The inevitability of market distortions

Free-market economists espouse an ideal: eliminate market distortions, and the economy will flourish. This makes them somewhat starry-eyed. Show me a capitalist economy, especially a successful one, without such distortions. They can occur as market ‘imperfections’ such as imperfect competition in the form of oligopoly or monopoly, or as externalities such as the costs of pollution. These are only imperfections in that they are lapses from the ideal, an imaginary condition called perfect competition. This theoretical construct, requiring minimal barriers to market entry, a large number of firms competing with each other, so that none have the power to influence the price of a homogenous product, seldom occurs in reality. Thus governments often intervene to regulate markets in the public interest, even if this is to try to move them closer to perfect competition.

Governments also intervene on a larger scale. They levy taxes to fund a whole range of public services, infrastructure, welfare and defence. These taxes inevitability ‘distort’ markets, but depending on your political persuasion, some or all of these state provisions are necessary. Few would deny that public education up to some maximum age is essential to a prosperous society. The cost of this is large, but a more educated population is more likely to be able to gain employment and contribute to their own, and the nation’s, well-being. This is only one example of a significant and necessary state intervention in the economy. Defence spending may be more controversial, but is often justified as necessary as at least a deterrent to the potential enemies of freedom and democracy in many nations. Those more to the political left may decry such spending, preferring that it be spent on the promotion of greater social justice through a stronger welfare state, or on more ‘productive’ areas such as infrastructure or research and development into new technologies which can both add to the nation’s long-term prosperity.

The structural change that occurs naturally in an evolving and growing economy may also require labour market institutions and policies which make such change less disruptive to workers, potentially making them more open to change and less insecure. Unemployment benefits and re-training for new kinds of work can provide essential support in a changing labour market and help new industries hire those with relevant skills. All this costs money, and will ultimately require state support. Again, the taxes levied to fund these things will distort markets, but will support economic and social change.

Thus all political sides implicitly agree that states and markets are inseparable through significant forms of intervention and the deliberate creation of market distortions. There may be room for improving the efficiency of state taxation and spending, but they seem to be an inevitable part of a functioning capitalist economy and society.

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