While economics is a complex and deep science in its own right, it is important for average citizens to grasp some fundamental concepts since much policy is decided in the political realm. Unfortunately I have found there exists a fair amount misunderstandings on this topic. This is to such an extent that we often find individuals advocating for economic policies which will directly harm their own economic interests. Part of this is also due to the legacy of the cold war which cultivated an avoidance of economic topics which were viewed as fodder for the expansion of communism. I think it is timely that the public revisit some of these ideas.

One of the finest intellectual achievement of humans is the microeconomic model of a ‘perfect market’. Beginning in the 1870’s with the work of French economist Léon Walras the theory of general equilibrium and partial equilibrium was developed into the 20th century. In this toy economic model, the costs associated with production, infrastructure, raw materials, supply of labor and demand drive the system towards an equilibrium which optimizes consumption and production. An industry produces and adds additional units of labor until the additional costs of adding a new unit of labor equal the additional revenue it can generate.

These ideas form the basis of microeconomic theory as it is currently taught in schools. This simple model works beautifully and elegantly, but its efficient operation is contingent on the existence of a true ‘Perfect Market’. The recurring problem in discourses about markets is that people confuse the benefits of a free market with a ‘perfect market’ as given in this model. The common meaning of a free market usually means a market without government interference where people are free to exchange value. A ‘Perfect Market’ by contrast is rigorously defined as follows:

A large number of buyers and sellers Perfect Information No barriers to entry or exit No transaction costs Homogeneity of products

There are a few more qualities like rationality and externalities but these I think encapsulate the heart of the idea. With a little reflection it is clear that such a thing will never pop into existence on its own and the existence of a ‘free market’ doesn’t guarantee a ‘perfect market’. The fact that production costs tend to fall with volume produced or scale of economies will destroy item one fairly quickly via monopolies or oligopolies and pretty much no market exists which has 2,3 or 4. However close approximations have existed delivering stupendous value to all participants.

Yet in all instances the participation of society and government to ensure its proper operation is essential. I mention this since there exists a pernicious and pervasive idea that such a thing can exist outside of the context of government laws, taxes and regulation. This is simply factually wrong. Governments can be corrupt and help destroy good markets, but they are also essential in bringing them into existence.

The labor versus capital market is an especially important market and failures in this market have profound consequences for society. Just as with the other commodities, the labor versus capital markets require the same rules to ensure the existence of a ‘perfect market’. That is large numbers of buyers and sellers, no barriers to entry, perfect information and no transaction costs. As in the former case a true ‘perfect’ labor market is non-existent but here reaching an approximation of a perfect market is even more challenging since the market power of capital is intrinsic to the very physics of this market. This is because the very existence and power of money is its ability to physically represent vast amounts of capital. Also in order for capital to be productive it usually requires a minimum level of concentration and the productive efficiencies often escalate with concentration. Thus in the absence of any other collectivizing force, capital will always be at a negotiating advantage over labor in fixing its market value. Capital has natural market power which labor lacks. This is because each person can only contribute one unit of their own labor, while one entity can negotiate on behalf of vast amounts of capital. Or put another way, there will always be many more labor providers than companies which require labor.

To be sure labor can also collectivize via unions, however the process is much more difficult with many barriers. The result is that most ‘free’ labor markets will drive the price of labor below what would otherwise be dictated in the perfect market model. The failure of this market creates a very important feedback mechanism for the accumulation of vast amounts of wealth in fewer and fewer actors. This is because as capital concentrates so also does its market power and ability to drive wages lower. It is for this reason that historically, the rate of return on capital has always exceeded that of longterm economic growth. This fact has been carefully studied and shown in Thomas Piketty’s famous book, “Capital in the Twenty-First Century”.

This feedback mechanism drives the growth of asymmetry in wealth distribution in an economy. This asymmetry has other profound consequences for the macroeconomic health of an economy which I will discuss in the next article.