When inequality is significant, free markets are not necessarily the way to go, says Northwestern economist

• Link to: Northwestern Now Story

One of the most classic intuitions in economics is the idea that competitive markets are the best way to allocate resources in society. However, in a new paperto be published in the journal Econometrica, economists Piotr Dworczak of Northwestern, Scott Duke Kominers of Harvard and Mohammad Akbarpour of Stanford conclude that free markets are optimal under some circumstances — but at other times price controls can be a better solution, particularly when there’s significant societal inequality.

“We often see regulators implement price controls or other policies that distort the market’s function,” said Dworczak, assistant professor of economics in the Weinberg College of Arts and Sciences. “Local housing regulators, for example, often ensure that some housing is ‘rent-controlled,’ to give lower-income people access. Another common example is minimum wage, which is a form of price controls in the labor market, and is often regulated at a local level.

“Classical economic theory suggests these sorts of regulations aren’t the best policy,” Dworczak explained. “But our paper shows that they can, in fact, be optimal.”

In particular the authors show that when inequality is significant, it can be optimal for a policymaker who regulates only one market to distort prices in order to “redistribute through the market.” Such policies have a special advantage in effecting redistribution because market participants’ behavior can help identify those who are most in need. 

Kominers, the MBA Class of 1960 Associate Professor in the Entrepreneurial Management Unit at Harvard Business School and a faculty affiliate of the Harvard Department of Economics, used rideshare drivers during the current pandemic as an example. 

“As the virus started spreading around the country, being a rideshare or delivery driver became a far riskier proposition. But some people kept driving — and some people even started driving for the first time. What can we infer about those people? Given the risks, it’s likely that many of them really needed the money,” he explained. 

“Their behavior in the market is a signal of need — they were willing to take a substantial risk in exchange for a little bit of extra income. The basic principle of supply and demand says that when people become more desperate to sell their labor, their wage should decrease. But that’s precisely when — from a social perspective — we would like people to be paid more, all else equal. Our paper demonstrates that setting the wage above what a fully ‘competitive’ market would do can be optimal in such cases.”

Kominers added that setting a high wage has negative consequences, too.

“The service becomes more expensive for buyers — who in turn reduce their demand. This means fewer driving hours for the drivers,” he said. “Accordingly, our results donot say that you alwayswant to distort markets in order to redistribute. But they do suggest that it may sometimes be a good idea — especially when inequality among market participants is particularly pronounced.” 

The authors hope their paper will provide a means to a more productive debate about these issues. 

“There’s an argument for housing assistance, minimum wages and programs like food stamps,” said Akbarpour, assistant professor of economics at the Stanford Graduate School of Business. “There’s also the possibility that new marketplace businesses might use our ideas to make their markets more equitable — adding a bit of a social mission in a way that grows the pie for everyone. Although businesses traditionally focus on maximizing profits, their public image serves as an important incentive to consider broader social objectives in their planning.”

Earlier this month, their work generated significant buzz on Twitter with more than 500 retweets and comments and approximately 230,000 views.

Dworczak said their paper made precise an intuition that many people have had for a long time — and that has been gaining traction recently.

“It is increasingly common to view the market system as a contributor to growing inequality, which in turn has driven both progressive activism and populist backlash,” he said. “Some policymakers and social scientists have even gone so far as to suggest that markets should be eliminated or banned.”

Said Kominers: “But our paper suggests that there is a middle ground. It’s possible, at least in principle, to structure markets in ways that improve equity.”

The authors were surprised and pleased by the enthusiastic reaction that the paper has generated, and said that all the ingredients of their argument are already present in previous economic models. 

“Other papers have, at least implicitly, made similar points in more complicated settings,” Akbarpour said. “We were just trying to distill the key intuition in the simplest, most classical model, which makes the insight especially striking. As far as we can tell, that’s what spoke to people.”