Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't

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“Despite abundant evidence from around the world to the contrary, too many of our nation’s elites—including academics, journalists, politicians, and authors—claim that free enterprise does not work. Instead, they advocate increased government regulation and central planning. In
Freedomnomics
, John Lott dispels the myths and shatters such “conventional wisdom.” Based on fact, not ideology, he demonstrates how free market principles produce the greatest success, whether it involves business, labor, crime control, or public policy. This book is essential to those who seek to understand liberty.”

—Edwin Meese III, former U.S. attorney general under President Reagan

 

 

“Freedomnomics
is a terrific exposition of matters pertaining to political economy—the interaction of politics and economics. Truly, this is a perspective that is enlightening and worthy of presentation. As Thomas Jefferson once uttered, ‘the price of freedom is eternal vigilance.’ John Lott has meaningfully contributed to the necessary vigilance toward the preservation of freedom with the tales of his professional journey.”

—John Raisian, Director and Senior Fellow, Hoover Institution, Stanford University

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.

—Adam Smith,
The Wealth of Nations
¹

 

 

The free market works. This notion was clear to Adam Smith in the early days of capitalism, but since then it has come under a great deal of skepticism. These criticisms are nothing new, of course. As far back as 1848, Karl Marx published a Communist Manifesto, advocating an alternative economic system that would replace the market with state planning. Communism was adopted in countries ranging from Russia to North Korea, but somehow the outcome was always the same—mass shortages. Most Communist regimes eventually scrapped their dysfunctional economic system, if their populations didn’t rise up and do it for them. Today, there are only a few remaining Communist countries, and the only ones that have any kind of economic success—like China—are the ones that are reestablishing free enterprise.

Meanwhile, countries that stuck with the free market have prospered. There is a simple reason for this—as Smith observed, the free market is based on the pursuit of economic self-interest. The market acknowledges that people’s behavior is largely determined by incentives,
whether in the form of carrots or sticks. Allowing people the freedom to improve their own economic condition helps to make society wealthier overall. Smith understood that free trade takes place because both parties in an exchange profit from it. Whether a person buys a new car, a computer, or a movie ticket, the customer values the good he purchases more than the money that he pays for it. The seller, for his part, values the money that he receives more than the product.

Yet, despite its proven success, a profound distrust of the free market has spread even among the citizens and governing elites of wealthy, free nations. In the United States, politicians convene hearings to rail against oil companies, accusing them of ripping off consumers and insisting on the need for price controls or higher taxes on the firms’ profits. Newspapers denounce “corporate greed,” arguing that the only thing keeping any big company from turning into another Enron is the watchful eye of government regulation. The general public grumbles that high medicine prices mean that drug companies are getting rich at their expense.

As a telling example of the prominence of this view, the book
Freakonomics
achieved phenomenal popularity, selling over a million copies. In it, authors Steve Levitt and Stephen Dubner purport to unveil the “obfuscation, complication, and downright deceit” that pervades our everyday life.
²
Naturally, suspicion of corporations is a paramount theme. But the authors’ misgivings go much further. They see experts such as doctors, funeral directors, and life insurance agents as unscrupulous sharks looking to cash in on their expertise by swindling their own clients. “If you were to assume that many experts use their information to your detriment, you’d be right,” they warn.
³
The pair even compare real estate agents to members of the Ku Klux Klan. In their world, almost everyone—from teachers to Sumo wrestlers to politicians—is cheating or lying to somebody. Whether it is Levitt and Dubner or Michael Moore, popular authors have found plenty of buyers for the argument that nearly all corporations are committing crimes.
⁴

But are free market economies really based on fleecing the consumer? Is the U.S. economy truly just a giant, Hobbesian free-for-all that encourages duplicity in our everyday transactions? Is everyone from corporate CEOs to your local car salesman really looking to make a buck at your expense?

The analysis presented in this book, based on dozens of economic studies spanning my entire career, hardly fits in with the conventional wisdom these days. Sure, some people will always lie or cheat—that’s just human nature. But a close study reveals that these problems are by no means systemic in the market—in fact, they’re relatively rare. For every Enron, there are thousands of companies of all sizes in America that play by the rules, simply trying to make a profit by supplying people with something they want. As we shall see, there is a reason why gas prices spike even before a natural disaster hits, why monopolies exist in our economy, and why liquor is so expensive at bars and restaurants. The answer is a little more complex than “corporate greed,” but all these examples are really just instances of a free market acting efficiently.

This reflects one great benefit of a free market—it creates incentives for people to behave honestly. Consumers don’t like to be cheated—when they think they’re being swindled, they take their business elsewhere. Companies and individual entrepreneurs who treat consumers right, however, stand to make big profits from satisfied, repeat customers.

A major deterrent to cheating, often overlooked by critics of the free market, is the importance of maintaining a good reputation. When a company commits fraud, most of its lost revenue stems from its damaged reputation—not government fines or legal actions. So even without the threat of criminal charges, there are big incentives for corporate shareholders to keep their executives and accountants honest. As technology improves, companies are developing incredibly inventive ways to profit from their reputations. For example, consider eBay, the Internet
auction site. Even in its anonymous forums, sellers develop reputations by allowing customers to rate their transactions. Studies show that having a good reputation allows an eBay seller to charge higher prices.
⁵
Whether on-line or on the street, there is money to be made by behaving honestly.

Reputations keep people honest in all kinds of realms besides business. This is even evident among politicians—possibly one of the few professions that popular opinion holds in lower esteem than corporate executives.
⁶
Conventional wisdom holds that politicians en masse are subservient to special interests that provide the money to ensure their re-election. But do politicians really base their votes on the wishes of their donors? If that were the case, shouldn’t we see retiring legislators in their last term break away from special interests, whose money they no longer need for re-election?

Yet, we do not see this at all. Politicians tend to vote the same way throughout their career regardless of the onset or ending of donations, even in their final terms. Could it be that politicians, deep down, believe in the “special interests” they support? Is it really impossible to imagine that a congressman from Michigan supports the automotive industry not because of its donations, but because he actually believes that the industry is critical to America’s future?

In discussing campaign financing, most observers bemoan the problem of “too much” money in politics while avoiding the really key question: Why are so many individuals and interest groups sinking so much more money into politics than before? The answer is that the government is spending much more than it did previously. With so much government money at stake, a lot more people are going to try to influence how it’s spent.

This leads to another interesting question: What has caused the sky-rocketing growth in the size of government over the last century? Believe it or not, women’s suffrage appears to be the biggest factor.
Granting women suffrage explains at least a third of the expansion in the size of government.

Misunderstanding incentives—those that make companies charge high prices, keep firms and politicians honest, and encourage politicians to vote in certain ways—frequently leads to demands for more government regulations. Since the market seems to be failing, the government is asked to step in and make things “fair.” But government intervention often only succeeds in making things worse. From campaign finance laws to rules for gaining a professional license, government regulation tends to hinder free competition. This often reflects the unique incentives that the government itself has. For example, because government-run firms frequently are more interested in market share than profits, they are more likely than private firms to engage in predatory pricing.