All Commentary
Thursday, May 26, 2011

Free Markets Are Regulated

The myth of disorder.

In recent years defenders of markets have begun to realize that language matters.  In earlier columns I wondered about the usefulness of the term “capitalism” to describe the free market (see this and this). Here I’d like to explore how the terms “regulation” and “deregulation” are used and what exactly they mean in the market context.

The usual dichotomy is between the “unregulated” or “deregulated” market and the “regulated” market, which includes significant government intervention.  Advocates of free markets have long made the case for the advantages of unregulated markets and exposed the problems associated with regulation, often using spontaneous-order arguments.  The fundamental insight of economics from Adam Smith forward has been that free markets are capable of producing order without design.  We do not need “regulation” in the sense of State intervention for markets to generate socially beneficial outcomes.  And when we do attempt to “regulate” them through the State, the result is a variety of undesirable unintended consequences.

Order without Design

This is all correct, of course, but it misses an opportunity to emphasize even more strongly the idea that markets produce order without design.  The language of “unregulated” or “deregulated” markets makes it difficult to talk about order without design because those very words seem to suggest that there is no order to the marketplace. A “regulated market” in contrast sounds orderly.  I think we can get around this problem by arguing that free markets are in fact highly regulated and that government-“regulated” markets often lack any meaningful regulation.

Merriam-Webster offers this definition of “regulate” first:  “to govern or direct according to rule.”  It also includes a second definition: “to bring order, method, or uniformity to.”  One understanding of “regulated” is that some process operates according to a rule or rules and thereby is orderly.  This is the sense we use when we talk about a regulated physical process being predictable and orderly, or to describe something that repeats in predictable ways, for example, “our regular waiter” at the local restaurant.

In this sense, free markets are indeed highly regulated.  Economic theory demonstrates that free markets operate according to rules that we can recognize and understand.  These rules enable us to make what F. A. Hayek called “pattern predictions” about the behavior of markets.  We know, for example, that when price rises, all else constant, quantity demanded will fall, or that above-normal profits in an industry will bring new sellers into that market — even if we cannot predict either outcome precisely.  Market participants will not act haphazardly, nor will outcomes be chaotic.  People’s behavior is regulated by the laws of economics, which in turn produce orderly patterns.

Government attempts to improve on markets are often described as “regulation.”  In some sense this is accurate: Government does try to impose its own set of rules that are intended to produce something more orderly in the eyes of the regulators.  In addition, economists can make similar pattern predictions about the unintended and undesirable results of that regulation, for example that a price ceiling set below the market-clearing price will produce a shortage.

State Reduces Order

However, we could also argue that such intervention reduces the level of regulation in the market because intervention invariably puts a great deal of discretion in the hands of both the “regulators” and those being regulated.  Are “regulated” markets more predictable than “unregulated” ones?  Is it easier for entrepreneurs to anticipate the actions of bureaucrats with discretionary powers or of competitors seeking profits according to the rules of the marketplace?  Is behavior more “regular” when firms are genuinely profit-seeking or when they attempt to manipulate the “regulators” through rent-seeking?  Bob Higgs’s concept of “regime uncertainty” captures how government intervention makes markets less regulated by undermining rules that generate predictability for participants.

In the free market truly competitive firms can’t simply do whatever they wish, at least not if they want to make profits and continue as viable enterprises.  Their desire to make profits regulates their behavior in ways that drive them to serve consumers by expanding and diversifying output and reducing prices.  In contrast to the implicit picture of “unregulated” markets in which firms can do whatever they wish, economics depicts the free market as governed by clear rules.

Years ago, Hayek pointed out that the question facing societies is not “to plan or not to plan” but “who should plan – individuals and firms or the state?” Similarly, the question is not to regulate or not to regulate, but which type of regulation – market rules or State discretion – works better.

In other words, free markets are regulated.

Find a Portuguese translation of this article here.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.