So-Called "Free Markets" Are Anything but Free

LONDON -- In the last decade, the free market has been blamed for many things, including the collapse of Enron, the credit crunch, and the recent scandal in which dealers at Barclays  (LSE: BARC.L  ) and some other banks manipulated the benchmark London inter-bank offered rate, or LIBOR. The problem is that none of these events took place in a country that has a free market economic system, so how can it be the free market's fault?

A market is free only if the government doesn't influence the price, the supply, and the demand for goods and services. Furthermore, producers in a free market cannot earn economic rents (extra profits) thanks to laws that restrict competition. Few economies, if any, have ever come close to meeting these criteria.

Too expensive to compete
If the construction industry had been so badly run that the government needed to rescue it to prevent the fallout from wrecking the economy, you might think that a host of new building companies would quickly spring up to compete with these poorly run firms.

This is just what happened to the banking industry in 2008 and 2009, but have any new banks popped up in the high street since then? No. All that seems to have changed is that more branches nowadays bear the Santander logo.

The problem is that because banking is Britain's most highly regulated industry, the fixed costs of setting up a new bank to compete with the likes of Barclays and The Royal Bank of Scotland are enormous. Also, given that the government owns 84% of RBS and 41% of Lloyds Banking Group (LSE: LLOY.L  ) , it is strongly incentivized to restrict competition to protect these banks' profits (when they eventually start making any).

Don't hire anyone else
If a regulation makes it more expensive to do business -- for instance, compelling a business to spend 100,000 pounds a year in order to comply with an overly bureaucratic standard before it can sell widgets -- it's likely that a large company with an established presence in the widget market lobbied in favor of it. That's because these costs act as a barrier to deter small companies from entering that particular market.

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Another way in which small businesses are hampered by regulations is when there's a cutoff limit for a particular regulation that only applies to businesses employing more than a certain number of employees. The reason behind the limit is that it is expensive to comply with the regulation, so this gives small businesses a break.

The problem is that this is also a great incentive not to hire more staff and thereby trigger the regulation. So many small businesses that could grow will instead choose to remain small, which is good news for their larger competitors.

Carving up the market
In some industries -- most notably cars and bulk chemicals -- the nature of the market is such that it is dominated by an "oligopoly"; a few massive companies possess economies of scale so large that it's exceptionally difficult for a newcomer to enter the market.

In an oligopoly, companies don't need to compete with each other on price. Instead, they do so by differentiating between their products, which can easily cause them to be much less responsive to their customers' wants.

America's "Big Three" car manufacturers once formed an oligopoly, which allowed them to thrive, even though they were making unpopular, low-quality cars. Then along came the Japanese companies with superior products, and the Big Three couldn't compete with them on a level playing field. But instead of improving their cars, they retaliated by successfully lobbying the government to restrict Japanese car imports.

The big four
With their 75% share of the British food retail market, the big four supermarkets -- Wal-Mart subsidiary Asda, WM Morrison, Sainsbury's, and Tesco, display some of the characteristics of an oligopoly.

The British state has helped the supermarkets entrench themselves in the market by making it difficult for someone to create a new chain. A fifth giant supermarket would need to quickly build a lot of big supermarkets in good locations to obtain sufficient economies of scale, yet our planning laws are designed to prevent this from happening.

You must buy from us
One of the best businesses to own is a monopoly, because your customers must either buy from you or go without. Two good examples are the electricity company National Grid (LSE: NG.L  ) and the water company United Utilities (LSE: UU.L  ) , both of which are members of the FTSE 100 index.

No one is going to compete with National Grid or United Utilities in their existing markets, barring a radical technological development such as commercial wireless electricity, because the cost of duplicating their electricity and water distribution networks would be prohibitive.

So their monopolies are strictly regulated to prevent their economic rents from becoming too large, which means that, like most businesses, they don't operate in a free market.

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Tony owns shares in Lloyds Banking Group, Sainsbury, and National Grid, but he doesn't own shares in any of the other companies mentioned in this article. The Motley Fool owns shares of Tesco. Motley Fool newsletter services have recommended buying shares of Tesco. Motley Fool newsletter services have recommended creating a bull call spread position in Wal-Mart Stores. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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