A Brief Introduction to the Theory of The

A Brief Introduction to the Theory of The

A Brief Introduction to the Theory of the

Regulation of a Market Economy

Herbert Gintis

June, 2012

I have found that many students of political economy believe market competition is good and government intervention (regulation) is bad, or vice-versa. Of course, virtually all concerned parties admit that some minimal regulation is important (e.g., to protect private property and enforce contracts), and there are few today who propose a wholesale scrapping of market competition in favor of ubiquitous state planning. However, given these caveats, the analysis of market regulation tends to be highly polarized in public discourse.

While I admit that some highly visible professional economists are similarly polarized, these individuals are not representative of most economists, and they do not reflect the current state of economic theory. My goal here is simply to state some basic principles that, according to contemporary economic theory should guide the analysis of when and where markets should be left to themselves, and when they should be regulated. The criterion I will use in evaluating regulation is simple: economic efficiency and growth. I realize that fairness, justice, and equity issues also enter into the analysis, but I will put these issues aside in the interest of clarity.

There are two distinct scenarios for evaluating economic policy: regulating market dynamics and influencing the equilibrium allocation of economic resources. I will deal with dynamics first.

The basic model of the market economy is the so-called Walrasian general equilibrium model, in which there are households who own the factors of production (land, labor, capital, resources) and firms that rent these resources from households (e.g., they hire labor for a wage and borrow funds at an interest rate), and produce goods and services that they sell back to the households. The economy is in equilibrium when the price structure for goods, services, and factors of production is such that supply and demand are equal in all markets. This is called market-clearing. The firms are owned by households, who have a portfolio of shares entitling them to a portion of the profits of each firm. In equilibrium, firm profits are equal to the return, at the equilibrium interest rate (corrected for risk) on the firm’s capital stock which is then distributed to the owners of the firm, who are households.

Famous economists proved after World War II that with several critical assumptions that I discuss below, there always exists a set of prices at which all markets clear. This is called the proof of the existence of market equilibrium. However, economists have been unable to develop a plausible model of how the market economy behaves out of equilibrium, and hence cannot whether the market economy is stable or unstable, or whether it is fragile or robust in reacting to exogenous shocks (such as new technologies and political instability). For a discussion of the history of attempts to develop a model of the dynamics of a decentralized market economy, see this paper, which is on my web site: “The Dynamics of Pure Market Exchange,” in Approaches to the Evolving World Economy: Complex Dynamics, Norms, and Organizations (International Economics Association, 2012).

Because of this failure of economic theory, all of our understanding of market dynamics is based on atheoretical empiricism. Historically, the most important type of economic dynamics is (a) convergence toward market clearing, and (b) the business cycle, in which aggregate demand varies systematically over a three to five year period. Every market economy has regulations aimed at smoothing the business cycle, including monetary policy, fiscal policy (increasing government expenditure and reducing taxes during a downturn, and doing the opposite during an upturn), and automatic stabilizers (e.g., unemployment compensation, progressive taxation) that automatically move net government debt in the opposite direction as aggregate demand in the private sector.

In the current period, financial instability is the key dynamical instability problem of advanced economies, and the standard economic models (Keynesian and rational expectations macroeconomic models) are completely incapable of handling the problem, because the financial sector is simply not represented in the standard economic models. Of course, intensive work by economists is now under way to correct this problem, but it will be several years before an adequate model is developed.

In the popular press, free market lovers blame financial crisis on government intervention, and intervention lovers blame the crisis on in adequate regulation. I have investigated this matter, relying on experts in the field, and I conclude that the failure is almost certainly due to improper regulation of the financial sector. The notion that the financial sector of a market economy is robust in the absence of extensive regulation is simply an article of faith unsupported by theory or experience.

Let us move from market dynamics to market equilibrium. The basic question of when free markets are the most effective instruments of economic efficiency was worked out in the post World War II period, and remain valid today, a half century later. This theory is called the theory of market failure.

Market Failure I: Increasing returns to scale sectors. In some goods, the optimal efficient firm size is so large that competition is precluded. For instance, water to a city may be supplied by a single reservoir and a unified system of delivery and waste removal. There is simply no room for multiple firms to compete, so the service is supplied by the government. Many municipal services are of this form. The problem can sometimes be handled by requiring firms to share the resource that accounts for increasing returns, such as railroad tracks or an electric grid.

Market Failure II: Public goods. Some goods are non-exclusionary---they are consumed equally by many or all individuals (although they may be valued differently by different individuals). For instance, national defense protects all equally, and many forms of public health measures affect the incidence of diseases for the entire population. Public goods must be publically provided in most cases.

Market Failure III: Externalities. Some goods are produced using technologies that release waste products into the environment at zero or low cost to the producer but that impose high costs on everyone else. Economic theory suggests that the costs imposed by these effluents be charged to producers, or in some cases that the release of effluents be prohibited by law (e.g., making it illegal to release chemical waste into a river or lake).

Market Failure IV: Ensuring product quality: In many industries in which the quality of a product cannot be ascertained until after purchase, and in which reputation effects are not sufficient to ensure a minimum quality level, quality can be maintained only by legal regulation. For instance, most countries have health standards for restaurants and quality standards for hotels (perhaps rated by one to five stars, or some such) that prevent an upstart from profiting at the expense of consumers and the high quality firms. Similarly, professionals may be licensed (e.g., medical and legal services), and pharmaceuticals may be regulated for safety and effectiveness.

Market Failure V: Merit goods: There are some goods that are not permitted to be bought and sold on markets for ethical reasons. An example is votes and body parts.

Of course, just as there is market failure, so there is “state failure,” which means that the regulating agencies fail to operate in the public interest because of corruption, special interest lobbying, and the like. Sometimes it is thus better to let imperfect markets work rather then replace them by even more imperfect government production and regulation.