MKT 3000: THE CASE FOR 'FREE
MARKETS' AND THE (ECONOMIC) ROLES OF GOVERNMENT
The previous notes outline the logic of the market mechanism: -
the principles of
- <>the Production
Possibility Frontier (ppf) - which (conceptually at
least) characterises the productive capacity of an economy (community,
region, country or the whole world) in terms of the maximum quantities
of goods and services which the collective actions of people and their
tools and rules are capable of producing now (this year), given their human capital (their
number, their skills, experience, training and knowledge etc.), their physical capital (plant,
equipment, vehicles etc.), their social capital (their
operating practices, transaction and interaction networks,
institutional codes and rules etc.), their natural
capital (land, minerals, natural environment, natural
resources etc.) and their spatial capital
(whereabouts they are relative to their neighbours and traders - which
(in part) determines their abilities and opportunities to trade with
other economies). It is the PPF which determines the basic shape
of the economy's supply curves - in an economy operating as
efficiently and effectively as possible (i.e on its ppf), then it will
cost more to get an increased supply of any given product, good or service -
supply curves slope upwards in an efficient and effective economy (but
not, necessarily, in an inefficient or ineffective economy.) The
higher the price offered for any good or service (or the longer the
queues for a limited supply), the more likely it is that more people
will make more effort to provide the high priced, limited supplied good
or service, rather than doing something else. In effect, the supply side of the economy
(firms, businesses and their supply chains and infrastructurses,
can be though of as continually adopting, adapting and innovating to
explore the production possibilities of the avaiable resources
('capitals') in response to social preferences, as expressed by
consumers and conditioned by governments and citizens. <>
- <>Social
preferences - conceptually illustrated with the indifference curve (boundary) between
the current consumption bundle (mix) of goods and services, and those
bundles which would be considered preferable, and those which are
revealed by the current choice to be inferior (less preferable) - which
gives the basic shape to demand curves - consumers and society will be willing to
pay less for additional quantities of any good or service (other things
being equal) - quantities purchased (demanded) will decline with
increases in the product price, and vice
versa. In effect, it is consumers and citizens who 'make
the rules' about survival and persistence of the socio-economic
producer species, through Adam Smith's invisible hand of the
market - both directly through their purchases of the goods and
services (or not) and also through their legitimatisation of the rules
and laws about property rights, enforcement of contracts and so forth
exercised on their behalf by Government and the State.
- The
Circular Flow of Income - through which the
expenditure flows from households (consumers and citizens) are
translated into income flows to the owners of the 'factors of
production' (the basic resource capitals - land, labour, physical
capital (buildings, plant and equipment etc.) and managment), who then
re-exercise their preferences as consumers.
The economic theory of welfare optimisation stems from
Adam Smith, and although variously extended and developed, still
provides the foundation for economic policy analysis. In essence,
the
theory holds that a system of competitive markets (in which there is freedom of entry and
exit, all actors are price-takers
(there are sufficiently many of both that no one can set their own
price) and for
whom private costs and benefits are identical with social costs and
benefits - there are no significant marekt failures)
is capable of generating a socially optimal
allocation of resources to
the production of goods and services for the population, such that no
one person can be made better off without making at least on other
person worse off (the Pareto welfare criterion). While the
elementary
versions of this theory assume perfect information, more sophisticated
developments allow that information can never be perfect and that
information-gathering, decision making and associated risk-taking
themselves are resource-using activities, and subject to optimisation
and effcient use of scarce reosurces within the economic welfare
calculus.
Given these basic features of the
economic system, the capacity of the system to continually evolve to
make the best of available resources (and generate the interest and
wherewithall to make more resources (invest in capital plant and
equipment; training and education; health; land improvement etc.))
depends on specialisation and trade, and the 'price mechanism' of 'free
markets' is an apparently more effective process for encouraging and
developing this than any other practical system yet devised.
"Free Markets" here means markets which are appropriately governed - to
ensure the probity of contracts, security of property rights, absence
of corruption etc.
The idea that economic behaviour can be explained and understood as an
evolutionary system is not new (Alchian, 1950) even if it is not (yet)
mainstream. “The suggested approach
embodies the principles of biological evolution and natural selection
by interpreting the economic system as an adoptive (sic) mechanism
which chooses among exploratory actions generated by the adaptive
pursuit of “success” or “profits” (ibid, p211). Alchian notes that
the ideas of profit or utility maximisation as motivations for
behaviour are sufficiently unrealistic as to be nonsensical, especially
in the real, uncertain and complex world. As he says (p. 212), “In the presence of uncertainty - a
necessary condition for the existence of profits – there is no
meaningful criterion for selecting the decision that will maximise
profits.” He goes on (p 213) “This
is the criterion by which the economic system selects survivors: those
who realise positive profits are the survivors; those who suffer losses
will disappear. .. Positive profits accrue to those who are better than
their actual competitors, even if the participants are ignorant,
intelligent, skilful etc. .. The greater the uncertainties of the
world, the greater is the possibility that profits would go to
venturesome and lucky rather than to logical, careful, fact-gathering
individuals. .. Success (survival) accompanies relative superiority;
and, second, it does not require proper motivation but may rather be
the result of fortuitous circumstances.” Alchian pursues this
analysis by separating the elements of good fortune (luck) from
conscious adaptive behaviour by considering a socio-economic
environment which only adopts “appropriate” survivors (in the absence
of any adaptive behaviour). This system is, in essence, the natural
selection system, in which the single organism or gene has no
discernable individual motivation or adaptation capacity whatsoever.
Providing that we know (or can make educated guesses about) the
system’s prerequisites for success, survival and replication, we can
still predict the characteristics of the revealed successful firms
(households), even if these entities have no individual motivation or
adaptive capacities at all, even if the whole system is simply driven
by chance actions. “Individual
motivation and foresight, while sufficient, are not necessary”, ibid, p 217. Of course, motivation
and conscious adaptive behaviour are human (if not also higher animal)
characteristics. Alchian notes two behaviours in particular: imitation
of apparently successful behaviours; innovation by conscious trial and
error. As he says (p. 219), “Adapting
behaviour via imitation and venturesome innovation enlarges the model.”
In short (220), “The economic
counterparts of genetic heredity, mutations and natural selection are
imitation, innovation and positive profits.”
Effectively, the market system continually explores (through trial and
error) the shape and location of the PPF with reference to social
preferences exhibited through the demands expressed in the market place
– consumer demand provides the endogenous determination of the rules
and norms for the selection criteria required by the socio-economic
evolutionary process (for which the selection criteria are ENDOGENOUS
not exogenous – the Garden of Eden story in a nutshell).
Blume and Easley, 2002,
explore the mathematical logic of an evolutionary process of economic
behaviour and development using an evolutionary general equilibrium
model. Their results are important. They find that profitable firms
grow and unprofitable firms shrink if the economic environment is held
constant, as Alchian (op cit.) argues and as Nelson
and Winter (1982) explore in considerable and convincing detail.
However, in a general equilibrium system, prices change as factor
demands and output supply evolves. Blume and Easley examine, first, a
world without capital markets, where firms can only grow through their
own retained earnings, and find that in this case, evolution favours
profit maximization, again as Alchian argues and Nelson and Winter
demonstrate. However, Blume and Easley do not find, even in their
necessarily fairly simple model (e.g., with consumer preferences fixed)
that the dynamic equilibrium paths are necessarily Pareto optimal
(above), or have automatically stable steady states. In other words,
even such a simple reflection of our general equilibrium system is
susceptible to cycles and to sustained depression – the Keynesian
condition – echoing natural population cycles generated using the same
‘mechanistic’ principles. When the capital markets (see next set of
notes) are added, things get even worse for the evolutionary system.
In this simple model of the world, there are four major functions for government.
i. The Policeman: to establish
and maintain the legal and judicial framework within which the market
will operate, both at the national and the international level,
including the important role of establishing and policing property
rights. The free market involves a massive number of
transactions, each of which can be viewed as a contract between buyer
and seller. The efficient working of this system requires that
both sides of the market have confidence in the security and probity of
these transactions. The costs of ensuring this are typically
assumed away in elementary analyses, but are not insignificant,
especially in atomistic
markets (with a great many individual buyers and/or sellers)
characterised by long-term decisions and associated difficulties of
uncertainty and risk, such as the agricultural or housing
sectors. Solid and well-policed laws of contract are necessary
(but not always sufficient) conditions for the efficient operation of
the free market. In short, at the door of every auction room
there stands a policeman, and the long arm of the law is necessarily
attached to Adam Smith’s invisible hand.
ii. The Doctor/Engineer to correct
"market failures" including at
least the organisation of the provision of public goods (defence, government
itself, etc.) and the correction of the free enterprise system for externalities, imperfect competition and monopoly,
all of which prevent the free market from attaining the social
optimum.
The key problems with public goods
are: a) that these goods are non-rival in consumption, meaning that one
person’s use or consumption of the good (or service) does not deny
another person use of that same (unit of) good; b) that
prevention of people (such as non payers) from consuming or using of
the good is either impossible or impossibly expensive - the so-called
non-exclusion characteristic. In other words, once a public good
is supplied to one, it is supplied freely to all, a market condition in
which private entrepreneurs cannot survive. Hence the pure free
market would not be expected to provide any of (or at least not enough
of) these goods.
Externalities (pollution is the traditional example, pretty
landscapes, pleasant housing estates or the converse, dilapidated
estates are others) exhibit a similar problem in that rational market
transactions cannot account properly for their production or
consumption. They arise as more or less unintended by-products of
either consumption (C) or production (P), and once produced are
difficult or impossible to price, often since they have public good
characteristics, as in the above examples. However, since they
are directly associated with normal market transactions, textbook
solutions of adjusting the price of the marketable good through taxes
or subsidies can theoretically correct the market signals for these
goods. (For more on Public Goods and Externalities, see seperate notes).
Imperfect Competition (Monopoly)
- where producing/supplying companies 'exploit' their
customers/consumers by restrciting supplies and increasing prices (or
engaging in predatory and anti-competitive practices to gounge the
consumers). Generally regulated in modern economies through organs of
state such as the Competition Commission
(UK)
iii. The Pharmacist/Mechanic:
to encourage and foster socio-economic efficiency, both in static terms
- the need for which can be seen as resulting from the public good
characteristics of information; and in dynamic terms to assist in
adjustment to changing circumstances, which might be associated with
externalities of progress and growth and with the public good aspects
of technological change. This function can also be seen as
operating at both the macro and micro level in the economy.
iv. The Judge: to
redistribute income and wealth in the interests of equity, since
welfare optimisation theory takes the initial resource endowment
distribution between people as given, while (eg. Rawls, 1971) there is
every reason to suppose that societies regard equitable (not
necessarily equal) distributions of endowments (wealth, income, good
and service provision and entitlement, and spatial patterns of economic
activity) as desirable.
Notice, especially, that the market system is likely to be capricious
and ephemeral in the distribution of incomes and wealth amongst the
population. Profits are (Alchian) more often than not happy accidents -
accumulation of wealth is seldom a reflection of individual effort or
social worth, more likely an accident of birth or the lucky chance of
being in the right place at the right time, and happening to do the
"right" thing. One of Government's key roles is to exercise our
social consciences for us, and provide protection and support for the
less well off at the expense of the better off - to redistribute
income, and provide universal services (education and health) for all
regardless of willingness (ability) to pay. As a consequence,
democracies tend to bifurcate into 'left' and 'right': the 'left'
representing the interests of those either left out of, or left behind
in the capitalist market 'race' for improved prosperity, including
organised labour (unions), and the 'right' representing those with
faith in the market mechanism to deliver their prosperity, 'if only it
were .........(managed/regulated/de-regulated/better in their favour)'.
v. In addition to these four well-recognised
functions of government in a market economy, a fifth function should
also be added: The Priest: - as the
guardian of public morals and ethics, requiring additional roles to
those envisaged by the clinical calculus of neoclassical economics for
the policeman and the judge - though very possibly impossible to
achieve/decide upon in a democracy - do we just allow the special
advocacy groups to determine the appropriate social morals for the rest
of us?
FOR AN EXCELLENT REVIEW OF TRADE AND SOCIO-ECONOMIC DEVELOPMENT, SEE LOVE
& LATTIMORE: International
Trade: Free, Fair and Open?, OECD, 2009.
Return to Economic Principles.
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