In the current Democratic presidential debates, concern is raised that free market capitalism is contributing to income and wealth inequality. Capitalism now is seen as crony capitalism, where businesses get political and regulatory favors to benefit themselves rather than most Americans, thus increasing income inequality. Is there a better economic system than free market that brings growth and prosperity to the nation and its people?
Presidential candidate Sen. Bernie Sanders is a proponent of “democratic socialism,” a term borrowed from the economic system of Nordic countries (such as Sweden, Norway, Denmark) that existed in the 1960s. These countries are now far removed from socialism and have a thriving free market system, more freedom (g), less regulation, higher per capita income and lower income inequality than the US. They have a very robust and extensive social safety net compared to the US, and their residents are willing to pay higher tax rates to support it.
What kind of free market system produces high growth and prosperity that benefits most people in a country? Contrary to the general notion among many economists, William L. Baumol, professor of economics at Princeton and New York Universities (now deceased), cogently argued in his book “The Free-Market Innovation Machine” that an oligopolistic market structure with few firms dominating in competitive free markets drives innovation and growth. Free market competition among a few dominant firms forces them to make innovations part of their economic strategy to survive. Innovations are “systematized” and “routinized” in oligopolies and are the drivers of economic growth and higher standard of living. Utah’s growth is largely driven by innovating industries, called super-centers by the Brookings study (The New Yorker, Feb. 3, 2015). Utah is one of the top 15 innovation centers in the country.
Oligopolies have resources to routinize innovations and keep track of other firms’ behavior in order to be competitive. However, a large number of small firms competing in perfectly competitive markets (an ideal free market structure) do not have resources to routinize the innovation process. In addition, they cannot keep track of other competitors’ economic strategies, ascertain emerging technologies and dynamic movements of markets.
Many individual innovators and entrepreneurs eventually transform themselves into larger oligopolistic firms. Examples of new small-scale startups that eventually became giant multinational companies are Google (now part of Alphabet), Microsoft and Apple. These companies compete in oligopolistic markets and are constantly engaged in incremental product innovations to keep ahead of their competitive rivals.
A labor force that matches the skills and talents needed in innovative companies participates in the economic growth and prosperity. Professor Thomas Philippon argues in his book “The Great Reversal” that market concentration in the U.S. has been increasing since the 1990s due to oligopolies, thus causing income inequality and efficiency problems. However, as Baumol, John Panzar and Robert Willig contend in their book on contestable markets, efficiency problems do not arise when markets are contestable, where entry and exit of businesses are relatively easy. Antitrust laws and regulations must make sure that there are minimum barriers to entry and exits in markets.
The threat of entry is precisely what persuades incumbents to constantly engage in innovations, maintain market share and increase profitability. In the long run, exorbitant profits are driven down by competition due to the entry of new competitors, who also bid up wages for the labor they need to compete. I am sure most are familiar with the fate of companies such as IBM, Xerox and Kodak, and traditional auto companies due to the entry of Tesla.
The U.S. economy is a free market economy and increasingly dominated by oligopolistic firms, mostly in service and high tech industries. In the short run, the labor market is going through a structural change, because it has not kept up with the emergence of new technologies. In some corners of the country, there is a battle cry for democratic socialism since a significant part of the labor force, due to inadequate technological training, especially in manufacturing, has not participated in the prosperity of businesses and the economy.
The short-term hardship of Americans, who are severely impacted by technological change, must be dealt with. But democratic socialism and crony capitalism (with tacit political favoritism) are not the answers. I hope our government learns some of the novel ways Nordic countries have dealt with the economic hardships of their citizens, not by promoting socialism and crony capitalism but by adopting free market strategies that promote innovations and growth.