What Markets Do(1)

Richard G. Lipsey, Peter O. Steiner,

Douglas D. Purvis and Paul N. Courant

How Markets Coordinate

Any economy consists of thousands upon thousands of individual markets. There are markets for agricultural goods, for manufactured goods, and for consumers' services; there are markets for intermediate goods such as steel and pig iron, which are outputs of some industries and inputs of others; there are markets for raw materials such as iron ore, trees, bauxite, and copper; there are markets for land and for thousands of different types of labor; there are markets in which money is borrowed and in which securities are sold. An economy is not a series of markets functioning in isolation but an interlocking system in which an occurrence in one market affects many others.

Any change, such as an increase in demand for a product, requires many further changes and adjustments. Should the quantity produced change? If it should, by how much and by what means? Any change in the output of one product will generally require changes in other markets and will start a chain of adjustments. Someone or something must decide what is to be produced, how, and by whom, and what is to be consumed and by whom.

The essential characteristic of the market system is that its coordination occurs in an unplanned, decentralized way. Millions of people make millions of independent decisions concerning production and consumption every day. Most of these decisions are not motivated by a desire to contribute to the social good or to make the whole economy work well but by fairly immediate considerations of self-interest. The price system coordinates these decentralized decisions, making the whole system fit together and respond to the wishes of individual consumers and producers.

The basic insight into how a market system works is that decentralized, private decision makers, acting in their own interests, respond to such signals as the prices of what they buy and sell. Economists have long emphasized price as a signaling device. When a commodity becomes scarce, its free-market price rises. Firms and households that use the commodity are led to economize on it and to look for alternatives. Firms that produce it are led to produce more of it. When a shortage occurs in a market, price rises and profits develop; when a glut occurs, price falls and losses develop. These are signals, for all to see, that arise from the overall conditions of market supply and demand.

The Role of Profits and Losses

Although the free-market economy often is described as the price system, the basic engine that drives the economy is economic profits. Except when there is monopoly, economic profits and losses are symptoms of disequilibrium, and they are the driving force in the adaptation of the economy to change.

A rise in demand or a fall in production costs creates profits for that commodity's producers. Profits make an industry attractive to new investment. They signal that there are too few resources devoted to that industry. In search of these profits, more resources enter the industry, increasing output and driving down price, until profits are driven to zero. A fall in demand or a rise in production costs creates losses. Losses signal the reverse and an excess of resources devoted to the industry. Resources will leave the industry until those left behind are no longer suffering losses.

The importance of profits and losses is that they set in motion forces that tend to move the economy toward a new equilibrium.

Individual households and firms respond to common signals according to their own best interests. There is nothing planned or intentionally coordinated about their actions, yet when, say, a shortage causes price to rise, individual buyers begin to reduce the quantities that they demand and individual firms begin to increase the quantities that they supply. As a result, the shortage begins to lessen. As it does, price begins to come back down, and profits are reduced. These signals in turn are seen and responded to by firms and households. Eventually, when the shortage has been eliminated, there are no profits to attract further increases in supply. The chain of adjustments to the original shortage is completed.

Notice that in the sequence of signal-response-signal-response no one has to foresee at the outset the final price and quantity, nor does any government agency have to specify who will increase production and who will decrease consumption. Some firms respond to the signals for "more output" by increasing production, and they keep on increasing production until the signals get weaker and weaker and finally disappear. Some buyers withdraw from the market when they think that prices are too high, and perhaps they reenter gradually, as prices become "more reasonable." Households and firms, responding to market signals, not to the orders of government bureaucrats, "decide" who will increase production and who will limit consumption. No one is forced to do something against his or her best judgment. Voluntary responses collectively produce the end result.

Because the economy is adjusting to shocks continuously, a snapshot of the economy at any given moment reveals substantial positive profits in some industries and substantial losses in others. A snapshot at another moment also will reveal windfall profits and losses, but their locations will be different.

The price system, like an invisible hand (Adam Smith's famous phrase), coordinates the responses of individual decision makers who seek only their own self-interests. Because they respond to signals that reflect market conditions, their responses are coordinated without any conscious planning.

Coordination in the Absence of Perfect Competition

To say that the price system coordinates is not to imply that it always leads to the results that perfect competition would produce. The price system coordinates responses even to prices that are "rigged" by monopolistic producers or that are altered by government controls. The signal-response process occurs in a price system even when the prices have not been determined in freely competitive markets.

When an international cartel of uranium producers decided to reduce production and raise the price of uranium, they created a shortage (and a fear of worse future shortages) among those electric utilities that depend on uranium to fuel nuclear power plants. The price of uranium shot up from under $10 per pound to over $40 in less than a year. This enormous price rise greatly increased efforts among producers outside the cartel to find more uranium and to increase their existing production by mining poorer grade ores previously considered too costly to mine.

The increases in production from these actions slowly began to ease the shortage. On the demand side, high prices and short supplies led some utilities to cancel the construction of planned nuclear power plants and to delay the construction of others. Such actions implied a long-run substitution of oil or coal for uranium. Only the fact that the OPEC cartel had also sharply raised the price of oil prevented an even more rapid reversal of the previous trend from oil to nuclear powered generators. With the prices of both uranium and oil quadrupling, the demand for coal increased sharply, and its price and production rose. Thus, the market mechanism generated adjustments to the relative prices of different fuels, even though some prices were set by cartels rather than by the free-market forces of supply and demand. It also set in motion reactions that placed limits on the power of the cartel.

The Case for the Market System

In presenting the case for free-market economies, economists have used two different approaches. One of these may be characterized as the formal defense. It is based upon showing that a free-market economy consisting of nothing but perfectly competitive industries would lead to an optimal allocation of resources.

The other approach is at least as old as Adam Smith and is meant to apply to market economies whether they are perfectly competitive or not. It is based on variations and implications of the theme that the market system is an effective coordinator of decentralized decision making. The case is intuitive in that it is not laid out in equations representing a complete formal model of an economy, but it does follow from some hard reasoning, and it has been subjected to much intellectual probing. What is the nature of this defense of the free market?

Flexible and Automatic Coordination

Defenders of the market economy argue that, compared with the alternatives, the decentralized market system is more flexible and leaves more scope for adaptation to change at any moment in time and for quicker adjustment over time.

Suppose, for example, that the price of oil rises. One household might prefer to respond by maintaining a high temperature in its house and economizing on its driving, while another might do the reverse. A third household might give up air conditioning instead. This flexibility can be contrasted with centralized control, which would force the same pattern on everyone, say by rationing heating oil and gasoline, by regulating permitted temperatures, and by limiting air conditioning to days when the temperature exceeded 80 degrees fahrenheit.

Furthermore, as conditions change over time, prices will change and decentralized decision makers can react continually. In contrast, government quotas, allocations, and rationing schemes are much more difficult to adjust. As a result, there are likely to be shortages and surpluses before adjustments are made. The great value of the market is that it provides automatic signals as a situation develops, so that all of the consequences of some major economic change do not have to be anticipated and allowed for by a body of central planners. Millions of adaptations to millions of changes in tens of thousands of markets are required every year, and it would be a Herculean task to anticipate and plan for them all.

A market system allows for coordination without anyone needing to understand how the whole system works. As Professor Thomas Schelling put it:

The dairy farmer doesn't need to know how many people eat butter and how far away they are, how many other people raise cows, how many babies drink milk, or whether more money is spent on beer or milk. What he needs to know is the prices of different feeds, the characteristics of different cows, the different prices [for milk], the relative cost of hired labor and electrical machinery, and what his net earnings might be if he sold his cows and raised pigs instead.

It is, of course, an enormous advantage that all the producers and consumers of a country collectively can make the system operate without any one of them, much less all of them, having to understand how it works. Such a lack of knowledge becomes a disadvantage, however, when people have to vote on schemes for interfering with market allocation. This contrast lies at the heart of the intuitive argument in favor of market systems.

Stimulus to Innovation and Growth

Technology, tastes, and resource availability are changing all the time, in all economies. Twenty years ago there was no such thing as a personal computer or a digital watch. Front-wheel drive was a curiosity. Students carried their books in briefcases or in canvas bags that were anything but waterproof. Manuscripts only existed as hard copy, not as computer records. In order to change one word in a manuscript, one often had to retype every word on a page. Video cassettes did not exist. The next 20 years will surely also see changes great and small. New products and techniques will be devised to adapt to shortages, gluts, and changes in consumer demands.

In a market economy individuals risk their time and money in the hope of earning profits. While many fail, some succeed. New products and processes appear and disappear. Some are passing fads or have little impact; others become items of major significance. The market system works by trial and error to sort them out and allocates resources to what prove to be successful innovations.

In contrast, planners in more centralized systems have to guess which are going to be productive innovations or products that will be in demand. Planned growth may achieve wonders by permitting a massive effort in a chosen direction, but central planners also may guess wrong about the direction and put far too many eggs in the wrong basket or reject as unpromising something that will turn out to be vital. It is striking that the last decade has seen the two largest centrally planned economies in the world, the Soviet Union and mainland China, make increasing use of markets.

Relative Prices Reflect Relative Costs

A market system tends to drive prices toward the average total costs of production. When markets are close to perfectly competitive, this movement occurs quickly and completely; but even where there is substantial market power, new products and new producers respond to the lure of profits, and their output drives prices down toward the costs of production. . . . [M]arket choices are then made in the light of opportunity costs. Firms will choose methods that minimize their own cost of producing output, and in so doing automatically will minimize the opportunity cost of the resources that they use. Similarly, when households choose commodity A over commodity B, even though A uses resources of twice the total value of the resources used to produce B, they will have to pay the (difference in) price. They will only do so when they value A correspondingly more than B at the margin.

When relative prices reflect relative costs, producers and consumers use the nation's resources in a manner that is consistent with allocative efficiency.

Self-Correction of Disequilibrium

Equilibrium of the economic system is continually disrupted by change. If the economy does not "pursue" equilibrium, there would be little comfort in saying things would be bright indeed if only it reached equilibrium. (We all know someone who would have been a great surgeon if only he or she had gone to medical school.)

An important characteristic of the price system is its ability to set in motion forces that tend to correct disequilibrium.

To review the advantages of the price system in this respect, imagine operating without a market mechanism. Suppose that planning boards make all market decisions. The Board in Control of Men's Clothing hears that pleated shirts are all the rage in neighboring countries. It orders a certain proportion of clothing factories to make pleated shirts instead of the traditional men's dress shirt. Conceivably, the quantities of pleated shirts and traditional shirts produced could be just right, given shoppers' preferences. But what if the board guesses wrong and orders too many traditional shirts and not enough pleated shirts to be produced? Long lines would appear at pleated-shirt counters, while mountains of traditional shirts would pile up. Once the board sees the lines for pleated shirts, it could order a change in quantities produced. Meanwhile, it could store the extra traditional shirts for another season or ship them to a country with different tastes.

Such a system can correct an initial mistake, but it may prove inefficient in doing so. It may use a lot of resources in planning and administration that could instead be used to produce commodities. Further, many consumers may be greatly inconvenienced if the board is slow to correct its error. In such a system the members of the board may have no incentive to admit and correct a mistake quickly. Indeed, if the authorities do not like pleated shirts, the board may get credit for having stopped the craze before it went too far!

In contrast, suppose that in a market system a similar misestimation of the demand for pleated shirts and traditional shirts is made by the men's clothing industry. Lines develop at pleated-shirt counters, and inventories of traditional shirts accumulate. Stores raise the prices of pleated shirts and at the same time lower them for traditional shirts. Consumers who care more about price than fashion could get bargains by buying traditional shirts. Pleated-shirt manufacturers could earn profits by raising prices and running extra shifts to increase production. Some traditional-shirt producers would be motivated to shift production quickly to pleated shirts and to make traditional shirts more attractive to buyers by cutting prices. Unlike the planning board, the producers in a market system would be motivated to correct their initial mistakes as quickly as possible. Those who would be slowest to adjust would lose the most money and might even be forced out of business.

Decentralization of Power

Another important part of the case for a market economy is that it tends to decentralize power and thus requires less coercion of individuals than does any other type of economy. Of course, even though markets tend to diffuse power, they do not do so completely; large firms and large unions clearly do have and do exercise substantial economic power.

While the market power of large corporations and unions is not negligible, it tends to be constrained both by the competition of other large entities and by the emergence of new products and firms. This is the process of creative destruction that was described by Joseph Schumpeter. In any case, say defenders of the free market, even such aggregations of private power are far less substantial than government power.

Governments must coerce if markets are not allowed to allocate people to jobs and commodities to consumers. Not only will such coercion be regarded as arbitrary (especially by those who do not like the results), but the power surely creates major opportunities for bribery, corruption, and allocation according to the tastes of the central administrators. If at the going prices and wages there are not enough apartments or coveted jobs to go around, the bureaucrats can allocate some to those who pay the largest bribe, some to those with religious beliefs, hair styles, or political views that they like, and only the rest to those whose names come up on the waiting list. This line of reasoning has been articulated forcefully by the conservative economist and Nobel Prize winner Milton Friedman, who argues that economic freedom the ability to allocate resources through private markets is essential to the maintenance of political freedom.