Wealth of Nations — Part 5: Markets

I like to quote Ludwig von Mises to my socialist friends (who also do double-duty as the enemies of humanity in keeping with their ideology). Mises wrote, “A man who chooses between drinking a glass of milk and a glass of a solution of potassium cyanide does not choose between two beverages; he chooses between life and death. A society that chooses between capitalism and socialism does not choose between two social systems; it chooses between social cooperation and the disintegration of society. Socialism is not an alternative to capitalism; it is an alternative to any system under which men can live as human beings.”

Socialism Equals Misery

That it’s not mere exaggeration and hyperbole is clear from the fate of socialist economies, both contemporary and of the past. Socialism impoverishes nations. But why? Because socialism does not use markets to conduct economic activities. Instead of voluntary exchange in free markets, socialism uses force and coercion, command and control. That leads invariably to the disintegration of society.

The sad truth is that most people are simply not aware of what markets are and why they are important. Paradoxically, most people (even in socialist nations) use the market to get on with their lives, even if they don’t fully appreciate why markets work, and how they work.

I don’t mean to insult the intelligence of the readers of this blog (who are obviously a discriminating lot considering that they read this brilliant blog) but it is never a waste of time to review the fundamentals every now and then. And so in this piece, I am going into the fundamentals of what a market is, what a free market is, and why the absence of markets guarantees material misery.

The wealth of all nations arises from the use of markets. Note all nations, even the socialist nations. The socialist economies benefit from the wealth that markets in the capitalist nations create.

I feel uneasy using the word capitalist. It is not very well defined and consequently has a lot of baggage. I am with Douglass North when he said that he avoids using the word capitalism because he does not know what it means. I prefer to use the phrase “a system of private property rights and free markets” instead of capitalism.

Markets

A market is a place (not necessarily a physical space) where exchanges take place. An exchange is a transfer of something between two parties. Thus an exchange of a sandwich for money between a buyer and a seller establishes a market for that sandwich. The seller is willing to let go of the sandwich at a price that the buyer is willing to pay for the sandwich. This simple act of giving and receiving establishes a price that is negotiated between the two parties.

The important thing to note is that this exchange, or trade, is entirely voluntary. There is no compulsion involved. Either party can simply walk away from concluding the deal. If the deal does indeed go through, then one thing can be established with complete certainty: it implies that both the buyer and seller have benefited from the trade because if either of them had felt that it was not to his benefit, the deal would not have happened.

Conclusion: all voluntary exchanges are welfare improving. This is the most amazing thing in our material world. The simple act of voluntary exchange leads to benefits. No new thing is created. Both before and after the trade, the amount of stuff remains the same and yet the two parties in the exchange walk away more satisfied than they were before the trade. Note that nothing was produced nor consumed in this simple exchange. Just a trade.

Now multiply this one solitary, simple act of exchange a gazillion times as happens in the world every day, and you have enormous increases in welfare among the buyers and sellers. Voluntary exchange is the great unnoticed, unsung miracle of the material world.

Private Property

There’s another thing we need to pay attention to: ownership. For trade to occur, it should be clear that someone owns something. That means the sandwich is owned by someone prior to the exchange, and that someone has the rights that are associated with owning the sandwich. The act of exchange transfers those ownership rights to the buyer from the seller.

All this is painfully clear and one may object to the stating of the obvious. But it’s important to keep this in mind as we move from the obvious to the non-obvious. Property rights — the notion that something is owned by someone — has profound implications for human welfare. If it were not clear who owns what, it leads to all sorts of avoidable misery.

Free Markets

A market is where ownership rights are exchanged between owners of different goods. For example, one person gives up the rights to a sandwich and the other gives up the rights to some agreed upon amount of money.

A free market is one in which there are no barriers to entry into the market, and no barriers to exit from the market. Not only are the exchanges completely voluntary, but who can be buyers and who can be sellers are entirely voluntary. Free entry means anyone can if he chooses be a seller (or a buyer) and anyone can refuse to be a buyer (or a seller) in the market place. In a free market, there is no compulsion to be a buyer or a seller, and no one preventing another from being a buyer or a seller.

Free markets allow competition between sellers. Each seller of some particular good competes with other sellers to attract buyers. And each buyer competes with other buyers to get the stuff that sellers are offering. The sellers don’t compete with buyers, and buyers don’t compete with sellers. Only parties on the same side of the market compete with each other.

Each act of voluntary buying and selling is conducted at a price that is mutually agreed upon between the buyer and the seller in a free market. The prices of various goods are thus arrived at through those myriad exchanges of those various goods. The prices in a free market are not dictated by a third party. Instead, the prices emerge from the decisions of buyers and sellers. The prices are the result of human action but not a result of human design, to paraphrase Adam Ferguson, one of the pillars of the Scottish Enlightenment.

Price Controls

As noted above, when exchanges take place at mutually agreed prices, both parties benefit from the trade. If a third party — say the government — intervenes and sets price limits, then it prevents certain trades from occurring that would have otherwise occurred in the absence of those controls.

Price controls hurt both parties for sure. Consider minimum wage laws. That sets a price floor, meaning one cannot be paid less than that wage. Imagine that I can only produce $10 worth of value for an employer. Therefore I can be hired for no more than $10 wages. But if the minimum wage is set at $15, I will not find work because no one would be willing to pay me the $15 and get only $10 worth of work out of me. That trade — my labor by $10 — will not take place. I am out of work and the potential employer out of an employee.

Multiply the loss of benefits to lower-than-minimum wage productivity workers like me a million times and you’d guess the overall social welfare loss.

Barriers to trade are the single most important source of avoidable economic losses to society. Barriers to entry into and exit from markets are barriers to trade. Socialism enforces barriers to trade and over time leads to immiserization, poverty and economic dysfunction.

The idea of free markets is unique in its power to create wealth.

(The cartoon at the head of this post is really interesting. It is instructive in ways that its creators perhaps don’t understand. Think about it and post your views in the comments below. This one below is good for a laugh.)

3 thoughts on “Wealth of Nations — Part 5: Markets

  1. Consider minimum wage laws. That sets a price floor, meaning one cannot be paid less than that wage. Imagine that I can only produce $10 worth of value for an employer. Therefore I can be hired for no more than $10 wages. But if the minimum wage is set at $15, I will not find work because no one would be willing to pay me the $15 and get only $10 worth of work out of me. That trade — my labor by $10 — will not take place. I am out of work and the potential employer out of an employee.

    If only it were that simple!
    There is usually a huge asymmetry between employers and employees in power and knowledge.
    Naive young people (interstate immigrants, say from Bihar to Mumbai) have no idea how much their labor is worth, and too easily undersell themselves. Employers leave no stone unturned to exploit their naivety or lack of other opportunities.

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    1. There is another explanation to consider. The employer in such a case simply passes on the difference to the consumers of his product or services. In the U.S., the minimum wage is not set arbitrarily or intentionally high but is based on the existing price structure, inflation over the years, etc. If ones skill set is limited, the employers may hire them as independent contractors, per task basis like a lawn mover. Other societal issues are overproduction of children by thoughtless parents and greed of the business owners. This is nothing new. My two cents. Thanks.

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