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Behavioral Science Explains the Failure of Free Markets

March 23, 2016

Most of you know me as a behavioral science guy, but I have to make a confession: my initial training is in Economics and business administration. Being born in a country with a communist dictatorship, with a centralized economy and spending much of childhood and teenage years in a chaotic backwards transition to market economy, I firmly believed in the virtues for free markets.

 

Perhaps because of this experience and seeing what free markets can do in a society unaccustomed to how they work, made me think hard if free markets are as virtuous as I thought them to be. And the answer is ambivalent: on the one hand, yes! It is absolutely obvious that a free market economy is far better than a centralized and corrupt one. On the other hand, however, free markets can be extremely perverse and lead to severely sub-optimal results (equilibrium).

 

Too often free markets fail to achieve the goal of maximizing consumer benefit.

 

When thinking about the pros of free markets, there are two prevalent assumptions:

(1) people (buyers) fully understand what they are buying and

(2) people can punish sellers by not buying from them anymore.

 

When these two assumptions are met and when there is competition among sellers, free markets work just fine.

 

 

Consider the example of fruit and vegetables. Anyone can understand what they are, anyone can quickly assess their quality, even if not necessarily before purchasing. Since they are bought frequently anyone can punish a seller by not buying from him or her next time they are shopping. Moreover, if the product is faulty, the damage to the buyer is minimal.

 

Another similar example is that of hair-dresser saloons (establishments). Anyone can quickly assess if they are happy with their new haircut, with the service provided etc. Although we don’t usually visit the hairdresser as often as we buy fruit and vegetables, the purchase of such services is frequent enough to allow the buyers to punish the sellers by not going to their establishment next time they get a haircut. Again, the damage caused to the buyer if the service is faulty is relatively low (unless it’s your wedding day).

 

In such situations free markets work just fine with minimal (common sense) regulation.

 

When the two assumptions of (1) people (buyers) fully understand what they are buying and (2) people can punish sellers by not buying from them anymore are not met, free markets are disasters waiting to happen.

 

An obvious example is the banking / credit market. For the huge majority of people a loan is a difficult to understand product and not seldom banks (credit institutions) make them even more complicated than they should be. Understanding the exponential relationship between the cost of the credit and the duration of the loan is extremely difficult even for trained economists. Fully understanding the maze of interest rates and fees requires a chess-master’s mind coupled with lengthy deliberation, computations and spreadsheets. The huge majority of people who take loans do not have these abilities or afford the necessary effort and time. Instead they rely on simple / simplistic rules of thumb (heuristics) such as how much do I like the person selling this or which one has the smallest monthly payment.