Patterico's Pontifications


“Human Action” and Robert Murphy’s “Choice,” Part 9: Defining and Studying the Market Economy

Filed under: Economics,Human Action and Choice — Patterico @ 12:56 am

This is Part 9 of a 17-part series of posts summarizing Bob Murphy’s indispensable book Choice: Cooperation, Enterprise, and Human Action. Murphy’s book is itself is a summary of Ludwig von Mises’s classic treatise “Human Action.” Like previous posts, this post is a summary of a summary.

The purpose of these posts is to popularize and spread the word about Austrian economics and educate the public. Rather than list all the previous parts, I have created a category for all these posts, called “Human Action and Choice,” so that all these posts can be read (in reverse order) with a single click. Note well: any errors in these summaries are mine and not Murphy’s.

Mises describes the market economy as a “process” — as “the social system of the division of labor under private ownership of the means of production.” It is the way individuals coordinate their activities voluntarily, acting on their own behalf, but aiming to satisfy others’ needs as well as their own.

Mises studies what would happen in a pure market economy even though no such economy actually exists. Some criticize this as unrealistic, but any policy proposal requires one to conduct a thought experiment about how things would be, if one’s proposal were accepted. This is no different.

We must now classify different people in the economy and the money they receive for what they provide. Workers provide labor and receive wages. Landowners and capitalists provide similar things as one another, and both receive interest. (While land, or natural resources, is not man-made, it is similar to man-made capital in that it provides entrepreneurs a head-start in time in the production process. More on this later.) Entrepreneurs adjust the factors of production in anticipation of the future, and receive profits when their foresight is accurate.

More definitions: Capital is the market value of assets minus the market value of liabilities. Income is the amount of consumption that can occur without reducing capital. Saving is the difference between income and consumption.

Mises was very clear that in a capitalist economy, the consumer is sovereign. The notion that everything is controlled by guys with white mustaches and top hats carrying around giant sacks with dollar signs on them (thanks to Tom Woods for the image) is a socialist fabrication. According to Mises, a businessman may be at the helm of the ship, but he has to obey the captain’s orders — and: “The captain is the consumer.”

Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt, and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.

The steering by consumers is not always explicit, of course — but it happens nonetheless. Murphy gives as an example two entrepreneurs, a jeweler and a house builder. The jeweler makes pretty and affordable jewelry with gold, while the builder makes houses that are lined with gold inside and out, in the manner of European kings, making the prices of his houses astronomical. If people buy the jewelry, but reject the houses as too expensive, this means the consumer has steered the use of gold into jewelry rather than house-building. It’s not that the consumer explicitly told these entrepreneurs to use gold for one purpose, and not to use it for another . . . but in effect the consumer did communicate that message, through his decision to buy jewelry, but not absurdly priced houses.

In this way, price signals allow entrepreneurs to direct the economy’s resources in such a manner that they best satisfy the preferences of the consuming public. Rather than having government make arbitrary decisions, people vote with their dollars. There is, in this process, a deep connection between economic freedom and political liberty. Mises said:

No government and no civil law can guarantee and bring about freedom otherwise than by supporting and defending the fundamental institutions of the market economy.

This is critical, and I believe it with every fiber of my being. There is no political liberty without economic freedom.

Competition is what gives market actors freedom within the market economy. Workers who feel exploited can work elsewhere. Consumers who don’t like the product can buy elsewhere. (Try doing that with government!) But competition is a process, and while a snapshot at any given time may cause one to believe incorrectly that there is no competition, because one firm has a large market share, that is usually shown to be wrong over time. As long as government does not impose barriers to entry, lack of competition is an indication that the current goods and services are being provided at an adequate price. Meanwhile, any industry that appears to be a dominant and overbearing force is either a) a product of government, and/or b) faces extinction when technology finds a new way to accomplish the same goal in a better, cheaper way.

The railroads seemed like a monopoly at one point, Mises noted — and indeed, the lack of competition at one point in time showed that there was really no reason for other firms to invest in more rail lines, when the existing ones were sufficient. But this did not prevent the invention of the automobile or the airplane.

Next, we consider what Murphy calls “the vexing issue of (in)equality.” Murphy explains that “inequality of income and wealth is an unavoidable feature of a market economy.” If there are 100 people, and two are singers, and 98 are fans, the 98 may be willing to work a little harder to give money to one of the singers. The 98 fans may be willing to work a lot harder to give a lot more money to the other singer. This will result in the singer who makes the most people happy gaining a greater income and having more wealth — but if you changed this system, it would prevent or negate voluntary transfers, and might have an effect on the satisfaction of the consumers.

Once the critical role of monetary calculation in allocating resources is understood, it becomes clear that governmental redistribution of income impairs economic calculation and the proper distribution of scarce resources. Price signals are distorted and the consumer is less satisfied.

Another implication of monetary calculation is that the most efficient allocation of resources (satisfying the most people) can happen only in the pure market economy. Government cannot allocate resources efficiently, because the profit motive is alien to government bureaucracy. Bureaucratic management is different from profit management, not just in incentives. Bureaucracy need not convince consumers to voluntarily part with their money, and can (unlike businesses) prevent competition. Thus, the forces that make resource allocation efficient in the market economy are utterly absent in bureaucracy.

Enough for today. We’re over halfway done with the book! I hope this made sense. These are central concepts that show why the market is better than governments in allocating resources. Tomorrow, we’ll discuss how prices are formed on the market.

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