Wednesday, November 26, 2008

FREE MARKET-CAPITALISM

A free market is a market where prices of goods and services are arranged completely by the mutual non-coerced consent of sellers and buyers, determined generally by the supply and demand law with no government interference in the regulation of costs, supply and demand. The opposite of a free market is a controlled market, where government sets or regulates prices directly or through regulating supply and/or demand.[1] Although a free market necessitates that government does not regulate supply, demand, and prices, it also requires the traders themselves do not coerce or mislead each other, so that all trades are morally voluntary.[2] This is not to be confused with a perfect market where individuals have perfect information and there is perfect competition.

The notion of a free market is closely associated with laissez-faire economic philosophy, which advocates approximating this condition in the real world by mostly confining government intervention in economic matters to regulating against force and fraud among market participants. Hence, with government force limited to a defensive role, government itself does not initiate force in the marketplace beyond levying taxes in order to fund the maintenance of the free marketplace. Some free market advocates oppose taxation as well, claiming that the market is better at providing all valuable services including defense and law, or that such services can be provided without direct taxation. Anarcho-capitalists, for example, would substitute arbitration agencies and private defense agencies.

While most economists regard the free market as a useful if simplistic model in developing economic policies to attain social goals, some regard the free market as a normative rather than descriptive concept, and claim that policies which deviate from the ideal free market solution are 'wrong' even if they are believed to have some immediate social benefit. Samuelson treated market failure as the exception to the general rule of efficient markets. But more recently the Greenwald-Stiglitz (1986) theorem [3] posits market failure as the norm, establishing "that government could potentially almost always improve upon the market's resource allocation." And the Sappington-Stiglitz theorem "establishes that an ideal government could do better running an enterprise itself than it could through privatization"[4] (Stiglitz 1994, 179).[5]

In political economics, one opposite extreme to the free market economy is the command economy, where decisions regarding production, distribution, and pricing are a matter of governmental control. Other opposites are the gift economy and the subsistence economy. The mixed economy is intermediate between these positions and is the preferred basis of socioeconomic policy for most countries and political parties.

In other words, a free market economy is "an economic system in which individuals, rather than government, make the majority of decisions regarding economic activities and transactions."[6] In social philosophy, a free market economy is a system for allocating goods within a society: purchasing power mediated by supply and demand within the market determines who gets what and what is produced, rather than the state. Early proponents of a free-market economy in 18th century Europe contrasted it with the medieval, early modern, and mercantilist economies which preceded it.

Theory

Voluntary exchange

The key idea of a free market is voluntary exchange. If an exchange takes place under coercion or fraud, then that exchange is not considered a free market exchange. For example, if someone threatens someone with a gun to purchase what he is selling or exaggerates the item's quality, then that is a not a free market. If the government legally prevents a merchant from selling his goods at any prices he wishes and that buyers agree upon, that is not a free market. Or, if the government decrees what quantity of a commodity one must manufacture, it is not a free market. Thus, the operation of supply and demand is not sufficient for a free market if decisions on supply and demand are made under the threat of coercion. If an individual is lied to in order to persuade him to purchase something, such as when a product or service is misrepresented, this is not considered morally voluntary either. Thus, a free market is one without "force or fraud."

In the realm of advertising and product regulation, fraud may also be considered the attempt to manipulate the inherent attributional errors stemming from human design.

Supply and demand

Supply and demand are always equal as they are the two sides of the same set of transactions, and discussions of "imbalances" are a muddled and indirect way of referring to price. However, in a unmeasurable qualitative sense, demand for an item (such as goods or services) refers to the market pressure from people trying to buy it. They will "bid" money for the item, while sellers offer the item for money. When the bid matches the offer, a transaction can easily occur (even automatically, as in a typical stock market). In reality, most shops and markets do not resemble the stock market (eg the job market), and there are significant costs and barriers to "shopping around" (comparison shopping).

When demand exceeds supply, suppliers can raise the price. Consumers who can afford the higher prices may still buy, but others may forgo the purchase altogether, buy a similar item, or shop elsewhere. (i.e., the consumer might say: "A two-dollar hot dog? I'd rather buy a hamburger at McDonald's!"). As the price rises, suppliers may also choose to increase production. Or more suppliers may enter the business. For example, the gourmet coffee business, pioneered by Starbucks, revealed a demand for three-dollar cups of coffee. Other stores began offering such coffee to satisfy the demand.

Increased demand (meaning volume) can indirectly result in lower prices, particularly with computers and other electronic devices. Mass production techniques have been steadily reducing prices 20 to 30% per year since the 1960s. The functions of a multi-million dollar mainframe computer in the 1960s could be performed by a $500 dollar computer in the 2000s. The camcorder has been said to place "a television studio in your hand".

Economic equilibrium

The law of supply and demand predominates in the ideal free market, influencing prices toward an equilibrium that balances the demands for the products against the supplies. At these equilibrium prices, the market distributes the products to the purchasers according to each purchaser's preference (or utility) for each product and within the relative limits of each buyer's purchasing power.

This equilibrating behavior of free markets makes certain assumptions about their agents, for instance that they act independently. Some models in econophysics have shown that when agents are allowed to interact locally in a free market (ie. their decisions depend not only on utility and purchasing power, but also on their peers' decisions), prices can become unstable and diverge from the equilibrium, often in an abrupt manner.The behavior of the free market is thus said to be non-linear (a pair of agents bargaining for a purchase will agree on a different price than 100 identical pairs of agents doing the identical purchase). Speculation bubbles and the type of herd behavior often observed in stock markets are quoted as real life examples of non-equilibrium price trends. Free-market advocates, especially Austrian school followers, often dismiss this endogenous theory, and blame external influences, such as weather, commodity prices, technological developments, and government meddling on non-equilibrium prices.

Distribution of wealth

On the purely theoretical level proponents of a free market do not care about the distribution of wealth resulting from the system, however, on a practical political level the issue is important. The distribution of purchasing power in an economy depends to a large extent on the nature of government intervention, social class, labor and financial markets, but also on other, lesser factors such as family relationships, inheritance, gifts and so on. Many theories describing the operation of a free market focus primarily on the markets for consumer products, and their description of the labor market or financial markets tends to be more complicated and controversial. The free market can be seen as facilitating a form of decision-making through what is known as dollar voting, where a purchase of a product is tantamount to casting a vote for a producer to continue producing that product.

The effect of economic freedom on society's and individuals' wealth remains a subject of controversy. Kenneth Arrow and Gerard Debreu have shown that under certain idealized conditions, a system of free trade leads to Pareto efficiency, but the traditional Arrow-Debreu paradigm within economics is now being challenged by the new Greenwald-Stiglitz paradigm (1986) [3]. Many advocates of free markets, most notably Milton Friedman, have also argued that there is a direct relationship between economic growth and economic freedom, though this assertion is much harder to prove both theoretically and empirically, as the continuous debates among scholars on methodological issues in empirical studies of the connection between economic freedom (EF) and economic growth clearly indicate: [8] [9] [10]. "there were a few attempts to study relationship between growth and economic freedom prior to the very recent availability of the Fraser data. These were useful but had to use incomplete and subjective variables" [11].An Empirical Study Joshua Epstein and Robert Axtell have attempted to predict the properties of free markets in an agent-based computer simulation called sugarscape. They came to the conclusion that, again under idealized conditions, free markets lead to a Pareto distribution of wealth.

On the other hand more recent research, specially the one led by Joseph Stiglitz seems to contradict Friedman's conclusions. According to Boettke:

:Once incomplete and imperfect information are introduced, Chicago-school defenders of the market system cannot sustain descriptive claims of the Pareto efficiency of the real world. Thus, Stiglitz's use of rational-expectations equilibrium assumptions to achieve a more realistic understanding of capitalism than is usual among rational-expectations theorists leads, paradoxically, to the conclusion that capitalism deviates from the model in a way that justifies state action--socialism--as a remedy.[5]

Laissez-faire economics

The necessary components for the functioning of an idealized free market include the complete absence of artificial price pressures from taxes, subsidies, tariffs, or government regulation (other than protection from coercion and theft), and no government-granted monopolies (usually classified as coercive monopoly by free market advocates) like the United States Post Office, Amtrak, arguably patents, police, fire fighter, US Armed Forces, etc.

Deregulation

In an absolutely free-market economy, all capital, goods, services, and money flow transfers are unregulated by the government except to stop collusion that may take place among market participants. As this protection must be funded, such a government taxes only to the extent necessary to perform this function, if at all. This state of affairs is also known as laissez-faire. Internationally, free markets are advocated by proponents of economic liberalism; in Europe this is usually simply called liberalism. In the United States, support for free market is associated most with libertarianism. Since the 1970s, promotion of a global free-market economy, deregulation and privatization, is often described as neoliberalism. The term free market economy is sometimes used to describe some economies that exist today (such as Hong Kong), but pro-market groups would only accept that description if the government practices laissez-faire policies, rather than state intervention in the economy. An economy that contains significant economic interventionism by government, while still retaining some characteristics found in a free market is often called a mixed economy.

Low barriers to entry

A free market does not require the existence of competition, however it does require that there are no barriers to new market entrants. Hence, in the lack of coercive barriers it is generally understood that competition flourishes in a free market environment. It often suggests the presence of the profit motive, although neither a profit motive or profit itself are necessary for a free market. All modern free markets are understood to include entrepreneurs, both individuals and businesses. Typically, a modern free market economy would include other features, such as a stock exchange and a financial services sector, but they do not define it.

Legal tender and taxes

In a truly free market economy, money would not be monopolized by legal tender laws or by a central money maker authority which coerces society to use its own money as the unique medium of exchange in trades, in order to receive taxes from the transactions or to be able to issue loans. Minarchists (advocates of minimal government) contend that the so called "coercion" of taxes is essential for the market's survival, and a market free from taxes may lead to no market at all. By definition, there is no market without private property, and private property can only exist while there is an entity that defines and defends it. Traditionally, the State defends private property and defines it by issuing ownership titles, and also nominates the central authority to print or mint currency. "Free market anarchists" disagree with the above assessment -- they maintain that private property and free markets can be protected by voluntarily-funded services under the concept of individualist anarchism and anarcho-capitalism . A free market could be defined alternatively as a tax-free market, independent of any central authority, which uses as medium of exchange such as money, even in the absence of the State. It is disputed, however, whether this hypothetical stateless market could function freely, without coercion and violence.

Ethical justification

The ethical justification of free markets takes two forms. One appeals to the intrinsic moral superiority of autonomy and freedom (in the market), see deontology. The other is a form of consequentialism—a belief that decentralised planning by a multitude of individuals making free economic decisions produces better results in regard to a more organized, efficient, and productive economy, than does a centrally-planned economy where a central agency decides what is produced, and allocates goods by non-price mechanisms. An older version of this argument is the metaphor of the Invisible Hand, familiar from the work of Adam Smith.

Modern theories of self-organization say the internal organization of a system can increase automatically without being guided or managed by an outside source. When applied to the market, as an ethical justification, these theories appeal to its intrinsic value as a self-organising entity. Other philosophies such as some forms of Individualist anarchism and Mutualism (economic theory) anarchism believe that a truly "free market" would result in prices paid for goods and services to align with the labor embodied in those things.

In practice

While the free-market is an idealized abstraction, it is useful in understanding real markets whether artificially created and regulated by governments or non-governmental agencies, or phenomena such as the black market and the underground economy, which can be remarkably robust in persisting despite attempts to suppress these markets; in fact, many proponents of the free market point to sectors such as the drug trade to prove the phenomenon is both spontaneous and can function without government intervention though some would still prefer the contracts be brought under court protection.

Index of economic freedom

The Heritage Foundation, a conservative think tank, tried to identify the key factors which allow to measure the degree of freedom of economy of a particular country. In 1986 they introduced Index of Economic Freedom, which is based on some fifty variables. This and other similar indices do not define a free market, but measure the degree to which a modern economy is free, meaning in most cases free of state intervention. The variables are divided into the following major groups:
  • Trade policy,
  • Fiscal burden of government,
  • Government intervention in the economy,
  • Monetary policy,
  • Capital flows and foreign investment,
  • Banking and finance,
  • Wages and prices,
  • Property rights,
  • Regulation, and
  • Informal market activity.
Each group is assigned a numerical value between 1 and 5; IEF is the arithmetical mean of the values, rounded to the hundredth. Initially, countries which were traditionally considered capitalistic received high ratings, but the method improved over time. Some economists, like Milton Friedman and other free market fundamentalists have argued that there is a direct relationship between economic growth and economic freedom, but this assertion has not been proven yet, both theoretically and empirically. Continuous debates among scholars on methodological issues in empirical studies of the connection between economic freedom (EF) and economic growth still try to find out what is the relationship, if any. [8] [9] [10]. [11].

:"In recent years a significant amount of work has been devoted to the investigation of a possible connection between the political system and economic growth. For a variety of reasons there is no consensus about that relationship, especially not about the direction of causality, if any." (AYAL & KARRAS, 1998, p.2) [11]

History and ideology

Some theorists assert that a free market is a natural form of social organization, and that a free market will arise in any society where it is not obstructed (ie Ludwig von Mises, Hayek). The consensus among economic historians is that the free market economy is a specific historic phenomenon, and that it emerged in late medieval and early-modern Europe. Other economic historians see elements of the free market in the economic systems of Classical Antiquity, and in some non-western societies.By the 19th century the market certainly had organized political support, in the form of laissez-faire liberalism. However, it is not clear if the support preceded the emergence of the market or followed it. Some historians see it as the result of the success of early liberal ideology, combined with the specific interests of the entrepreneur.

Marxism

In Marxist theory, the ideology simply expresses the underlying long-term transition from feudalism to capitalism. Note that the views on this issue - emergence or implementation - do not necessarily correspond to pro-market and anti-market positions. Libertarians would dispute that the market was enforced through government policy, since they believe it is a spontaneous order and Marxists agree with them because they as well believe it is evolutionary, although with a different end.

Liberalism

Support for the free market as an ordering principle of society is above all associated with liberalism, especially during the 19th century. (In Europe, the term 'liberalism' retains its connotation as the ideology of the free market, but in American usage it came to be associated with government intervention, and acquired a pejorative meaning for supporters of the free market.) Later ideological developments, such as minarchism, libertarianism and objectivism also support the free market, and insist on its pure form. Although the Western world shares a generally similar form of economy, usage in the United States is to refer to this as capitalism, while in Europe 'free market' is the preferred neutral term. Modern liberalism (American usage), and in Europe social democracy, seek only to mitigate what they see as the problems of an unrestrained free market, and accept its existence as such.

To most libertarians, there is simply no free market yet, given the degree of state intervention in even the most 'capitalist' of countries. From their perspective, those who say they favor a "free market" are speaking in a relative, rather than an absolute, sense—meaning (in libertarian terms) they wish that coercion be kept to the minimum that is necessary to maximize economic freedom (such necessary coercion would be taxation, for example) and to maximize market efficiency by lowering trade barriers, making the tax system neutral in its influence on important decisions such as how to raise capital, e.g., eliminating the double tax on dividends so that equity financing is not at a disadvantage vis-a-vis debt financing. However, there are some such as anarcho-capitalists who would not even allow for taxation and governments, instead preferring protectors of economic freedom in the form of private contractors.

Criticism

Whether the marketplace should be or is free is disputed; many assert that government intervention is necessary to remedy market failure that is held to be an inevitable result of absolute adherence to free market principles. These failures range from military services to roads, and some would argue, to health care. This is the central argument of those who argue for a mixed market, free at the base, but with government oversight to control social problems.

Critics of laissez-faire variously see the "free market" as an impractical ideal or as a rhetorical device that puts the concepts of freedom and anti-protectionism at the service of vested wealthy interests, allowing them to attack labor laws and other protections of the working classes.

Because no national economy in existence fully manifests the ideal of a free market as theorized by economists, some critics of the concept consider it to be a fantasy - outside of the bounds of reality in a complex system with opposing interests and different distributions of wealth.

Martin J. Whitman

Not all advocates of capitalism consider free markets to be practical. For example, Martin J. Whitman has written, in a discussion of Keynes, Friedman and Hayek, that these "…great economists…missed a lot of details that are part and parcel of every value investor's daily life." While calling Hayek "100% right" in his critique of the pure command economy, he writes "However, in no way does it follow, as many Hayek disciples seem to believe, that government is per se bad and unproductive while the private sector is, per se good and productive. In well-run industrial economies, there is a marriage between government and the private sector, each benefiting from the other." As illustrations of this, he points at "Japan after World War II, Singapore and the other Asian Tigers, Sweden and China. The notable exception is Hong Kong which found prosperity on an extremely austere free market concept.

He argues, in particular, for the value of government-provided credit and of carefully crafted tax laws.[18] Further, Whitman argues (explicitly against Hayek) that "a free market situation is probably also doomed to failure if there exist control persons who are not subject to external disciplines imposed by various forces over and above competition." The lack of these disciplines, says Whitman, lead to "1. Very exorbitant levels of executive compensation… 2. Poorly financed businesses with strong prospects for money defaults on credit instruments… 3. Speculative bubbles… 4. Tendency for industry competition to evolve into monopolies and oligopolies… 5. Corruption." For all of these he provides recent examples from the U.S. economy, which he considers to be in some respects under-regulated,[19] although in other respects over-regulated (he is generally opposed to Sarbanes-Oxley).[20]

He believes that an apparently "free" relationship—that between a corporation and its investors and creditors—is actually a blend of "voluntary exchanges" and "coercion". For example, there are "voluntary activities, where each individual makes his or her own decision whether to buy, sell, or hold" but there are also what he defines as "[c]oercive activities, where each individual security holder is forced to go along…provided that a requisite majority of other security holders so vote…" His examples of the latter include proxy voting, most merger and acquisition transactions, certain cash tender offers, and reorganization or liquidation in bankruptcy.[21] Whitman also states that "Corporate America would not work at all unless many activities continued to be coercive."[22]

"I am one with Professor Friedman that, other things being equal, it is far preferable to conduct economic activities through voluntary exchange relying on free markets rather than through coercion. But Corporate America would not work at all unless many activities continued to be coercive."[23]

Noam Chomsky

Noam Chomsky has argued that the asymmetric application of free market principles creates a "privatized tyranny": "The talk about labor mobility doesn't mean the right of people to move anywhere they want, as has been required by free market theory ever since Adam Smith, but rather the right to fire employees at will. And, under the current investor-based version of globalization, capital and corporations must be free to move, but not people, because their rights are secondary, incidental." Further, he emphasizes that it can matter what entities have rights in the market—"Do they inhere in persons of flesh and blood, or only in small sectors of wealth and privilege? Or even in abstract constructions like corporations, or capital, or states?"—and remarks that of what he sees as the three tyrannical systems of the 20th century, Bolshevism, and fascism have "collapsed", but "private corporatism… is alive and flourishing… [a] system of state corporate mercantilism disguised with various mantras like globalization and free trade."[24]

Chomsky argues that the wealthy use free-market rhetoric to justify imposing greater economic risk upon the lower classes, while being insulated from the rigours of the market by the political and economic advantages that such wealth affords.[25] He remarked, "the free market is socialism for the rich—[free] markets for the poor and state protection for the rich."[26]

Catholic Church

As explained in Rerum Novarum[27] and The Catechism of the Catholic Church,[28] the Catholic Church upholds the right to private property, requires the employer to pay a decent wage to support the worker, requires the worker to work faithfully and respect the property of his employer, and does not permit "the market" to be used as an excuse to violate moral principles.

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