What’s Wrong with Free Markets: “The ‘Wisdom’ of the Crowds”

This may seem obvious to many, but it’s been very clarifying for me.

People often argue against the free-market system — which is based on the idea of rational actors — by saying “people are obviously not rational actors!”

But that’s a stupid argument. It misses the point. Nobody thinks that everyone, always, makes rational decisions. That would be dumb. Rather, the Wisdom of the Crowds idea is that the market operates as if everybody makes rational decisions.

Here are the assumptions underlying that thinking:

The free market results in the best allocation of resources.

Because: People make decisions about what they want to buy, so resources flow to producers of those things.

Even though: Individual purchase decisions are often irrational — not delivering maximum utility to the purchaser (much less to society as a whole).

But: All those irrational decisions cancel each other out, so the rational decisions dominate, effectively allocating resources.

Because: The irrational decisions are random — non-systematic.

The final assumption — which most free-market advocates don’t know they’re making — is the fatal flaw underlying the belief system. (Or at least one of the fatal flaws.)

Bryan Caplan addressed this issue beautifully in his Myth of the Rational Voter. (Some comments on it here.) He points out (and demonstrates) that people’s voting choices are irrational. But more importantly, he shows that they’re systematically irrational. So rational choices don’t float to the top of crowd; they’re dominated by systematically irrational decisions by that crowd.

Example (mine, not his; he has lots of his own): People A) think foreign aid is a big part of the U.S. budget (it’s well under 1%), B) are naturally driven by jingoism and ethnocentrism, C) underestimate the personal and national benefits deriving from foreign aid (just ask Mullen and Gates), and D) don’t like taxes. So they vote for people who promise to cut the budget (hence taxes) by cutting foreign aid.

But Bryan is a free-market believer. So he doesn’t apply the same thinking to purchase decisions that he does to voting decisions. He doesn’t consider (or acknowledge) that in fact, the crowd’s purchase decisions are also systematically irrational.

Example: People A) vastly overestimate their own driving skills (almost everybody believes they’re above average, or even in the top 10%), B) underestimate the dangers of traffic accidents (#1 cause of death in children) while overestimating other dangers (child abduction or terrorist attack: vanishingly small odds), and C) greatly overestimate the value of maneuverability and visibility (sitting up high and looking down on others) in avoiding accidents (braking distance is what counts). So they systematically underspend on what matters for auto safety (braking distance, air bags, etc.), favoring power (“I need it to get out of dangerous situations”; yeah, right), style, size (which generally increases braking distance), and “handling” instead.

So in this case and myriad others, because of systematic human irrationality, the free market does not deliver the best allocation of resources — either for individuals or for society as a whole.

I won’t get into what we as a society do and should do given these facts. (If you want to, you could start here.) Just to say, it’s important to know the facts.