Economists love free markets. The reason is that free markets provide a distribution of goods and services that is efficient, that is no one can be made better off, without making someone worse off.

Note that there is an important difference with fairness: if I have to split 100€ with you, splitting it 0.01€ to you and 99.99€ to me is completely efficient. Only if we leave part of the money on the table, would it be inefficient. If we worry about fairness, so economic theory goes, we should get the initial allocation right and then the market will do the rest.

There is also an import difference between a free market and an unregulated market, even though the two are often confused. A free market is a theoretical construct that has a number of critical underlying assumptions that must be met for it to work as described above. The required assumptions and how these would lead to efficiency were shown by the late Kenneth Arrow  and Gérard Debreu as described here. IF these assumptions are met, the market functions as described above and it needs no further regulation; that is, it can be an unregulated market. The catch is of course that markets do often NOT meet these assumptions, in which case we may need regulations. Environmental economists are well aware of the distinction between unregulated and free markets as shown in the survey by John Whitehead and Tim Haab (also posted on our blog). They should be, of course; the absence of externalities is a main assumption of the free market, whereas the presence of externalities, and what that presence does, is a main field of study for environmental economics.

In certain cases, including to correct externalities, policies intervening in the market are valid. Economists propose policies that remove externalities up to the point where they are no longer a net burden from a societal perspective. How we do determine such policies? We measure benefits and costs to everyone and determine what is worth it and what not. That’s what economists would do, but policy makers are not economists, and may have other concerns and motives. So some policy makers may make decisions that do not make economic sense from a societal perspective. Examples abound across a wide variety of topics and places, including irrational executive orders, discussed here and here, pipeline construction in culturally valuable and vulnerable watersheds discussed here, and confused policies on GMO crops, discussed here.

Perhaps then it would be good to take a step back, and consider what it is that drives policy makers in their decisions. If we do so from an economic view point we enter the domain of political economy. Qianqian Shao, a PhD student of whom I was the day-to-day supervisor (co-promotor) did just that. In her thesis, which she defended last March, she looked in how originally well-meaning policies get distorted by lobbying interests. She shows, for example, that food policies may get distorted when groups lobby for anti-GM. Another interesting find is that she showed that if a policy maker is inclined to weigh the effect of regulation on industry’s profit heavier than societal gains from a better environment, moving from autarky to trade improves environmental quality rather than worsening it. However, this is only because the policy maker was doing a bad job in regulating environmental externalities in the first place!

All in all, then perhaps, it would be good if economists would focus a bit more on the real world, when asked to help design policies. As Qianqian, and the recent “interesting” flow of executive orders from the White House have shown, the way policies are designed and implemented may be as important as the problem we are trying to address. Or as Esther Dufflo put it so eloquently in her Richard T. Ely Lecture: Economists should be more like plumbers, taking into account the nasty little real world details when designing policies, and “mindful that tinkering and adjusting will be necessary since our models gives us very little theoretical guidance on what (and how) details will matter.”