21 April 2014

Free Market VS Capitalism (What is a Free Market?)

[part 2 of 10, Free Market VS Capitalism essay series.  Part 1 here]

So, what do I mean by the assertion that capitalism and the free market are different things?
The key feature of a free market is that all individuals are free to participate and make their own decisions.
We treat the term "capitalism" as if it's key feature were the same, but the real key feature of capitalism is that some people accumulate wealth - capital - and use that wealth in ways that allow them to leverage additional wealth out of existing wealth, without having to personally contribute any additional productivity. 
The easiest way to think of a free market is imagining a literal market: a flea market or farmer's market.
You have a big empty lot partitioned into more or less equally sized parcels.  A bunch of different independent vendors rent one, and sell whatever they want, for whatever price they want.  Customers wander around and buy whatever they want.  Seller and buyer can negotiate prices, and sellers with better product will sell more and/or can raise prices, but as long as each seller does better than break even, they will likely show up again next week, keeping competitive pressure on every one else and keeping variety available for the consumer.

Under capitalism any one vendor which has any form of advantage - maybe they have a better product or a more efficient process that allows them to lower prices (or maybe they just have an advertising guy with a degree in psychology, or they are friends with the market manager, or they inherited a million dollars from Great Uncle Giles, or they use slave labor; the point is it really doesn't matter what the advantage is, and there is no reason to assume it is always a better product) - can use that initial advantage to first buy 5 or 6 different stalls in the same market (but as likely as not, give them all different brand names so that customers don't know), and then 1/2 of all the stalls, and eventually all of them, so that its really just one single vendor (pretending to be many small vendors, for marketing purposes).  At that point they can set prices and lower quality, because there is no competition, and consumers no longer have any choices.

Really, in the real world that process would be simpler and more straight forward - the big empty lot that once housed the market would become the parking lot to the new WalMart, done and done.

When Adam Smith talked about the invisible hand of the free market, he was explicitly talking about the former scenario, and not the latter.  When people point out the efficiency of markets, how many people acting independently can produce complex things more efficiently than central planning can, whether they realize it or not, its the free market they are talking about.
Remember this the next time you hear anyone use the "invisible hand" analogy, or support the notion of the efficiency of individual self-interest in the context of capitalism - these concepts were never meant to apply to capitalism.  They are referring specifically to a free market.
There are a bunch of individual factors that are necessary for the "invisible hand" of individual self-interest to actually maximize efficiency and utility for a society:

-Virtually unlimited buyers and sellers - any industry which has seen significant corporate consolidation is out

-No barriers to new sellers opening up shop - anything which requires major investment in infrastructure or equipment doesn't count

-Complete transparency of information - the internet has gone a long way to providing this one - in the past this one made the entire idea purely hypothetical. 
So, score one for Free Markets.

-Zero transaction costs - any purchase made by credit card isn't a free market transaction.  Also all financial industry transactions, stocks purchases, loans, by definition, don't operate in a free market

-Non-increasing returns to scale - as soon as you outsource manufacturing because you can't keep up with demand, you have left the free market, and transitioned into capitalism.

-Rational buyers - the entire $44 billion advertising industry is devoted almost entirely to preventing rational buyers. Pre-Edward Bernays advertising was generally of the format: "This product exists.  These are its features.  This is what it costs."  Post-Bernays marketing is about using psychology to manipulate individual behavior; getting people to buy something which they wouldn't without the ad, even if they knew about it.

-No externalities - anything that produces pollution or draws on common goods can not be claimed to operate in the free market.

Obviously that doesn't leave much left. 
Even in the best of circumstances, its very unlikely that all of those conditions would apply.  The entire thing was a theoretical framework to begin with. But it is certainly possible for an economy to lean more in one direction than the other.  The more we set things up to encourage capitalism, the further we get from a free market.

There are a few other factors in addition to the ones above, but if you don't want to enroll in an economics class before finishing this blog post, there is one very easy and quick way to tell whether a particular industry or company is actually operating in a free market, in the original Smith use of the term:
In a free market, sellers make zero profit.

Read that last sentence again a couple times.
Think about all it implies.
Understand - this is not my own personal opinion or interpretation.  This is what Adam Smith, father of economics, wrote in his famous, oft quoted, book, The Wealth of Nations.
Perfect competition dictates that sellers will sell at the lowest possible price that allows them to break even.
This does not make being in business pointless.
Profit is what is left over after paying not just costs for materials and rent and advertising and loan payments, but also paying the employees, including management.
People are still making money.  If the manager is the owner, the money they make is not profit, it is salary.
That is the point in running the business.  There is even still a point in investing, as the company could still pay interest on their loans.  Profit is what is left over after all costs.
Any industry or company that has more than zero profit is not operating in the free market.


  1. Really enjoyed this series, it was eye opening and I tend to agree with everything you've written!

    One point, the "quote" (or what I thought looked like a quote and you made it sound like a direct quote) of "In a free market, sellers make zero profit" - I could not find this anywhere in the Wealth Of Nations book PDF file that I found on line... Was there a section that you read and then paraphrased it into the shorter catchier sentence?


    1. Its definitely not a quote, and it wasn't my intention to make it look like one. I just underscored it for emphasis.
      Adam Smith wrote the book in the style of the day. There are lots of in-depth examples from history and (then) current times, and discussions about them, but relatively little direct statements, theory, or mathematics, the way there is in modern economic books.
      It was only after the fact that the long, sometimes rambling examinations of various nation's systems and his commentary of them that principals were distilled and simplified, and later still that graphable equations of things like supply and demand were worked out.

      The most direct is from Ch 9 "The highest ordinary rate of profit may be such as, in the price of the greater part of commodities, eats up the whole of what should go to the rent of the land, and leaves only what is sufficient to pay the labour of preparing and bringing them to market, according to the lowest rate at which labour can anywhere be paid, the bare subsistence of the labourer."

      Beyond that, and particularly the relation of profit to various regulations, he only goes so far as to imply it, and then only with combining several different passages together.

      "The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, be either perfectly equal or continually tending to equality. If in the same neighbourhood, there was any employment evidently either more or less advantageous than the rest, so many people would crowd into it in the one case, and so many would desert it in the other, that its advantages would soon return to the level of other employments. This at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper. Every man's interest would prompt him to seek the advantageous, and to shun the disadvantageous employment."

      "In a country which had acquired its full complement of riches, where in every particular branch of business there was the greatest quantity of stock that could be employed in it, as the ordinary rate of clear profit would be very small, so the usual market rate of interest which could be afforded out of it would be so low as to render it impossible for any but the very wealthiest people to live upon the interest of their money. All people of small or middling fortunes would be obliged to superintend themselves the employment of their own stocks. It would be necessary that almost every man should be a man of business, or engage in some sort of trade."

      "In a country which had acquired that full complement of riches which the nature of its soil and climate, and its situation with respect to other countries, allowed it to acquire; which could, therefore, advance no further, and which was not going backwards, both the wages of labour and the profits of stock would probably be very low. In a country fully peopled in proportion to what either its territory could maintain or its stock employ, the competition for employment would necessarily be so great as to reduce the wages of labour to what was barely sufficient to keep up the number of labourers, and, the country being already fully peopled, that number could never be augmented. In a country fully stocked in proportion to all the business it had to transact, as great a quantity of stock would be employed in every particular branch as the nature and extent of the trade would admit. The competition, therefore, would everywhere be as great, and consequently the ordinary profit as low as possible."


    2. All through out are various examples of ways in which different nation's law and policy restricts competition in both commodities and labor markets, with the effect of reducing efficiency and manipulating costs and wages, usually to the profit of capital holders, and of the anti-competitive nature of corporations, too many to try to quote here.

      Rather than being a textbook style collection of theory and information, the book basically served as the basis for the textbooks that followed. The basic principal of supply and demand, in both goods and labor, developed from Smith's ideas, tells us that under perfect competition there can be no profit (and that any profit that does occur does so as a market inefficiency). If any company is making a profit, than another company making the same product could either sell for slightly less or pay slightly more, therefor gaining all of the customers and/or workers of the first, which would then need to match the second companies cost/pay, reducing their profit. This continues until the marginal price exactly equals the marginal cost, which leaves nothing left over to be profit.
      (Of course the price (of goods and/or labor) won't ever go less than that, because then it would be counter-productive for the company to be in business at all, and the owner would close down operations)

    3. Thank you Bakari, for replying so quickly and with a great explanation, to a 5 year old blog post, you are a legend!

      I did try to read a bit of The Wealth of Nations but found it very hard to digest... ramblings indeed as you say!

      All the best.


If you ask a question, I will answer it.

NEW: Blogger finally put in a system to be notified of responses to your comments! Just check the box to the right, below, before you hit "publish"