How Free Markets Work for Investors

The free market that has assumed dominance in much of the world over the past few centuries is not lacking for enemies. Perhaps now more than ever, individual economic liberty is being challenged. With movements such as “Occupy Wall Street” and the more recent appeal to raise the minimum wage, many reasonable people are losing faith in the efficiency of free markets. The question is, as investors, can you trust markets to set the appropriate prices? Or, is there a better mechanism for deciding how things ought to be valued?

In The Price of Everything, a fictional parable about how prices are set in free economy, economist Russell Roberts describes a situation in which a hurricane strikes a city and leaves many people without power. At the beginning of the novel, the main characters visit the local hardware store to get a flashlight and some other supplies. To their dismay, the store is sold out of almost everything! So, they reluctantly decide to go to the new mega-store down the street, Big Box.

When they enter Big Box, they encounter a sign that says, “Today only, everything in the store is DOUBLE the regular price.” The main characters are outraged! How could they do that? How could they take advantage of the vulnerabilities of consumers during a natural disaster? Shouldn’t that be illegal? As angry as they are, they do need supplies. So, they continue on to do their shopping. And, here’s the thing: even though the items are twice as expensive as usual, the main character are able to find everything on their list.

Roberts’ major point is this: prices allocate scarce resources. The local hardware store in the scenario above, by not raising their prices to reflect the rising value of their merchandise, actually did its consumers an injustice. Because they could afford it, some consumers may have bought two or three flashlights, causing the store to run out of stock before other consumers could even get one. On the other hand, by raising its prices, Big Box incentivized its consumers to buy only what they needed–allowing availability to remain for other consumers.

And what happens when governments tamper with prices? They send the wrong signals to consumers. When prices are made artificially low (caps on rent costs in some cities), availability runs out. When prices are made artificially high (minimum wages), there is excess availability. It is only when prices are allowed to freely set themselves that the incentives of buyers and sellers appropriately align. Does that mean that everyone gets what they want? Of course not. As long as resources are limited, we’ll never have everything we want. But it does mean that we are dealing with reality.

As investors, that’s what you want. You want a realistic idea of how products, companies, and industries should be valued. To date, the free market is the best mechanism for understanding the true value of things. Why? In this system, it is each and every one of us that is setting the prices–through our collective decisions to buy or not to buy. If you need any help understanding how the free markets work, please feel free to contact us for a free consultation. We would love to help in any way that we can.