Why The Efficiency of The Free Market is a Myth

Why The Efficiency of The Free Market is a Myth

We are frequently told in our society that the free market is the most efficient mechanism to distribute goods and services. This is an almost universally accepted hypothesis from the most liberal Democratic politician to the angriest college libertarian. We plot our supply and demand curves and we understand that the market-clearing price is the most ‘efficient’ point at which an economic exchange can take place. 

However, the concept of market efficiency is nothing more than an a priori assumption about how economic relations should occur. We assume the market is efficient but we have no evidence to support this and it cannot be proven. Our entire economic system is built on our unquestioning devotion to this idea.

My argument rests on the two possible definitions of ‘efficiency’ and demonstrating how efficiency thus conceptualized cannot be proven (to the extent that any concept in social science is ‘proven’). First, I define efficiency in the most frequently accepted manner: A good is said to be sold for an ‘efficient’ value when it is sold at the market clearing price in a free exchange. This definition assumes that a good has no inherent value in itself; the value of a good is equal to the price the buyer is willing to pay. How do we demonstrate that this is truly what happens in a free market, or to be more scientific, what evidence would we need to see to disprove this assertion? In order to evaluate this definition of efficiency, for any given exchange we would have to know every possible value every possible buyer would be willing to pay for the good. The final price at which the good were sold must equal to the highest price any possible buyer was willing to pay. When you are able to do this, let me know. I would contend that it is impossible to understand the willingness to pay of every potential buyer in a market. For this definition to be true, the seller would have to have perfect knowledge of every possible buyer. It is impossible to prove this hypothesis with observational data since you can never know that you have understood the willingness to pay of every buyer. Furthermore, it is interesting to note that under this definition of ‘efficiency’ it becomes impossible to overpay for anything since solely the market defines value. The idea that any organization overspends for certain products is impossible if you assume the value of a product is decided by whatever price someone is willing to pay.

Alternatively, we can define efficiency as a good being sold at a price equal to its value when value is a product of the labor and materials used to manufacture the good. To test this hypothesis we must predict the value of a good by studying the value of its constituent labor and materials. If the sale price of the good were different than our predicted value we would assume the market is inefficient. However, how can we know that our predicted value was correct? Whenever we try to compare predicted and market values we can never be certain if the result is the product of market forces or imprecise modeling. Until we can develop a price model that is 100% accurate we can never effectively test the efficient market hypothesis.

In reality, the free market is not efficient. We know this to be true but often forget. We understand the market through a theoretical model; a model that is constructed based on a series of impossible assumptions about reality. Market efficiency is a self-fulfilling prophecy; it may not be ‘true’ if we can convince ourselves that it is we behave as if the market really were efficient and so the process of exchange that the model describes becomes true. The efficient market, like the existence of God, is not a falsifiable assumption. Belief in the free market is encouraged because its existence produces the necessary outcomes to support the capitalist model of production. If we wish to reshape our economy we must first see past the smokescreen of economic theory and understand the structure of ideology.

Matthew Hutchinson

Matthew Hutchinson is a recent graduate of Indiana University’s School of Public and Environmental Affairs having previously earned a Master’s degree in European Studies at the University of Westminster. In the spring of 2010 Matthew won the University of Toronto’s Silvia Ostry Prize in Public Policy. His work has also appeared in Public Policy and Governance Review, The Journal of Environmental Studies and Sciences, The Indiana Business Review and Incontext magazine.