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, it breaks down completely under certain specific conditions.  Those conditions were true in the early 1800’s, and they are also true today. I’d like to look at exactly what “broke” the free market in the early 1800’s, and examine why the same forces are at work now.

But before diving in, I want to make the punch-line clear: The “free market” does not work in today’s society. I’m not making one of those pragmatic “it doesn’t work because humans are imperfect” arguments, either.  The basic premises of the free market economy are actually incorrect even in principle in today’s economy.  So economic conservatives, libertarians, and others who put their complete faith in the belief that “free market dynamics will eventually find the optimal solution” are, quite simply and quite bluntly, wrong.

I repeat: I’m not saying this in a “the real world is more nuanced than they are considering” type of wrong; I’m saying it in a “the fundamentals of their basic economy assumptions don’t apply” type of wrong.  That’s the punch line.

But 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 it, because you can Google it yourself and find enough reading to last you a lifetime on the topic. But suffice it to say that basic concepts like supply and demand, the finding of “optimal” prices for goods and “optimal” wages for workers, and the process through which competition leads to increases in efficiency and decreases in prices, are all closely tied to the key assumption of diminishing marginal returns.

At its core, it is an intuitive assumption. 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. When you assume all other things are constant, a company gets more out of producing its first 1000 widgets than it gets out of producing the next 1000 widgets.   A company gets more out of hiring its first 100 workers than hiring its next 100 workers. And so on.

Of course, good old Adam Smith, writing in the late 1700’s, was more fond of agricultural examples: the amount of product a farmer gets out of the first 100 acres of land is greater than the product he gets out of the next 100 acres. In the world of farming, of course, this assumption usually makes sense.  As time went on, the same argument could be made of factory workers on assembly lines, as well. So in addition of being intuitive, there seemed to be plenty of circumstances where the assumption held up.

It also didn’t hurt that during the mid-1900’s we had this thing called the “Red Scare” and the “Cold War,” when there was a lot of political motivation to “prove” that capitalism was absolutely the best economic system ever.  One can hear plenty of stories in the halls of Economics departments about publications that questioned the basic assumptions of free market capitalism being actively suppressed from the 1950’s all the way up through the 1980’s. Government funding was always there, however, 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.

But I digress.

Decreasing marginal returns act as an engine to drive the free market economy in part because of scarcity. If you get more out of your first 100 acres than your second 100 acres, then there is a huge motivation for competitors to get into the market: being a new start-up has an inherent advantage to it.  If the resource (in this example, land) is scarce, then the price is high enough to deter larger existing owners from simply gobbling up everything (when their return is less the more they have), whereas the incentive to pay the price will still be dominant for smaller start ups, because they would enjoy higher returns on the land as an initial investment.

American ExpansionIn 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 the resource of land was not scarce.  People did not have to make decisions based on getting the “best” land, they did not have to pay a premium to get land. Any effort that was applied to land was likely to have a favorable return, because the price was so low and there was so much of it.

In economic textbooks, this kind of scenario is described as a kind of fantasy Robinson Crusoe situation (see, e.g., Samuelson and Nordhaus 1992). When you are alone on a lush and abundant island, then there is no scarcity: the only limiting factor is your own labor, because whatever resource or work you decide to apply your labor to, there will be enough raw materials to give you a return.

In economics textbooks, this is usually described as a fantasy scenario in order to illustrate that “reality” is different. Specifically: in “reality” there are decreasing marginal returns.

But during the expansion and settlement of North America, increasing marginal returns were the reality. People went anywhere, everywhere, and the more land they gobbled up for themselves (with little effort or cost) the better it was for them.

Now, it should be said that Carey was a protectionist and an abolishionist.  According to an interesting passage from a paper by 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.

So this was an observation made in the mid-1800’s, that slavery could be a natural tendency toward which markets gravitate when they are characterized by increasing marginal returns.

I want to pause to re-iterate that, and put a spotlight on it from today’s political context: Economic conservatives and libertarians insist, doggedly and dogmatically, that if only we allow the free market to operate on its own principles, it will always lead to the best possible outcome in the end.

According to Carey, that is only true when certain assumptions, like decreasing marginal returns, apply. When you “break” one of the basic assumptions of the free market dyanmics–for example, when you have a situation of increasing marginal returns–you can have non-optimal, degenerate outcomes. For example: slavery.

What does all of this have to do with today?

Well, in the last several years, some economists have observed that technology has once again put our society into a situation where we have increasing marginal returns.  The reason this time is not an over-abundance of land, but rather the particular properties of network-based technology.

It all really started with the telephone, and the telephone is still really the simplest example.  What is the value of a company producing and selling the first telephone? NOTHING.  A single telephone, that is the only telephone in the world, is useless.  But, with each additional telephone that is sold, the usefulness of those telephones increases. Because these are technological devices that operate on the premise of networking, they are characterized by increasing marginal returns.  The more you sell, the more a person can do with it, and the more value each one has.

The classic example discussed in economics classes is the whole VHS versus Betamax evolution. 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.  As a result, in the end it drove the other out of business.

These were once novelty examples, pointed out specifically because they went against the “normal” economic examples. Of course, until very recently all of the “normal” examples were still rooted in land cultivation and assembly-line production.  But it’s now the year 2012, and these “novelty examples” are now the driving force of our economy, and will only become more so as time goes on.

So we now have a fragile situation in which the fundamental core of the “free market” ideology simply doesn’t apply.  Although it’s for different reasons, we have a similar mechanism (increasing marginal returns) at play to the one that broke the free market in the early 1800’s, during the expansion.

During the expansion period, there was almost no effort put into finding the best land… instead the effort went into getting there first.  Does that sound familiar? The same can be said for a lot of internet-based applications today.  Who cares if Twitter and Facebook had horrendous and crippling bugs the first year or two out of the gate: the point was simply to stake out their territory, and become known as the provider of that particular service. This is the norm for internet technologies. We are in the “great land-grab” era of network technology.

It’s exciting, in that wild-west kind of way. But remember the economic down-side: wages get driven through the floor, because the fundamental equalizing power of the law of diminishing returns is gone. We already see it. How many people feel like they have to “prove” themselves by creating a technology for free (for their “portfolio”) before anyone will hire them? How many people volunteer themselves for “projects” because they feel they have to get “noticed” (even  if they don’t get paid).

This is how it starts: this is the psychology of a broken free market at work. You only have to look at warnings written in the 1800’s to see why.


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