The Case for Market Regulation
Unshackled markets are no match for real-life messiness. Here are four ways they fall short
Economists have come under fire of late for a laundry list of transgressions. They are said to have misread economic downturns with outdated frameworks and to be out of touch on big challenges such as climate change. Should economics be renamed Wreckonomics or are the criticisms unfair? In this series of essays, economists at Queen’s University weigh in.
A common misconception about market economies is that unregulated free market capitalism is the most efficient form of capitalism. This view comes from the belief that markets are self-regulating and that government intervention, as a rule, disturbs the delicate balance.
While the appeal of this argument is understandable — and unregulated markets sometimes do work well — it overlooks important realities about markets and the essential and often hidden role of government regulation. Here are four ways in which free markets often fall short.
1. Unchecked market power
Competition is the heart of market efficiency, matching buyers and sellers through market-clearing prices and allocating resources, products and services to those who value them most and use them best.
Yet fully efficient markets require perfect or absolute competition. Barriers to entry, producer control of input supply, consumer switching costs and other industry characteristics can all bestow market power on firms. These lead to a variety of ills, including: lower product quality; less product variety; and the possibility that prices exceed the willingness to pay of too many consumers (those who would have purchased goods or services at the competitive price).
Government intervention — such as antitrust regulation by the U.S. Department of Justice and Federal Trade Commission or Canada’s Competition Bureau — can address these problems by reining in market power and ensuring competitive markets.
Certain market structures indeed lend themselves naturally to monopolies. In these cases, competition can be inefficient. Utilities are a prime example, where fixed costs are large relative to market size (consider the infrastructure required to connect electricity or water supply to all the homes in a city). But these cases typically call for even stronger oversight to contain that monopoly power.
2. Unaccounted for externalities
Externalities are the indirect costs or benefits of market activities that affect third parties that did not choose to incur them.
Pollution is a prime example of a negative externality. A manufacturing plant that contaminates a river may harm downstream communities that bear the health costs of pollution despite not being involved in the economic activity causing it. Environmental standards and other regulations are often the only way to ensure that businesses account for the broader impact of their operations.
3. Undelivered public goods
Essential services such as national defence and infrastructure have widespread benefits to society, but left to the free market they may be underprovided. These services often need a centralized organization for their creation, operation and funding. Government intervention through the subsidized provision of public goods, typically financed by tax collection, ensures broader and fairer access to crucial public services.
4. Unequal access to information
When one party in a business transaction has more or better information than another, the efficient function of the market is often disrupted.
Consider the health-care industry. Patients often lack the information to make informed decisions about medical treatment, while drug and medical device companies have extensive knowledge. This imbalance can lead to unnecessary or ineffective treatments or high prices. Regulations, such as those governing pharmaceutical clinical trials and treatment guidelines, narrow this information gap.
Other industries characterized by asymmetric information may be under-regulated and operate inefficiently as a result. The auto repair industry is a conspicuous case. Car owners often lack sufficient information to make informed decisions about car repairs. This creates a conflict of interest for auto repair businesses, who decide which repairs to conduct and profit from those repairs. This information failure can lead to under- or over-repair, distorted repair prices and plenty of wasteful economic activity.
While free market capitalism holds a certain ideological allure, it is a simplified model that abstracts away the complexities of real-world markets. Government regulation is necessary to address market failures such as excess market power, externalities, the provision of public goods and asymmetric information.
Henry Schneider is an associate professor and Commerce ’64 Fellow of Business Economics at Smith School of Business.