Free Market Oversights

Broken Feedback Loops

Last modified: February 2010 Draft
 
We have been taught that market forces maximize value, balance supply with demand, and stabilize resource usage. Many Americans perceive these positive outcomes of markets to be dependable truths. However, for our economic theories to actually be true profits must be tightly linked with costs and risks through (mathematically) negative feedback.
In negative feedback, forces that push opposite directions, such as supply and demand, are intrinsically linked to each other. Negative feedback is intrinsically stabilizing. However, an economic system may temporarily exist in positive feedback mathematically speaking, where related forces strengthen each other. Stock market bubbles are examples of positive feedback. The market rises. Everybody believes it will rise more. So they invest more The market rises more. Positive feedback loops will eventually crash.
A third situation called an open loop may also occur. In an open loop no feedback exists. As a result, the system will have no stabilizing factors, and will drift away from optimum. Like positive feedback, open loop systems tend to drift away from stability until the system fails.
Our economy has many more open loop and positive feedback factors than we are willing to acknowledge. These factors push our economy into unstable situations and bubbles where the economy does not behave according to free market theory. Below we look at some obvious examples of our economy operate with free market feedback.

Sections

Reminders

  • Negative feedback = stabilizing
  • Open Loop = drifting
  • Positive feedback = destabilizing

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Free markets should contain tightly linked feedback. But does our economy really contain this feedback? Let your community organization examine situations for yourselves.

 

Resource Factors in Economic Systems

All production is derived from using environmental resources. No single company pays the full costs for the all of the resources they use. This failure to pay full costs for resources used reduces, or even eliminates, the stabilizing and maximizing forces of the market. The markets do not work according to free market theory. The ancient Greeks termed the consequences of this disconnect "the Tragedy of the Commons," a situation where resources get depleted or destroyed. Here we review a few examples of how this happens.

The Downstream Open Loop

In some cases a person upstream reaps the benefits of an economic activity, while a person downstream pays the economic/environmental costs of that activity. Many examples of this have been identified.

Corn growers in the Midwest use fertilizer on their fields. The fertilizer flows downstream into the ocean and alters the chemistry of the ocean. The chemistry change leads to dead-zones where much of the potentially harvestable fish die off. The farmers reap the economic benefits, while the fishermen suffer the economic costs.
Similar downstream effects occur with smokestack emissions and mine runoff. Those who reap the profits do not pay the costs. The costs are paid by others downstream, who are not connected to the economic benefits. No free market feedback connects the downstream costs to the upstream profits.
The Next Generation Open Loop
In similar situations, many economic activities lead one generation to realize the economic benefits, while a later generation suffers the economic costs. Again, no feedback exists between costs and benefits, because those who pay the costs are separated from those who reap the profits by a large span of time.
In farms, irrigation leads to soil degradation and depletion of ground water which leads to drops in food production and farm productivity. One generation makes a large profit from mining. A later generation suffers subsidence.

Downstream

Next Generation

 
Previous Generation Open Loop
At the opposite extreme of the next generation open loop would be the previous generation open loop. Many industries have been built up by the risks, hard work, and innovations of one generation. A subsequent generation of executives came in, down-sized the company and pocketed the accumulated wealth built up by the previous generation. This process has been a regular part of American business news for at least 40 years.
In all of these down-sizings and reorganizations, those who take the profit and those who invested risk and labor are separated by a business generation or more. No free market feedback exists to stabilize the system and ensure the continued profitability, productivity, and prolonged support of human wants. The loop is open.
Private Profit from Public Property Positive Feedback Loop
The cases above remind us that frequently private profit is derived from otherwise public, or common, property. In the examples above profit was derived from property that would otherwise belong to others downstream, or another generation.
Since nature follows natural laws, not legal laws of property, much profit derived from natural resources actually comes from properties other than those for which the profiting company paid.
Wells derive water and oil from under other properties. But the neighbors do not get compensated. Seafood travels freely throughout the ocean. For each fishing team to profit, they must catch the fish before the other team does. That leads to overfishing, which depletes the fishing region. The fishers do not pay the cost of restocking the ocean. But others will eventually pay for the consequences of overfishing.
Private profit from public property occurs in any situations where resources are fluid and flow across boundaries. This includes water, oil, fish, and game. This also includes extracting resources from public lands without paying the costs of buying and maintaining the lands. Logging public lands and gold-rushes are prime examples of this.

Private Profit from Public Property

  • fishing
  • hunting
  • logging
  • oil wells
  • water wells
  • dams
  • roads
 

Cultural Broken Loops

Popular economic theory is based on the assumption that people make rational well-informed decisions. However, it is well known that decisions are rarely both rational and well-informed. In fact, both psychology and cultural anthropology invest great effort into studying how our irrational poorly informed decisions. The result is that economic theory fails to account for how we really make our decisions. Below we look at some of the irrational decisions that economic theory overlooks.

Status Costs

In our culture risk and physical effort tend to be pushed down to lower status positions. Profit tends to be pulled up to higher status positions. People accept and go to great lengths to rationalize why our economic system should work this way. But this status separation breaks up the free market feedback loops. Those who reap the profits are not the same as the people who took the risks, and frequently have minimal connection to those who paid the costs.

The breaking of the free market feedback can be seen in much of the business news. Executives are given bonuses even when they make costly mistakes. Workers are laid off even when they have been highly productive. Miners and steel workers suffer serious injury from low pay jobs even while their bosses receive high incomes. Cultural acceptance of status eliminates the very free market feedback that many people believe justifies the status.

Eliminating Social Feedback

Communities depend on social feedback. Social feedback is one of the many forms of feedback that preserve free markets. However, we have created structures that eliminate social feedback. Corporate size and office compartmentalization keep executives free from the feedback of their subordinates at work. Highways and zoning laws keep the high status executives separate from low status workers at home. When an executive takes a large bonus for laying off workers, he faces no social feedback because he can isolate himself from the laid off workers. Recently, we have seen the rise of executives who use antidepressants. They are not depressed. They have just found that antidepressants make them less concerned with how their actions affect others. They create a form of chemically induced asbergers syndrome to isolate themselves from the social awareness (moral thinking) that would drive them to be concerned for those they have affected.

Irrational Beliefs: Addiction, Image, & Advertising

We all invest much of our resources into irrational choices. These choices may be made for image, or irrational belief or fears. Because the choices are irrational from the start, we fail to seek the best combination of price and quality. But without considering combinations of price and quality when we make our choices free market feedback (supply and demand) does not occur.

Younger Americans all know Joe Camel and older Americans all know the Marlboro Man. But did the smokers ever achieve the image and status through the product, or did they simply develop bad breath and lung cancer? High school girls wear ugly clothing that says "Abercrombie" and inner-city youths go out of their ways to spend higher prices on sneakers and clothing. None of these people took time to consider the balance of price and quality. They simply acted on irrational beliefs.

Similarly, many Americans bought houses bigger than they could afford. Their mortgage companies gave them mortgages even against the evidence that they might not be able to pay it back. They sold the risky investments to others who should have had reason to suspect that the investments were extremely risky. All these people based their choices on an unfounded belief that the market could constantly rise faster than both incomes and inflation.

Irrational beliefs lead people to choices that totally ignore the feedback gained by balancing price with quality. People join pyramid schemes and unsustainable trends even against the evidence that something is not quite right. The larger the portion of the population that buy into the irrational beliefs, the less free market feedback will maintain the economy.

System Drift:

Engineers design negative feedback into their designs to stabilize them. However, the same methods that create stabilizing negative feedback can create destabilizing positive feedback if components within the system change values. Engineers must ensure that minor changes in the components values will not cause the system drift into the positive feedback region.

In the first decade of the 2000s, we saw feedback drift occur in the housing market and stock market. Ideally, buyers should want the lowest possible price while sellers want the highest possible price. But during this decade, speculation drove prices up rapidly. People came to believe in an endlessly rising market. Investors failed to compete for the best possible price, as they reasoned that they would be able to sell for even more than they paid. This erroneous belief was the basis of the positive feedback that created the housing bubble. Bankers and regulators supported the positive feedback, such that it continued until it could no longer support itself. The system crashed as all systems in positive feedback do.


Author's note: I once attended a dinner party where my date's brother said, "I have a friend who made a million dollar bonus for laying off a large number of workers." Recognizing that the company had just invested a huge sum of money into eliminating its potential, I laughed and said, "It's easy to see where the problem is!" The man and my date both gave me a dirty look. This typifies the problem of broken cultural feedback loops. Those taking the profit suffered none of the risk or costs from which their profits were taken. They faced no social (ethical) feedback that would prevent them from harming others for personal gain.

We've seen this story repeated all over America. Many of us have lost jobs more than once to executives making choices that benefit themselves at the cost of both the employees and the company they are being paid build up.

 

Cultural Separation of Status and Risk

 

Conclusions & Considerations

A rich American once said, "To get rich you need other people's ideas, other people's money, and other people's work." In terms of feedback mathematics, that means that to get rich you need to break the chains of free market feedback. To the extent that this claim is true, the number of rich in any country is a rough measure of how broken their free market system is.

There is no way to perfectly account for the cost or value resource utilization. We can not with certainty say what would have been the value of public resources (water, roads, fish & game) that we use for our private property. There is no way to perfectly measure the cost of our impact on public property (water, air, ecosystems) that we use for private profit. There is not even a clear means to determine who has been impacted so that we may compensate them. Thus, no economy will work with perfect free market feedback.

For the economy to function with free market feedback, some means must be introduced to connect the user of the resource (the one profiting) back to the cost of using that resource. One method suggested for is to tax the usage of that resource according to an estimate of the downstream costs. For greenhouse emissions some have suggested a carbon tax. Regardless of the method, reestablishing free market feedback to shared resources can only occur perfectly when the impact on those resources is known. Ironically, free market feedback requires the existence of a tax or regulation on all fluid and large scale resources.

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