Concluding remarks on price formation

Couple of months ago I have started a series of posts on price formation in the free market or how and why the free market does (not) work.

In the first part of the series we have discussed economic laws of supply and demand. We have learned that the cheaper the product is the more people will be willing to buy it. Also that the more people are willing to pay for the product, the more of the product will be produced.

In the second part we have discussed a simple example in which printing press failed to predict the demand for the book. We have discussed how non-optimal prices emerge as a result of this miscalculation.

In the third part of the series we have discussed the implications of the cobweb model, which attempts to explain how the prices and produced quantity converge to equilibrium. We have noted that this convergence is not immediate and may take some time.

In the fourth part we have looked into the price formation from game theory perspective. We discussed why competition should emerge and why it might not. We had also discussed some interesting implications of the "price war" game, which highlight crucial importance of the competition.

In the fifth part we have also analyzed the proposed alternative to the "neo-liberal" idea of the globalization and the free trade. We have concluded that it is a terrible idea, which is neither novel, nor successful.

Through out this series of posts we have discussed few simple models lying behind the idea of free markets. We have discussed the assumptions, which are made and which must hold for the free markets to produce desirable outcome. From these posts, and many others on Physics of Risk, we should have obtained a good understanding that self-organization does not always result in a "good" (desired) outcome.

So what should we do?

Debate between the free market ideology and economic nationalists suggests that these are the only two possible choices. But such claims are wrong. We are not forced to choose between two alternatives, we should figure out a reasonable middle (or even "perpendicular") way. We should approach economics as a complex system. We should understand that models work and fail for some reasons, which need to be understood. The key to this is understanding that the reasons lie in the assumptions of the models. As the assumption are violated, the models fail.

Having all of this in mind it is rather easy to conclude that we must stay with the free markets, but we must adjust our understanding of what that means. Anarchism as well as strict regulation will definitely fail, thus reasonable regulation (guided by science and not ideological BS) is a must.

While it is hard to provide exact policy suggestions, the primary goal should be promoting competition between the market participants. This could be done by making market information transparent, freely and easily available. By making it easier for new competitors to enter and deter existing competitors from going into price wars with new ones. Though it is worth to note that there already are a lot bad examples of trying to achieve this with simplistic means (see John Oliver's video below). It is extremely important for governments to be subtle, to regulate and to create good incentives for the market participants.