16:   The Free Rider Syndrome

Dix Sandbeck

A Perfect Fantasy World

Most Canadians who have encountered economics at a formal level will, as part of that experience, have been introduced to a fantasy world in which perfect markets work, and the public is considered an element preventing their efficiency. Prominent in creating this perception is the theorem of the deadweight of taxation. However this theorem, besides its unrealistic assumption of perfect markets, also leaves out the complexities of modern societies including the existence of alleged externalities.

Societies in fact also have non-economic goals. Thus, as a logical construction the deadweight theorem can be likened to a military strategist claiming that armies with only front line soldiers and no logistics support system are the most efficient. That armies need logistics just as modern economies need a number of complex government functions of course doesn’t preclude the highly relevant discussion of how to improve their internal efficiency or how to improve the balance between the different sectors of society.

More precisely, theorems based on the logic of perfect competition are undermined by the prevalence of monopolistic competition, the recognizance of which emerged following the work of the American economist Chamberlin in the early 1930s. Modern critique has further added the notion that markets are not separable from their surroundings of general social activities and therefore cannot be derived from any presupposition of perfect states.

What emerges is seen as the result of individuals or agents (such as households, firms, government bodies, non-profit organizations, et cetera) that act and react to changes in their own social goals, but also to the acts and attitudes of other social actors that they come into contact with. This includes a desire to live in a modicum of social harmony. In many societies this means that economic gains are often willingly sacrificed for that purpose.

As in the physical world, economic activity and reactivity are dependent on the relative magnitude of opposing forces and their state of momentum. But in the social world the difference on the individual level is that its events are encountered as discrete experiences, unpredictable in an absolute sense.

The assumption of a marginality principle that can be described by continuous and differentiable functions is therefore not true on the level of individually encountered economic events, and only partly so for aggregated or sequenced events that demand closed and stable operational values. The changes occurring in the economic circumstances we encounter can therefore be likened to throwing stones into water. In a quiet pond, the waves can clearly be followed as they propagate in orderly patterns from the stones’ point of impact. And – if one keeps throwing stones into the pond around the same place – their patterns quickly become discernable and somewhat predictable. Conversely, if one throws stones into the water from the end of an ocean pier, the patterns quickly disintegrate in the much stronger ocean waves, making their patterns difficult to follow, let alone predict.

The New Economic Order

Industrial production and distribution create a structural demand for concentration of assets without which it cannot take place. As society and its economic structures develop growing complexities, structural asymmetries and inequalities arise unless checked by government action or Galbrathian countervailing forces.

This structural demand for asset concentrations favours large-scale firms that can take advantage of increasing returns to scale, a hallmark of economic activities in industrialized societies. In the current late industrial phase, the service sector and in particular distribution has moved to the center stage of the economy causing the trend of accelerating asset concentrations to become a prominent feature of these sectors too.

Consequently, in the advanced economies, monopolistic and oligopolistic competition has become the main form of competition, not only in product markets, but also in factor markets (in which the formal terms, respectively, are monopsonistic and oligopsonistic competition). While competition seldom, if ever, reaches the stage where pure monopolies emerge in the private market sector, some corporations anchored in distribution have achieved positions as dominant oligopolists, which means that they have attained a level of market concentrations a notch above the other competitors, in the process gaining very high levels of market power and price-setting abilities. Well-known examples are Wal-Mart (today the biggest company in the world, based on its stranglehold on the low-price warehouse market segment), Home Depot, Best Buy and Indigo-Chapters’ domination of the Canadian book retail market. The latter represents the worrying corporatization of culture that increasingly is turning it into meaningless cultutainment (to draw a parallel to the situation within the news media that lead to coining the term infotainment) as exemplified by bestseller hits such as Philosophy for Dummies, a title that must be considered the ultimate oxymoron.

Modern factor markets, in which firms acquire their inputs, are likewise structured along patterns of monopolistic (monopsonistic) competition. Thus large-scale firms have under the current market conditions attained strong positions as price-makers also in factor markets. Despite the tremendous importance that has for the social income distribution this trend is seldom analyzed in standard economic expositions.

A main consequence of monopolistic and oligopolistic market conditions is that they allow prices to be set above (or in factor markets below) their competitive and supposedly market clearing levels. According to the competitive price-quantity model this will maximize profits but at the cost of reduced quantities. However, under current conditions this, for several reasons, does not always happen. First, modern corporate strategies often focus on cash flows, which means that quantities in many consumer markets have emerged as a major operational goal. Second, dominant corporations have a number of effective means at their disposal – for instance advertisement and brand name creation – that turn market elasticities to their favour, allowing them to raise prices without facing any substantial impact on quantities demanded.

The rise of offshoring has played a major role in solidifying the distribution sector’s central role in modern economies; partly as a consequence of the growing division between manufacturing and distribution that offshoring has created. This division enables oligopolistic distributors to select manufacturers for their sales lines on a worldwide basis without having to shoulder any long-term commitments. Consequently, input quantities to their distribution systems can be geared up and down on a relatively short notice without this causing any great impact on their investment schedules or holdings of fixed assets. In other words, even relatively large changes in sales quantities can be implemented with relatively little impact on their levels of fixed costs.

Income Effects

A well-known part of standard economic theory is that price changes in product markets create both substitution effects and income effects. Thus, when increasing levels of monopolistic competition shift prices higher, households will experience a real income effect that reduces their purchasing power. What is seldom touched upon is the parallel but much more direct effect that occurs in factor markets when demand under monopolistic competitive conditions drives the price of labour factors down.

As in the product markets, the theory’s assumption that the depression of factor prices is paralleled by a reduction in quantities demanded is not true, in particular when offshoring is part of the picture. When a monopolist in an advanced economy cuts off local supply and replaces it with offshored products, it typically will mean that labour with a high marginal productivity is substituted by labour with a lower marginal productivity, requiring more use of labour than before. Despite this, the differentials in wage levels are such that the marginal value product resulting from labour substitution becomes favourable when converted into input costs.

For the economy in the home country, the labour substitution connected to offshoring also creates a strong income effect as there emerges an oversupply of labour that used to be employed in its generally higher paid manufacturing sector. Much of this oversupply of labour will eventually be forced to seek employment in the service sectors where they lack skills (which anyway are required less and less) to command premium wages on par with the ones they used to get in manufacturing. Adding to the woes of the displaced workers is the competition they face from immigrants in many of the low-skill service sectors and in the construction industry, a problem that is particular acute in countries like the US that almost appear to have adopted illegal, wage-depressing immigration as an official policy.

The Free Riders of the Corporate Elite

Not surprisingly, one claim of standard economics that has proven true is the assumption that growing levels of oligopolistic conditions will expand the surplus of the firms. These growing excesses have partly been used to enhance traditional shareholders profits, but more often than not the primary beneficiaries of their accumulations have been top management, the salaries of which have grown astronomically in recent decades.

More worrying, however, is the fact that the redirection of a growing part of society’s aggregate surplus into the hands of this group has been accompanied by its concurrent growing influence on the social and economic agenda of society. One result is that the commercial activities of the corporations have led to a massive physical restructuring of the urban and cultural landscape that has gone on with little overall guidance or restriction by official government planning bodies, which not only as a general rule are understaffed, but also are directed by politicians captive to the corporate interests.

Another function of the growing clout in the political arena that the top executives of large corporations have acquired is that our political system increasingly has acquiesced to the free rider syndrome. In particular, this has led to the perpetuation of a laissez-faire attitude among politicians to the exponentially growing problems caused by urban congestion and environmental degradation. When reelection becomes a primary political goal, it always seems easier to garner corporate support dollars on the bland message of more tax cuts that also promises more votes on election day from an electorate that has been nurtured into emulating the corporate free-rider syndrome. As long as this political reality remains uncontested, it will push to the side the harsher message that our current industrial culture has reached its limit of viability, and that a totally different level of commitment of society’s resources is needed to turn it back from the brink.

Dix Sandbeck

-- from Economic Reform, December 2005