Where Free Market Capitalism Fails

Negative externalities in the workplace.

One of the challenges that we have in today’s world is that much political discussion is driven by ideology rather than evidence. This problem seems to happen on both the right and the left. The left claims that corporations are intrinsically evil and that organized labor is the only real path to a sustainable, fair economy. The right, on the other hand, frequently claims that capitalism—everyone acting in their own best interests—is responsible for the advancement of the world, and that if we just leave the free market alone, it’ll solve all the world’s problems.

Ever since Ronald Reagan, free market capitalism has been on a giant upswing. People with money have recognized that they can buy mindshare for their political beliefs, to the extent that there’s now a popular “news” network that embraces bias, reinterpreting all events through its free-market lens.

To a certain extent, it’s true that free market capitalism can achieve amazing things. Think about all the products available in Target or Walmart. These products are sourced all over the world, yet are almost always available whenever you want them, at amazingly low prices. However, capitalism also has a major problem, and that’s negative externalities.

Negative exter-what???

The way most businesses work is they acquire raw goods, buy machinery and hire people to transform those goods in some way, and then sell the resulting product. If the business wants to be sustainable, it has to sell the product for more than the cost of the raw goods, machinery, and salaries so that it can make a profit. If you can buy steel for $1, pay someone $3 to operate a machine that bends the steel into hedge clippers, and sell the hedge clippers for $10, you’ve got a business. If you can only sell them for $3.50, you won’t last too long.

This is all seems simple and elegant, but a problem arises when there are hidden costs not factored into the price of your product. For instance, suppose the person who mined the iron to make the steel ends up with a bunch of tailings—useless rock after the iron has been removed. The cheapest thing to do with those tailings is to just dump them. However, if runoff rain water from the tailings get into a stream, it might poison the water supply for a town. The poisoned the water supply doesn’t cost the steel company or the hedge clipper company anything, but has a high cost for the people in the town. Thus, this is a negative externality—a cost not borne by the businesses, but someone else.

Similarly, smelting the iron using coal will lead to air pollution, increasing healthcare costs, killing farmers’ fields, and increasing the carbon dioxide in the atmosphere (leading to things like droughts and hurricanes). That air pollution will cost the company nothing, but has a large negative impact on other people.

The consequences

I think negative externalities are the biggest problem with the arguments of people who believe in free-market capitalism. In many cases, the costs are real, potentially higher than the cost of the product itself. Maybe it costs $25 to get a barrel of oil out of the ground, but—depending on how you value human life—the cost of the negative externality of carbon dioxide pollution—causing hurricanes in Florida, drought in the Midwest, and forest fires in California—might be $50.

But the oil industry never sees that the true cost of a barrel of their oil is $75. Rather, they’re making massive profits at that price and will want to pump even more. Thus, the free market is broken because pricing isn’t reflecting actual costs.

The simple solution

The obvious solution is regulation—either requiring businesses that emit carbon dioxide to stop doing it, or adding taxes so that the true cost of those carbon dioxide emissions are taken into account. Typically, the right wing would protest that such regulations are destroying the market and jobs. To a certain extent they’re right—if you increase the costs of a business, you’ll increase the costs of their product, which will reduce demand, so fewer people need to be hired. However, it’s actually representing the true cost of production, thereby ensuring that the economy is making the “right” decision.

For instance, suppose I decided to create a dog walking service, and to save time and effort, I just dropped off the dogs into your yard to run around all day, tearing up your garden, disturbing your neighbors, and pooping everywhere. You might decide that you didn’t like me doing this, and ask me to stop. Well, it would ridiculous for me to then claim that you’re destroying my business with your silly regulations. What you’re actually trying to do is get me to take into account the negative externalities. (In fact, maybe you’ll say, “you can continue putting the dogs in my yard, but you have to pay me $1000 per month.” That would be the equivalent of the taxing the negative externality.)

Of course, this doesn’t stop the right wing from claiming that regulations are destroying the economy. I guess they’re fine having crap on their lawn.

Why the simple solution doesn’t work

The problem with these sorts of regulations is that the economy is now global. If I force my steel factories to eliminate their carbon emissions, the cost of their steel will increase, and my steel producers will not be competitive with the unregulated steel producers in your country.  So, customers will choose to buy your cheap unregulated steel rather than my pricy regulated steel. I’ll go out of business, and the carbon dioxide will still be pumped into the atmosphere.

There are two solutions I can think of to this problem, neither one of which is great. The first solution is to ensure sensible regulations within trade agreements, so that everyone’s on a level playing field. The problem is that this approach typically doesn’t work well in reality. The steel producers will lobby (bribe) the participants to reduce or eliminate regulation. Countries won’t be able to agree on what’s fair, countries will cheat, and nothing real will get done.

The second approach is tariffs. If products from an external country don’t meet the requirements of my country, then tax them to make up for the negative externality. However, this approach also doesn’t work. First, it’s difficult to do this in a consistent way (like, what if one factory in China meets my regulations, and the others don’t. Can we buy our steel from only that factory?) Second, tariffs will often be viewed as simple protectionism (and much of the time, they probably will be). Finally—and most importantly—it won’t happen because trade agreements forbid it. The country levying the tariff will be sued in international trade courts, and lose. Trade agreements today don’t care about negative externalities, just eliminating tariffs.

The actual solution

So what’s the real solution to these global issues like global warming, where a negative externality has the potential to cause massive harm for everyone?  I don’t know if there is one, other than a unified world government, a cure that might be worse than the sickness. Thus, I think the most likely outcome is that people will fret about these problems indefinitely, nothing will be done to address them, and the problems associated with global warming will explode, making life much harder for everyone.

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