An Essay into the Nature and Causes of Poverty — Part 3

It is hard to overemphasize how critically important exchange is in any economy, including that of primitive hunter-gatherer societies. Only hermits who voluntarily choose to live in extreme isolation don’t engage in exchange, and those who are marooned on deserted islands are forced to be self-sufficient.

Exchange 

For the rest of us, we rely on exchange for meeting practically all our needs. Just reflect on the fact that every one of us consumes a very tiny fraction, if anything at all, of what we actually produce. The factory worker produces cars but most of his consumption consists of non-cars; the doctor produces medical services but consumes very little of that; similarly the architect, the farmer, the green grocer, ad infinitum. 

Exchange allows us to decouple our consumption from our production. Production allows us to consume but without exchange, we would produce very little, and therefore consume very little. 

Later we will consider production but for now let’s continue our focus on exchange, assuming for now that we have what we have produced or acquired as gifts and inheritance. Suppose you have some oranges and I have some apples. What we have we call our endowment. 

We have a natural preference for variety. I have apples but I also like oranges, and vice versa for you. If we choose to trade apples and oranges, then both of us are better off after the trade than we were before the trade. The claim that the trade was mutually beneficial is evidenced by the fact that we voluntarily traded apples for oranges. We stop trading when we have exhausted all possibilities of mutual gain. After the trade, each of us ends up with a different basket of apples and oranges than we started with.

Also in the process of trading, we found out the exchange rate between apples and oranges. We discovered a price — the price of apples in terms of oranges (and conversely the price of oranges in terms of apples.)

Markets

We have a particular name for where exchanges take place. It’s called the market. The market is often a physical place but it need not be. Also, for the moment we will consider the market to be just a place where exchanges happen but a more inclusive way of understanding the market is to recognize it to be a dynamic process that unfolds over time. But that’s for later.

When a buyer and seller conclude a trade, we say that the market “clears.” If the buyer and the seller could not agree on a price for the trade, we say that the market did not clear. Perhaps the buyer was offering a price that the seller considered too low; or the seller was asking a price that the buyer considered too high. The market failed to clear. The traders could not agree on a price. 

Another reason for the market to not clear could be because of imperfect information. If the buyer does not know of the existence of the seller, or the seller does not know that there’s a buyer, then the trade would not take place. The mechanism developed to help the seller find the buyer is through advertising. Advertising is valuable for that reason.

Naturally, there’s a cost to advertising. In the pre-internet days, newspapers and radio were the only mediums for broadcasting advertising messages. These days because of the internet and widely available computing and communications devices like computers and smartphones, the cost of advertising has fallen. We say that the “transaction costs” have fallen. 

Free Markets

In my professional opinion, the market is humanity’s greatest invention. All other inventions flow from it. Without it, we would not have the wealth we enjoy and so easily take for granted. We can be sure that markets have been around for at least 10,000 years — from the time of settled agriculture — and perhaps even earlier than that  if hunter-gatherers bartered things amongst themselves.

However, what are called “free markets” must be a more recent innovation. The market reaches its true potential as the engine that generates wealth when it is a free market. The importance of free markets cannot be over-emphasized. Every educated person should know what that is and why it is so important. 

If Bob wants to sell apples in the market but cannot do so without a permit from some official, that’s an entry barrier. If Jim wants to buy apples but needs some officials permission, that’s an entry barrier. If Bob does not want to sell his apples but is forced to do so, that’s an exit barrier. If Jim doesn’t want to buy apples but is forced to do so, that’s an exit barrier.

The defining characteristic of a free market is the buyers and sellers are free to enter and exit at will without any third party forcing them to enter or exit the market. The operative word is force. When force enters the picture, the market is not free.

Here are some examples of markets that are not free. Consider the slave labor market. The enslaved person is forced to “sell” his labor; he cannot refuse to work for the “master.” The enslaved cannot exit the labor market. 

Consider the market for labor with a minimum wage law. Bob wants to employ Jim at $10 an hour and Jim is willing to work for Bob at that wage, but the state (the third part) imposes a $15 minimum wage, a wage that Jim is not willing to pay. That means Jim is not free to sell his labor below the minimum wage. Jim is being prevented from entering the market as a seller, and Bob is being prevented from entering the market as a seller. 

Free Trades are 2-Party

Exchange or trade in free markets is always between two parties — the buyer and the seller. There is no third party. If there’s a third party which intervenes in any trade between those two parties, it ceases to be a free market. The third party imposes entry or exit barriers and by doing so prevents free trade. The third party is usually the government or the state. The instrument that the third party uses to intervene in the market is physical force, usually involving guns and other lethal weapons.

The state imposes its will on voluntary exchanges through legislation that require permits, and permissions, and licences and quotas. All of them prevent the market from operating by preventing voluntary trades between two parties. As a result, wealth which could have been generated does not obtain.

You may ask, are there any instances anywhere in the world where markets are truly free? The answer is no. All markets to varying degrees are not free in all parts of the world, rich or poor. When you pay sales tax, or an income tax, or an import duty, or a license fee, … the list goes on, you are not in a free market. If you don’t pay the sales tax, you cannot buy, for example. It’s not a free market. 

But those parts of the world where the markets are relatively free are more prosperous than where markets are less free. Poor countries are made — and kept poor — by the state’s interference in free markets. A major cause of the poverty of nations is government  intervention in markets.

The positive analysis of markets shows that free markets are the engines of economic prosperity. The normative analysis follows from that — to increase economic prosperity, the state should remove all barriers to entry and exit from markets.

Free markets and free people are conjoined twins. You cannot have one without the other. How can any people be considered free if they are not free to engage in trade?  Note that I did not write, “free to engage in voluntary trade” because the word “voluntary” is implied in trade. If an activity is coerced, it is by definition not trade. It’s the imposition of one person’s will on another.

Why don’t states allow free markets when it is clear that free markets lead to prosperity? Because of a basic asymmetry between costs and benefits: the people suffer the losses and the functionaries of the state enjoy the benefits. The state’s functionaries are able to extract bribes and other legal and illegal payments for licenses, quotas, permits and permission. 

The more extractive and exploitative the state, the less free are the markets. The less free the markets, the less prosperous the people, and the more prosperous the politicians and bureaucrats. 

Black Markets

There are many trades that are prohibited by the state. These are illegal and consequently the market does not legally exist for those trades. But humans are inventive. The trades don’t stop but only go underground. Those markets are pejoratively labeled “black markets”. Black markets are good in the sense that they circumvent the state-imposed barriers to trade and mitigate some of the harm that a lack of legal markets entail.

Examples abound. Prostitution is one such. Another is trade in illegal substances. Smuggling of goods. Employing unlicensed labor. All illegal occupations generate income which cannot be revealed to the state, and therefore the state is unable to tax that income. That income becomes “black money.” 

Struggle for Freedom

The focus in this part was on markets because without exchange, we would all be not just poor but in fact dead. We couldn’t survive if we could not exchange. The most efficient mechanism for exchanges is a free market. Free people trade in free markets, and to the extent the market is not free, the people are not free. And if the people are not free, they are not prosperous.

In the next bit, I will focus on a necessary condition for trade: private property. Without private property there can be no exchange. And no exchange, once again, means no creation of wealth, and therefore poverty.

India, like all other poor countries, severely restricts markets, The US and other advanced, industrialized, rich nations have relatively freer markets. India can become richer but the government being what it is will not allow that. The politicians and bureaucrats have too much to lose if Indians are allowed to be free. 

This is not surprising. The British exploited and extracted wealth from Indians during their rule. They created all the institutions, the rules and laws necessary for them to profit at the expense of the Indians. After the British left, the new rulers absolutely loved the opportunity to do their own exploitation and extraction. So they kept the controls the British had established and imposed some new ones — to better extract and exploit.

It’s a sad but little known story. That’s why Indians should educate themselves and seek to free themselves from their rapacious government if they are to stop being poor.

Next part: Part 4. Previously in this series: Part 1 and Part 2.

{Image at the top of the post: A 750 ml bottle of Patron Tequila at my local Costco for $5,999.99. I will buy it when I have a little more spare change.}