I want to understand more about assumption 5 from an article impose below. Just two things I'm asking for clarity on.

ASSUMPTION FIVE:You only get what you pay tor. Nobody can impose a cost on somebody else, nor obtain a benefit from them, without paying.

REALITY FIVE:Externalities, both positive and negative, are pervasive. In a free market, polluters can impose costs on the rest of us without paying. And when a public good like a park is built or roads are maintained, everyone benefits whether or not they helped to pay for it.

1. How is assumption 5 violated, or the possibility of "market failure" or less than optimal economic results? What would be a real-life example?
2. And is or is not a realistic, reasonable market assumption?

Here's the Article provided if you need to read it.

SHAKING THE INVISIBLE HAND

The Uncertain Foundations of Free-Market Economics

BY CHRIS TILLY

November 1989; updated March 2011

It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest ... [No individual] intends to promote the public interest ... [rather, he is] led by an invisible hand to promote an end which was no part of his intention.

-Adam Smith, The Wealth of Nations, 1776

Seen the Invisible Hand lately? It's all around us these days, propping up conservative arguments in favor of free trade, deregulation, and tax-cutting. Today's advocates for "free," competitive markets echo Adam Smith's claim that unfettered markets translate the selfish pursuit of individual gain into the greatest benefit for all. They trumpet the superiority of capitalist free enterprise over socialist efforts to supplant the market with a planned economy, and even decry liberal attempts to moderate the market. Anything short of competitive markets, they proclaim, yields economic inefficiency, making society worse off.

But the economic principle underlying this fanfare is shaky indeed. Since the late 19th century, mainstream economists have struggled to prove that Smith was right-that the chaos of free markets leads to a blissful economic order. In the 1950s, U.S. economists Kenneth Arrow and Gerard Debreu finally came up with a theoretical proof, which many orthodox economists view as the centerpiece of modern economic theory.

Although this proof is the product of the best minds of mainstream economics, it ends up saying surprisingly little in defense of free markets. The modern theory of the Invisible Hand shows that given certain assumptions, free markets reduce the wasteful use of economic resources-but perpetuate unequal income distribution. To prove free markets cut waste, economists must make a number of far-fetched

assumptions: there are no concentrations of economic power; buyers and sellers know every detail about the present and future economy; and all costs of production are borne by producers while all benefits from consumption are paid for by consumers (see box for a complete list). Take away any one of these assumptions and markets can lead to stagnation, recession, and other forms of waste-as in fact they do. In short, the economic theory invoked by conservatives to justify free markets instead starkly reveals their limitations.

The Fruits of Free Markets

The basic idea behind the Invisible Hand can be illustrated with a story. Suppose that I grow apples and you grow oranges. We both grow tired of eating the same fruit all the time and decide to trade. Perhaps we start by trading one apple for one orange. This exchange satisfies both of us, because in fact I would gladly give up more than one apple to get an orange, and you would readily pay more than one orange for an apple. And as long as swapping one more apple for one more orange makes us both better off, we will continue to trade.

Eventually, the trading will come to a stop. I begin to notice that the novelty of oranges wears old as I accumulate a larger pile of them and the apples I once had a surplus of become more precious to me as they grow scarcer. At some point, I draw the line: in order to obtain one more apple from me, you must give me more than one orange. But your remaining oranges have also become more valuable to you. Up to now, each successive trade has made both of us better off. Now there is no further exchange that benefits us both, so we agree to stop trading until the next crop comes in. Note several features of this parable. Both you and I end up happier by trading freely. If the government stepped in and limited fruit trading, neither of us would be as well off. In fact, the government cannot do anything in the apple/orange market that will make both of us better off than does the free market.

Adding more economic actors, products, money, and costly production processes complicates the picture, but we reach the same conclusions. Most of us sell our labor time in the market rather than fruit; we sell it for money that we then use to buy apples, oranges, and whatever else we need. The theory of the Invisible

Hand tells us a trip to the fruit stand improves the lot of both consumer and seller; likewise, the sale of labor time benefits both employer and employee. What's more, according to the theory, competition between apple farmers insures that consumers will get apples produced at the lowest possible cost. Government intervention still can only make things worse.

This fable provides a ready-made policy guide. Substitute "Japanese autos" and "U.S. agricultural products" for apples and oranges, and the fable tells you that import quotas or tariffs only make the people of both countries worse off. Change the industries to airlines or telephone services, and the fable calls for deregulation. Or re-tell the tale in the labor market: minimum wages and unions (which prevent workers from individually bargaining over their wages) hurt employers and workers.

Fruit Salad

Unfortunately for free-market boosters, two major short-comings make a fruit salad out of this story. First, even if free markets perform as advertised, they deliver only one benefit-the prevention of certain economically wasteful practices-while preserving inequality. According to the theory, competitive markets wipe our two kinds of waste: unrealized trades and inefficient production. Given the right assumptions, markets ensure that when two parties both stand to gain from a trade, they make that trade, as in the apples-and-oranges story. Competition compels producers to search for the most efficient, lowest-cost production methods-again, given the right preconditions. Though eliminating waste is a worthy goal, it leaves economic inequality untouched. Returning once more to the orchard, if I start our with all of the apples and oranges and you start out with none, that situation is free of waste: no swap can make us both better off since you have nothing to trade! Orthodox economists acknowledge that even in the ideal competitive market, those who start out rich ,stay rich, while the poor remain poor. Many of them argue that attempts at redistributing income will most certainly create economic inefficiencies, justifying the preservation of current inequities.

But in real-life economics, competition does lead to waste. Companies wastefully duplicate each other's research and build excess productive capacity. Cost-cutting often leads to shoddy products, worker speedup, and unsafe working conditions. People and factories stand idle while houses go unbuilt and people go unfed. That's because of the second major problem: real economies don't match the assumptions of the Invisible Hand theory. Of course, all economic theories build their arguments on a set of simplifying assumptions about the world. These assumptions often sacrifice some less important aspects of reality in order to focus on the economic mechanisms of interest.

Assumptions and Reality

The claim that free markets lead to efficiency and reduced waste rests on eight main assumptions. However, these assumptions differ sharply from economic reality. (Assumptions 1, 3, 4, and 5 are discussed in more detail in the article.)

ASSUMPTION ONE:No market power. No individual buyer or seller, nor any group of buyers or sellers, has the power to affect the market-wide level of prices, wages, or profits.

REALITY ONE:Our economy is dotted with centers of market power, from large corporations

to unions. Furthermore, employers have an edge in bargaining with workers because of the threat of unemployment.

ASSUMPTION TWO:No economies of scale. Small plants can produce as cheaply as large ones.

REALITY TWO:In fields such as mass-production industry, transportation, communications, and agriculture, large producers enjoy a cost advantage, limiting competition.

ASSUMPTION THREE:Perfect information about the present. Buyers and sellers know everything there is to know about the goods being exchanged. Also, each is aware of the wishes of every other potential buyer and seller in the market.

REALITY THREE:The world is full of lemons-goods about which the buyer is inadequately informed. Also, people are not mind-readers, so sellers get stuck with surpluses and willing buyers are unable to find the products they want.

ASSUMPTION FOUR:Perfect information about the future. Contracts between buyers and sellers cover every possible future eventuality.

REALITY FOUR:Uncertainty clouds the future of any economy. Futures markets are limited.

ASSUMPTION FIVE:You only get what you pay tor. Nobody can impose a cost on somebody else, nor obtain a benefit from them, without paying.

REALITY FIVE:Externalities, both positive and negative, are pervasive. In a free market, polluters can impose costs on the rest of us without paying. And when a public good like a park is built or roads are maintained, everyone benefits whether or not they helped to pay for it.

ASSUMPTION SIX:Price is a proxy for pleasure. The price of a given commodity will represent the quality and desirability and or utility derived from the consumption of the commodity.

REALITY SIX:"Conspicuous Consumption" (Veblen) and or "snob effects" will often distort prices from underlying utility and marketers will try to position commodities accordingly.

ASSUMPTION SEVEN:Self-interest only. In economic matters, each person cares only about his or her own level of well-being.

REALITY SEVEN:Solidarity, jealousy, and even love for one's family violate this assumption.

ASSUMPTION EIGHT:No joint production. Each production process has only one product.

REALITY EIGHT:Even in an age of specialization, there are plenty of exceptions to this rule. For example, large service firms such as hospitals or universities produce a variety of different services using the same resources.

-Chris Tilly and Bryan Snyder

But in the case of the Invisible Hand, the theoretical preconditions contradict several central features of the economy. For one thing, markets are only guaranteed to prevent waste if the economy runs on "perfect competition": individual sellers compete by cutting prices, individual buyers compete by raising price offers, and nobody holds concentrated economic power. But today's giant corporations hardly match this description. Coke and Pepsi compete with advertising rather than price cuts. The oil companies keep prices high enough to register massive profits every year. Employers coordinate the pay and benefits they offer to avoid bidding up compensation. Workers, in turn, marshal their own forces via unionization-another departure from perfect competition.

Indeed, the jargon of "perfect competition" overlooks the fact that property ownership itself confers disproportionate economic power. "In the competitive model," orthodox economist Paul Samuelson commented, "it makes no difference whether capital hires labor or the other way around." He argued that given perfect competition among workers and among capitalists, wages and profits would remain the same regardless of who does the hiring. But unemployment-a persistent feature of market-driven economies-makes job loss very costly to workers. The sting my boss feels when I "fire" him by quitting my job hardly equals the setback I experience when he fires me.

Perfect Information?

In addition, the grip of the Invisible Hand is only sure if all buyers and sellers have "perfect information" about the present and future state of markets. In the present, this implies consumers know exactly what they are buying-an assumption hard to swallow in these days of leaky breast implants and chicken a la salmonella. Employers must know exactly what skills workers have and how hard they will work-suppositions any real-life manager would laugh at.

Perfect information also means sellers can always sniff out unsatisfied demands, and buyers can detect any excess supplies of goods. Orthodox economists rely on the metaphor of an omnipresent "auctioneer" who is always calling out prices so all buyers and sellers can find mutually agreeable prices and consummate every possible sale. But in the actual economy, the auctioneer is nowhere to be found, and markets are plagued by surpluses and shortages.

Perfect information about the future is even harder to come by. For example, a company decides whether or not to build a new plant based on whether it expects sales to rise. But predicting future demand is a tricky matter. One reason is that people may save money today in order to buy (demand) goods and services in the future. The problem comes in predicting when. As economist John Maynard Keynes observed in 1934, "An act of individual saving means-so to speak-a decision not to have dinner today. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence ... or to consume any specified thing at any specified date. Thus it depresses the business of preparing today's dinner without stimulating the business of making ready for some future act of consumption." Keynes concluded that far from curtailing waste, free markets gave rise to the colossal waste of human and economic resources that was the Great Depression-in part because of this type of uncertainty about the future.

Free Lunch

The dexterity of the Invisible Hand also depends on the principle that "You only get what you pay for." This "no free lunch" principle seems at first glance a reasonable description of the economy. But major exceptions arise. One is what economists call"externalities"-economic transactions that take place outside the market. Consider a hospital that dumps syringes at sea. In effect, the hospital gets a free lunch by passing the costs of waste disposal on to the rest of us. Because no market exists where the right to dump is bought and sold, free markets do nothing to compel the hospital to bear the costs of dumping-which is why the government must step in. Public goods such as sewer systems also violate the "no free lunch" rule. Once the sewer system is in place, everyone shares in the benefits of the waste disposal, regardless of whether or not they helped pay for it. Suppose sewer systems were sold in a free market, in which each person had the opportunity to buy an individual share. Then any sensible, self-interested consumer would hold back from buying his or her fair share-and wait for others to provide the service. This irrational situation would persist unless consumers could somehow collectively agree on how extensive a sewer system to produce-once more bringing government into the picture.

Most orthodox economists claim that the list of externalities and public goods in the economy is short and easily addressed. Liberals and radicals, on the other hand, offer a long list: for example, public goods include education, healthcare, and decent public transportation-all in short supply in our society. Because real markets deviate from the ideal markets envisioned in the theory of the Invisible Hand, they give us both inequality and waste. Bur if the theory is so far off the mark, why do mainstream economists and policymakers place so much stock in it? They fundamentally believe the profit motive is the best guide for the economy. If you believe that "What's good for General Motors is good for the country," the Invisible Hand theory can seem quite reasonable. Business interests, government, and the media constantly reinforce this belief, and reward those who can dress it up in theoretical terms. As long as capital remains the dominant force in society, the Invisible Hand will maintain its grip on the hearts and minds of us all.