Why the free market is superior to all other systems of allocation

In a free market economy resources are allocated via the price mechanism. We all see this every day without giving it a great deal of thought. How it works is very simple.

Chart: Demand Curve

As the price of a good or service rises, demand for it falls, as the chart above shows (excuse my poor excel skills). Let’s call the good in this example good X.

Chart: Supply Curve

On the supply side the opposite occurs. As the price for a good or service rises the number of suppliers entering the market willing to supply the good rises. Super imposing the two curves onto the same chart we see the point where the demand curve and supply curve cross for good X to be at £5. This is what we call the equilibrium price. In a free market prices will adjust until they reach the point where supply equals demand.

Chart: Equilibrium Price

This all seems extremely logical and very simple; indeed, it is one of the first lessons you will learn in your microeconomics lectures, if you choose to study economics for your undergraduate degree. The beauty of this system is that it is super-efficient i.e. the nations resources are allocated to maximise utility.

Before moving on I should state the assumption of “perfect competition” underlies free market analysis. Where perfect competition is defined as the situation prevailing in a market in which buyers and sellers are so numerous and well informed that all elements of monopoly are absent and the market price of a commodity is beyond the control of individual buyers and sellers.

Now of course we know this is not the case in the real world. All agents in an economy are not equally informed. This slight imperfection is not enough however for other systems of allocation to produce a better overall outcome. In the modern world, the internet and advancements in technology have moved us closer to a situation where we can achieve this hypothetical perfect competition scenario. At the touch of our finger prints we can gain knowledge on almost any good or service. Price comparison sites have popped up in almost all industries. These sites analyse data from all suppliers and provide consumers with details of the best offerings from the market. Technology is also breaking down the barriers to entry for entrepreneurs, it is now much cheaper and easier than ever to enter the market as a supplier.

Innovation is bringing down prices and freeing up resource. You hear often from those on fearful of the future, concern around automation when in fact this should be embraced. The way most of us look at employment is completely wrong. The labour force is a resource, automation will simply mean you can produce more with less labour. We will have more of the labour force available to focus on pastures new, think big, space exploration, researching diseases, developing new methods for harnessing energy etc. This truly is an exciting time for humanity.

This being said efficient allocation does not mean an equitable distribution of resources. As it happens inequality was the subject of my post graduate thesis. Since then my view on this subject has become more liberal, where I once believed it was the role of the state to help temper inequality. I now believe it is both not possible and not desirable for the state to control.

Inequality was one of the main themes for labour Labour under Ed Miliband. Now with the election of Jeremy Corbyn to the leadership of the labour party, labour has once again become a socialist party. The doctrine of socialism is to deliver a more equal society through collectivism. In practice how this is done, is either by the state directly taking control of the factors of production or by the state setting prices.

If we go back to the above charts for good X. Let’s say the state decided to intervene in the market by setting a price below the equilibrium price we see then clearly what happens. The demand for the good or service goes up, while at the same time the supply goes down. You end up with a shortage. Conversely if the state were to set a price higher than the equilibrium market price you end up with a surplus.

You get similar problems if the state directly takes control of the factors of production via nationalisation. The price mechanism then becomes redundant but you then have a state monopoly. The state then must make the complicated decisions on how much to produce trying to forecast demand. Inevitably this level will not be anywhere near as efficient as the market equilibrium level resulting in surplus’ and shortages. We saw this is communist Russia in the last century. In the process by nationalising you will have killed off innovation as the incentives for entrepreneurship will have disappeared. Corbyn and McDonnell are effectively selling snake oil. They would promise those at the bottom more, they would fail and in the process, violate the individual liberty of everyone else.

Now the orthodoxy in Britain is social democracy. Both the liberal democrats and the conservative party to varying degrees are now parties which are dominated by social democratic thinking (also the dominant ideology of new labour). A social democrat tries to move the market equilibrium by providing incentives or taxing in specific areas.

Giving an example of how this works in practice lets go back to the charts for good X. Let’s say good X was demand for a high polluting fuel, arbitrarily let us say petroleum. Now the state might want to limit consumption of petrol and make it more desirable to use alternatives. It can do this by putting a tax on sales of petrol.

Chart: Equilibrium after Tax

We see now the supply curve has shifted to the left. With the additional cost of the tax, suppliers now want a higher price for each unit. This has resulted in an equilibrium with a higher price per unit that the original, with a lower level of demand.

This is an improvement on the socialist approach as you still have an efficient allocation of resources. Where there are externalities like climate change, not accounted for by the free market, the state should intervene in this way. I say this on this situation because it a problem for all of us i.e. there isn’t a single citizen rich poor, black white, male, female that doesn’t need a solution for climate change.

In most circumstance however the state should not intervene at all. It certainly shouldn’t be favouring one group in society over another. The major problem with both the social democratic approach and the socialist approach is that it assumes the state knows what is best for its citizens and does not consider our individual differences. Because of this an overarching state which taxes us and makes choices for us on how resources are allocated is a violation of individual liberty. To repeat only in circumstances where state intervention is absolutely to the benefit of every citizen should the state intervene (Even in this circumstance the evidence must be overwhelming).

Most intervention in the markets by government is for the purpose of delivering a more equitable distribution of resources. The problem is, inequality is for the most part caused by differences in ability/ choices etc. We are not all equal, some of us work harder than others, some of us are more intelligent than others, some of us are physically fitter than others, some of us are better looking than others, for the state to intervene to try and make us all equal is a violation against nature.

The fact is in the United Kingdom it doesn’t matter what your background is, if you are talented, ambitious and willing to work hard, you will succeed. Taking from the person who has done the right things, educated himself, invested wisely, looked after his own health to provide for the person that hasn’t is morally wrong. Therefore, ultimately the laissez-faire liberal approach to the world is the best. Leave everyone alone to live their lives. Taxation for the purpose of redistribution is in no meaningful way different from theft.

Idreece Khan

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