Guest commentary: Markets and inequality

David Lupton, an economist who works in developing countries, sent me the following opinion piece about markets and inequality. I sympathise with the view that the free market doesn't prevent monopolies. What's the answer?

A subject often raised as an election issue is increasing income disparities and the distribution of wealth. It is, of course, not a problem unique to New Zealand. In fact we are told that the world's 85 richest have as much wealth as the 3.5 billion poorest. 

Several parties express concern about this issue, but – probably because they do not understand why income disparities are increasing– the only solution proposed so far is more tax. Now I don’t think the 85 richest accumulated their billions by not paying tax. Nor do I think redistributing incomes (or preventing these people becoming so rich) is actually going to do much for the poor. Dispossessing the world’s 85 'rich pricks' and distributing all their money to 3.5 billion poor would give them $500 each. Maybe a lot for them, but it isn’t going to eliminate poverty. 

How did the 85 get to be so rich? Why is our society creating a wealthy elite? It is naive to blame it on our local politicians or expect them to come up with answers. It's a worldwide phenomenon, and one that  politicians themselves do not understand or control. Some people blame it on capitalism. If by that they mean the market economy I think they may have a point. But it is not the concept of a free market itself that is the problem; it's the way it has been working.

The basic tenet of the market economy is that there are many producers and many buyers, and there is competition between the producers and competition between the buyers. In the time of Adam Smith, this was a reasonable approximation to what was really happening. 

What's been happening since the end of the Second World War is that transport and distribution costs have been falling; barriers to international trade have been negotiated away and communications have improved so that it has become possible (and profitable) for companies in many spheres of activity to become larger. In many industries, costs fall as production sizes increase. While transport and communications costs were high, it was cheaper to buy locally made products. But once distribution cost came down, it made sense for these industries to consolidate. As a result, we've seen huge monopoly-like companies emerge. The worst cases are the Internet firms – an extra customer costs Facebook or Google nothing yet increases these companies’ advertising power and revenues. 

Now think what happens if the size of companies increases. The management of the bigger company is handling decisions with greater financial consequences. The choice of CEO can make the difference of billions of dollars to a global company. No wonder the company is willing to pay generously to get the right person - it behoves the shareholders to find the best possible CEO and management team. Even for local companies, managerial salaries reflect the size of the operation they manage, and amalgamation of firms has put additional upward pressure on remuneration. 

Contrast that with the role of the accounts clerk or the worker on the factory floor. Increasing the size of the business doesn’t increase the importance of their role, just the number of people that need to be employed – reducing as companies become more efficient.

So one factor driving wage inequality is the increasing size of firms. As a result, the free market is not working the way it should. Does this mean we should throw out the idea of a free market?  Not really. The alternative – a planned economy – comes a dismal second. We do have a third way – a supervised market.

If we start from the position that a free market requires competition between buyers and competition between sellers, the first thing to ask is, “Are those requirements being met?” And if not, to ask the second question which is, “What is the minimal intervention that will correct for the lack of competition?” 

Regulation to force companies to pass on their benefits of scale could have some effect. If it didn’t stop the rich becoming richer, it might at least pass on more of the benefit to the poorer. Ideally the price of a good should reflect the marginal cost of production, and governments should intervene on behalf of customers where this is not the case.   

But this leads us to a third, often forgotten question, which is, “Does the benefit from the intervention exceed the cost, or are we better off living with the imperfection?”  The third question is very important. Some might see the dominance of large firms and the huge salaries they pay their senior employees as an unfortunate consequence of  markets not operating as they should, but be prepared to live with this knowing government intervention might just make things worse. 

So asked whether we should limit the size of companies or reintroduce barriers to imports, the answer is “Probably not” because the reason for the trend to larger companies is that larger companies are more efficient. 

We benefit from being able to import goods at lower prices, and from the lower production costs of fewer larger firms. 

If that results in greater inequalities in our society, maybe that's a price we need to pay.