The Market Process

Chapter 8

The Market Process

When I go to the supermarket, I encounter a veritable cornucopia of food--from milk and bread to Wolfgang Puck's Spago Pizza and fresh kiwis from New Zealand. The average supermarket today has 30,000 items, double the number just 10 years ago. Like most shoppers, I take this abundance for granted. I stand in the middle of this culinary festival and say something like, "I can't believe this crummy store doesn't have Diet Caffeine-free Cherry Coke in 12-ounce cans!"

But how does this marvelous feat happen? How is it that I, who couldn't find a farm with a map, can go to a store at any time of day or night and expect to find all the food I want, in convenient packages and ready for purchase, with extra quantities of turkey in November and lemonade in June? Who plans this complex undertaking?

The secret, of course, is precisely that no one plans it--no one could plan it. The modern supermarket is a commonplace but ultimately astounding example of the infinitely complex spontaneous order known as the free market.

The market arises from the fact that humans can accomplish more in cooperation with others than we can individually, and the fact that we can recognize this. If we were a species for whom cooperation was not more productive than isolated work, or if we were unable to discern the benefits of cooperation, then we would not only remain isolated and atomistic; as Ludwig von Mises explains, "Each man would have been forced to view all other men as his enemies; his craving for the satisfaction of his own appetites would have brought him into an implacable conflict with all his neighbors." Without the possibility of mutual benefit from cooperation and the division of labor, neither feelings of sympathy and friendship nor the market order itself could arise. Those who say that humans "are made for cooperation, not competition" fail to recognize that the market is cooperation.

The economist Paul Heyne compares planning with spontaneous order this way: There are three major airports in the San Francisco Bay area, he says. Every day thousands of airplanes take off from those airports, each one bound for a different destination. Getting them all in the air and back on the ground on time and without colliding with each other is an incredibly complex task, and the air traffic control system is a marvel of sophisticated organization. But also every day in the Bay area people make thousands of times as many trips in automobiles, with far more individuated points of origin, destinations, and "flight plans." That system, the coordination of millions of automobile trips, is far too complex for any traffic control system to manage, so we have to let it operate spontaneously within a few specific rules: drive on the right, stop at lights, yield when making a left turn. There are accidents, to be sure, and traffic congestion--much of which could be alleviated if the roads themselves were built and operated according to market principles--but the point is that it would be simply impossible to plan and consciously coordinate all those automobile trips. Contrary to our initial impression, then, it is precisely the less complex systems that can be planned and the more complex systems that must develop spontaneously.

Many people accept that markets are necessary but still feel that there is something vaguely immoral about them. They fear that markets lead to inequality, or they dislike the self-interest reflected in markets. Markets are often called "brutal" or "dog-eat-dog." But as this chapter will demonstrate, markets are not just essential to economic progress, they are more consensual and lead to more virtue and equality than government coercion.

Information and Coordination

Markets are based on consent. No business sends an invoice for a product you haven't ordered, like an income tax form. No business can force you to trade. Businesses try to find out what you want and offer it to you. People who are trying to make money by selling groceries, or cars, or computers, or machines that make cars and computers, need to know what consumers want and how much they would be willing to pay. Where do they get the information? It's not in a massive book. In a market economy, it isn't embodied in orders from a planning agency (though of course, theoretically, in socialist economies producers do act on orders from above).

Prices

This vitally important information about other people's wants is embodied in prices. Prices don't just tell us how much something costs at the store. The price system pulls together all the information available in the economy about what each person wants, how much he values it, and how it can best be produced. Prices make that information usable to producer and consumer. Each price contains within it information about consumer demands and about costs of production, ranging from the amount of labor needed to produce the item to the cost of labor to the bad weather on the other side of the world that is raising the price of the raw materials needed to produce the good. Rather than having to know all the details, one is presented with a simple number: the price.

Market prices tell producers when something can't be produced at a cost less than what consumers will pay for it. The real cost of anything is not the price in dollars; it is whatever could have been done instead with the resources used. Your cost of reading this book is whatever you would have done with your time otherwise: gone to a movie, slept late, read a different book, cleaned the house. The cost of a $10 CD is whatever you would have done with that $10 otherwise. Every use of time or other resources to produce one good incurs a cost, which economists call the opportunity cost. That resource can't be used to produce anything else.

The information that prices deliver allows people to work together to produce more. The point of an economy is not just to produce more things; it's to produce more things that people want. Prices tell all of us what other people want. When prices for certain goods rise, we tend to reduce our consumption of those goods. Some of us calculate whether we could make money by starting to produce those goods. When prices--that is, wages or salaries--for some kinds of labor rise, we consider whether we ought to move into that field. Young people think about training for jobs that are starting to pay more, and they move away from training that prepares them for jobs where wages are declining.

In any economy more complex than a village--maybe even more complex than a nuclear family--it's difficult to know just what everyone wants, what everyone can do, and what everyone is willing to do at what price. In the family we love one another, and we have an intimate knowledge of each person's abilities, needs, and preferences; so we don't need prices to determine what each person will contribute and receive. Beyond the family it is good that we act benevolently toward other people; but no matter how much preachers and teachers exhort us to love one another, we will never love everyone in society as much, or know their needs as well, as the people in our family. The price system reflects the choices of millions of producers, consumers, and resource owners who may never meet and coordinates their efforts. Although we can never feel affection for--or even meet--everyone in the economy, market prices help us to work together to produce more of what everyone wants.

Unlike government, which at best takes the will of the majority (and more often acts according to pressure from a small group) and imposes it on everyone, markets use prices to let buyers and sellers freely decide what they want to do with their money. Nobody can afford everything, and some people can afford much more than others, but each person is free to spend his money as he chooses. And if 51 percent of the people like black cars, or Barry Manilow, dissenters are free to buy something else; they don't have to organize a political movement to get the whole country to switch to blue cars or Willie Nelson.

Competition

All this talk about the marvel of coordination shouldn't leave the impression that the market process isn't competitive. Our individual plans are always in conflict with those of other people; we plan to sell our services or our goods to customers, but other people are also hoping to sell to the same customers. It is precisely through competition that we find out how things can be produced at least cost, by discovering who will sell us raw materials or labor services for the lowest price.

The basic economic question is how to combine all the resources in society, including human effort, to produce the greatest possible output--not the most pounds of steel, or the most computers, or the most exciting movies, but the combination of output that will satisfy people most. We want to produce as much as we can of each good that people want, but not so much that it would be better to produce something else instead. The prices we're willing to pay for a good or service, and the prices we're willing to accept for our labor or for what we've produced, guide entrepreneurs toward the right solution.

When we make decisions in the market, each decision is made incrementally, or "on the margin": do I want this steak, one more magazine, a three-bedroom house? Our willingness to pay, and the point at which we're not willing to buy another unit, tells producers how much they can afford to spend on producing the product. If they can't produce another one for less than the "market-clearing" price, they know not to devote more resources to production of that product. When consumers show rising interest in computers and declining interest in televisions, firms will pay more for raw materials and labor to produce computers. When the cost of hiring more labor and materials reaches the limit of what consumers are willing to pay for the finished product, firms stop drawing more resources in. As these decisions are repeated thousands, millions, billions, of times, a complex system of coordination develops that brings to consumers everything from kiwis to Pentium chips.

It is the competition of all firms to attract new customers that produces this coordination. If one firm that senses that consumer demand for computers is increasing, and it is the first to produce more computers, it will be rewarded. Conversely, its television-producing competitor may find its sales declining. In practice, tens of thousands of firms do well, and thousands go out of business, every year. This is the "creative destruction" of the market. Harsh as the consumers' judgment may feel to someone who loses a job or an investment, the market works on a principle of equality. In a free market no firm gets special privileges from government, and each must constantly satisfy consumers to stay in business.

Far from inducing self-interest, as critics charge, in the marketplace the fact of self-interest induces people to serve others. Markets reward honesty because people are more willing to do business with those who have a reputation for honesty. Markets reward civility because people prefer to deal with courteous partners and suppliers.

Socialism

It is the absence of market prices that makes socialism impossible, as Ludwig von Mises pointed out in the 1920s. Socialists have often considered the question of production an engineering question: Just do some calculations to figure out what would be most efficient. It's true that an engineer can answer a specific question about the production process, such as, What's the most efficient way to use tin to make a 10-ounce can of soup, that is, what shape of can would contain 10 ounces with the smallest surface area? But the economic question--the efficient use of all relevant resources--can't be answered by the engineer. Should the can be made of aluminum, or of platinum? Everyone knows that a platinum soup can would be ridiculous, but we know it because the price system tells us so. An engineer would tell you that silver or platinum wire would conduct electricity better than copper. Why do we use copper? Because it delivers the best results for the cost. That's an economic problem, not an engineering problem.

Without prices, how would the socialist planner know what to produce? He could take a poll and find that people want bread, meat, shoes, refrigerators, televisions. But how much bread and how many shoes? And what resources should be used to make which goods? "Enough," one might answer. But, beyond absolute subsistence, how much bread is enough? At what point would people prefer a new pair of shoes rather than more food? If there's a limited amount of steel available, how much of it should be used for cars and how much for ovens? Most importantly, what combination of resources is the least expensive way to produce each good? The problem is impossible to solve in a theoretical model; without the information conveyed by prices, planners are "planning" blind.

In practice, Soviet factory managers had to establish markets illegally among themselves. They were not allowed to use money prices, so marvelously complex systems of indirect exchange--or barter--emerged. Soviet economists identified at least 80 different media of exchange, from vodka to ball bearings to motor oil to tractor tires. The closest analogy to such a clumsy market that Americans have ever encountered was probably the bargaining skill of Radar O'Reilly on the television show M*A*S*H. Radar was also operating in a centrally planned economy--the U.S. Army--and his unit had no money with which to purchase supplies, so he would get on the phone, call other M*A*S*H units, and arrange elaborate trades of surgical gloves for C-rations for penicillin for bourbon, each unit trading something it had been over-allocated for what it had been under-allocated. Imagine running an entire economy like that.