Chapter 2 Liberal Market Capitalism (latest revision 2009)
In Part I, we will consider the liberal market economy and the social market economy. The liberal market economy, or free market economy, is most associated with the United States and Great Britain. But it is also found in Canada, Australia, New Zealand, and Ireland. The social market economy is found mostly on the European continent. But there are variations within the social market economy; the social market economies of Scandinavia are different from the social market economies of France and Italy.
This chapter will examine the theory of the liberal market economy. “Liberal” is from the Latin word for “free”. (Do not confuse this with political liberals.) Economists have both studied and appreciated liberal market economies since the 18th century. The “father” of the theory of the market economy is Adam Smith, a Scottish philosopher who lived mainly in the late 18th century. His most important work was published in 1776. The views he propounded have been enhanced by a large number of people over more than two centuries and are held in some form by the majority of economists today. Throughout this course, we will be considering the shift to greater use of free markets in most countries of the world. The ideas of this chapter are a major reason for this important shift.
1. Values of a Liberal Market Economy
Let us begin by considering the values inherent in a liberal market economy. Whether you agree or disagree with these values greatly determines your support or opposition to a liberal market economy. The first value in the theory of a liberal market economy is the assumption about the nature of people. This type of person has been called “Economic Man”. This was mentioned in the previous chapter. People are assumed to act as rational, self-interested, maximizers. Consumers attempt to maximize the satisfaction they get from their purchases, given their limited incomes. Businesses attempt to maximize their profits. Workers attempt to maximize their wages or other benefits of a job.
A second value of a liberal market economy is individualism. The individual is seen as the center of society. The function of government is to serve the individual. One prominent economist who supported the liberal market economy argued that President John Kennedy’s call to “ask not what your country can do for you; ask only what you can do for your country” is not an acceptable statement for a free people.
A third value of a liberal market economy is that life is a competitive struggle in which the fittest people survive and prosper. People of great wealth are admired as being particularly intelligent, bold, brave, and so forth. On the other hand, poverty is seen as a moral failing. So when President Obama proposed in 2008 that taxes be raised on people earning more than $250,000 per year, many on the political right charged that “this was designed to punish the successful”.
A fourth value of a liberal market economy is equality of opportunity. Everyone should have an equal opportunity to succeed. This is sometimes called a meritocracy. Liberal market economies are opposed to feudalism, a system in which people are born into certain stations in life. However, equality of opportunity is not the same as equality of results. Supporters of liberal market economies often oppose redistributions specifically designed to make people more equal.
A fifth value of a liberal market economy what sociologist Max Weber called the Protestant Ethic. In this ethic, people are to work hard, be thrifty, and seek personal economic gain. However, accumulated wealth is never to be used for “conspicuous consumption”. Instead, it is to be used for good works and to be re-invested. Therefore, we see very wealthy people endowing universities (Stanford, Duke, Vanderbilt, Rockefeller) or creating foundations to do charitable work (Gates).
2. Basic Institutions of a Liberal Market Economy
A most important institution of a market economy is private property. A certain individual (or group of individuals) own some property and therefore have all of the rights and responsibilities that result from that ownership. He or she has the right to use the property in a lawful manner and also to prevent others from using that property (that would be called stealing). He or she has the right to sell the property, the right to use the property in a business and therefore profit from the property, and the right to change the property. Private property is essential to provide incentives to accumulate wealth. No one would accumulate wealth if he or she believed that this wealth could be taken away at any time. We will see later in the course that some of the countries that are converting from communism to market economies have had problems because they have not had properly specified and enforced property rights.
A second major institution of a liberal market economy is called Free Enterprise. This allows each person the right to engage in any type of economic activity. In the theory of liberal market economies, the word “freedom” means “freedom from government restriction”. As long as the government neither limits your action nor requires you to do certain things, you are considered free. As we will see, other people have had different definitions of “freedom”.
Finally, liberal market economies require Free Competitive Markets. As we saw in Chapter 1, in a market economy, the three questions (what, how, and for whom) are answered through the interactions of buyers and sellers. Competition means that no one buyer and no one seller can influence the price of product alone. Therefore, no one buyer or seller can determine what will be produced, how it will be produced, or who will get it. Sufficient competition is a major requirement. It encourages innovation to lower costs of production or to improve products. It creates variety for consumers.
3. The Invisible Hand
We want an economy to work as well as possible for the benefit of society. But when we say "society", exactly whom do we mean? In the days of Adam Smith (1776), the prevailing view was called mercantilism. In this view, the goal of an economy was to earn gold and silver for the king. The king would then use the gold and silver to pay for a large military for defense and conquest. To Smith, this was wrong. The goal of an economy, he argued, was to serve consumers. "The consumer is the king." This has been called "consumer sovereignty".
(A) A Change in Consumers’ Tastes
To illustrate Smith’s argument, assume there are two products: A and B. The consumer (the king) has a change in tastes; consumers now prefer more of A and less of B. Let us start with A. The demand for A increases. There is now a shortage of A, as buyers want to buy more while sellers have not changed the amount they wish to sell. Recognizing this shortage, sellers of A will raise the price of A. The price has two main functions in a market economy: first, it provides information telling people what to do. Second, it provides incentives for them to act on this information. The increase in the price tells sellers all they need to know; they do not need any fancy market research. The increase in the price tells sellers of A to produce more of A because buyers want more of A. It also provides the incentive to do just that. Sellers are self-interested. Their goal is the maximization of their profits. They produce more of A because doing so increases their profits. Sellers probably do not know why the price increased. And they do not need to know this. Sellers certainly do not care that they made buyers happy by producing A. But by acting in their own self-interest, they have also acted in the social (consumers') interest.
Now, let us look at sellers of B. The demand for B has fallen. There is now a surplus of B because buyers are not buying as much while sellers have not changed the amount they wish to sell. Recognizing this surplus, sellers will be forced to lower the price of B. (Think of what happened when airlines or automobile companies found that they could not sell enough of their product.) The decrease in the price of B provides all the information these sellers need; it tells them that buyers do not desire as much B. It also provides an incentive to produce less B. Producing less B provides sellers of B with the highest possible profit under the new condition of reduced demand for B.
What about the workers? A major goal of workers is to maximize wages. As the production of A increases, producers of A will need to hire more workers. To attract them, the wages paid to workers producing A rise. As the production of B decreases, the producers of B will either hire fewer workers or will reduce the wages of their workers. Those facing lower wages or loss of jobs in B will find the higher wages in A attractive. Workers will move to produce those goods and services that consumers desire most. As just one example: nature was "cruel" and located a large amount of oil in Alaska. Consumers desire oil greatly, but Alaska is not a desirable location for most workers. How did oil companies get workers to go to Alaska to produce oil? The answer, of course, was that they raised the wages substantially. A person working maximum overtime could earn perhaps $75,000 or more in six months in Alaska. That attracted all the workers that the oil companies needed.
Both companies and workers are guided, as if by an invisible hand, to produce the goods and services that are most desired by consumers. And this occurs when all of them were only pursuing their own self-interest. To quote Adam Smith, "He...neither intends to promote the publick (sic) interest, nor knows how much he is promoting it...he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."
Imagine that sellers of B and their workers refuse to follow the information and incentives provided by the falling price of B. They truly love what they are doing and do not wish to change. They would produce a certain amount of B. Some of the B that they produce will not sell. Their profit is less than if they had decreased production. The reduced profit will eventually force them out of business. Producers and workers must follow the wishes of consumers, even if they hate it, or perish.
Assume that sellers actually cared about consumers and wanted to make consumers happy. How would they know what to do? Imagine the time and cost to get all the information they would need to know. More than likely, they would still not produce the right goods or services. Yet, in trying to maximize their own profits or wages, people are guided to produce the right goods and services. They may not even know that they are doing so. To quote Adam Smith again, "by pursuing his own self-interest he frequently promotes that of society more effectively than when he really intends to promote it."
(Question: Explain why there are so many reality shows on television.)
(B) A Change in the Relative Scarcity of Factors of Production
Let us take a different example. In 1973, there was a mysterious disappearance of the anchovy catch off the Peruvian coast. The supply of anchovies was significantly reduced. This hardly seems like the most important news; in fact, very few people even knew of it. In the United States, anchovies are mainly used in the production of animal feed. When the supply of anchovies was reduced, producers of animal feed had to turn to other sources of protein (mainly wheat). These other sources were more expensive. This increase in cost caused an increase in the price of animal feed. When the price of animal feed increased, the costs of production increased for those companies producing beef and pig products. The rising costs of production forced them to increase the prices of the beef and pig products. Consumers were totally unaware of the disappearance of the anchovies. But when they went to market, they noticed that the prices of hamburger, steak, ham, and bacon had all increased. Faced with these higher prices, they ate more chicken, fish, and cheese. They were guided, as if by an invisible hand, to economize on that which had become scarce. Again, the rising price provided all the information consumers needed to know. They did not need to know why the beef and pig product prices had increased. And it provided the incentive for them to buy fewer products that were produced with anchovies and more products that were not. The market not only guides producers to produce those products consumers desire, it also guides consumers to buy less of those products that use resources that have become relatively scarce. (As another example, when oil became relatively scarce, it was important that consumers use less of it. This was accomplished once the price of gasoline rose to more than $4.50.)
To summarize: the "invisible hand" is the market. The most important variable in the market is the price of the product. The price has two functions: it provides information to both buyers and sellers and it provides incentives to act on that information. People act in the own self-interest. Buyers act to maximize the satisfaction they get from the products they buy, given the limitations of their incomes. Sellers act to maximize profits. Workers act to maximize the wages they receive. In pursuing their own self-interest, sellers and workers ultimately do that which is best for society as a whole (that is, for consumers), even though doing so is not their intent and even though they may not know they are doing so. This is the magic of the market.