The broken free market: now, and 200 years ago.

The “standard model” of free market capitalism functions well under limited “idealized” circumstances, and is adequate in many situations. However, there are certain specific conditions under which it breaks down completely.  Those conditions were true in the early 1800’s, and they are also true today. Both then and now, there are people who have warned us about it. Both then and now, those people were ignored.

Because this is a tough topic that many people have preconceived ideas about, I’d like to provide a “content warning” up front: the conclusion this article is heading to is that free market economies do not work. I will not be making some kind of pragmatic “oh it only doesn’t work because people are imperfect!” argument, either. Free market economies do not work even in principle. They make assumptions about economic processes that are wrong: not simplified, not idealistic, just wrong. That’s where this article is heading.


Let’s begin at the beginning.

One of the basic driving forces of free market economic theory is the law of diminishing marginal returns. I’m not going to spend a lot of time on the basics, because you can Google it yourself if you want a simple overview. What I want to focus on here is that the promises that free market economic theory makes, such as the ability to find “optimal” prices for goods and “optimal” wages for workers and the process through which competition leads to increases in efficiency and decreases in prices, all depend on the key assumption of diminishing marginal returns.

It seems like a reasonable assumption, intuitively. The more you have of something, the less you get out of having more of it. The more a company makes of something, the less benefit it gets out of making even more of it. If you were taught this idea in school, chances are you were given agricultural examples or industrial examples. A farm gets more value out of its first 1000 acres than the next 1000 acres. A company gets more out of producing its first 1000 widgets than the next 1000 widgets. Most of these examples were written in the 1700’s or 1800’s.

Decreasing marginal returns are a critical factor that drives free market economies toward efficiency and optimal wages and pricing. If you get more out of your first 100 acres than your second 100 acres, then there is incentive for competitors to get into the market: being a new start-up has an inherent advantage. Decreasing marginal returns are the damping mechanism that is supposed to push back against monopoly formation. How? If the resource (in this case, land) is scarce, then gobbling up the supply will drive up the price of land and act as a deterrent for larger land owners who are already getting a smaller marginal return. On the other hand, smaller start-up farms have a higher price that they are willing to pay because they will enjoy higher returns on land as an initial investment.

All of this sounds well and good. But it’s not how things work. Or at least: not always.

American Expansion

In 1848, a guy named Henry C. Carey was looking at the way land was settled in North America. He noticed an interesting pattern: during North American expansion and settlement, the economy was behaving as if there were increasing marginal returns, not decreasing. The reason, he postulated, was that land was not scarce.  People did not have to make decisions based on getting the “best” land, and there was no mechanism to drive up the price of land as they bought more. The fact that there was so much land, and the price was so low, literally any effort you put into developing new land was likely to have a favorable return.

Here is an interesting twist: Carey was a protectionist and an abolishionist, and according to ethnologer John M. Steinberg at the University of Massachusetts:

Carey worried that in situations of increasing marginal returns, profit was not only to be made by owning good land and using it efficiently but also by reducing the cost of labor to an absolute minimum. That is, an economic system characterized by increasing marginal returns could degenerate into a relatively short-term economic program in which the reduction of labor costs was paramount in order to make a profit. The extreme form of the reduction of labor costs is slavery—the un-economic control over labor. For Carey, classes were not an inherent part of complex society with a healthy division of labor but the misguided result of apparent free trade. He believed that the forceful control over labor was really responsible for social stratification. He argued that protectionism was necessary to end slavery.

Carey made the link in the mid-1800’s that free markets characterized by increasing marginal returns would have a natural tendency toward slavery.

Now let’s fast forward 100 years or so.

When I was a graduate student at the University of Michigan I was part of a graduate certificate program in Complex Systems in addition to working toward my Ph.D. in Mathematical Psychology. The program frequently had special guest speakers, and one of these was W. Brian Arthur. As a graduate student, I was in awe! Arthur had co-founded the Morrison Institute for Population and Resource Studies at Stanford, was a member of the External Research Faculty at the Santa Fe Institute for Complexity Sciences, had been a member of the Lindisfarne Association, and was considered a key contributor to the rise of the field of Complex Dynamic Systems theory.

This is what I remember of the talk he gave at the University of Michigan.

For the last several decades our economy has been experiencing increasing marginal returns. This time it is not caused by an over-abundance of land. Instead, it is because of network-based technology.

It all really started with the telephone, and the telephone is still the easiest example to use as an illustration. What is the value of a company producing and selling the first telephone? Not just their first telephone, but the first telephone. NOTHING. A single telephone is useless. However, with each additional telephone that is sold, the usefulness of all of the telephones increases. These technological devices show increasing marginal returns because their operation depends on networking. The more you sell, the more a person can do with it, and the more value each one has.

The other classic example that gets discussed in economics classes is the whole VHS versus Betamax debacle. This example is usually used to illustrate the consequences of positive feedback in utility: if one item gets a small edge early on, then this will become amplified by the property of increasing marginal returns. VHS initially sold more, so even though its technology was not as good as Betamax, it was seen as more useful.  In the end VHS drove Betamax out of business.

These were once novelty examples, pointed out as “exceptions” rather than the rule. But the internet computer technology have taken center stage as driving forces in our economy. Now, all of those illustrations in your economics textbooks rooted in land cultivation and assembly-line production are not merely out of date; they don’t describe the fundamental reality of our economy.

The symptoms we are seeing are depressingly similar to the conditions described by Carey in 1848, as well. Without the equalizing power of diminishing returns, wages get driven through the floor. With increasing marginal returns, big companies have an intrinsic advantage over smaller startups, reducing incentives to create competition.

All of this was interesting, but there was one part of this lecture that stuck out, and that I will never forget.

Arthur mentioned, in a casual and even offhand seeming way, that although he had been trying to get these ideas published since the 1970’s nobody would publish his work on this topic. This was at the height of the Cold War and the “Red Scare” and there was a lot of political motivation to “prove” that capitalism was absolutely the best economic system ever.

Publications that questioned the basic assumptions of free market capitalism were actively suppressed from the 1950’s all the way up through the 1980’s. On the other hand, government funding was always there for anyone working hard to prove that the basic assumptions of the free market would always produce optimal pricing, optimal wages, optimal market dynamics, and unicorns that fart glitter.

That’s why economics textbooks from that period describe scenarios of increasing marginal returns as odd-ball fantasy scenarios, if they are even acknowledged at all. The textbooks would say: Sure, when you live in some kind of Robinson Crusoe situation, alone on a lush and abundant island, you will have no scarcity and there can be increasing marginal returns. But that’s not how the real world works!

It made me sad to hear the undercurrent of frustration in Arthur’s voice, giving this lecture in the late 1990’s. I tried to imagine how bitter-sweet it must feel for him to now be getting so much praise and recognition for an idea that he was unable to get published at all for decades, all because of politics and American fanaticism. And even now, it is not as though people are paying attention enough to change the system.

It is unfortunate, because we know where this goes. We were warned about it by Brian Arthur in the 1900’s, and we were warned about it by Henry C. Carey in the 1800’s. Who knows? Maybe we are almost ready to listen.