What an awesome irony it would be if the new economy turned out to be making free-market capitalism unsustainable. Yet that is the implication of a paper by two American academics studying the "new economy"*. They say laissez-faire markets will deliver increasingly undesirable results the more the economy depends on weightless knowledge goods such as software or music. What's more, in the age of the Internet, buyers might have too much information for their own good. To reach these counter- intuitive conclusions, they look at the hidden assumptions underlying Adam Smith's case for the superiority of the invisible hand of the free market. As Smith put it: "By pursuing his own interest [every individual] frequently promotes that of society more effectually than when he really intends to promote it."
The unintended efficiency of unco-ordinated decisions taken by countless self-interested individuals arises from the fact that prices send a dual signal. They ration demand and call forth supply. Any interference in the process leads to the wrong amount of consumption and the wrong amount of production.
Price signals do not work ideally in all conditions. Economists have long admitted in certain cases "externalities" mean there is a case for government intervention in the market. A classic example is a public good such as clean air. We all value it but any company that invests in emitting fewer pollutants will be giving a free ride to companies that do not. The free market will lead to little clean air.
The interesting characteristic of public goods, giving rise to the problem of free riders, is that unlike normal goods everybody can consume them at the same time. Many new goods or even pharmaceuticals are non-rival in the sense that the cost of supplying them to one extra consumer after the first is almost zero. For the greatest consumer satisfaction, they should be supplied free to everyone who wants one. But if the price is nil, no producer will have an incentive to create the goods in the first place.
A related problem to non- rivalry is non-excludability. It is hard to stop people who do not have to pay from using such goods. In a sense this is true of all goods because the might of the law is needed to protect private property. But although the legal framework exists to protect intellectual as well as physical property, it is much harder to stop music piracy than to prevent thieves walking off with physical goods. Even worse for the efficient operation of the market, it might be the case that consumers are getting too much of the wrong sort of information and not enough of the right sort.
Think about buying a piece of computer software. The sensible way to buy a standard package is to shop around on the Internet for the lowest price. So obvious is this that ShopBots have been created to do the online bargain-hunting for you. But prices charged reflect not only the intrinsic cost of the good, but also the quality of the service with which it is sold - say, additional information about the software, tips for use or an advice line. Suppliers charging the higher price for better service have every incentive to discourage ShopBots.
So do retailers offering a particular item as a loss-leader to get customers into their virtual store; they do not want to sell goods at a loss to people who will not give them extra business.
But it is impossible to get enough information about many intangible goods because they are a bundle of present and future services. What you want to buy is the ability to make your computer perform certain tasks. You can't know for sure whether it will do what you want until you have tried it. This problem explains why many software companies give away test versions or simpler versions of their products.
One conclusion from this attack on the Invisible Hand is simply that governments need to do what they already do more effectively. They must find ways to enforce the law of intellectual property more vigorously, and across national boundaries. Technology is catching up with the problem, developing "digital watermarks" giving unique identification of a piece of software or dataset or picture. Cryptography offers a way of restoring excludability, requiring consumers to buy a decryption key.
But this does not address the philosophical question posed by the authors: are price signals doomed to be inefficient in the new economy? If the answer is yes, and producers supply too little of something which for economic well-being would be supplied free to all consumers who want it - whether a miracle drug or a Catatonia CD - you could draw a radical conclusion. Anyone for nationalising the pharmaceuticals or music industry? Or how about a form of global common ownership of Microsoft?
* `The Next Economy', by Bradford De Long and Michael Froomkin: http://econ161.berkeley.edu/Econ_Articles/newecon.htm
Hamish McRae is on holiday