The Economic Way of Thinking Part 3: The Free Market System
No free market can exist without several necessary conditions.
DECEMBER 01, 1993 by RONALD NASH
Dr. Ronald Nash is a contributing editor to The Freeman and professor of philosophy and theology at Reformed Theological Seminary in Orlando. He is the author or editor of 25 books including Poverty and Wealth: Why Socialism Doesn’t Work (Probe Books) and Worldviews in Conflict (Zondervan).
Prior segments of this eight-part series explained the nature of economics, especially the way in which scarcity forces us to rank our options and make choices. They also discussed the importance of recognizing that all economic value is subjective. A necessary third step in becoming economically literate includes understanding what “the market system” is and how it operates.
Different Kinds of Markets
One reason some people have trouble grasping the meaning of the word “market” is because the word is used to refer to trading in different kinds of commodities as well as to trading that goes on at increasingly general levels. For example, a mother can tell her son to run over to the market and buy six ears of corn. The owner of that store can tell one of his employees to go downtown and buy twelve dozen ears of corn from the market; in this second case, the market is a single seller (or group of sellers) who wholesales to merchants. The wholesaler may then ask someone to check how corn is doing that day on the futures market. For a single commodity like corn, there are a number of different markets.
Markets differ of course in more ways than size and general level. We speak of different markets for different kinds of things. There are stock markets and bond markets. There is the new car market and the used car market. There are markets in which collectibles like coins, stamps, paintings, and even comic books are traded.
The word “market” in this essay does not refer to any of the specific markets already mentioned, although it does include them. Specific markets are places where two or more people exchange goods and services. The market that I’ll be discussing is the set of procedures or arrangements that prevail throughout a society which allows voluntary exchanges. In one sense, the market is the framework of customs and rules within which specific voluntary exchanges in specific markets take place. Instead of talking simply about “the market,” we could refer instead to the market system.
The Market System
What economists call “the market” is not a specific place or thing. Neither is it simply the collection of particular markets in which goods and services are exchanged. Rather, it is a spontaneous and impersonal order of arrangements that serves as the framework within which individual human beings make economic choices.
One example of a spontaneous and impersonal order is an urban traffic pattern. As a city develops and grows over a long period of time, certain traffic patterns evolve. Anyone getting into a car in preparation for a drive across town must make numerous choices in response to such things as one-way streets, traffic lights, stop signs, and speed limits. Such traffic patterns are impersonal because they apply to everyone; they were not designed just for college graduates or white people or Presbyterians. The traffic order is also spontaneous in the sense that it evolved more as a result of trial and error than as the end product of a 50-year plan. People learned that traffic flowed more safely and smoothly, for example, with a traffic light at one intersection and a stop sign at another.
While the traffic pattern lays down rules, people still have a considerable degree of freedom as to how and where they will drive. The traffic pattern does not force anyone to drive down only one street, for example. This example of an urban traffic pattern illustrates how a spontaneous and impersonal set of arrangements can help produce order, prevent chaos and harm, and still allow for a considerable degree of individual freedom.
What we call the market functions in much the same way. It lays down rules that provide a framework for economic exchanges. Among other things, those rules say that people should not be coerced into making economic exchanges. Such exchanges should be free from force, fraud, and theft. People should honor their contracts.
Economist Ludwig von Mises once referred to the dynamic character of the market by describing it as a process. The market is not static; it is in a constant state of change. How could it be otherwise since behind the actions of people in the market lie the innumerable and constantly changing value judgments of that countless number of economic agents?
No human invented the market process. It is an impersonal social institution in which individual people make economic choices in accord with their personal value scales. The market simply provides the institutional order or the framework of rules within which these choices are made.
The Market and Social Order
One of the more remarkable features of the market is the way it produces order where we might well expect to find chaos. One way to see the emergence of such order is to reflect on the extraordinary way in which the most ordinary wants of people in a free society are satisfied. The reader can do this by making a list of all the goods and services he wants and finds obtainable over a period of several days. My own list would begin with orange juice from Florida, coffee from Brazil, and toast made from wheat grown in Kansas, milled into flour in Illinois, and baked into bread in Tennessee. My list would also include shoelaces, a razor blade, toothpaste, shampoo, clothes, gas for my car, and the paper on which I am writing these words. For each of us, the list would be very long and complicated.
Most of us lack the ability to make or provide most of the goods and services we want. How then do we persuade others to do all these nice things for us? When I go to a grocery store, the things I want are there. This is just as true of the drugstore, the gas station, and the department store. When I need a plumber or electrician or dentist or auto mechanic, someone is there ready to satisfy my want. Do people supply all these nice things because their primary goal in life is to make me happy? I think not. People do all these wonderful things for me because of their prospect of receiving something in return, usually money. And where do I get the money I use to pay all these people? I receive it from still other people who pay me for performing some service or providing some good for them. Reflecting about the market in this way helps us better understand the extent to which we depend upon other people. All of us need other people to supply the goods and services we have come to depend on. But we also need people who will pay us for the goods and services that we can supply, thus providing the money we require to pay those who supply our wants.
The Market System and Human Specialization
In more primitive times, people were often forced to provide for all or almost all of their wants through their own efforts. And so the same individual might have to make his own clothes, grow his own food, build his own house, and so on. A market economy permits people to specialize in those things they do best. Some people are better at plumbing than they are at teaching philosophy. Some are better auto mechanics than preachers. This specialization enables most of us to do a better job with our time and effort. But this specialization also increases our dependence on others.
Supply and Demand
While it sometimes happens that the supply of some good may be too great or too small, these occasional glitches in the system are short-lived. It is worth pondering why, in a free market system, goods and services are usually available in a supply sufficient to take care of people’s wants. We all have heard about people in socialist societies being forced to stand in line for hours to secure small quantities of bread or meat. We also have heard about incredible distribution blunders in socialist societies where all the garbage cans end up in one city and the tops to the cans end up in another. How do we explain the much greater efficiency and order that we find in a free market system? Did anyone plan it this way? Is there some unknown central planner overseeing the entire process of production and distribution whose omniscient and benevolent planning results in almost everything being available when we want it? Since this is not the case, what accounts for the incredible order we find in a free market system that lacks any centralized coordination?
The answer, of course, is that all of this order is the product of the impersonal mechanism we call the market. When things go wrong, the impersonal mechanism soon produces results that remedy the problem. The language of this last sentence should not be taken literally, as though the market itself acted. What happens in a market system is that individual people alter their choices in response to changing incentives. For example, imagine that a commodity like gasoline is suddenly in short supply. If people continued to demand gasoline in the same quantities as before the shortage, prices would rise; perhaps they would rise dramatically. As the rising price of gasoline affected the way consumers evaluated the cost, the quantity demanded would begin to slacken. But the rising price of gas would also serve as an incentive for new suppliers to enter the market. The combination of reduced quantity demanded and increased quantity supplied would serve to remedy the temporary shortage.
The Informational Function of the Market
The market supplies important information via changes in the relative prices of goods. When the price of some good rises, the market is telling buyers and sellers that the good is less readily available relative to the quantity people wanted at its old price. A decrease in price communicates information that the good is less scarce, relative to demand. Increases or decreases in price can result from a number of factors including changes in people’s tastes, the discovery of new supplies, or the availability of new information. The reason people enter into market exchanges is to improve their respective situations. When rising prices raise people’s perception of the cost of some option above a certain point, those who value that option less will begin to consider other alternatives.
Producers of goods and services receive information from the market by also paying attention to profits and losses. Losses tell a business person that something is wrong and that he had better stop and re-evaluate things. Profits and losses give people incentives to act in ways that turn out to benefit society. Wise entrepreneurs will divert resources away from less profitable goods and services towards goods and services that more people want. A market system makes people accountable for their economic activities. When individuals and businesses act in ways that waste resources, they will be penalized by lower wages or profits (or perhaps by even larger losses). One of the major problems with an economic system that concentrates decisions in a group of central planners is that accountability too easily gets lost in the system. But in a decentralized market system, market prices serve to reward people who work efficiently, who plan prudently, who provide goods that others earnestly want, and who act in other economically wise ways.
I have not been discussing some specific market or collection of markets but the market system, the institutional framework within which individual voluntary economic exchanges can take place. This market system is spontaneous in the sense that no human invented it. It is impersonal in the sense that it is supposed not to discriminate for or against specific individuals. Like an urban traffic pattern, it ensures that countless numbers of individual drivers, all seeking their own goals, will reach their destinations in an orderly way. Without any help from any group of central planners, the impersonal market system does a remarkable job of supplying the countless wants of countless numbers of people. It does this by supplying information about people’s ever-changing wants and preferences through changes in prices. As buyers and sellers act in ways that they believe will maximize their own benefits and minimize their own costs, extraordinary consequences appear. Goods and services that people want are supplied in ways that many believe possible only when someone with complete and perfect knowledge is issuing orders. But as the collapse of socialism in the past decade reveals, societies that adopt a centralized economy inevitably fall far short of the efficiency of those that follow a decentralized market approach.
Necessary Conditions for Any Free Market
No free market can exist without several necessary conditions. They include an enforced right to own and to exchange property, an enforcement of contracts, and laws that forbid the use of force, fraud, and theft. Government has several important roles to play in all this. It must set up a stable system of rules within which exchanges can take place. Both the market system and the people who trade in the market need protection from the kinds of actions that hinder or prevent free exchange. This requires the existence of a government. But there are also necessary limits to the role of government in the economy. When government exceeds its legitimate role as the maker and enforcer of rules, it can do enormous harm to the economy and can be the source of much injustice. Readers will find articles that discuss the harm that governments do to their economy in every issue of The Freeman. Younger readers would profit much by beginning now to compile a list of these harmful acts.