competitive market structures can be solved by breaking up large firms, i.e. through anti-trust policy. But sometimes there are good reasons not to do so. When there are significant technological economies of scale that smaller firms cannot take advantage of, the loss of technological efficiency may be greater than the gain in allocative efficiency from breaking up large firms to increase market competition. (9) But in many cases large firms are not broken up even when there are no legitimate economic reasons for failing to do so. They are not broken up simply because large firms are politically powerful and successfully pressure the political system to permit them to continue their profitable but socially inefficient practices. Unfortunately, anti-trust policy is in serious decline in the United States as opponents argue ever more successfully that failure of other national governments to embrace anti-trust policy limits the ability of the U.S. government to subject our large corporations to vigorous anti-trust prosecution without crippling the ability of U.S. corporations to compete against foreign behemoths. An alternative to anti-trust action is to regulate the behavior of large firms in non-competitive industries. This practice is also, regrettably in decline, as regulatory agencies are increasingly “captured” by the companies they are supposed to regulate and turned into vehicles for promoting industry objectives (Munkirs 1985).

* There are well known policies to ameliorate inefficiencies due to market disequilibria. Both fiscal and monetary policies can be used to stabilize business cycles. Indicative planning and industrial policies can be used to eliminate disequilibria between sectors of an economy. Regulation of foreign exchange and financial markets particularly prone to bubbles and crashes are almost always an improvement over ex post damage control consisting mostly of bailouts for powerful economic interests most responsible for creating problems in these markets in the first place. Unfortunately, these policies have all fallen into disfavor over the past two decades not only among conservatives but among “new Democrats” in the United States and among “new wave” social democrats in Europe as well. Both national economies and the global economy have experienced huge losses in economic efficiency as a result (Hahnel 1999).

Why Markets Undermine the Ties that Bind Us

In effect, markets say to us. You humans cannot consciously coordinate your interrelated economic activities efficiently, so don’t even try. You cannot come to equitable agreements among yourselves, so don’t even try. Just thank your lucky stars that even such a hopelessly socially challenged species such as yourselves can still benefit from a division of labor, thanks to the miracle of the market system. In effect, markets are a decision to “punt” in the game of human economic relations–a no-confidence vote on the social capabilities of the human species. If that daily message were not sufficient discouragement, markets harness our creative capacities and energies by arranging for other people to threaten our livelihoods. Markets bribe us with the lure of luxury beyond what others can have and beyond what we know we deserve. Markets reward those who are the most efficient at taking advantage of his or her fellow man or woman, and penalize those who insist, illogically, on pursuing the golden rule–do unto others, as you would have them do unto you. Of course, we are told we can personally benefit in a market system by being of service to others. But we also know we can often benefit more easily by taking advantage of others. Mutual concern, empathy, and solidarity are the appendices of human capacities and emotions in market economies–and like the appendix, they continue to atrophy.

But there is no need to take the word of a market abolitionist such as myself on this matter. Samuel Bowles, who strongly supports a “socialized” market system, provides eloquent testimony regarding this failure of markets.

Markets not only allocate resources and distribute income, they also shape our culture, foster or thwart desirable forms of human development, and support a well defined structure of power. Markets are as much political and cultural institutions as they are economic. For this reason, the standard efficiency analysis is insufficient to tell us when and where markets should allocate goods and services and where other institutions should be used. Even if market allocations did yield Pareto-optimal results, and even if the resulting income distribution was thought to be fair (two very big “ifs”), the market would still fail if it supported an undemocratic structure of power or if it rewarded greed, opportunism, political passivity, and indifference toward others.

The central idea here is that our evaluation of markets–and with it the concept of market failure–must be expanded to include the effects of markets on both the structure of power and the process of human development….

As anthropologists have long stressed, how we regulate our exchanges and coordinate our disparate economic activities influences what kind of people we become. Markets may be considered to be social settings that foster specific types of personal development and penalize others. The beauty of the market, some would say, is precisely this: It works well even if people are indifferent toward one another. And it does not require complex communication or even trust among its participants. But that is also the problem. The economy–its markets, workplaces and other sites–is a gigantic school. Its rewards encourage the development of particular skills and attitudes while other potentials lay fallow or atrophy. We learn to function in these environments, and in so doing become someone we might not have become in a different setting. By economizing on valuable traits–feelings of solidarity with others, the ability to empathize, the capacity for complex communication and collective decision making, for example–markets are said to cope with the scarcity of these worthy traits. But in the long run markets contribute to their erosion and even disappearance. What looks like a hardheaded adaptation to the infirmity of human nature may in fact be part of the problem. (Bowles 1991, 11-13)

Why Markets Subvert Democracy

Confusing the cause of free markets with the cause of democracy is astounding given the overwhelming evidence that the latest free market jubilee has disenfranchised ever larger segments of the world body politic. The cause of economic democracy is not being served when thirty year-old MBA (Master of Business Administration) employees of multinational financial companies trading foreign currencies, bonds, and stocks in their New York and London offices affect the economic livelihoods of billions of ordinary people who toil in third world economies more than their own elected political leaders.

First, markets undermine rather than promote the kinds of human traits critical to the democratic process. As Bowles explains:

If democratic governance is a value, it seems reasonable to favor institutions that foster the development of people likely to support democratic institutions and able to function effectively in a democratic environment. Among the traits most students of the subject consider essential are the ability to process and communicate complex information, to make collective decisions, and the capacity to feel empathy and solidarity with others. As we have seen, markets may provide a hostile environment for the cultivation of these traits. Feelings of solidarity are more likely to flourish where economic relationships are ongoing and personal, rather than fleeting and anonymous; and where a concern for the needs of others is an integral part of the institutions governing economic life. The complex decision-making and information processing skills required of the modern democratic citizen are not likely to be fostered in markets. (Bowles 1991, 16)

Second, the more wealthy, generally benefit more than the less wealthy from free market exchanges even when markets are competitive. Economic liberalization breeds concentration of economic wealth, and in political systems where money confers advantages it leads indirectly to the concentration of political power as well. (10) Those who deceive themselves (and others) that markets nurture democracy ignore the simple truth that markets tend to aggravate disparities in wealth and economic power, and focus instead on less important effects. It is true that the spread of markets can undermine the power of traditional elites, but this does not imply that markets will cause power to be more equally dispersed and democracy enhanced. If old obstacles to economic democracy are being replaced by new, more powerful obstacles in the persons of CEOs (Chief Executive Officers) of multinational corporations and multinational banks, the new global mandarins at the World Bank and IMF, and the chairs of adjudication commissions for NAFTA (North American Free Trade Act) and the WTO, and if these new elites are more effectively insulated from popular pressure than their predecessors, it is not the cause of democracy that is served. (11)

Why Markets Subvert Democracy

Support for the theory that markets promote democracy stems from the dominant interpretation of modern European history in which the simultaneous spread of markets and political democracy is assumed to be because the former caused the latter. It is hardly surprising that perhaps the most intrusive social institution in human history would have disrupted old, pre-capitalist obstacles to democratic rule. The question, however, is not whether markets undermined old structures of domination–which they clearly did–but, if the new patterns of economic power that markets create are supportive or detrimental to democratic aspirations. I am skeptical that markets deserve nearly as much credit as mainstream interpretations award them for the emergence of European political democracy. I suspect this interpretation robs Europeans who fought against the rule of monarchy and feudal lord in the seventeenth, eighteenth, and nineteenth centuries, Europeans who fought for universal popular suffrage in the nineteenth and twentieth centuries, and all who fought against fascism in the twentieth century of much of the credit they deserve. But a worthy rebuttal to the thesis that we owe whatever advances democracy has made to the rise of the market system would take me too far a field and require more historical knowledge than I pretend to have.

Commercial Values vs. Equitable Cooperation

Disgust with the commercialization of human relationships is as old as commerce itself. The spread of markets in eighteenth century England led Edmund Burke to reflect: “The age of chivalry is gone. The age of sophists, economists, and calculators is upon us; and the glory of Europe is extinguished forever” (quoted in Arrow 1997, 757). Thomas Carlyle (1847, 235) warned: “Never on this Earth, was the relation of man to man long carried on by cash-payment alone. If, at any time, a philosophy of laissez-faire, competition, and supply-and-demand start up as the exponent of human relations, expect that it will end soon.” And of course running through all his critiques of capitalism, Karl Marx complained that markets gradually turn everything into a commodity and, in the process, corrode social values and undermine community.

[With the spread of markets] there came a time when everything that people had considered as inalienable became an object of exchange, of traffic, and could be alienated. This is the time when the very things which till then had been communicated, but never exchanged, given, but never sold, acquired, but never bought–virtue, love, conviction, knowledge, conscience, etc.–when everything, in short passed into commerce. It is the time of general corruption, of universal venality…. It has left remaining no other nexus between man and man other than naked self-interest and callous cash payment. (Marx 1955, Chapter 1, Section 1)

More recently, Robert Kuttner (1997) has bemoaned the fact that the labor market is becoming even more market like: “Most of us recognize work as a central source of our identity and livelihood, a valued (or resented) affiliation, and sometimes a calling. But today, downsizing, out-sourcing, leveraged buyouts, relocations, and contingent employment are reshaping the labor market into a product market where customers employers–can buy labor for only as long as they need it.” And Margaret Jane Radin (1996) has argued that treating every activity as a commodity is deeply offensive at some level to all of us. Her book received sufficient attention to provoke no less than Kenneth Arrow to respond with a book review in the Journal of Economic Literature (June 1997) to what he called the “oldest critique of economic thinking.” As Arrow presents them, both Radin’s concern and her recommendation are remarkably mild.

Her target is related to but perhaps a little different from that of the nineteenth century critics. They were primarily concerned with social relations; the market was in theory and practice replacing all social relations. Radin is somewhat more in the spirit of individualism. Her concern is that actions which are essential to personal identity fall under the sway of the market…. A basic part of her approach is the notion of ‘incomplete commodification,’ recognition that some form of purchase and sale is called for but with restrictions of one kind or another. (Arrow 1997, 758)

Arrow’s response to her concern and suggestion was blunt: “The market is not something one need enter. A corner equilibrium is a perfectly reasonable outcome even under conditions of full commensurability and fungibility” (Arrow 1997, 761).

However, it is not true that individuals are free to take markets or leave them. If access to the fruits of economic cooperation are available only through participation in markets, then while true that anyone can choose to be an outcast, one does so at great personal cost. How many of us living in a market economy are going to refuse to buy and sell? What the older, and in my view more important critique of markets amounts to, is an objection to the organization of economic cooperation in a way that is not only personally distasteful and demeaning–robs us of our “personhood” as Radin puts it–but unnecessarily sours human relations. It is a plea to others to come to their senses and join the search for a different way to organize economic cooperation. In terms Arrow surely understands, markets are a matter of social, not individual choice, and like all social institutions, markets provide incentives that promote some kinds of behavior and discourage others. In essence, what any economic institution does is reduce the transaction costs of engaging in certain kinds of economic behavior. But as we saw above, while markets reduce transaction costs for individuals seeking to buy and sell from one another, markets leave formidable transaction costs for external parties seeking to express their collective interest. In other words, markets are biased in favor of individual negotiations between two parties, and biased against collective negotiations among multiple parties, leading to predictable inefficiencies. Moreover, since the forms of interaction that are encouraged are mean spirited and hostile, and the forms of cooperation that are discouraged are respectful and empathetic, the detrimental effects on human relations are far from trivial.


The degree of allocative inefficiency due to external effects is significant. Hope for reasonably accurate Pigovian correctives is probably a pipe dream. Market prices diverge ever more widely from true social opportunity costs as individual consumers, whose preferences are endogenous to some extent, rationally adjust their desires to accommodate significant institutional biases in the market system. Efficiency losses also mount as real markets become less competitive, with no sign of meaningful antitrust or regulatory correctives in sight. And, as financial regulation, stabilization policies, and industrial policies all fall out of vogue, efficiency losses due to market disequilibria escalate even further. In sum, at the dawn of the new millennium the invisible foot is gaining strength on the invisible hand every day. Meanwhile, market exchanges continue to empower those who are better off relative to those who are worse off–undermining economic and political democracy–and the anti-social biases and incentives inherent in the market system continue to tear away at the tenuous bonds that bind us to one another.


(1.) To sharpen debate I have often described myself as a “market abolitionist.” By this I do not mean that I call for the abolition of markets tomorrow. I am fully aware that markets are here to stay for the foreseeable future. What I mean is that I do not believe markets have any role to play in a truly desirable economy, i.e. that our long run goal should be to replace markets entirely with some kind of democratic planning.

(2.) Political economists who developed the conflict theory of the firm had to overcome a similar misconception about labor markets. Profit maximization requires employers to choose inefficient technologies if they enhance employer bargaining power sufficiently even if labor markets are perfectly competitive. In other words, making labor markets perfectly competitive does not eliminate socially counter productive behavior regarding the selection or rejection of new technologies. See Hahnel and Albert 1990, chapter 8.

(3.) Note that the magnitude of the effect on a single external party compared to the effect on the buyer and seller is not the relevant issue. The effects on individual external parties are almost always small compared to the effects on buyers and sellers. But it is the magnitude of the effects on ALL external parties summed together, compared to the effect on the buyer and seller that determines whether or not external effects lead to a significant misallocation of resources. In a 1998 report, the Center for Technology Assessment estimated that when external effects are taken into account the true social cost of a gallon of gasoline consumed in the United States might have been as high as $15. When the report was published I was paying $1.50 a gallon in southern Maryland, which already included some hefty taxes. Obviously they were not hefty enough!

(4.) Similarly, when buyers are few it is in their interest to demand, collectively, less than is socially optimal.

(5.) Axel Leijonhufvud (1967; 1968) was among the first to interpret the insights of Keynes in this insightful way. He and others went on to develop a “Post-Walrasian” school of macroeconomic theory emphasizing the importance of quantity as well as price adjustments and exploring the consequences of “false trading”–which unfortunately, is not covered in most graduate level macroeconomic curricula today.

(6.) I gladly offer those who call themselves free market environmentalists the following deal: I, for my part, will concede that the government should not bother to get involved in cases where there is only a single victim of pollution, if they, for their part, will drop their objections to government intervention whenever there are multiple pollution victims.

(7.) In competitive market interactions, efficiency does not hinge on buyers knowing anything at all about the costs of suppliers, or sellers knowing anything about the benefits to buyers–because buyers and sellers are both price takers. However, there is no market in the situation Coase examines, and neither party is a price taker. There are negotiations between a single polluter and a single victim, and what each thinks the other’s marginal benefit or damage curve looks like has a significant impact on likely outcomes. When the curve of the party with the property right is unknown to the other party, the party with the property right can benefit greatly by misrepresenting their situation. Moreover, when they do so the predictable outcome of the negotiations is far from the efficient level of pollution. Coase’s implicit assumption that both parties operate with “complete information” about the situation of the other greatly exceeds the traditional assumption that those who participate in markets have perfect self- knowledge regarding their own costs and benefits and the market price, and is far less plausible (see Hahnel and Sheeran, forthcoming).

(8.) For a rigorous demonstration that endogenous preferences imply snowballing inefficiency when there are market externalities see Hahnel and Albert 1990, theorem 6.6 and theorems 7.1 and 7.2.

(9.) Neither financial nor advertising economies of scale are valid reasons for failing to break up large firms. Only true technological economies of scale provide efficiency reasons for allowing markets to remain uncompetitive.

(10.) See chapter 3 in Hahnel 2002; Appendix B in Hahnel 1999; and Hahnel 2006 for simple models that demonstrate how and why those who are better off in the first place will usually be able to capture the lion’s share of efficiency gains that result from exchanges even when markets are competitive.

(11.) Prior to the arrival of Europeans in the Western hemisphere, some more powerful indigenous tribes and nations oppressed less powerful ones. While European colonization did remove old obstacles to self-determination for some indigenous groups by weakening their native oppressors, 1 know of no example where the sovereignty of any indigenous tribe or nation was ultimately advanced by the European conquest, I think this analogy is apt when considering the supposed “liberating” effects of marketization on oppressed sectors in traditional societies.

The author is a Professor of Economics at American University in Washington, D.C. and is currently a visiting Professor at Lewis and Clark College in Portland, Oregon. His most recent book is Economic Justice and Democracy: From Competition to Cooperation. Routledge, 2005

COPYRIGHT 2007 Association for Evolutionary Economics COPYRIGHT 2008 Gale, Cengage Learning

Free Trade is Fair Trade


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