Limitations of free market policy: "externality" and "behavioral choice"
In a "perfect" (unregulated) free market policy, people are free to perform any voluntary transaction (or refuse any given transaction), without limits to competition between participants, and with perfect information about other possible transactions.

An approximate picture of a perfect free market is a shopping mall. People are free to look at prices and decide what would be the most profitable things to purchase with their money. Sellers are free to set prices to what they think will bring them the most profit.

Theoretically, then, transactions will happen only if they are beneficial for all parties at once. (Anyone is free to simply walk away from a purchase or sale that does not seem to benefit them.)

Moreover, given sufficiently many participants, competition will push the system towards optimal transactions, i.e. those transactions that benefit everyone the most. (There is profit to be made if a transaction can be optimized.)

Direct regulation of the market can take many forms: limits on high prices, subsidies (guaranteed lowest prices), limits on quantity, prohibition of certain transactions (despite people willing to carry them out), or enforcing agreement on certain transactions whenever they are offered (despite people unwilling to carry them out). However, all forms of regulation are doing one thing: they categorically (i.e. without any nuances) prohibit certain kinds of behavior that people would otherwise engage in. Any direct regulation (however small) will always strictly reduce the number of allowed transactions. This seems to be incontrovertible.

Indirect regulation of the market will tax certain transactions more than others. The result will be that certain transactions will be happening less frequently than without regulation.

According to the free market theory, all transactions happen only because they are beneficial to all participants. Therefore, any "relevant" regulation (i.e. strictly decreasing the number of transactions that actually happen) will strictly reduce the total benefit that people derive from the market. As a result, we conclude that people on the whole will always benefit strictly less under a regulated market than they would under a perfectly free market.

It occurred to me that there are at least two limitations of the perfectly free market that can make certain transactions suboptimal, in the sense that the participants and/or society as a whole would have been better off without these transactions, or with fewer of them (and with more transactions of some alternative kind). In these cases, the free market cannot itself prevent these transactions from happening or reduce their occurrence. Only regulation (i.e. non-market force) can do this.

I call the first limitation "externality", and the second "behavioral choice".


1. "Externality" means the effect of a transaction on third parties who do not directly participate in negotiating the transaction.

For example, if persons A and B agree to pay to person C for playing music very loudly in front of them, there will be many other persons "external" to the transaction who will also have to listen to the loud music. These other people never agreed to this transaction and are not direct participants; in a perfectly free market, the external people have no say in whether the transaction will take place. However, they have to bear certain consequences, or "externalities", that could be either positive or negative depending on circumstances.

Another example: A factory agrees to produce N tons of bricks for a client who builds a house in the same city, but producing that quantity of bricks will somewhat increase the air pollution in the city around the factory. The people who live and work in buildings around the factory are "external" parties who do not have a direct involvement in the transaction but have to bear some of the consequences.

There would have been no externality if it were somehow possible that all the people who live and work in buildings around the factory were magically able to read each other's thoughts and also join with the buyer in a telepathic union. Then they could all at once negotiate with the factory about purchasing N tons of bricks. In that impossible fantasy, the collective brain of the people would be able to weigh the necessity of having bricks for one person against the increase of the pollution for other people. The negotiated price of the bricks will then perfectly reflect that trade-off.

In reality, there are many cases where market prices cannot automatically regulate the air pollution concerns. For instance, the client who purchases bricks could be located far away from any brick factories and cannot know the circumstances of people who live or work next to the factories. Different factories compete on price, but they do not necessarily compete on air pollution. Factories could advertise that they are "eco-friendly" as part of negotiations, but this will not compensate the lack of a direct involvement of the external parties. For instance, the client is still free to purchase bricks, say, from China, where environmental and safety concerns are nonexistent, and prices are low.

The free market guarantees mutual benefit only for parties who directly take part in negotiations, but not for any external parties. If there is harm to external parties, it's tough for them - they cannot prevent the transaction from happening. This invalidates the theoretical free-market argument that all transactions are always beneficial for the society at large. If a transaction involves external parties who do not participate in the decisions but bear significant consequences, we cannot automatically conclude that the society benefits as a whole. Free market theory applies without qualification only when there are no externalities involved. For example, an idealized shopping mall is completely free of externalities if there are relatively few people, and if everyone purchases something in a bag and takes it away. In that case, any purchase can be carried out simultaneously without interfering with any other purchases and without any effects on third parties.

The contemporary solution for limiting the air pollution externality is a combination of taxation and/or categorical prohibition of certain pollutants. The regulation is delegated to an elected or appointed government official. This solution has the positive effect that, e.g., extremely harmful or dangerous pollution can be categorically prohibited. However, the appointed official cannot stand in for the real interests of citizens, simply because people can't read minds of other people. The appointed officials, whatever their political views, will tend to do what all governments tend to do: Continue to impose more and more regulation, whether or not it is beneficial for the society as a whole.

The long-term result will always be that regulation will grow beyond its beneficial extent. The additional regulation could, for instance, create significant hurdles for people who purchase building materials (and thus hiking up the housing prices), while achieving a miniscule improvement in environmental protection. Many more kinds of transactions will become prohibited or taxed by the logic of government than the people would actually want to prohibit or tax if they were given the choice.

The money collected in taxes from the free market will be spent on projects that the government decides are beneficial, not necessarily on projects that people would have decided to carry out in a free market when given that amount of tax money. Again, beyond a certain extent, incremental benefits of taxation will decrease and become harmful to the society, simply because governments tend to expand their domain of influence without limit, and spend money on things that people would usually not spend money on.

2. "Behavioral choice" is a more subtle defect of the free market system. What I mean by "behavioral choice" is a situation when a person chooses to carry out a transaction, but later regrets that choice and realizes that the transaction was not really beneficial.

Of course, everyone makes mistakes once in a while, and anyone can change their mind later. I am not talking about random choices that we later regret, but about systematic choices that people make when put into particular circumstances.

For example, when a customer is choosing a bottle of wine, the salesperson can show them a number of wines. A trick is to show first some very expensive wines that the customer is surely not going to buy - and to say something like "We have some really good wines here.... of course, they're not cheap - NN dollars per bottle..." The customer will decline, and the salesperson then shows some less expensive (but still not cheap) wines. After seeing the expensive wines, the customer will be more willing to pay a higher price for another wine because of the unconscious perception that "wines typically cost NN dollars".

Another trick to influence behavior is to say or to show something that implies that "many other people have done X". This significantly increases the chances that a person will also choose to do X.

People buy more if they can have the item right away but don't have to pay for it in cash at that time. People buy less if they have to pay in advance but will get the item several days or weeks later.

It has been long known that the mere writing of the words "sale price" on an item will increase sales by about 30%.

Yet another trick is to frame the situation so that the customers feel a lot of control over the choices they make. For example, a letter asking for donations says: "Check this box if you wish that we never contact you again about this donation." People feel more in control: now they could stop these pesky donation mails, if they wished. To be sure, some people check the box and donate nothing. However, the overall rate of positive response to these letters increases by factor 2, compared with letters that simply ask for a donation.

Recently, a pseudo-science called "behavioral economics" has studied several classes of circumstances where this kind of "behavioral choice" can be constructed. Salespeople have long know some of these tricks. People do not feel manipulated when this is done to them, but the changes in the behavior are very significant.

So, according to the free market theory, all these circumstances are perfectly voluntary choices, since there is no coercion. However, the choice has been skewed by skillful behavioral manipulation in favor of one side of the transaction. This is what I call a "behavioral choice".

When behavioral choice techniques are used, the transactions are no longer automatically beneficial to both parties. Regulation does not seem to help here: there is no way to prescribe what constitutes a behavioral choice. Certain kinds of transactions involving behavioral choice are prohibited for young people (e.g. gambling or sex services), but it seems to be very difficult to effectively prohibit adults from doing anything so subtle as behavioral choice.