The Virtues of Free Markets?


In our books, Dubner and I have argued that economic analysis (at least the way we try to do it) is neither moral nor immoral. We try to start with a question, obtain a set of facts, and then understand where those facts lead, trying not to be prejudiced one way or the other by moral considerations when coming to a conclusion.

Similarly, I’ve never really thought of markets as being moral or immoral.

Mark Zupan, the dean of the University of Rochester’s William E. Simon School of Business, thinks differently. In a recent piece, Zupan makes an argument that most people will find counterintuitive: he claims that free markets foster integrity and cooperation.  I’m not sure I fully agree with him, but the basic idea is sensible and straightforward. Markets lead to firms that survive for long periods of time. Reputations are important to firms, which leads them to behave in virtuous ways, not because they’re inherently moral, but because virtue is good for business in the long run.

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  1. Josh says:

    Is this really a new perspective? It seems like a description of a microcosm of Smith’s Invisible Hand to me: Markets allow people and entities with primarily selfish ambitions to ultimately benefit the greater good through competition.

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  2. SomeCallMeTim says:

    As a graduate of the University of Rochester with Economics and Political Science degrees, I respectfully have to call *bullshit* on Dean Zupan’s theory. This is based on recent observations.

    – BP has been around for a long, long time, and will most likely be around for much longer. However, they have a history of failure when considering safety and environmental issues. They’ve failed to keep the Alaskan Pipeline maintained, which cause tremendous environmental damage due to oil spills. Their failure with the Deepwater Horizon not only caused massive environmental damage, but also killed 11 people.
    – The major banking and insurance firms failed the “integrity” test with their derivatives and mortgage securitization activities. Some of the companies did ultimately fail, but most are still in business, with the whole 2007-2009 fiasco just a dip on their income statements.

    The theory may hold water at the local level – a deli that fails to treat the neighborhood properly may not survive, but once a company hits a certain size the theory fails. After all, “integrity” and “cooperation” are not words I think of when I think of Exxon, BP, CitiCorp, Haliburton, etc. (well, “cooperation” does come into play when considering collusion, but that kind of cooperation is hardly ethical).

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    • RogerP says:

      Perhaps I’ve missed something obvious, living outside the First World, but surely those institutions that were up to they eyeballs in the 2007-2009 fiasco would have gone to the wall if the free market held sway.

      My simple understanding is that the governments in those countries took over the toxic debt that would have sunk those institutions and passed it on to the citizens in the form of spending cuts. The alternative would have been a collapse of the banking system, in which case it would be the morals of political establishment that allowed the institutions to survive, not the morals of the free market.

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    • ChrisB says:

      I don’t think Zupan’s theory is negated by your example of BP and large banks because you have to remember that a large company that has existed over a long period of time has had many leaders at the helm and those CEOs and corporate executives have each had a different view of how to best guide their company. The tenures of those leaders may have started out brilliantly but their decisions along the way became self-certained, corrupted, or just plain stupid. Contrast that with a small biz owned by a single proprietor: it can also suffer from bad leadership and eventual ruin, but its existence will be much shorter.

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  3. rationalrevolution says:

    No, the basic idea isn’t sensible. Why is economics still so filled with obvious hacks and dominated by evidence-less thought experiments? Why are “thought experiments” that have been disprove by facts hundreds of times still given any consideration at all in the field of economics? This isn’t true is pretty much any other field. Well we know why, because people stand to profit from this misinformation is why, but good lord, why do so many people keep falling for it?

    First of all, what is a “free market”? Is it an “unregulated market”? Unregulated by whom? Define regulation. Is a market that isn’t regulated by any government authority, but is dominated by a monopoly “regulated”? What about trade groups, what about the mafia?

    In a market with no “regulation” what prevents “manipulation”? Again, trade groups, mafia, monopoly, oligopoly, etc.?

    Now lets get to some examples, examples of market obfuscation. Let’s talk about natural gas extraction companies.

    Now, given that consumers never purchase natural gas from natural gas extraction companies, there is no market mechanism by which the actions of natural gas extraction companies can be impacted by consumers. Natural gas is extracted by a combination of small to large extraction companies, who then sell the gas to middle-men, who then sell the gas to energy suppliers, from whom the consumers buy it. The interests of the various middle-men may have nothing in common with the consumers.

    The actions of the natural gas companies have no discernible impact on the consumers. If they engage in practices in another state that taint the drinking water of people, then buy off the local officials to prevent action and buy off the news to keep them from reporting on it, how would consumers even be aware of this? Why should their buyers (the middle-men) even care?

    Furthermore, if people in one state are buying gas that’s extracted in other state, and the ill effects of the extraction process don’t effect them, instead they just effect the people of the other state, even if they were aware of it, why should they, acting in rational self-interest, even care? Indeed they could prefer such gas because it would reduce production of pollution in their own state.

    What “free markets” do in practice is they create layers of obfuscation, which we can plainly see right in front of us. We buy goods made in China and Vietnam under conditions we would never allow our own children to be subject to and would never tolerate if the same practices were employed here and we as consumers watched the processes taking place in front of us.

    Look at our industrial farming system. If consumers had to watch the treatment of the animals and harvesting of food from end to end at the point of purchase there is no doubt that people’s purchasing decisions would be much different than they are today. The producers intentionally obfuscate and hide their practices from the consumers. The result is not that integrity is rewarded, but rather that deception is rewarded.

    Furthermore, there is a clear contradiction between the short-term and the long-term, because in order to survive for the long-term you first have to survive the short-term. If you don’t survive in the short-term you never make it to the long-term.

    The 2008 mortgage crisis is a clear real-world example of this. There were many loan originators who KNEW, KNEW, KNEW that what they were doing was wrong, who didn’t want to write these loans and knew that they would invariably blow up down the road. They had a very clear understanding of the problem, but guess what, they couldn’t do anything about it, because of the “dictatorship of the market”.

    The dictatorship of the market is a situation where if you don’t go along with the market you lose or go out of business, etc. It’s when you know the market is wrong, but you have no choice but to follow.

    You see, if the originators didn’t take on these bad loans during the peak of the bubble they would have lost all their business at that time and gone out of business, because everyone WANTED the bad loans! So if the originators were responsible and honest what would have happened is they would have lost all their business in 2005-2007 because the lenders would have stopped using them and gone to other originators that were giving them what they wanted, which was far more business, indeed this is the real experience of originators. So the “bad” originators created a situation where you had to follow their practices in the short-run in order to survive. The long-run wasn’t even a part of the picture. You would have gone bankrupt trying to plan for the long-run in the “free market”. Runs and bubbles and short-term schemes driven by bad information and intentionally dishonest actors can dominate the short-run, thereby making the long-run irrelevant.

    The point is this, long-term benefits don’t matter if there are no short-run benefits, or if there are short-run forces that trump the long-run benefits. This is why markets fail, over and over and over and over and over and over again, and idiots like Zupan keep spouting total f*ing bs and more idiots keep buying it…

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    • Joshua Northey says:

      Excellent post. I just don’t understand how these people who understand mathematical models so well don’t understand:

      1) How wild the oscillations in them can be and how this makes them completely inapplicable to the real world. If your free market paradise ends up at value 10 on the hedon scale but on the way there passes through point -7, there is no recognition that at point -7 there will be revolution and civil war and the rules of the game will change, ensuring you never get to value 10.

      2) People are really really really really really really really short sighted and irrational. They did not psychologically evolve for this environment. It is ridiculous what a poor model of human behavior is plugged into most of these models predicting sanguine outcomes to little math games. People cannot even make effective decisions about simple questions like whether to buy this TV now or 6 months from now, much less the much more complicated decisions they encounter on a day to day basis. When most college graduates cannot answer the Monty Hall problem correctly you know you still have a long way to go before you can turn governance over to a trust in people’s rationality.

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    • Clancy says:

      Absolutely right.
      Also, what this paper and almost all thought experiments about “free markets” fail to deal with are information asymmetry (marketing, PR, advertising, etc.) and externalities. The free market (in its purest form) has no method to prevent negative externalities or encourage positive ones. Drillers who sell their gas to energy companies have no market incentive to avoid a reputation as polluters.
      Most importantly though, what firms need to maintain in the paper is not morality per se, but the reputation or image of morality. If a company has an image problem, the executives will sit down and run the numbers and decide which is more cost effective: A companywide restructuring and purging of “immoral” employees and executives and a program to change the corporate culture to become a truly “moral” company? Or a massive PR campaign with lots of images of smiling, diverse working-class folks with puppies in undulating wheat fields, etc. which will be more effective?

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    • Clifton Griffin says:

      Your examples are not necessarily representative of the average transaction in the market place.

      Natural gas drillers deal in commodities. Commodity markets have many suppliers with essentially identical goods at set prices. And, in that sense, you’re right, they are pretty immune to the consumer.

      But, no one is really arguing for anarchy here. They are discussing whether the basic forces at work in a free market lead to virtuous behavior by most participants. It isn’t that there are no examples of evil, just that the incentives push the other way. You can’t anecdotally unseat that assertion.

      Your second examples deals with the intra-bank transactions: the buying and selling of mortgages as a product. This is also a good example of a market that is somewhat removed from the consumer, but it is not unlike a commodity market in that sense. Almost no one cares what happens to their loan after they get the desired principal at the desired rate.

      Your description of immoral practices of bundling and selling toxic loans is historically accurate, except you do not account for why those loans were even in in the system: the Community Reinvestment Act.

      This law requires lenders to make loans to low income applicants in minority communities. The effect of this is that lenders are forced to provide loans that do not make economic sense in order to make loans at all. They are forced to make the percentages come out right, or they are essentially unable to continue lending to more economically qualified applicants.

      This artificial market pressure created this stream of toxic loans. And each lender acted rationally (if immorally) in selling them up stream. They knew if they could get them far enough away from their own balance sheets, the half-government, half-private Fannie/Freddie conglomerates (another great government idea) would absorb the real cost.

      This also created incentives for speculation on those loans. Ad naseum.

      The point is, you can’t use the actions of actors an artificial economy with high amounts of government intervention as an example of why free markets don’t work. In the free market, those loans would have never been approved in the first place.

      I know I will get voted down for this post and the view point it represents, but I offer it anyway. I enjoy these discussions.

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      • rationalrevolution says:

        No, the CRA was not the CAUSE of the housing market bubble, that has been disproven many times over. Not to mention that the CRA went into effect in 1977, why did it take until 2003ish for it to have the effect? Anyway its not even worth getting into that.

        I’ll make this much more fundamental.

        Market theory states that in a “perfect market” profits would be zero. A perfect market is a market in which all participants are completely rational and have total knowledge of every aspect of the market, and there are no barriers to entry, with no individual having the ability to set prices.

        Under such conditions competition would drive profits to zero, and it is by this principle that market theory, especially as advocated by Adam Smith, is used to argue that “free markets” operate for the public good, because profits are deemed a product of inefficiency and a rent on the system. In a “free market” competition is supposed to drive profits down, toward zero, and the driving down of profits is the public good that is the supposed product of markets.

        But the participants in the market don’t WANT profits to be zero, indeed their objective is to MAXIMIZE profits, to levy the biggest rents on the system they possibly can.

        The theory is that competition prevents this from happening.

        But, the participants in the market are incentivized exactly to undermine market principles. They are incentivized to restrict or misrepresent information, to encourage irrational decision making, erect barriers to entry, and try to fix prices.

        That’s exactly what every market participant is incentivized to do in order to maximize their own self-interest, in other words, every individual participant has the incentive to undermine the system in order to maximizes profits.

        Can anyone look at the real world can honestly claim that that isn’t how market participants act? Marketing is nothing but a clear attempt to encourage irrational behavior. Market participants don’t want people to make rational buying decisions, exactly the opposite, and every school of marketing plainly says so.

        Market participants don’t share information, indeed the opposite. A huge portion of our economy is dedicated to hiding information and keeping it proprietary. John Paulson didn’t come out in 2006 and 2007 and say, “Hey guys, this housing market is going to crash, I’ve seen the books of the banks, this is a bubble, we need to let ease this down.” No, he secretly collected as much information as he could, held it close to his chest and cheered the bubble on waiting for it all to come crashing down so he could GET (not make) a killing.

        Every business model out there is built on trying to create barriers to entry for possible competition. Heck, that’s what patents are, its enforced right into our legal system. As a business you want to block competition. Why? So you can maximize profits.

        Now, here is the thing that makes the whole concept of “free markets” an oxymoron: In an “unregulated market” (which is what most people call a “free market”) the focus of all market participants will be working to undermine the markets, because that is how you maximize profits. That’s why we’ve long had regulated markets, to prevent people from undermining market principles.

        This is why “free markets” are an oxymoron, because in a “free” (unregulated) market, the market participants will undermine market principles.

        And if you want another example of an unregulated market, the biggest unregulated market in the world is the illegal drug market. Would you say that participants in the illegal drug market display the qualities espoused by Zupan? Heck no, all kinds of cutting and bad drugs, etc. are involved. According to Zupan’s logic, we should expect illicit drugs to be of higher quality than the regulated pharmaceutical drugs that are governing by the FDA and numerous other bodies.

        So you tell me, if you go to the street and buy cocaine or ecstasy and I go to Walgreen’s and buy aspirin or Vicodin, which one do you think will test out to be more pure?

        If Zupan’s reasoning is sound, the illicit drug market should be of superior integrity to the regulated pharmaceutical market.

        I’d argue that neither market fosters integrity, but that the regulated pharmaceutical market fosters more integrity than the unregulated illicit drug market. My view is that in a world of “unregulated markets” all the world would resemble the drug trade.

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      • Joshua Northey says:

        This is exactly the heart of the matter:

        “But, the participants in the market are incentivized exactly to undermine market principles. They are incentivized to restrict or misrepresent information, to encourage irrational decision making, erect barriers to entry, and try to fix prices.

        That’s exactly what every market participant is incentivized to do in order to maximize their own self-interest, in other words, every individual participant has the incentive to undermine the system in order to maximizes profits.”

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      • Dave Johnson says:

        The CRA did not “require lenders to make loans to low income applicants in minority communities.”

        Banks were encouraged to make loans in the communities where they are chartered — consistent with safe and sound operation.

        Race had nothing to do with it, and this story being spread about forcing banks to make loans to minorities should tell us all who is circulating this story and why. And the racial aspect of this story tells us a lot about the people who repeat it.

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    • ThatMattGuy says:

      “You see, if the originators didn’t take on these bad loans during the peak of the bubble they would have lost all their business at that time and gone out of business, because everyone WANTED the bad loans! So if the originators were responsible and honest what would have happened is they would have lost all their business in 2005-2007…”

      Ummm…does that mean that BB&T went out of business without anyone knowing? And as to people not caring who’s hurt by the acquisition of the products they buy, you must have not heard of the Fair Trade movement. Or the Wal-Mart/Nike/Kathie Lee Gifford sweatshop stories that were all over the news a few years back. Do people still care? Nope. They continued to buy the products after the start of the next news cycle. Don’t blame what you see (for whatever reason) as a free market for all of these things, blame the average American. Corporations aren’t your enemy, the family sitting around their fiberboard dining table watching a sitcom who “don’t have time” to watch anything approaching actual news that doesn’t reinforce their beliefs are.

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  4. Jaime says:

    I would need some serious convincing to believe the premise that Markets lead to firms that survive for lon periods of time. I believe that is a fallacy and without it the moral argument crumbles.

    But maybe I’m just cynical from having met too many people make it rich by shorting a firm’s assets.

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  5. BL1Y says:

    When you put a letter in the mail, do you trust the post office to get it to its intended destination? Of course (and if not, why are you putting it in the mail?). But, the post office doesn’t operate in the free market. There are other parcel services, but no one else does door-to-door letter carrying.

    Even authoritarian regimes are concerned with reputation. As reputation in certain areas (security, economic competence, criminal justice) declines, the chance of revolution increases.

    There are also plenty of examples of regulations increasing trust. Disclosures filed with the SEC help increase trust in companies and the stock market at large; the FDA and USDA save you the time and effort of interviewing the manager of your grocery store to make sure the food is safe.

    Zupan’s article reads more like an advocacy piece than a serious look at how different market structures affect honesty and integrity. The free market really has little to do with it. What matters is information disclosures and the the ability to punish bad actors.

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    • Clifton Griffin says:

      The post office is absolutely subject to the forces of the free market.

      If their reputation became so poor that people no longer trusted them to deliver mail, they would absolutely feel the pain in one way or another. They would not be able to sustain ineffectiveness without consequences (political and market). Their virtuous behavior is absolutely a product of market forces.

      The real crime concerning the post office is that tax dollars allow them to operate with inefficiencies and a price scheme that is economically impossible. They are able to get billions from congress to shore up their yearly losses.

      People essentially pay less than the actual cost required to deliver their mail. Who wouldn’t use a service like that?

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      • BL1Y says:

        The chance that you will feel consequences for poor performance does not mean that you are in a “free market.”

        If a nation institutes a draft,t hey have to work on making sure that the war is seen as just and necessary by the public, and that the strategy is sound so that lives are not merely being thrown away. Poor administration of a war will increase draft dodgers. That doesn’t make the draft a “free market.”

        Slave owners who are particularly cruel to their slaves, giving them little food, working them extremely hard, and administering savage beatings, will run an increased risk of having their slaves run away, facing a slave rebellion, or having non-slave owners abolish slavery. Doesn’t make slavery a “free market.”

        Community dictatorships always run the risk that too much oppression and economic mismanagement will result in a revolution. Doesn’t make communism a “free market.”

        Or, maybe all these things are a “free market,” in which case everything is a free market, and Zupan’s claim is meaningless.

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  6. Joshua says:

    And so, the invisible hand of self interest causes them to act in a way which benefits society.

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  7. Dave says:

    I think reputation is only a force in a relatively small market. In national or global markets there are enough customers who either don’t know or don’t care about a firms bad reputation so it doesn’t make any difference.

    Then there are cases where all the available providers have a bad reputation. For example, I can only get internet access from Comcast or AT&T, both of which I despise. Of course, that’s not really a free market as competition is limited by the government.

    Someone mentioned BP and I think they’re an example of the global economy being so big and so convoluted that you end up supporting them indirectly without even knowing it so they’re bad reputation doesn’t matter.

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  8. nobody.really says:

    How do market forces shape people’s empathy for others? Consider how the Ultimatum Game is played in various countries.

    Briefly, the Ultimatum Game studies people’s demand for egalitarianism. You are told that someone has received a windfall of $X on the condition that he shares a portion with you. You have the option of accepting the amount offered to you (in which case you get the money offered) or rejecting it (in which case you both get nothing). Classical economics suggests that you’d take whatever is offered to you; after all, it’s free money! But research indicates that Americans are prone to reject offers that are less than 45% of the windfall amount. One interpretation of this result is that people are willing to pay money for the privilege of punishing those who offend our sense of egalitarianism.

    Ok, that’s fine for Americans. But can we generalize to people in other cultures? Some research (can’t find the cites right now) indicate the people who live in market economies also have this same demand for egalitarian treatment, but people who live in smaller, tribal hunter/gatherer communities don’t. One interpretation of these results is that the Ultimatum Game is influenced by the amount of experience you have serving – and relying on service from – strangers. People in tribal communities may not have as much experience with strangers. Loyalty to the tribe is the primary virtue. To extend egalitarian treatment to a stranger means to retain fewer resources for your own clan.

    In short, traditional societies tend to encourage a “love thy family” philosophy; market economies tend to encourage a “love thy neighbor” philosophy.

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