Economic Thoughts, Part X: The Power of the Market

This posting is Part X in a series of postings about economic thoughts.

Milton and Rose Friedman, in Chapter 1 of their 1979 book, Free to Choose: A Personal Statement, discuss the power of the market:

...we know of no society that has ever achieved prosperity and freedom, unless voluntary exchange has been its dominant principle of organization. We hasten to add that voluntary exchange is not a sufficient condition for prosperity...but...is a necessary condition...

THE ROLE OF PRICES

The key insight of Adam Smith's Wealth of Nations is misleadingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it. Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another.

This key insight is obvious for a simple exchange between two individuals. It is far more difficult to understand how it can enable people living all over the world to cooperate to promote their separate interests.

The price system is the mechanism that performs this task without central direction, without requiring people to speak to one another or to like one another...the price system enables people to cooperate peacefully in one phase of their life while each one goes about his own business with respect of everything else...

...It was a startling idea then, and it remains one today, that economic order can emerge as the unintended consequence of the actions of many people, each seeking his own interest.

The price system works so well, so efficiently, that we are not aware of it most of the time. We never realize how well it functions until it is prevented from functioning, and even then we seldom recognize the source of the trouble...

Prices perform three functions in organizing economic activity: first, they transmit information; second, they provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes; third, they determine who gets how much of the product - the distribution of income. These three functions are closely interrelated...

Transmission of Information

The price system transmits only the important information and only to the people who need to know...

A major problem in transmitting information efficiently is to make sure that everyone who can use the information gets it without clogging the "in" baskets of those who have no use for it. The price system automatically solves this problem. The people who transmit the information have an incentive to search out the people who can use it and they are in a position to do so. People who can use the information have an incentive to get it and they are in a position to do so...

The transmission of information through prices is enormously facilitated these days by organized markets and by specialized communication facilities...

Anything that prevents prices from expressing freely the conditions of demand or supply interferes with the transmission of accurate information. Private monopoly...is one example...Price controls on oil and other forms of energy by the U.S. government [are another.]...

Important as private distortions of the price system are, these days the government is the major source of interference with a free market system - through tariffs and other restraints on international trade, domestic action fixing or affecting individual prices, including wages, government regulation of specific industries, monetary and fiscal policies producing erratic inflation, and numerous other channels...

Incentives

The effective transmission of accurate information is wasted unless the relevant people have an incentive to act, and act correctly on the basis of that information...One of the beauties of a free price system is that the prices that bring the information also provide both an incentive to react to the information and the means to do so.

This function of prices is intimately connected with the third function - determining the distribution of income - and cannot be explained without bringing that function into the account...

Prices also provide an incentive to act on information not only about the demand for output but also about the most efficient way to produce a product...

We have discussed the incentive effect so far in terms of producers and consumers. But it also operates with respect to workers and owners of other productive resources...

Distribution of Income

In countries like the United States the major productive resource is personal productive capacity - what economists call "human capital." Something like three-quarters of all income generated in the United States through market transactions takes the form of the compensation of employees (wages and salaries plus supplements) and about half the rest takes the form of the income of proprietors of farm and nonfarm enterprises...

The accumulation of physical capital...has played an essential role in economic growth...

But the accumulation of human capital - in the form of increased knowledge and skills and improved health and longevity - has also played an essential role. And the two have reinforced each other. The physical capital enabled people to be far more productive by providing them with the tools to work with. And the capacity of people to invent new forms of physical capital, to learn how to use and get the most out of physical capital, and to organize the use of both physical and human capital on a larger and larger scale enabled the physical capital to be more productive. Both physical and human capital must be cared for and replaced...

The amount of each kind of resource each of us owns is partly the result of chance, partly of choice by ourselves or others...

The price that the market sets on the services of our resources is similarly affected by a bewildering mixture of chance and choice...the price we receive for the services of our resources through the market also depends on our own choices - where we choose to settle, how we choose to use those resources, to whom we choose to sell...services, and so on.

In every society, however it is organized, there is always dissatisfaction with the distribution of income...In a command system envy and dissatisfaction are directed at rulers. In a free market system they are directed at the market.

One result has been an attempt to separate this function of the price system - distributing income - from its other functions - transmitting information and providing incentives. Much government activity during recent decades...has been directed at altering the distribution of income generated by the market in order to produce a different and more equitable distribution of income...

However we might wish it otherwise, it simply is not possible to use prices to transmit information and provide an incentive to act on that information without using prices also to affect, even if not completely determine, the distribution of income. If what a person gets does not depend on the price he receives for the services of his resources, what incentive does he have to seek out information on prices or act on the basis of that information?...If prices are prevented from affecting the distribution of income, they cannot be used for other purposes. The only alternative is command. Such authority would have to decide who should produce what and how much...

A BROADER VIEW

Adam Smith's "invisible hand" is generally regarded as referring to the purchases or sales of goods or services for money. But economic activity is by no means the only area of human life in which a complex and sophisticated structure arises as an unintended consequence of a large number of individuals cooperating while each pursues his own interests.

Consider, for example, language...

How did language develop? In much the same way as an economic order develops through the market - out of the voluntary interaction of individuals...One or another meaning was attributed to a word, or words were added as the need arose. Grammatical usages developed and were later codified into rules. Two parties who want to communicate with one another both benefit from coming to a common agreement about the words they use...As a wider and wider circle of people find it advantageous to communicate with one another, a common usage spreads and is codified in dictionaries. At no point is there any coercion, any central planner who has power to command...

Another example is scientific knowledge. The structure of disciplines [within science] was not the product of a deliberate decision by anyone...

Within any discipline the growth of the subject strictly parallels the economic marketplace. Scholars cooperate with one another because they find it mutually beneficial. They accept from one another's work what they find useful. They exchange their findings...The esteem or approval of fellow scholars serves very much the same function that monetary reward does in the economic marketplace....

A society's values, its culture, its social conventions - all these develop in the same way, through voluntary exchange, spontaneous cooperation, the evolution of a complex structure through trial and error, acceptance and rejection...

The structures produced by voluntary exchange...develop a life of their own. They are capable of taking many different forms under different circumstances. Voluntary exchange can produce uniformity in some respects combined with diversity in others. It is a subtle process whose general principles of operation can fairly readily be grasped but whose detailed results can seldom be foreseen.

These examples may suggest not only the wide scope for voluntary exchange but also the broad definition that must be attached to the concept of "self-interest." Narrow preoccupation with the economic market has led to a narrow interpretation of self-interest as myopic selfishness, as exclusive concern with immediate material rewards...That is a great mistake. Self-interest is not myopic selfishness. It is whatever it is that interests the participants, whatever they value, whatever goals they pursue...all are pursuing their interests, as they see them, as they judge them by their own values.

THE ROLE OF GOVERNMENT

...what role should be assigned to government?

It is not easy to improve on the answer that Adam Smith gave to this question...

...According to the system of natural liberty, the sovereign has only three duties of great importance...first, the duty of protecting the society from violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.

The first two duties are clear and straightforward: the protection of individuals in the society from coercion whether it comes from outside or from their fellow citizens. Unless there is such protection, we are not really free to choose...

...it is one thing to state the purpose that an institution, particularly a governmental institution, "ought" to serve; it is quite another to describe the purposes the institution actually serves. The intentions of the persons responsible for setting up the institution and of the persons who operate it often differ sharply. Equally important, the results achieved often differ widely from those intended...

A major problem in achieving and preserving a free society is precisely how to assure that coercive powers granted to government in order to preserve freedom are limited to that function and are kept from becoming a threat to freedom. The founders of our country wrestled with that problem...We have tended to neglect it.

Adam Smith's second duty goes beyond the narrow police function of protecting people from physical coercion; it includes "an exact administration of justice."...There must be some way to mediate disputes...

This role of government also includes facilitating voluntary exchanges by adopting general rules - the rules of the economic and social games that the citizens of a free society play. The most obvious example is the meaning to be attached to private property...The major way that society has come to agree on the rules of property is through the growth of common law...

Adam Smith's third duty raises the most troublesome issues. He himself regarded it as having a narrow application. It has since been used to justify an extremely wide range of government activities...

The valid element arises because of the cost of producing some goods and services through strictly voluntary exchanges...

A more subtle example involves effects on "third parties," who are not parties to the particular exchange - the classic "smoke nuisance" case...

To lapse into technical jargon, there is a "market failure" because of "external" or "neighborhood" effects for which it is not feasible to compensate or charge the people affected...

Almost everything we do has some third-party effects...In consequence, Adam Smith's third duty may at first blush appear to justify almost any proposed government measure. But there is a fallacy. Government measures also have third-party effects. "Governmental failure" no less than "market failure" arises from "external" or "neighborhood" effects. And if such effects are important for a market transaction, they are likely also to be important for government measures intended to correct the "market failure."...

If it is difficult for private parties to identify who imposes costs or benefits on whom, it is difficult for government to do so. As a result a government attempt to rectify the situation may very well end up making matters worse rather than better - imposing costs on innocent third parties or conferring benefits on lucky bystanders. To finance its activities it must collect taxes, which themselves affect what taxpayers do - still another third-party effect. In addition, every accretion of government power for whatever purpose increases the danger that government, instead of serving the great majority of its citizens, will become a means whereby some of its citizens can take advantage of others...

The lesson to be drawn from the misuse of Smith's third duty is not that government intervention is never justified, but rather that the burden of proof should be on its proponents...This [benefits/cost] course of action is recommended not only by the difficulty of assessing the hidden costs of government intervention but also by another consideration. Experience shows that once government undertakes an activity, it is seldom terminated...

A fourth duty of government that Adam Smith did not explicitly mention is the duty to protect members of the community who cannot be regarded as "responsible" individuals. Like Adam Smith's third duty, this one, too, is susceptible of great abuse. Yet it cannot be avoided.

Freedom is a tenable objective only for responsible individuals...We must somehow draw a line between responsible individuals and others, yet doing so introduces a fundamental ambiguity into our ultimate objective of freedom. We cannot categorically reject paternalism for those whom we consider as not responsible...

LIMITED GOVERNMENT IN PRACTICE

In today's world big government seems pervasive. We may well ask whether there exist any contemporaneous examples of societies that rely primarily on voluntary exchange through the market to organize their economic activity and in which government is limited to our four duties.

Perhaps the best example is Hong Kong [pre-1997 takeover by Communist China]...

Hong Kong has no tariffs of other restraints on international trade...It has no government direction of economic activity, no minimum wage laws, no fixing of prices. The residents are free to buy from whom they want, to sell to whom they want, to invest however they want, to hire whom they want, to work for whom they want.

Government plays an important role that is limited primarily to our four duties interpreted rather narrowly. It enforces law and order, provides a means for formulating the rules of conduct, adjudicates disputes, facilitates transportation and communication, and supervises the issuance of currency. It has provided public housing for arriving refuges from China...[taxes] remain among the lowest in the world...low taxes preserve incentives. Businessmen can reap the benefits of their success but must also bear the costs of their mistakes...

Though Hong Kong is an excellent current example, it is by no means the most important example of limited government and free market societies in practice...

The United States is another striking example...

A myth has grown up about the United States that paints the nineteenth century as the era of the robber baron, of rugged, unrestrained individualism...

The reality was very different. Immigrants kept coming...The early ones might have been fooled, but it is inconceivable that millions kept coming to the United States decade after decade to be exploited. They came because the hopes of those who had preceded them were largely realized...The newcomers spread from east to west. As they spread, cities sprang up, ever more land was brought into cultivation. The country grew more prosperous and more productive, and the immigrants shared in the prosperity...

...the flowering of charitable activity in the United States in the nineteenth century: Privately financed schools and colleges multiplied; foreign missionary activity exploded; nonprofit hospitals, orphanages, and numerous other institutions sprang up like weeks. Almost every charitable or public service organization from the Society for the Prevention of Cruelty to Animals to the YMCA and YWCA, from the Indian Rights Association to the Salvation Army, dates from that period. Voluntary cooperation is no less effective in organizing charitable activity than in organizing production for profit.

The charitable activity was matched by a burst of cultural activity - art museums, opera houses, symphonies, museums, public libraries arose in big cities and frontier towns alike.

The size of government spending is one measure of government's role. Major wars aside, government spending from 1800 to 1929 did not exceed about 12 percent of the national income. Two-thirds of that was spent by state and local governments, mostly for schools and roads. As late as 1928, federal government spending amounted to about 3 percent of the national income...

It is often maintained that while a let-alone, limited government policy was feasible in sparsely populated nineteenth-century America, government must play a far larger, indeed dominant, role in a modern urbanized and industrial society. One hour in Hong Kong will dispose of that view.

Our society is what we make it...none prevents us, if we will, from building a society that relies primarily on voluntary cooperation to organize both economic and other activity, a society that preserves and expands human freedom, that keeps government in its place, keeping it our servant and not letting it become our master.

Part XI to follow...

For previous postings on Economic Thoughts, refer to:

Part I: What is Economics?
Part II: Myths About Markets
Part III: Why Policy Goals are Trumped by Incentives They Create & the Role of Knowledge in Economics
Part IV: The Abuse of Reason, Fallacies & Dangers of Centralized Planning, Prices & Knowledge, and Understanding Limitations
Part V: The Relationship Between Economic Freedom and Political Freedom
Part VI: More on the Relationship Between Economic Freedom and Political Freedom
Part VII: The Role of Government in a Free Society
Part VIII: The Unspoken, But Very Real, Incentives That Drive Governmental Actions
Part IX: More on the Coercive Role of Government