Freeman

THE CALLING

Markets Are Messy

That's just them at work.

NOVEMBER 10, 2011 by STEVEN HORWITZ

We defenders of free markets often find ourselves responding to two kinds of criticism. One takes the form of pointing out imperfections in real-world markets and using those to argue why markets don’t work and why government intervention is necessary. The other is a sort of frustration that we can’t explain exactly how markets will solve some particular problem. This second criticism says in effect: “If you can’t explain how markets will do something, why should I believe that they will do it?”

I think these two lines of criticism are connected and serve as a reminder about how defenders of free markets should respond. The link is that both overlook the nature of markets as a discovery process — albeit a messy one. Expecting markets to be perfect or for us to know ahead of time how exactly people will solve problems using the market is to misunderstand what markets do, how they do it, and why they are our preferred problem-solving process.

Dispersed, Tacit, Contextual, Imperfect

To understand why markets are discovery processes, we first have to recognize that the fundamental problem facing any attempt at social cooperation is that human knowledge is dispersed, tacit, contextual, and imperfect: Each of us knows different things; we may not be able to articulate what we know; our knowledge might only be relevant in particular contexts; and what we think we know might be wrong. The challenge, as F. A. Hayek put it in his most famous essay, “The Use of Knowledge in Society,” is how to enable other people to use the knowledge we possess so that we can collaborate in order to allocate resources more effectively to  improve living standards. The problem of social cooperation and economic growth is a problem of how best to use knowledge.

Thus the role of competition in a free market is to help us discover both what consumers want and how best to produce it by making that dispersed knowledge socially available. The key to doing so is the role prices play as knowledge surrogates. They signal to producers and consumers what people know and what they value, and enable us to coordinate our behavior appropriately. Profits and losses tell us afterward if we made the right choice. The competitive market process is best understood as a way for us learn what we otherwise would not know. Just as we figure out which baseball team is best by playing the game, so do we figure out how best to produce things by letting competition take place.

But let’s face it: Competition is messy. Because it’s a discovery process, entrepreneurs will always be making mistakes. They’ll try new products and consumers won’t want them (the Ford Edsel or New Coke). They’ll try to make existing products in new ways that turn out not to be profitable either because they are too costly or consumers don’t like the change. Entrepreneurs may overlook what in retrospect seems like an obvious opportunity. Failure is just as important to the functioning of the market as success. The result is that at any moment, markets look messy as mistakes are made and entrepreneurs try to figure out how to correct them. Real-world markets, unlike the equilibrium models many economists rely on, can never be perfect since they are always in the process of discovering.

No Advance Notice

The messiness of markets also explains why we cannot know ahead of time exactly how people will solve problems using the market. Expecting a detailed response to that criticism is equivalent to expecting a scientist to tell you what her research will discover before she begins! The justification of scientific freedom is that we can’t know in advance what will be discovered, because if we did, we wouldn’t need science. The same is true of the market: If we knew how markets would solve problems, we wouldn’t need them!

The response to these criticisms then boils down to explaining why we believe markets, as messy as they are, will solve problems better than government intervention. In a number of previous columns, I’ve discussed why the role of profit and loss cannot be duplicated by government and why government cannot access the knowledge generated by the competitive market process.

My point here, however, is that the messiness of the market is not a problem but a sign of its health. It is the discovery process in motion, helping us imperfect human beings to learn what to produce and how to produce it, both of which we could not otherwise know.

Dispersed,

ABOUT

STEVEN HORWITZ

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

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