Introductions to economics usually start with gushing tales about the magic of the free market. It is usually stated that the free market allows everyone to get the best quality goods at the cheapest prices. The magical invisible hand guides everyone to the best place without any unnecessary government intervention. Below is a link to a video typical of the kind. (I’ll ignore for the moment that it completely misrepresents what Adam Smith said). Its short and simple, but it is a simple argument. This is the typical free market argument with its claim that left alone it will bring the best world for everyone.
So in the video it compares two bakers offering bread and the consumer chooses either the cheaper or bigger baguette. The first charges £1, the second 50p, causing the first to charge 50p, causing the second to offer a larger baguette. Surely clear example of how the free market makes everyone better off, right?
However there are several reasons why reality isn’t so straight forward. There are several reasons why consumers may not buy the cheapest bread. First of all they don’t know what they’re buying (asymmetric information). For all I know this bread could be made from cheap dirty bread that will give them a disease. Unless I get sick instantly, there is no way for me to know the cause and act upon it. If it slowly wears down my health over years like cigarettes, there is no way for me to know. So just because something is cheaper doesn’t mean it’s better.
The second reason someone may pay more for one good rather than another is conspicuous consumption. Expensive goods are a sign of wealth. Unlike ordinary people, I can afford the luxury bread, therefore showing my success in life (obviously bread isn’t the only sign of success but a house full of luxury goods is). We are social creatures and view ourselves in comparison to others. So if I can afford better food and goods, I am better off, and implicitly a better person.
There is also the matter of fashion and culture. A purchase is not simply a question of what is cheapest, but what is cool. No one wants to drive around in a banger, be wearing the wrong sort of clothes or even eating the wrong kind of food. So people will buy the more expensive kind of bread even if it isn’t any better simply because it is fashionable. If you think I’m exaggerating, watch the number of people who will repeatedly buy disgusting bread simply because it is foreign and therefore exotic.
You might argue that if one shop charges a higher price for the same good, consumers will simply switch to a cheaper place. Unfortunately that’s not how our minds work. In fact as Dan Ariely discovered in his book Predictably Irrational, paying more for a good makes us value it more. He ran an experiment where he gave some people a drug valued $2.50 and others the same drug worth 10c (what he didn’t tell participants was that the drug was only a placebo). Almost all of the $2.50 drug people reported pain relief while only half of the 10c people did. Because they were paying more the valued the same item more. So if I increase the price of a baguette above the market rate, consumers will value these baguettes more and be willing to pay the higher price.
There is also the question of externalities or costs that aren’t included in the price. So you may think one baguette is cheaper but really it’s so bad for your health that it costs you more in later life. Or the reason it’s so cheap is that it uses old toxic smokestacks which emit dangerous pollutants into the atmosphere. It could upgrade to newer and cleaner facilities but that will cost it more and force up the price. Or its competitive advantage could be based on exploiting cheap labour in the third world.
So while in the video and all stories about the free market, when offered a clear choice between two goods (something that rarely happens), consumers will pick either the cheaper or the better quality one (though how consumers are supposed to measure quality is never explained). However there are many reasons why they might not. Problems of asymmetric information, conspicuous consumption, fashion, subjective valuing and externalities all prevent consumers from automatically choosing the cheapest option. They are all barriers to the market reaching an effective outcome. As long as they exist, it cannot be claimed that the free market will lead to the best situation for everyone.