The mainstream defence of the free market rests on the claim that it allocates resources more efficiently than any other system. To speak formally, it tends to bring about both productive and allocative efficiency. This first means that goods and services are produced at the lowest currently known cost. The second means that production satisfies the known wants of consumers in the fullest way currently possible.
We can best see this argument in the analysis of firms under perfect competition. Let it be granted: that there are many buyers and sellers in a market; that all the goods produced in this market are of the same quality; that there are no barriers to entry or exit for any player in the market; that there is perfect knowledge among all players in the market regarding prices and production methods. Granting these assumption, it is possible to express the outcome in a diagram:
Because each firm is too small for its production decisions to affect price, each faces a perfectly elastic demand curve for its output: it can sell as much or as little as it chooses to produce at exactly the same price. Because there is free entry for other firms, competition will bid price down to the lowest point in each firm's average cost curve, which will also be the point of intersection between average and marginal cost. Because knowledge is perfect, any firm that is able to lower its average cost of production will earn a supernormal profit only in the short term: in the longer term, other firms will copy its new production method, and will bid price down to the new lowest point in the average cost curve. All producers will then earn only "normal profit" - that is, they will make enough to cover all their costs, plus the imputed cost of paying the owner an income equal to what could be earned by doing the same job elsewhere as a salaried employee.
The long term equilibrium is productively efficient, because firms produce in the most economical manner currently known. It is also allocatively efficient, because no consumer will be deterred from buying something that he values above its cost of production.
The most obvious objection to this model is that competition is never perfect. There are few markets in which the product is of the same quality, very few in which no firm is able to influence price, almost none in which there is perfect freedom of entry and exit, and none at all in which knowledge is perfectly available to all players.
All this is admitted by the mainstream economists, and further diagrams can be produced to show the effects of the "imperfect" competition that exists in the real world. Take this to show monopoly or oligopoly:
Here, we can see that a firm that wants to maximise short term profit will set output short of the lowest point in its average cost curve. Because the firm is able to influence price by its output decisions, there is a divergence between average and marginal revenue, and the profit maximising point is where marginal cost intersects with marginal revenue. The result is higher prices than would emerge under perfect competition, and a supernormal profit in the long run. This profit is a pure surplus, serving no economically efficient purpose. Such a situation is neither productively nor allocatively efficient.(1)
Based on this sort of diagram, and on the analysis of asymmetric knowledge, we have the great superstructure of welfare economics. Markets are assumed in which all players have perfect knowledge of purchase and production and selling possibilities; and the overall success of the model is appraised on how well it approaches to a known or knowable state of equilibrium. When equilibrium does not come about, the economists cry "market failure", and start devising methods by which the government can step in and bring about equilibrium by the forced coordination of interests.
This is the intellectual justification for the control of monopolies and mergers, for consumer protection laws, for the regulation of advertising, and for the general level of interference in business decisions in which we now live. The purpose is to bring about a state of affairs in which no firm is big enough to have a significant effect on price, and in which consumers are as fully informed as they can be on a whole range of issues considered relevant.
Few mainstream economists are socialists. However, the subject - as they have developed it and as they normally teach it—has made many of their students into something like socialists. They are told at first that free markets are efficient in ways they manifestly are not. Reality then breaks in with the realisation that ideal and actual markets resemble each other vastly less than the models of classical mechanics do the real world of friction and variable gravity. They then accept levels of regulation that come close to abolishing market freedom.
This is particularly a problem with the current Labour Government. It is true that the Ministers have substantially changed their minds since around 1990. Stephen Byers, for example, the Secretary of State for Trade and Industry, used to be a Trotskyite. Gordon Brown, the Chancellor of the Exchequer, once wrote a book denouncing all the market reforms of Margaret Thatcher.(2) There have been many less fundamental changes of mind since the death of old style socialism. But there is a danger that, having dumped a model that is obviously wrong, they are now listening to glossy presentations from mainstream economists about market failure that will justify them in smuggling back into their programme much of their old distrust of markets. Undoubtedly, there is a worrying habit on their part to see market failure everywhere.
Of course, truth is truth. If the mainstream theory of the firm were correct, it would require us to challenge the present regulatory state from within the model. This can be done, and there is an honourable body of mainstream literature defending freedom of enterprise. There is, as already mentioned, the public choice school. Economists in this tradition accept the mainstream model as basically correct, but insist that like must be compared with like. We cannot empirically investigate markets, find them imperfect in some way, and then go about recommending intervention on the unexamined, but quite false, assumption that the people running a government are utterly disinterested Platonic guardians. Markets may fail, they say, but so do governments; and government failure is usually much worse.
Then there is the Chicago school, based around the work of Milton Friedman. Professor Friedman accepts the basic premises of mainstream theory, but builds on pre-Keynesian insights. His greatest technical achievement has been to re-establish control of monetary aggregates as the main subject of macro-economic management - "monetarism". This is based on a monumental empirical study of American monetary policy throughout the early 20th century, from which he concluded that the demand management theories associated with the name of John Maynard Keynes did not explain the economic facts of those years.(3)
After decades of academic obscurity, his moment came in the 1970s, when the Keynesian consensus collapsed in a long crisis of high inflation and rising unemployment that had previously been regarded as impossible. It was on the Friedmanites that both British and American governments called to fill the resulting policy vacuum. Professor Friedman was perhaps the main theoretical influence behind the Thatcher reforms of the 1980s; and it is his influence that can be seen in this classic statement of "Thatcherism" in 1984 from Nigel Lawson as Chancellor of the Exchequer:
It is the conquest of inflation, and not the pursuit of growth and employment, which is or should be the objective of macro-economic policy. And it is the creation of conditions conducive to growth and employment, and not the suppression of price rises, which is or should be the objective of micro- economic policy.
He has written widely on general issues, and has been one of the staunchest defenders of the free market to have emerged in the past 50 years.(4) His problem is that he has done all his work within a framework of wrong assumptions.
The Austrian Theory of the Firm
A better approach to understanding markets is provided by the economists of the "Austrian" tradition. Starting with Carl Menger and Eugen von Böhm-Bawerk in the 19th century, and continuing in the 20th with Ludwig von Mises, F.A. von Hayek, and in our own day with Israel Kirzner, this tradition is flatly opposed to the mainstream theory of the firm. Mainstream theory is obsessed with situations to the exclusion of process. It concentrates on the analysis of static situations in which all the necessary information regarding consumer preferences and production techniques and resources is already available, and the only function of the entrepreneur is to use this information to bring about equilibrium within a market. The economic problem, under these circumstances, is a simple matter of using the right means to obtain a known end.(5) If so, within a few years, this coordinating job could probably be managed by a computer. It can certainly be managed now by any bright economist working for a government regulatory body. Free market economists working within this framework of assumptions may praise private enterprise as doing the job of allocating resources better than the authorities. But their view of the entrepreneur is usually rather flat—he is a "profit maximiser", someone who organises production and takes risks, and makes the curves on the graph get into the right equilibrium.(6)
The Problem of Knowledge
One problem, as said, is that the knowledge assumed by mainstream theory is not available. Consumer tastes change from moment to moment, and usually in manners that are beyond prediction. Who, for example, could have predicted the sudden emergence in the early 1990s of a taste for tattooing and body piercing, and the consequent demand for magazines and other publications about this? Who knows when this taste will end? Who can predict whether people in England will want to buy mobile telephones with cameras built in? The fact that they may have some popularity in Japan is no indication that they will be popular here. We are already seeing that the third generation mobile telephones actually introduced here are not recovering their costs of introduction: not enough people, it seems, are interested in being able to access the Internet via the small keyboards and monitors now available. Equally, production techniques are not static, but in a state of continuous flux, as new techniques are discovered, and new uses found for old techniques.
From this, we can see that the demand and supply functions assumed in mainstream theory are radically indefinite, and indeed largely unknown in advance. Even when it seems possible to draw revenue curves, these are conjectural and based on information that may be wholly out of date. Suppose, for example, that a decrease in price for some commodity is accompanied by an increase in quantity bought. Does this show a movement along an unchanged demand curve? Or does it show an independent shift to the right of the demand curve? In the real world, we can never know the answer to this rather basic question. And so, in the real world, any attempt at measuring demand elasticities must always be a matter of guesswork rather than the precise analysis that we see explained in the standard texts.
In any market, there may be a tendency towards equilibrium—that is, the price of any commodity will tend towards a point at which demand and supply are exactly equal. But this point of equilibrium is so unstable that it is hardly ever reached, and then is not reached for more than a few seconds at a time. On this view of markets, information is not something like a dead body that can be laid out on a slab for careful dissection, but is more like the endlessly shifting colours of a million different kaleidoscopes. No one person can see perfectly what is happening as it happens. Even if the information can eventually be gathered by diligent data gathering, it will by then be useless as a guide to the current equilibrium.
Competition as Process
The second, and equally fundamental problem with mainstream economics is that it is worthless to try analysing markets in terms of a static equilibrium in which the competitive process has already done its work. And this criticism does not apply only to the perfectly competitive model developed by Marshall, but also to the imperfect competition models developed by Chamberlin and Robinson.(7) These models are more realistic, so far as they get away from the unlikely assumptions of perfect competition. But they fail because they are still concerned with the analysis of equilibrium states rather than the process by which they emerge.(8) They fail because they also assume away something that it is the main task of the analysis of competition to explain.
The real problem of economics is not to know what equilibrium looks like once it has emerged, but to understand the process by which it is continually approached. This is clearly stated by Hayek:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate "given" resources.... It is rather a problem of how to secure the best use of resources known to any of the members of society for whose relative importance only these individuals know. Of, to put it briefly, its is a problem of the utilization of knowledge which is not given to anyone in its totality.(9)
Bearing in mind, he argued, that the "omniscience yardstick" assumed by mainstream theory is not available, we need to judge institutional and market arrangements by how well they contribute to a process whereby the knowledge that exists scattered almost at random through countless millions of individuals can be somehow mobilised to contribute to the coordination of economic activity.
In this alternative view of markets—seen as a process rather than a situation, the role of the entrepreneur comes into better focus. Indeed, enterprise moves to the centre of the picture. It is no longer a matter of taking advantage of information that is already generally known, and shifting markets to their equilibrium. It is rather a matter of discovering information and then coordinating it. An entrepreneur is not so much someone who makes fastest use of knowledge, as someone who is alert to opportunities that no one else has yet discovered.
Israel Kirzner states this very clearly:
The successful businessman-entrepreneur "sees" what other market participants have not yet seen; the entrepreneur sees opportunities to buy at one price and to sell at a higher price. To see such opportunities will typically call for (a) superior imagination and vision (since the perceived opportunity to sell at the higher price is likely to exist only in the future) and (b) creativity (since such a profit opportunity is likely to take the form of selling what one buys in an innovatively different from, and/or different place, than was relevant at the time of purchase).(10)
Profit, therefore, is found where opportunities exist for a more complete coordination of economic activity. It is made where an entrepreneur discovers and exploits an opportunity that no one previously knew to exist. It shows a previous disequilibrium caused by the systemic ignorance that exists in the real world.
Suppose, for example, John Doe would rather work for an hour as a cleaner in return for £5, and Richard Roe would rather pay £10 to have his cleaning done than do it himself. Suppose further that neither knows the other. An entrepreneur who steps in and creates a market in which both can come together is identifying and correcting the uncoordinated plans of others. The £5 profit for doing so is his incentive for risking his time and other resources. The world has become a slightly more orderly place so far as the satisfaction of human wants is concerned. Resources have been freed to satisfy more urgent needs. Resources have even been created, since John Doe was previously idle in what is now a satisfying activity.
There are still many unsatisfied wants, because no one has yet perceived them, or realised any way of satisfying them. But opportunities for beneficial exchange have been created where none existed before. This is a simple point, but it is a point that cannot be explained in the mainstream theory of static equilibrium. Writers in this tradition can use an Edgeworth box diagram to explain how, when the indifference curves of two parties intersect, there is an opportunity for mutually beneficial exchange. But they are much less interested in discussing the means by which these parties become aware of the opportunity. In this sense, explaining exchange by simply taking enterprise for granted is rather like explaining a house fire by showing how a lighted candle near wooden furniture can enable combustion—and by assuming without further examination that someone has knocked the candle over.(11)
Or let us take a real and more elaborate example. Take the development of sound recording. By 1877, all the technology needed to record sound had been around for centuries—the sufficiently accurate clockwork mechanisms, the steel of sufficient hardness, the means of coating smooth wax onto a cylinder, the speaking trumpet needed to collect and focus sound, and so forth. At the same time, there was a demand—though no one had previously articulated it - for sound recording in both the commercial and entertainment sectors. And there was sufficient wealth in at least America and western Europe to create an effectual demand for a sound recording machine. There was no reason, given the perfect knowledge assumed in equilibrium models, for the phonograph not to have been invented in 1800, or even in 1700 or 1600. But it was Thomas Edison who put everything together in 1877 and thereby started the modern entertainment industry. He did this not because he was purely interested in the advancement of technology or the welfare of the masses—though these things did interest him—but because he was looking for new ways of making a profit for his research and development company.
Of course, once profits have been made—or once an opportunity for profit is announced—others come into the market and compete away the profits of the discovering entrepreneur. The final position, assuming no further change in preferences, is the equilibrium with which mainstream economics is most concerned. But it is the process of coordination that is really important, as it is the engine that drives towards a more satisfactory allocation of resources.
Profit here is the incentive—but it is not an incentive to work harder at allocating known resources to known ends. It is an incentive to stimulate the alertness of the entrepreneur to look out for previously unknown resources and apply them to previously unknown ends. It is also, as in the case both of the phonograph and of the cleaner, an incentive to create new resources. And what must be clearly understood is that, assuming markets are open to entry from outside—the meaning of this will be explored in the next chapter - high profits are evidence of great previous uncoordination. The higher the profit, the greater the previous uncoordination.
As with Edison, it is entrepreneurs seeking profit who have done most in the past few hundred years to raise the living standards of western societies. They have achieved this by doing things that no one had done before because no one had previously imagined that doing them was possible. The process has not been smooth and continuous - after all, entrepreneurs are only human beings who see a little further than others; and they frequently see the wrong object. But, while there have been many failures to set against each success, there have been more successes since around 1600 than in any other period of history.
If we want this progress to continue, we must learn to respect enterprise and not be frightened of it, or concerned to restrict it because certain consequences of letting it alone may be found to be unfortunate. According to the Austrian analysis, markets do not need to be "perfect" in the sense of the mainstream equilibrium models. They simply need to be vaguely open to entry from outside.
Attempts to regulate enterprise by government officials must be counterproductive to the progress of humanity. This will be so for two reasons:
First, let us take the usual "market failure" case for regulation. Perhaps some firms are making "excessive" profits—that is, their revenues are considerably higher than their total actual and imputed costs. Or perhaps there is an "under supply" of goods relative to their "social marginal benefit" as asserted by those in authority. Or perhaps there is an "over supply" of certain goods, like cigarettes or flammable nightclothes or chain letter companies, relative to their asserted social marginal benefit. Even assuming those in authority are motivated purely by desire to promote social welfare—a dubious assumption, bearing in mind the insights of public choice analysis—they lack the knowledge to respond better than the market to the actual preferences of consumers. These preferences are known in advance only to consumers themselves—and then not always very well. And then there is the conceptual problem of how to know and rank the scales of preference of all consumers, and then to aggregate them into a social welfare schedule. Regulators cannot know in advance what is the correct price of any product or the correct amount to be supplied. At best, they will impose their own preferences on the pattern of economic activity—and though tyrannical, this is at least honest and satisfactory to someone. At worst, they will introduce chaos into what would otherwise be an increasingly ordered state of affairs.
Second, and perhaps more serious, there is the fact that direct controls on prices, quantities, or qualities of output production, or profits, may discourage or block future activities that have not yet been imagined. Suppose, for example, that Edison had made fantastic profits from his invention of the phonograph, and that he tried to prolong these by very restrictive management of his patent—neither of these is true, by the way. Suppose then that the authorities in every country where he operated had stepped in and forced him to lower prices, or had imposed "windfall" taxes on his profit. Berliner then might not have been stimulated in 1888 to invent the gramophone. Later, others might have been deterred from investing in the hugely expensive business of developing electrical and then stereophonic and then digital recording. Intervening to correct what may even be real "market failures" in the present may block or distort the discovery process that entrepreneurs in unconstrained markets provide.
Is this a defence of mergers that create giant companies that dominate markets? Of companies that offer foreign holidays at the "obviously fraudulent" price of £29.50? Yes it is. Mergers are part of the discovery process. Until one has been tried, it is not possible to know the optimum scale of output in any given market. As for fraud, breach of contract should always be a matter for the courts of a just society—but never for government officials making judgments of what is or is not a fair price. Sooner or later, someone may discover a way of bundling products in a way that does give virtually free holidays to people. A society in which this sort of progress is welcomed should not be putting barriers in its way.
The Government is right. This country does need a culture of enterprise. If only it could understand that this is more than the regulatory equivalent of growing ivy on a garden trellis—allowing growth in one direction, positively encouraging it in another, and ruthlessly forbidding it in others. Real enterprise is a natural growth, and flourishes best when left to its own directions. This is an insight of the Austrian school of economists. But is has been eloquently stated by other economists over and over again. We find it in the works of the great economic journalist Henry Hazlitt, in the essays of the great 19th century French economist Frederic Bastiat, and of course in the writings of Adam Smith.(12) But let us end with this chapter with the words of the free trader Richard Cobden, speaking in Parliament back in 1846:
You may, by legislation, in one evening, destroy the fruits and accumulations of a century of labour; but I defy you to show me how, by the legislation of this House, you can add one farthing to the wealth of the country. That springs from the industry and intelligence of the people of this country. You cannot guide that intelligence; you cannot do better than leave it to its own instincts. If you attempt by legislation to give any direction to trade or industry, it is a thousand to one that you are doing wrong; and if you happen to be right, it is a work of supererogation, for the parties for whom you legislate would go right without you, and better than with you.(13)
We now proceed to the next and final issue of Free Life Commentary devoted to economic issues.
1. "Discuss the view that profit is an unnecessary surplus which should be removed by the imposition of high taxes"—from the Economics A Level paper set by the Associated Examining Board, Winter 1995. The fact that a discussion is called for, rather than a contemptuous three line dismissal, testifies to the bias of mainstream welfare economics.
Look also at the headline article in The Daily Mail for the 8th August 2001: "Windfall Tax on the Oil Giants' Profits?" Apparently, the Government is considering a tax on the oil companies because their profits are "too high". BP is earning about £1.3 million an hour. This was denounced as "obscene" and a sign of "excessive greed" by various motoring organisations. Doubtless, these reactions owe much to non-economic habits of thought. Even so, they are justified by the mainstream economic view that profit serves no purpose beyond the very short term need to bring markets into equilibrium.
2. Gordon Brown, Where There is Greed, Progress Press, London, 1989—an interesting read, bearing in mind what he is now saying. Indeed, Mr Brown can credibly be called Margaret Thatcher's best Chancellor of the Exchequer. He has so far avoided the policy overshoots that marred the work of both Geoffrey Howe and Nigel Lawson in the 1980s. Of course, he must be making serious mistakes, and these will become apparent with the passing of time. But, as of August 2001, there is hardly one criticism to be made of his financial management within the framework of the consensus established by Margaret Thatcher.
3. See his lecture, Unemployment versus Inflation? An Evaluation of the Phillips Curve, IEA Lecture No.2, the Institute of Economic Affairs, London, 1975; also his article, "The Role of Monetary Policy", American Economic Review, March 1968. See also (With Anna Schwartz) his monumental Monetary History of the United States 1867-1960, National Bureau of Economic Research Studies in Business Cycles, No.12, Princeton University Press, New Jersey, 1963.
4. See, among much else: Milton Friedman, Capitalism and Freedom, University of Chicago Press, Chicago and London, 1962; An Economist's Protest: Columns in Political Economy, Thomas Horton and Company, New Jersey, 1972; with Rose Friedman, Free to Choose: A Personal Statement, Penguin Books, Middlesex, 1980.
5. See, for example, James Buchanan, What Should Economists Do?, Liberty Press, Indianapolis, 1979, pp.17-37.
6. Takes this definition from one of the standard A Level textbooks:
"Entrepreneurs are individuals who:
(Alain Anderton, Economics, Causeway Press, Lancashire, third edition, 2000.
7. For the clearest exposition, see E.H. Chamberlin, The Theory of Monopolistic Competition, Harvard University Press, Massachusetts, 1956 (7th edition). See also Joan Robinson, The Economics of Imperfect Competition , Cambridge University Press, Cambridge, 1933.
8. For a good critique of equilibrium analyses of all kinds, see Israel Kirzner, Competition and Entrepreneurship, The University of Chicago Press, Chicago and London, 1973, pp.118-19 et passim.
9. F.A. von Hayek, "The Use of Knowedge in Society", published in Individualism and Economic Order, Routledge and Kegan Paul, London, 1949. See also his 1945 paper, "The Meaning of Competition", published in the same book
10. Israel Kirzner, "The Role of the Entrepreneur in the Economic System", The Freeman, a publication of The Foundation for Economic Education, Inc., New York, February 2000, Vol. 50, No. 2.
11. Israel Kirzner makes this point:
"[F]or an exchange transaction to be completed, it is not sufficient merely that the conditions for exchange which prospectively will be mutually beneficial be present; it is necessary also that each participant be aware of his opportunity to gain through the exchange.... [E]xchange may fail to occur because knowledge is imperfect, in spite of the presence of the conditions for mutually profitable exchange."
(Competition and Entrepreneurship, pp215-16)
12. See: Heny Hazlitt, Economics in One Lesson, Harper and Brothers, New York, 1946; Frederic Bastiat, "What is Seen and What is Not Seen", published in Selected Essays on Political Economy (translated by Seymour Cain), the Foundation for Economic Education Inc, New York, 1964; Adam Smith, An Inquiry Into the Nature And Causes of The Wealth of Nations, 1776—see especially:
"Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages." (Chapter II, "Of the Principle which gives occasion to the Division of Labour")
13. Richard Cobden, speech in the House of Commons on the Corn Laws, 27th February 1846—in Speeches on Questions of Public Policy by Richard Cobden, MP, edited by John Bright and J.E. Thorold Rogers. T. Fisher Unwin, London, 1870, vol. i, p.197.