My apology. As stated above, I noticed some mistakes. Well, not mistakes in a strict sense, but more like something that can potentially cause confusion. I have just realized that I really need to insert this paragraph somewhere in the text, and no where can I fit it in better than at the beginning of the article.So let me clarify one thing. I want to make it clear to all of you of there. Long story short, capitalism is about private ownership. Free market is about the freedom in exchanging of goods and services. Simply speaking, capitalism is accumulating privately-owned wealth, while free market or laissez faire economics is about freely trading your wealth after having it converted into something tradable. The two are entwined and quite often got mixed up. While free market requires capitalism to operate effectively and efficiently, capitalism does not necessarily need free market. In fact, in extreme case, capitalism can also exist in the absence of free market (like when only monopoly exists, what is monopoly? Google it). For simplicity, the article does not differentiate much between the two. Most of the time, you will see either term used in the same paragraph. Do not freak out! Despite the difference, the consequences resulted from having both or either one of the two (capitalism or free market) freely reign an economy are quite similar. At least, that is what I think!From my very first article, little did I write in favor government intervention or restriction on the free market system. It seems as if I am in full support of an economy with no or little government intervention. And that is not the case actually. In economics, we have something called "Market Failure". Market Failure is neither a myth nor an attempt of a government to gain more power. Market Failure is real, and it is pretty much related to Capitalism and Laissez Faire Economics.
In essence, capitalism is a key component of free market, and both are all about allowing people to pursue their dream, prioritize their self-interest, and optimize the use of their resources to attain the best possible outcome and maximum profit. We can also say that the many individual quests to accumulate wealth, combined, have given birth to capitalism, and the economic system that allows everyone to do so, or to be accurate, that enhances the effectiveness of capitalism and directs it towards the optimal path for the mass is the one that favors free market system with little or without exertion of external force or control is called Laissez Faire Economics.
Being free is good. People fight for freedom. They want to liberate themselves from all sorts of bondage. This is human nature, to be free because YOLO, you only live once. However, note that in theory, we mostly talk about economic freedom in its perfect form, we always talk about the extreme of this or that because it is just much easier to imagine and study, and much less complex to analyze as it gets rid of the myriads of other influential variables that increase uncertainty and unpredictability. The real world is not as simple, and for this reason, free market cannot and should not exist on its own. I will explain why that is the case later in the article.
Capitalism promotes free market which is believed to give birth to all sorts of great incentives for the people to work their buttS off because in capitalism, your get to reap what you sow. You speculate well, you seize the right opportunity at the right time, you invent and innovate, you add much brain power, energy and time as inputs, and the final product is yours to sell to the world. Your increased productivity drives the world economy forward. You work for yourself, but to increase your productivity, you hire people, i.e. pay them, to work for you. In that sense, everyone is better off! A single person's initiation, his spirit of entrepreneurship to create something of value from which he can derive profit, will, whether or not that is his aim, benefit the world and the society around him. Those beneficiaries are mostly the stakeholders, and who are they? They are employees, suppliers, buyers, society in which the business operates, and also the international community as well.
As mentioned, the great thing about free market is that a single person's greed is turned into everyone's benefits. The desire to produce to earn, the desire to beat your competitors by cutting cost, reinventing the wheel, giving birth to new invention and innovation, improving existing products and services... all result in betterment of human living standard as witnessed during the last couple of centuries. Nothing, nothing but capitalism/free market will ever respond so quickly to the new demand, want or need of consumers. Why? Because the ambitious ones always seek the gap that must be filled within a market. Businessmen respond and adapt quickly to the changes in market conditions, much faster than the government ever could, because they are the frontline soldiers, they have the expertise in their own respective fields of production, they know the drill, and the most important of all, they seek profit, and capitalism gives them the enabling environment to do so.
HOWEVER, wait for it...
TOO MUCH of anything is NEVER GOOD. Too much cake will make you fat, too much nightclub will make you bad, and too much study will make you sad. Like wise, too much of free market can corrupt the economy if not done right. Capitalism is good because the complex economic system turns self-interest into collective yields. Nonetheless, this simple reasoning that justifies the use of laissez faire economics was contested. Many times. And is still going on. And on. And on.
The challenger based their opposition to the free market on the so-called Market Failure, the Flaws of Capitalism and Laissez Faire Economics. Though much is true that free market has been good (or so we think) to us for many decades, leading to double-digit economic growth for nations like China for many years, capitalism still has its engine sparked and run by profit-seeking individuals who probably do not think much of the well-being of the rest of the world. Of course, somehow, free market dictates that their actions will keep the globe spun and everyone gets a piece of the sweetness. However, the greed driven behavior will make the system implode.
Capitalism/free market often does not lead to Pareto Efficiency or Pareto Optimality, an economic state where every individual well-being can no longer be optimized without causing harm in some sort of form to the others. The problem is that Capitalism/Free market will continue to drive the economy onwards even the cost to the society at large outweighs the profit to a small number of individuals, and no matter how much return certain actions will yield to the collective social welfare, capitalism fails to make them happen if the individual benefit is not there. This statement I made, I think (and if I am correct), pretty much sums up everything of the defects of capitalism. Simply put, social cost is just too great that the individual benefits yielded by an action (say a business action) is insignificant, and this leads to inefficiency or waste or huge opportunity cost.
I will give you more specific examples on the matter.
Let's us now look at market failure from a few different angles.
The first thing that comes to my mind when thinking about market failure is none other than Externalities. What are they? They are the by-products resulted before, during or after a business action that may either of beneficial or harmful effects for the people in general, not limited to the direct stakeholders. Now, let's focus on negative externalities so we can challenge the concept of free market. These are mostly unintended or perversely done so despite knowing the demerits. For instance, the severe environmental damage set in by the Chinese manufacturers in a number of regions in China, the burning forest in Indonesia leading to negative health impacts on countries like Singapore and so forth. These are all decisions made by profit-seeking individuals who may or may not have carefully studied the repercussion of their actions, and they ended up harming the communities or societies, even the ones of great distant from them.
Let's try to relate this to individual rationality and collective irrationality, the past article of this blog. I will give you an example. You see, when free market rules, individuals will exert their utmost effort to meet their own best vested interest, even in something some people consider trivial like driving. Everyone is pushing forward for the little available space on the lane so they can arrive at their destination a bit faster, and this is actually a very rational and free-market-like decision. What is the result? Traffic congestion. If the rule of getting in the line/queue was not firmly established and enforced, the result is traffic congestion. Smoking is also another example. Smoking is bad for the smokers, and well, these are individual choice knowing well that they are exchanging some of their own life span for those moments of transient pleasure. By the laws of free-market and freedom of choice, this should be okay. However, their decision introduces negative externality, smoke that is a threat to the health of the people around them. So now, we have smoke-free laws.
Talk about smoking, let us now get into de-merit goods and services. De-merit goods and services are those goods and services that despite their demand on the market, they are harmful in some way to all or certain segments of the population. Like? Like Cigarette or Alcohol or Drug. Without regulations and taxes placed on these goods, who knows what our world will turn into? These are why we have the no-drink-while-driving laws and such. It is of crucial importance to realize that certain limitation need to be in place for the market to function as it should.
How about public goods? Let us first define public goods. What are they? Well, they have 3 characteristics, but sadly, I only remember two, and googling or yahoo-ing or binging doesn't seem to help either. Actually, during my study, my prof specifically said that pure public goods are hard to come across or think of. Well, for simplicity, let's just say that public goods are the one that are non-rivalrous and non-excludable. Non-rivalrous goods are those which are not depletable. In other words, if you think of Hamburger as a public goods, then no matter how much group A consumes it, it will never exhaust the supply of Hamburger for group B. Non-excludable goods are those that everyone can consume, everyone can utilize. For instance, you cannot ban a person from enjoying the beautiful sunset or listen to free music played by some street bands. You cannot ban a person from fishing, but the more he fishes, the less fish there will be for the rest of the world. This is why we have fishing license and regulation! Come to think of it, maybe air is a pure public goods... I think.. not sure though. Don't take my words for it.
Anyway, when we talk about public goods, we are talking about the missing market that might as well be non-existent or insufficient to meet the people's demand when free market is allowed to reign a nation. What might those be? For instance, street light, national defense, highway and such. Why is that? Because of the "free-rider" problem. In other word, the moment you produces street light or something as big as national defense, you cannot exclude any citizen of a country from benefiting from it simply because he/she doesn't pay for it. National defense is for the whole nation, and if it was produced in a free-market, some people might refuse to pay for it, and this is a problem because the less you pay, the less you have to sustain the national defense. That is why we have the tax system, the tax laws that requires everyone to pay taxes. This is only made possible by an entity considered as the locomotive of the nation, the government. Not just national defense or street light, even education or health which is not a complete public goods might not be made enough to meet the demand under the free-market if the government does not intervene.
And do you think that the many transactions happening even as we speak can continue so smoothly without the laws and regulations to govern them? No. Of course not. This is partly due to the asymmetric information. In a transaction, it is not in their best interest for the sellers or sometimes also the buyers to disclose all the information (including intention and motive) they have available for the products or services. This is why we have the judicial branch to take care of things like fraudulence.
Last but not least (though there are so much more to talk about), I want to talk about income inequality. Free market is more likely to expand the gap of income than shrinking them. Free market does not stop the rich from accumulating more and more wealth (even some are doing it through the means of exploitation in various forms). Though this might sound negative, what I really meant is that free market won't stop rewarding you or reward you less for your success. It will keep doing so, and eventually, there will be a small bunch of people with great wealth and power while the majority will be in the range between middle-income and low-income. Many examples can be seen throughout the history of human kind, and like it or not, income inequality can lead to social unrest and revolution. Violent or not, the restructuring of the economic system through such means will drastically damage the economy as it upsets the balance of wealth and power once so familiar to the people. Income inequality, at its worst, can lead to what I would like to call "relative poor" portion of the population. This is a social problem. The relative poor is the one who is not exactly poor, by strict definition, but still thinks that he/she is poor when comparing to the richer few. This has a lot to do with the psychological phenomena which I am not knowledgeable enough to elaborate.
Well, this is a pretty long article, and I will end it here for the sake of saving you from boredom. This is not the end of it, and there are so much more to write. As you may have noticed, I really did not get into detail (which would only make it much longer). To sum up, what I want to convey to you, my dear reader, is that there is nothing that is good when taking to the extreme. Moderation is the key. It is easier talked than done, or in my case, written than done. When you talk about moderation, people ask "but to what extent? What is the appropriate degree of moderation?", well folks, this is a complicated question. Moderation cannot be perfectly executed because, easy answer, there is no perfection in this world, and to answer it in a bit more complicated way... the world, as we know it, is made of so many variables as the factors that influence an economy; by this rationale, in order to balance between free-market and central planning, we need to first gather data, analyse, see the pattern, see the trend, observe the reality, understand factors of production, conduct speculation, and do cross-sectoral meeting to discuss about the possible impacts of certain decisions to be made for the whole nation. One thing for sure is that a great economist must be present in order to coordinate and direct the process. A good decision can result in a leap-forward for an economy while a bad one can also result in a leap-backward or the lost of potential (huge opportunity cost) for an economy. So balancing and moderation are important, and... to be continued.
That's it for now. We will meet in our next article.