The Market Process 14:39

The knowledge of how markets operate is a cornerstone of libertarian thought. Boaz goes over key concepts in economics including prices, profit and loss, the division of labor, trade, and entrepreneurship.


David Boaz: So why do we need markets? Basically because we would all starve to death without markets. And it’s not we who would starve to death. There wouldn’t be 8 billion people on earth without markets. There would be far, far fewer people because most people would never have been born. Why is it that markets work? Well, one answer is because we are a species who can accomplish more by working together than we can individually. And we can recognize that. If we couldn’t recognize it, then we wouldn’t engage in market cooperation. But we do recognize that there are so many things that one person couldn’t do. Robinson Crusoe on a desert island can accomplish only so much. He maybe has time to weave a net in between actually catching fish and picking nuts and berries to survive. When you get one more person and then more people and more people, you get to cooperate to achieve a great deal more, and we understand that. And therefore, we need social institutions that make that possible. What makes possible markets is private property, understanding that this is mine and that is yours and we can trade it, we can combine it, we can give it away, whatever. But we start out understanding that this is mine, that’s yours, that’s hers, everything has an owner, and then we can work with it. Otherwise, we would all be enemies. We would be constantly trying to get the wood in order to build a house, the water in order to survive, the land in order to grow food. If it didn’t belong to anybody, we would all be trying to grab it, and we would be enemies of each other. So we understand that we want to cooperate. Markets, under the few limited rules, make that possible.

As markets develop, they allow us to undertake longer processes of production. Instead of just fishing today, we take the time to make a net. We take the time to build houses. Eventually, we build machinery and factories. And all of that requires capital investment. It requires producing more than we eat today, so that we have time and so that we have a division of labor to work on it. Prices are an integral part of the market system. Prices pool together information and make it usable. How do you know whether society needs more steel or more aluminum or more corn? Prices tell you. And you don’t have to know why there’s a rising demand for corn. All you have to know is the price of corn is rising. If I have land, I should probably plant more corn. Or if the price of corn is falling, maybe I don’t need as much land planted in corn. And of course that’s what’s happened in the United States. We’ve become so much more productive agriculturally that fewer and fewer people are involved in producing agricultural products, and they can move on and do something else. But prices are a form of information. They tell us what is being demanded by other people, and they do so in a very usable, easy way, a way that is so usable, we don’t even pay any attention to it. Prices are just a natural condition, but they have to be there in order for us to make those kinds of decisions. If something can’t be produced at a cost we’re willing to pay, prices will give us that signal. I would like to have a yacht. I’d be willing to pay $10,000 for it. Well, it turns out you can’t produce a yacht for $10,000; therefore, yachts are not going to be produced for people like me. Other things that I would buy will be produced, and I send those signals in the marketplace. When the price of apples goes up, I buy more oranges. That sends a signal, plant more oranges. It may help drop the price of apples because now fewer people are buying them. All of those things are signals, and they help us to produce more things that people want.

When socialist societies, like notoriously, the Soviet Union, try to eliminate prices, because they said that’s a capitalist tool, what happens? It means they have no idea what people want. They say, “Let’s produce more refrigerators.” Well, the first problem with producing refrigerators is you have to produce some steel and you have to produce some vacuum tubes and you have to produce glass and all these other things. But how do we know the glass should be used in refrigerators instead of automobiles and windows? Prices tell you that. And in the absence of prices, you’re just guessing. You’re saying, “Well, we should produce 100,000 refrigerators.” Why? You have no idea. That’s why some intelligent socialist once said, “When we take over the whole world for communism, we will keep New Zealand as a capitalist society.” Somebody said, “Why would you let New Zealand stay capitalist?” “So we’ll know how much stuff costs,” because the way the Soviet Union knew whether you should produce more cars or more refrigerators was they looked over in the capitalist world and they could see the relative costs and say, “Oh, I guess cars are like 10 times more important or costly. Cars require 10 times more resources.” New Zealand would be able to give them those signals.

Prices indicate what people are willing to pay on the margin. All of our economic decisions are made on the margin. Do I want this steak? Do I want one more book? Do I need a 3-bedroom house? Do I need power steering in my car? Well, how much does it cost? That’s what you ask. When the automobile dealer says, “Do you want power steering?” “Well, how much extra does that cost?” “Oh, $500, no, I don’t need it for that.” “Well, what if I give it to you for $250?” “Okay, I’ll do that.” That is sending a signal, and it’s telling them how much power steering to produce. This is how much people want it. That’s what we mean by on the margin. The decisions people make, “I have to buy enough food every day to eat.” On the margin, how much am I willing to pay for better food or for more food or for healthier food? Prices are sending us that signal.

Some people say, “Markets make people greedy.” I don’t think markets make people greedy. I don’t think markets induce self-interest. Markets recognize the reality of self-interest and create incentives to cooperate and serve others. We are all self-interested. We want to make a better life for ourselves and our families. One way to do that is to hit other people and take what they have. Another way to do it is to figure out what other people want and offer it to them in exchange for something they have that you want. And healthy societies figure out that the latter is better. I saw a cartoon once, just a newspaper cartoon, but it shows one guy saying to another, presumably a long time ago, “You have something I want. I’m either going to take it or buy it.” And the title of the cartoon was History. And that’s kind of right. That is the story of history. People started out saying, “Let’s get a gang together, the Vikings or Genghis Khan or whatever, and let’s go take other people’s stuff.” And then at some point, they found out first that if you settled down in one place and you just told people we’re going to take 25 percent of your stuff every year, that’s actually more efficient. And even the people who are being exploited prefer it to random raids by the Vikings. But second, they figured out, “You know, we’ll actually end up with more stuff for less trouble if we just start trading, buying and selling.” And that is the story of civilization. That’s how we get richer. But the point is everybody is self-interested. It is not markets making us greedy. It’s markets allowing us to satisfy our self-interest without raping and killing and pillaging.

Important topics in understanding free markets include division of labor. What is the division of labor? As a market gets bigger, it allows us to specialize. It allows us to divide our work. We’re on a desert island. I’m fishing, you’re collecting nuts and berries, and we trade. And presumably, by specializing, I could do the nuts and berries and the fishing. But because I fish, I develop better techniques for fishing. You develop better techniques for finding nuts and berries. Therefore, we have a higher total product, and if we trade, we’re both better off. The more people there are, the more we can specialize. Adam Smith talked about the pin factory. Can you believe there are 18 different functions involved in creating a pin? But because one person does each one of those things, he gets better and better at it. So rather than one person being able to produce 10 pins a day, a group of people can produce many more than 10 pins per person because they’re specializing and they’re dividing up the labor. And again, markets encourage that. They encourage people to find ways to collaborate better. Non-market institutions just can’t do that. They can order people, “You fish. You go look for nuts and berries.” They don’t have much incentive for people gravitating to the thing they’re actually good at or they enjoy, or hopefully, they both enjoy and are good at or can develop skill at. 

One of the important things in the market is the role of entrepreneurs. We think of entrepreneurs just as businessmen. But what entrepreneur really means is somebody who sees opportunities, somebody who sees something missing. It may be, “Hey, there’s no pizza in this neighborhood. Maybe I should open a pizza place.” It may be noticing that kiwis sell for more in the United States than they do in wherever they originally come from. So I could ship them over to the United States and make more money. It may be thinking of something nobody knew they wanted. Steve Jobs said, “If I create an iPhone, people will want it.” But he didn’t know. He was gambling. And plenty of people have created things that it turned out people didn’t want. And then that resource is wasted. We want the best entrepreneurs to keep coming up with ideas, and the way we do that is we reward them with profits so that they will have a chance to come up with more ideas. Entrepreneurs are noticing opportunities that other people don’t notice. And that is sort of the purest economic activity, figuring out how resources could be combined to make something that serves people’s needs better than what we have now. 

When entrepreneurs do that, some of them make profits, some of them make losses. You sometimes hear people demand windfall profits taxes. They say if an entrepreneur makes too much money, the government should take part of his profit, the windfall profit. Nobody ever, I think, suggested a windfall loss system where entrepreneurs that lose money should get half of their losses subsidized by the government. Now I say that in some theoretical way that’s true. But of course, we do know that there are bailouts. There are lots of bailouts in our modern society, but they’re not the dominant aspect of society. The dominant aspect of the market is if you make the right decisions, if you satisfy customers best, you make profits, and that encourages you to go on making more products and services that will satisfy consumers’ needs. And if you are not good at identifying what other people would want in satisfying their needs, then you will make losses, and you will have fewer resources with which to make these mistakes. 

Government also often looks at prices in the market and says, “These prices are unfair. Some people are making too much. They’re charging too much for their products, and people are being paid too little for their labor. Let’s set a price ceiling. Let’s set a price floor.” Maybe it’s a wage floor. Maybe it’s a price ceiling. When they do that, there an interesting question. Are they violating the First Amendment? They are interfering with communication. They are interfering with the communication of information. That is arguably not allowed under the First Amendment. But it’s also bad economics. This happens often after a natural disaster. The price of ice, the price of generators, the price of clean water may go up. And what does the government do? It puts a ceiling on the price. What happens when the government puts a ceiling on the price of water? Entrepreneurs 500 miles away, who were about to load up a truck and drive to New Orleans with clean water, say, “What’s the point? If I can only sell it for $2 a bottle there, it’s not worth driving to New Orleans.” So there will be less water just when the people of New Orleans need water. And price floors, of course, mean that producers will try to produce more than can be sold. And that is particularly true in the case of labor. If you put a floor under the price of labor, it means less labor will be demanded. If you can’t purchase labor for $7 an hour because there’s a minimum wage law of $10 an hour, then any labor that’s only worth $7 to you will not get purchased at all, and people whose marginal product is only $7 will not get employed.