On free markets

DA reader JS points out, in response to the post about why NBA players should own the league, that although I say that the business model according to which sports franchises operate is "funny", it's actually quite common:

I like the idea. But I don't think the NBA model is uncommon. What about things like financial firms? People can own them, and the value comes from the people who work for the firm rather than from any physical entity like a factory. He's right. A lot of the stock market consists of people who provide no value but own the right to draw profit from companies.

I hope to return to this issue, but I'd like to take a slight meandering detour first.

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In my introductory economics course in college, I heard what I think is a pretty standard story:

(a) A perfectly competitive market (PCM) leads to a certain kind of optimal society, one characterized by "Pareto Efficiency".

(b) Pareto Efficiency is defined by the following property: It's impossible to make anyone better off without making someone worse off. There are plenty of societies where you can make someone better off without making anyone worse off, and those societies aren't in a state of Pareto Efficiency. (Example – if I have some bread and jam in the back of my fridge that's going to go bad because I won't eat it, and I give it to a homeless person who's starving, he's better off and no one is worse off, so I think this would show that our society isn't at Pareto Efficiency.)

(c) Many Economists think that a Pareto-Efficient society is the ideal that we should strive for, so they praise PCMs. It's not completely clear to me that Pareto Efficiency would be the ideal society – I could imagine that some people might be doing badly enough in a state of Pareto Efficiency that the society would be better off overall if we improved the lot of the worse-off members, even if it slightly lessens the tremendously advantaged lot of the best-off members. But anyway, I think Pareto Efficiency would be a pretty good status to achieve, and PCMs are, if not part of the perfect society, at least pretty darn good things.

But a free market includes many features that many industries don't have. There is no collusion in a PCM, but tacit collusion is common in many industries and sports leagues are explicitly allowed collective bargaining, which is a form of collusion. There are no barriers to entry in a PCM. There are huge barriers to entry in many industries (including sports leagues). There's perfect knowledge in a PCM (and therefore no need for advertising). There's tons of advertising in many markets (including sports). And so on.

During the intro econ course, the professor will try to demonstrate in many examples that government regulations are bad by asserting (if not proving) that if a society is at a state of Pareto Efficiency and then adds regulations, it will end up away from this optimum point.


But here's the rub:

One final feature of perfectly competitive markets, according to the intro econ professor, is the zero-profit condition. In a PCM there is no profit, because with no collusion, zero barriers to entry, and perfect knowledge among the consumers, new firms will keep entering the market and underselling the existing firms, thereby driving down prices, until they are all selling at cost, at which point there's no profit left.

But wait a minute – many many industries have huge profits, which apparently ipso facto means that they are not at Pareto efficiency. (It's my understanding that only relatively few markets, such as the pork bellies market and timber logs market, are actually close to perfectly competitive.) What, now, is the reason to avoid government regulations? Is it obvious that if you start off away from the optimum point and add regulations you will end up further from the optimum point? Not to me.

I'm sure that serious economists have thought about this and probably have a very good response. But, having only taken a few low-level economics courses at the undergraduate level, I never saw such a response. If you have any comments, please let me know.