There was a long debate on "Free Market" Vs. "Regulation". Scholars who believe in "free market" are strongly against regulation or any other government intervention because they think the market could heal itself by competition and whatever powerful mechanism it already has by itself. However, other scholars argue that the market is not as powerful as the "free market" hypothesis claims and needs government intervention to make it more efficient.
You may notice that I used the past tense above when I mentioned the debate. As far as I understand, this debate was before Stiglitz and a few other Nobelists brought to our attention the information imperfection and other market frictions. I thought, after that, this debate was at least partly, if not fully, resolved by the agreement on the existence of market friction. However, I am often surprised by how many times this "free market" argument is raised in seminars in an ambiguous way. So I write this post to explain my understanding, and I really appreciated it if you could let me know whether I miss something in the big picture.
Most obviously, in a market with imperfect competition, the "free market" assumption is violated by its own definition: "a competitive market", not to mention other market frictions such as private information, agency problem and transaction costs.
However, regulations could be helpful under two circumstances. First, it may help mitigate the impact of some market frictions and bring the market closer to the first-best efficient world. Second, if you believe in the behavioral story, regulations could also help market participants make rational decisions and make the world a better place as a whole. The first scenario rationalizes the "Regulation" hypothesis to reconcile with the "Free Market" story, and that's what I believe in. Correct me if I am wrong, but I think what most "free market" believers are strongly against is the second case.
In many papers I read, the authors either stand in the extreme side of the debate: market is fully efficient or market participants are irrational, or simply avoid the argument by not talking about it. Often time I figure that those results could be easily rationalized by a story in a market with frictions, but it is a puzzle to me why they choose the ambiguous alternatives.
If I am right, the reason could come from the deficiency of research on market with multiple frictions, especially in the theoretical sides. Of course, this type of research could be very complicated due to multiple constraints. If you have already seen some dealer market models in the market-microstructure literature, you know how complicated this type of models could become. However, I believe this would be an interesting and potentially fruitful trend of research due to the following reasons:
First, different market frictions usually interact with each other. Some papers have already shown that they may sometimes cancel out each other in equilibrium and make the market more efficient. This could lead to the same results as shown in the "Free Market" hypothesis, yet with more realistic assumptions.
Second, it is a challenge to the theorists to come up with a simple model that could explain the complicated situations. I believe simple is beauty, not only in mathematics but also in economics and finance, or any other science.
Third, I am always skeptical about the behavioral stories. I admit that not every person is rational and even rational people could make mistakes, but I think it is irresponsible to attribute every abnormally to the behavioral story. Please allow me to use the medical metaphor again: this path of research is like to find out medical diagnoses for a complicated disease with mixed symptoms instead of simply calling it a miracle.
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