Libertarians like to think of themselves as economically literate, at least when compared to other political groups, and for the most part, I believe that’s true. But there are at least three mistakes that I keep hearing even libertarians make when talking about the free market.

Mistake #1: “The free market doesn’t need regulation.”

One of the dangers of talking with someone who disagrees with you, or sometimes even with someone who seems to agree with you, is that you talk past each other. I find that’s true in discussions about regulation.

Even among libertarians, whether and to what extent we need government regulation — for example, to prevent environmental catastrophe, to prosecute violent criminals, to defend against territorial aggression — is a subject of heated debate.

We’re fooling ourselves if we think that even in a free market, there won’t be unscrupulous sellers who will try to sell to unsuspecting buyers unsafe food and drugs, dangerous cars, and shoddy housing, or that there won’t be unscrupulous buyers who will try to cheat unsuspecting sellers with false claims about their ability to pay.

In the real world, knowledge is imperfect. It’s impossible always to know when someone is telling the truth, and people are vulnerable to opportunists. Such unsociable behavior, if not restrained by internal norms, requires external constraints — regulation — of some kind. But even libertarians too often concede that regulation means expanding the role of the state.

If, by “regulation,” we mean external constraints on harmful behavior by buyers and sellers, then people in free markets do need regulation to protect them. The mistake is to assume that only government — that is, a monopoly over the legitimate initiation of violence — can do the regulating.

Free markets unleash forces not only to lower costs and to innovate; they also unleash the resourcefulness of ordinary people to regulate antisocial behavior.

Mistake #2: “Markets will regulate themselves.”

Now, this statement isn’t a mistake if you understand that it’s shorthand for a more complex argument. The trouble is, to someone innocent of basic economics, it makes the free market sound like a magical black box. Worse, opponents of the free market like to twist it into the straw-man idea that sellers and buyers will exert enough self-control to regulate themselves individually, or that markets would form trade associations to maintain the quality and practices of members — which is true sometimes, but not always.

Better, then, to spell things out.

In a free market, a great deal of potentially unscrupulous behavior by sellers and buyers is indeed restrained by constraints that we internalize, called “norms.” They’re lessons we learn, usually early in life, about why it’s important to trust and to be trustworthy, and to be honest and play fair even when no one is looking. A free market wouldn’t flourish without these “non-market foundations of market processes.”

Again, while necessary, they won’t always be enough to keep buyers and sellers in line, and so we do need regulation. But…

In a free market, the heavy regulatory lifting, the lion’s share of constraining unscrupulous behavior, comes not from government but from competition. Competition pressures buyers and sellers to be trustworthy and to make fair and attractive deals or else risk losing business to their rivals.

So what does this market competition consist of?

Mistake #3: “Buyers and sellers compete with each other.”

In a free market, buyers do not compete with sellers, nor do sellers compete with buyers. In a free market, buyers compete with other buyers to offer sellers the best deal, and sellers compete with other sellers to offer buyers the best deal.

Now, because buyers and sellers often find themselves sitting on opposite sides of the bargaining table — when buying a car, selling a house, or closing a business deal — we sometimes associate that with market competition. It is not. There’s a difference between a buyer and a seller bargaining within a range of prices and the competition among buyers and buyers and among sellers and sellers that creates that price range.

Let’s say Jack would sell his house for as low as $100,000, and Jill would pay as much as $125,000 for it. Within those terms of trade, Jack and Jill will bargain for the best price from their point of view and, if the exchange is voluntary, both will gain from the transaction. But if Ralph would sell a similar house to Jill for $90,000, that would certainly help Jill (at the expense of seller Jack). Or if Alice would pay Jack as much as $140,000, that would certainly help Jack (at the expense of buyer Jill). Bargaining happens in the interstices left over from competition. And notice that competition disrupts bargaining situations, as happens when an OPEC cartel bargaining agreement gets disrupted by competition from non-OPEC oil producers.

Putting It All Together

So why isn’t government regulation superior to regulation via competition, especially when knowledge is imperfect and buyers and sellers are vulnerable?

First, markets do not require accurate and complete knowledge to work. Quite the contrary. Buyers and sellers have an incentive to discover mistakes and profit from them. If Jill erroneously thinks she can’t do any better than paying $100,000 for a house, Ralph has an incentive to see this and undersell Jack, keeping Jill from paying too much. Competition is an error-discovery and error-correction process.

Second, even if the men and women in government are no more or less selfish than the buyers and sellers they regulate, why should they have better information than profit-seeking buyers and sellers on the market, and why should they have a greater incentive to acquire it? If a product is defective, who is more likely to discover and correct the problem: a self-interested regulator who can’t profit from doing so, or a host of self-interested competitors who could profit from offering a better product?

Third, who effectively regulates the regulators? What checks and balances there are in government — voting, party politics, whistle-blowing — are cumbersome and much less effective than regulation by consumers and producers. And how do you make sure that the coercive power you give to good government regulators doesn’t get misused by opportunistic and self-interested regulators?

In the market, buyers regulate buyers and sellers regulate sellers via peaceful, competitive rivalry. In government, such an effective error-correction process is absent.

Find a Portuguese translation of this article here.

