Why the free market is successful

By Arthur Middleton Hughes

The
price system is just one of those formations which man has learned to
use…after he had stumbled upon it without understanding it. Through it, not
only a division of labor, but also a coordinated utilization of resources based
on an equally divided knowledge has become possible.

We
must look at the price system as…a mechanism for communicating information if
we want to understand its real function.

Assume
that somewhere in the world a new opportunity for the use of some raw material,
say tin, has arisen, or that one of the sources of supply of tin has been
eliminated. It does not matter for our purpose — and it is significant that it
does not matter– which of these two causes has made tin more scarce. All that
the users of tin need to know is that some of the tin they used to consume is
now more profitably employed elsewhere and that, in consequence, they must
economize tin. There is no need for the great majority of them even to know
where the more urgent need has arizen, or in favor of what other needs they
ought to husband the supply…The whole acts as one market, not because any of
its members survey the whole field, but because their limited individual fields
of vision sufficiently overlap…

The
most significant fact about this system is the economy of knowledge with which
it operates, or how little the individual participants need to know in order to
be able to take the right action. In abbreviated form, by a kind of symbol,
only the most essential information is passed on and passed on only to those
concerned. It is more than a metaphor to describe the price system as a kind of
machinery for registering change, or a system of telecommunications which
enables individual producers to watch merely the movement of a few pointers, as
an engineer might watch the hands of a few dials, in order to adjust their
activities to changes of which they may never know more than is reflected in the
price movement.

–  Friedrich Hayek  1945

                               Economics is about the actions of
individuals

The story of economics is the story of the
actions of individuals.  Human beings are
the heroes in economics — not social forces, not classes, not institutions or
government. Men have intentions, and purposes. Their goals and means are not
given to them, they create them. Unlike animals or inanimate objects, human
beings are conscious, they have free will, and they act deliberately to make
their situation better. Better for whom? For themselves and for people that
they care about.

Furthermore, people learn and react.
Defeated in what they try to do today, they learn what went wrong and try
another idea tomorrow. They look for the causes of the things that happen about
them, and seek the paths of action that will get them what they want.

Finally, people work together. They
cooperate, they trade, they bargain. They are always trying to exchange what
they have for what someone else has, coming out the better for it.

                                           Economic Schools of Thought

In the physical
sciences, there is a large body of theory which has been widely accepted as
correct. The disagreements are found only in very new concepts, like black holes
in space or global warming. Eventually these disputes are resolved by
experiments and the gathering of more information.

It is much more
difficult to resolve disagreements in economics. Since the subject matter of
economics deals with the interactions of millions of men and women, controlled
experiments are impossible. Gathering of information helps to disprove or
substantiate theories, but is seldom conclusive.

As a result, there
are today many different schools of economic thought with fundamental
disagreements about basic concepts. These schools include Socialists,
Monetarists, Keynesians, and Free Market Economists (sometimes called
Austrians). After years of teaching Keynesian Economics I have decided that I
was wrong. Today I concentrate on the free market approach. I worked for 32
years for the Federal Government – long enough to find out that government is
not the answer to most economic problems.

                                                     The market process

Man is a social animal. Virtually every
day he involves himself in trading activities with other people; exchanging
possessions, work, and time, for goods and services which he hopes to receive
from others. In deciding to undertake each exchange, each individual first asks
himself what he values most of several possibilities that occur to him. For
example, when the typical shopper enters a supermarket or department store, he
is confronted with thousands of things that he might conceivably buy. He can’t
buy them all, or even one percent of them. To make up his mind, he ranks the
items that occur to him based on his desires, and his budget, and fills up his
shopping cart. Some items he rejects as being too expensive. Others are not
what he wants.  In the end, he will
exchange his money for the items if the price is acceptable and profitable for
him, and the best deal he can get at the time. Consumers are the key to
determining market prices.

The “market” is the name for the
process whereby people interact with each other each day to cooperate, to work,
and to trade. Sellers meet buyers. Resource owners meet people who want to buy
their resources. Each person brings what he has or does, to trade it for
something that someone else has or does.

Success in the market is dependent on
providing something that other people want. Each is pursuing his own best self
interest, of course, but he finds that, in most cases, success is dependent on
pleasing others by providing them with what they are looking for at a price
that they are prepared to pay. Not all exchanges are successful. Many people
are offering products or services that are not in great demand. When this
happens, they find that they may have to revise their plans: they must offer
some other product, or reduce their price.

After a while, some people become
proficient at the market process. They discover a product or service in which
they have a comparative advantage: they find something that they can make or do
which other people desire and will pay for.

My own experience is relevant here.  I worked at direct marketing from 1978 to
2011.  In 1985 I discovered Database
Marketing: a method of creating a database filled with data about customers,
and using that to send relevant promotions to them.  It worked.
I wrote a book about it in 1991 – the first book in the US on database
marketing. It was a success. As a result, two years later, I was asked to give
a two day seminar on the subject at York University in Toronto to a group of 49
Canadian marketers.  It was a success. I
gave five such seminars over a two year period. Since I could fill a room with
paying Canadian customers, I thought I could do the same thing in the US.  So, I created the Database Marketing
Institute. I recruited Paul Wang, a marketing professor from Northwestern
University in Chicago to help me.
Together we gave 28 two day seminars on the subject to more than 1,400
Marketing VPs from major US corporations.
I banked more than a million dollars after expenses.  Then in 2000, the market crashed. I could no
longer give profitable seminars on database marketing. I had to find something
else to do to make a living. I wrote and had published eight database marketing
textbooks. I discovered that such books are a way of becoming well known, but
not a way to make a living.

I worked at four different corporations
from 2000 to 2011. At the last one in 2007 I discovered E-mail Marketing – the
great new thing after Database Marketing. Perhaps this is what I can sell to
make a living.

Competition in the market is a discovery procedure. No one knows at
any one time whether his product or service is still in demand, or whether it
will be displaced by a better or different product or service offered by
someone else. We may have been confident of what we were doing yesterday, but
tomorrow we will have to learn about the market all over again, because the
actions of thousands of people in the market may have changed the situation.
Yesterday’s knowledge may not be valid tomorrow. Competition, therefore, is a
never-ending “testing” process.

                                                      The role of prices

Prices are signals that convey information
to people in the market. When prices of a given commodity increase, it may be
because some disaster befell the supply of it, or because somewhere some people
are demanding more of it. It doesn’t matter which. The fact that prices are
rising sends valuable signals to thousands in the market who don’t know the
cause of the price changes. It tells buyers that they should switch to
something else, or economize in their use of it. It tells producers that they
should make more of the commodity.

One school of economics, equilibrium analysis, holds that
competitive markets are normally at “equilibrium”, and that the
prices in the market can be determined by mathematical equations which relate
demand and supply. Such static relationships have nothing to do with the real
market process which is a coordinating process of constant change through time
in which marketplace participants, each guided by their own particular
knowledge expectations and creative judgements discover information and
opportunities in the process of competition.

                                                The world is not random

The study of economics consists of
analyzing the actions of individual people, and trying to determine the logic
behind their actions. The world we live in is not completely random. Most
things that happen have some definite cause which, in theory, can be
discovered. The actions that people take in the market process are, therefore,
generally, quite logical when looked at from their point of view. If we can
understand the way people think, we can begin to understand why they are doing
what they are doing, and what they are likely to do in the future given certain
situations in the world around them.

Because economists sometimes can
anticipate what people are likely to do, given certain circumstances, however,
does not mean that economists can predict the future. Each person’s actions are
not just the product of the market forces which he experienced yesterday or the
day before. People are intelligent, thinking creatures who learn by past
experience, and have the creative imagination to dream up new reactions to new
or old situations. Learning what they did last year when interest rates went
up, therefore, is not necessarily a guide to what the same people will do this
year when the same thing happens. They are smarter this year. Some of them will
react differently as a result of previous experience.

                         Economic laws are qualitative, not
quantitative

The laws that economists derive from the
study of the logic of human action are qualitative laws, not quantitative ones.
An economist can say that if the supply of something goes down, while the
demand remains the same, the price will probably go up.  Economists cannot say that an X percent
reduction in supply will bring about a Y percent increase in price, because no
one can know that. Even if it happened last year, and the year before that,
there is no assurance that exactly the same thing will happen this year,
because the people involved have learned something and may not react the same
way on this occasion.

                                                The Subjectivist Method

Looking at the world from the perspective
of the people involved is called the subjectivist method. Ends, means, costs,
and benefits have meaning only when understood from the point of view of the
people who are taking the actions. Human minds classify, rank, and arrange the
world around them into categories of meanings and purposes that make sense from
their point of view. People usually (but not always) do the things that seem
most important and useful to them at the time, for reasons of their own.

Economics is not an experimental science,
like chemistry or physics. In these disciplines, a theory can be tested by
repeating an experiment over and over again, keeping all other factors
constant. If the scientist’s theory is correct, he always gets the same
results. This virtually never happens in economics, because the reactive units
being studied are not atoms, molecules, or chemicals, but thinking and
adaptable human beings with free will, individual creative minds, each looking
out for himself.

This strikes some people as wrong. After
all, they reason, scientists can
tell us precisely how much heat will be generated in a nuclear reaction. Why
can’t economists predict the price of gasoline? The difference is that
scientists are working with inanimate physical things like uranium, water, and
graphite. These objects of physical science do not act; they do not choose,
change their minds, and choose again. But people do change their minds, and
their actions, all the time. Their behavior cannot be predicted with
mathematical precision. Economist’s laws must deal with what human beings are
most likely to do in a given situation, recognizing that each person has a will
of his own, personal preferences known only to himself, and freedom to do what he
wants.

Is man an economizing machine?

This is a question posed by modern
economic analysis. There are two methods of answering the question today:

n  The first method –  equilibrium analysis — maintains that people
seek to maximize their welfare given the conditions that they face. Economic
choices can be turned over to computers, since any economic problem is solvable
if you have the proper formulas and inputs. Most economists today use
equilibrium analysis.

n  The second method — subjective analysis
– maintains that people have free will, the ability to think constructively,
and that they will react differently today from the way they reacted yesterday
because they have learned something from yesterday’s experience.

The problem with the equilibrium school is
that, reduced to its most basic elements, it allows no room for free will at
all; yet we know that people do think, learn, create, and often come up with
answers that no computer was ever programmed to think of.

A problem with the subjectivist idea is
that, reduced to its simplest terms, you cannot predict anything at all in
economics, since people, with free will, are capable of unpredictable responses
to the conditions they face.

Which is the better method for analyzing
economic behavior?

                                                    A gasoline tax example

To resolve the dilemma, let’s take a
specific example: an increase in the tax on gasoline. What will be the effect
of such a tax on the actions of the public?

Equilibrium
analysis
would suggest
that people try to maximize the value of their money. Since gasoline has become
expensive, and their incomes have not increased, to maximize their utility they
will switch to car pools, or public transportation, buy fuel efficient cars, and,
in general, try to reduce their consumption of gasoline.

Subjective
analysis
would conclude
that all of the foregoing analysis is correct, but that it leaves out important
human motivations. An automobile is not viewed by most people strictly as a gas
guzzling machine. A car is a status symbol. A car is a blessing to people in
that it provides more freedom of movement than any other form of
transportation. Cars make it possible to live way out in the country, and still
work in a city. Heavier cars are often preferred because lighter fuel efficient
cars tend to be more dangerous to drive. All of these ideas influence
automobile owners in their spending decisions.

Using equilibrium analysis, an economist
will construct a set of formulas concerning the elasticity of demand for
gasoline. He will feed these into a computer which will predict exactly how
many more fuel efficient cars will be purchased given a $1 per gallon gasoline
tax increase.

Subjective Analysis would suggest that
each person is an individual with his own set of subjective values. We cannot
predict which of the many values that automobiles represent to him will be most
important to him, so we cannot accurately predict the results of a gasoline
tax. However, Subjective Analysis would conclude that a higher tax of gasoline,
in the long run, will certainly lead some people to shift to more fuel
efficient solutions.

Which is the best method? Clearly both
concepts have something going for them. Once the price of gasoline gets high
enough, it becomes a factor in almost everyone’s transportation decisions. Some
percentage of the population at any given time will react as the equilibrium
analysts predict. Others will be governed by values other than strictly saving
money on gasoline, such as personal safety, freedom, and status, thus reacting
as the subjectivists predict.

In other words, raising the tax on
gasoline will have both predictable and unpredictable results. People’s reaction
to the increase will be as variable and imaginative as the human mind. The
economist should be humble in trying to predict public response to such a tax,
saying: “We think that many people will probably switch to fuel efficient
cars in the long run as a result of the tax, but we cannot be sure, and we
cannot give a specific numerical answer to the effect of the tax”.

            The lack of constants

Despite more than 100 years of recording
economic statistics in scores of countries around the world, economists,
econometricians, and social scientists have not been able to find a single
quantitative constant in human affairs. The physical sciences contain hundreds
of universal constants: the molecular weight of elements, the speed of light,
the boiling point of water, etc. The formulas of physical science are based on
manipulating these numbers. Economics, unfortunately, does not have even so
much as one of these universal constants. There is, therefore, no mathematical
formula in economics that is always true as there are formulas in physics.

Since we cannot make quantitative
predictions, have no constants, and therefore have no precise mathematical
formulas in economics, what can economists know about the world?

                                              What economists can know

An economist can see causal relationships:
if the supply of money goes up, and prices of commodities go up shortly
thereafter, the economist can think through how the increased money has
affected different people, what they probably did, and how their actions affected
other people. By working all of this out as a mental experiment, the economist
comes to understand why things happened.

If the government requires that a certain
percentage of motor fuel contains ethanol made from corn, for example,
economists can trace the relationship between these benefits to corn growers
and a subsequent rise in the price of corn in the market. The economists
discover that the use of corn to make gasoline will produce a shortage of corn
in the world market. Millions in third world countries may starve. Is this an
economic law?  Of course. The economist
cannot predict how much corn prices
will change, but he can understand the logic of what is happening, and why it
is happening. What economists know is that underlying all of these human
actions in the market is an important motivating force: self interest.

                                Self Interest: The Key to Human Action

One of the most important rules in economics
is a very obvious one: that people act to improve their personal situation.
This can be restated to say that people generally do what is in their own self
interest, whether they are consumers, employees, managers, or government
officials.

Every normal person has unsatisfied
desires which he would like to have satisfied. His actions — consciously or
unconsciously — are generally directed at improving his situation, as he sees
it. These desires are personal. They are subjective. Outsiders can never
completely understand them.

                                              Individuals act, not groups

Analysis of the logic of human action
tells us that actions are always taken by individual people, not by groups. You
will read in the press that “the community has decided to increase
military spending”, or “the economy is turning a deaf ear to labor
demands”. There is no such thing as the community or the economy
or labor in the sense of a force that
can decide to take an action.  What has
happened is that certain individuals in the community or the economy have taken
certain actions for reasons of their own. By trying to explain economic
phenomena as the result of the actions of classes of people, rather than the
actions of particular individuals, we make it harder to understand what is
happening rather than easier.

Economist Alfred Schultz said, “I
cannot understand a social thing without reducing it to human activity which
has created it, and beyond it, without referring this human activity to the
motives out of which it springs.”

                                                  The Division of Labor

One of the first economists in the world
was Adam Smith, who published his classic book The Wealth of Nations in 1776. Adam Smith laid the groundwork for
most of the branches of economics that exist today. He devoted the first part
of his book to a very important economic principle: the division of labor; a principle which was central to the industrial
revolution that was sweeping England in the years after 1760.

In primitive societies households often
have to provide everything for themselves. They grow their own food, make their
own clothes, and build their own houses. Because of their inefficient
production system, they are usually quite poor. Economic progress came about
when people learned to work on common projects, with each person specializing
in some one thing, and trading that commodity or service with others who were
also specializing. The process began with specialists like blacksmiths,
carpenters, bricklayers, weavers, shoemakers, and millers. These specialties
have existed in civilized communities for thousands of years. The division of
labor really started to improve the quality of life in a major way in the late
1700′s when factories were built in England in which many people specialized in
the production of one commodity: cotton thread, iron, or pottery. Scores,
hundreds, or thousands of people working in a single factory, turned commodities
available to them so rapidly and cheaply that the whole society benefited from
having lower cost consumer goods, and plenty of jobs.

                                              Adam Smith’s Pin Factory

In a famous passage, Adam Smith described
a pin factory. He began by pointing out that someone who was not acquainted
with the machinery involved would not know how to make a pin. But in the
factory he observed, they were making thousands:

“One man draws out the wire, another straights it, a
third cuts it, a fourth points it, a fifth grinds it at the top for receiving
the head; to make the head requires two or three distinct operations; to put it
on, is a peculiar business, to whiten the pins is another; it is even a trade
by itself to put them into the paper; and the important business of making a
pin is, in this manner, divided into about eighteen distinct operations…Those
ten persons, therefore, could make among them upwards of forty-eight thousand
pins in a day. But if they had all wrought separately and independently, and
without any of them having been educated to this peculiar business, they could
certainly not each of them have made twenty, perhaps not one pin in a day.”

In the England of Adam Smith’s day,
factories like this one were springing up for the first time. They have since,
of course, spread all over the civilized world, and brought untold wealth and
satisfaction to billions of people, as well as pollution to the environment and
congestion in the cities. Before the 1700′s, there were virtually no such
factories which made mass consumer goods anywhere. Today, factories are
everywhere.

The study of economics is closely
connected with the division of labor and the industrial revolution. Before the
1700′s life for the average person was slow, dull, and difficult. Wealth was
acquired by marriage, inheritance, conquest or royal favor, not by production.
Most people were born to a certain station in life – whether they lived in Europe,
Africa or China — and remained in this station until they died. Today, due to
the full development of the division of labor throughout the world, anyone in
most industrial countries can realistically dream of being able, if he is lucky
and works hard, to have a far richer, healthier and pleasanter life than the
average man ever had at any time in the past. Few people in non-industrial
countries today can have that expectation.

                                             An interdependent economy

The division of labor exploded far beyond
the walls of the factories in which it began. The pin makers prospered because
someone else was growing their food, and making their clothes. The factory
owners traded pins for money, and paid the workers with the money. Workers
could buy what they needed. The market went far beyond that. Traders bought
their pins, transported them to distant cities where they were wholesaled to
retail stores. Dressmakers used their pins to speed up and reduce the price of
clothing manufacture. What grew up in England, and eventually everywhere, was a
truly interdependent economy with thousands of specialized firms trading their
output in a vast market that supplied everyone’s needs. Today, we go to
shopping malls and supermarkets to buy consumer goods brought here from a
hundred countries including China, Korea, Japan, Italy, India, and Canada as
well as every part of the United States. We eat peaches from Georgia in the
summer, and peaches from Chile in the winter — and most of us are not even
aware of where they come from.

How is it that these millions of people
all over the world are willing to work to manufacture and ship to us the goods
that we find in our stores today? The answer, of course, is that they find it
profitable to do so. A huge worldwide market has evolved in which everyone
profits by making products and services for other people — usually people who
they have never met. How do they know what to make, in what quantities, and how
to price their products? Who tells them what to do? That is the magic of the
market system. No one is in charge.

                                                     The Invisible Hand

Adam Smith pointed out that the typical
person is really only working to benefit himself. In the market process,
however, he finds that to be successful he has to provide something that other
people want. Each person, he said:

“intends only his own security; and by directing [his]
industry in such a manner as its produce may be of the greatest value, 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. Nor is it
always the worse for the society that it was no part of it. By pursuing his own
interest, he frequently promotes that of the society more effectually than when
he really intends to promote it. I have never known much good done by those who
affected to trade for the public good
.”

Self interest, then, is the incentive that
makes the market system work, and and enables it to provide the goods and
services that people want.

Adam Smith – The First
Economist

 

Adam Smith
(1723-1790) grew up in Scotland, was educated at Oxford, and became a professor
of moral philosophy at Glascow. His first book, The Theory of Moral Sentiments made a splash at the time, and got
him talked about throughout the British Isles. As a result, he was invited to
give up his university post to go as tutor to the young Duke of Buccleugh,
traveling with him to France for two and a half years. On the trip he began
writing The Wealth of Nations,
finishing it ten years later in 1776. He spent the rest of his life as
commissioner of customs at Edinburgh.

Smith’s
ideas were new, and quite controversial. His principles were simple: a) the
prime psychological drive in man as an economic being is self-interest. b) the
competition of thousands of people each trying to further his own ends by
satisfying his customers results in the public good c) the best policy is to
leave the economic process alone — what has come to be known as laissez-faire,
economic liberalism, or non-interventionism.

Although
Smith, an acquaintance of James Watt, inventor of the steam engine, wrote at a
time when the Industrial Revolution was just getting underway, he himself was
quite unaware of it.  In 1770 the typical
water-driven factory held 300-400 workers. There were only twenty or thirty such
establishments in the whole British Isles at the time.

The Wealth of Nations is the first full-scale treatise ever
written on economics, containing a solid core of production and distribution
theory. His central theme is the workings of the invisible hand: it is not due
to the good will of the baker but to his self-interest that we owe our bread.
He saw the simple truth that through the market, private interests are
harmonized with social interests; without collective regulation, the market
economy conforms to orderly rules of behavior. Each person, looked at
separately, is ruled by the prices in the market, yet the prices themselves are
controlled by the sum total of the reactions of all market participants.

At the time
he wrote, many people believed that private enterprise must be anti-social
because it was pursued for private profit. Smith turned the argument around. He
showed that free competition of entrepreneurs bidding for resources tends to
optimize the allocation of resources between industries, thereby making the
best use of the resources of the country.

Smith
criticized the university education of his day, favoring teacher payment on a
private fee basis, rather than a fixed salary, thereby encouraging professors
to exert themselves to the utmost. Smith’s book was so sweeping and
comprehensive that it has formed the starting point for all subsequent economic
analysis. All economists since Smith, while they have had their differences
with him, have acknowledged him for his acute insight into the nature of the
economic process.

            The use of capital

What helped the division of labor to
become so successful was the widespread use of capital in the production
process. Capital can be defined as man
made goods which are used to produce other goods.
  The early pin makers had simple machinery to
work with. The machinery was their capital. Most of the work was still done by
hand, though. As technology advanced, more and more of our work is being done
by machines, and less and less by hand.

Today, the average worker is supported by
vast amounts of capital which makes him terribly productive. He sits at a
computer in an air-conditioned office under recessed lighting, using
electricity made by a massive generator a hundred miles away that he has never
seen, and will never see. He talks over a telephone system in which his
conversation is bounced off a satellite in space on its way to the other side
of the world. He places an order for delivery of textiles made in India, to be
delivered by ocean liners, railroads and trucks to a dress making plant in some
other country where it will be cut and basted by machines guided by computer
generated dress patterns.

Where did all of this capital come from?
From people saving and investing their income instead of spending it. Before
the owner of the pin factory could open for business, he had to save enough
money to buy the pin making machines, rent the building, purchase the wire, and
provide a salary for the workers while he waited for the finished pins to be manufactured
and sold. The capital had to come first. Capital is created by saving and
investment.

Capital is not a homogeneous product that
can be supplied equally to all businesses. Instead, capital consists of a
thousand particular special things — like the head grinding machine in the pin
factory — which are usually of little use to anyone outside of the particular
enterprise where they are located. The more capital that businesses in a
country use in their work, the more productive is the economy, and the richer
are the people.

                                                        Rich and Poor Nations

Why are the people in some countries
richer than the people in other countries? If we study many countries we will
find that the people in the rich countries have more capital to work with. How
did they get this capital? They got it by trading freely in the world wide
division of labor, and by saving their income so that they could accumulate the
capital. Beginning around 1900, the Japanese began to save and accumulate
capital. In the years from 1950 to 1990, the average Japanese saved about a
third of his salary each year, which went into building up the capital in the
enterprises in Japan. Through this process, Japan became one of the most
economically productive countries in the world.

In this chart, you can see the annual per
person income in 2009 in U. S. dollars in several countries. Norway leads with
an average of $151.23 per person. The United States is considerably behind, at
$128.77. China and India are far behind. There is a relationship between the
income and the amount of the gross domestic product (GDP) saved and invested
each year.

In many countries in Africa, Latin America
and the Middle East, one can see little evidence of any saving at all. Internal
unrest, civil war, and governmental systems that have made saving and
investment almost impossible have doomed the peoples of  Somalia, and North Korea, for example, to a
life of permanent poverty. At the same time, the peoples of South Korea,
Australia, and The United Kingdom are happily saving, investing and becoming
more and more wealthy.  The differences
are traceable to basic economic principles which can be derived from the logic
of human action.

                                                   Money and the free market

One reason why the division of labor has
been so successful is the free market system: a process in which goods and
services are freely traded for money. The money serves as a medium of exchange.  Pins are sold for money. The pin makers pay
their workers with this money. The workers buy their food, clothing and rent
with the money. The shopkeepers trade the money to get what they want to buy.
The market encourages competition. Anyone who can provide something more
desired by the consumers is encouraged to provide it by virtue of the profits
to be made through trading. In the process, those who make the most desirable
goods at the lowest prices succeed, and those who make higher priced goods less
desired by consumers tend to lose. These producers either have to revise their
production methods, or go out of business.

                                            Competition: The Spur to Progress

A key factor in making the market system
function is competition. No matter how successful an enterprise becomes, there
are always newcomers who can come up with a way to make a better or a less
expensive product, and take away some of the business from the larger firm. To
steal business from another company, you have to offer the public something
that they like better such as a newer product, lower price, improved
appearance, superior service, or more convenient and speedier delivery). Once the
new product begins to bite into the larger firm’s sales, its owners had better
change their product or improve their service, or they will be out of business.
In this way, each new entrant to the market, through competition, results in
everyone else being forced to install better technology, better service, or lower
prices.

                                                  The role of the entrepreneur

There were many factors that came together
at once in Adam Smith’s time to produce the explosion of production that we call
today the Industrial Revolution. We have seen, so far:

  •  The
    incentive of self interest
  •  The
    division of labor
  •  The
    role of money
  •  The
    role of capital
  •  The
    market system
  •  The
    role of competition

Missing from this list is a key person:
the entrepreneur — the person who assembles money, capital, workers, and a
successful idea, and organizes a profitable enterprise. The growth of
production and trade does not happen automatically. It is the work of
individual people who see an opportunity to enrich themselves by trading or
manufacturing products which they can sell profitably to other people on a mass
scale.

                                                    Alertness to opportunities

While everyone in the market is trading on
a daily basis (going to work and shopping), some individuals do more than
simple trading. Some people have the capacity for vision and discovery. They
discover possibilities, and design plans for bringing those possibilities into
existence. Entrepreneurs are alert to opportunities and discrepancies between
what is available in the market, and what people seem to want. They discover
that profits can be made by organizing to fill these wants.

Entrepreneurs bring resources together:
funds, workers, materials, machines, and figure out how to create something
that is wanted by other people. They make a profit by correctly anticipating
other people’s needs.

Success in entrepreneurial activity is often
fleeting. If a business is successful, other entrepreneurs will soon compete to
provide the same or better products or services. Those who anticipate the
public’s desires best will profit; others will lose. Every day there are new
opportunities, and new entrepreneurs are offering new methods, processes,
products and services.

There have always been a few such people
in the world. A combination of circumstances in England in the late 1700′s
permitted a large number of them to get started all at once. John Wilkinson
made a fortune in the iron business. James Watt made steam engines. Robert Peel
became rich spinning cotton thread.
Josiah Wedgewood built a very successful business producing pottery.

What made these men successful was their
alertness to opportunities in the market which others did not see. Looking
backward in time, many of the important developments in production seem
inevitable: electricity, the automobile, the airplane, television, the
computer. But these developments were not inevitable at all. They were the
result of imaginative entrepreneurs who saw them as an opportunity to improve
their situation in the world. In other words, the history of economics is not
the story of “market forces” but, instead, is the history of the
actions of individuals who, motivated by self interest, were alert to
opportunities and exploited them to produce output which they could sell
profitably to other people.

                                                               Nationalization

On the other hand, ever since Adam Smith’s
time, there have always been people who assumed that the economic progress that
they saw around them was an inevitable product of “economic forces”,
rather than the work of individuals. From Karl Marx to modern socialists, many
have lamented the fact that entrepreneurs become wealthy through organizing the
efforts of others. “Wouldn’t it be better if these great enterprises were
to be organized and run for the good of the general public, instead of for the
private profit of a few?” has been the general approach of these thinkers.
In many countries, like England, Chile, Argentina, and Mexico the government
nationalized large private corporations and banks to run them as governmental
enterprises. In the United States, the government has taken over most of the
subways, busses and trains. In Russia, China and a dozen other communist
countries, the take-over was done on a mass scale, often accompanied by the
murder of the previous owners.

The results have been a disappointment.
Most of the nationalized industries soon became inefficient, outmoded, and
unprofitable. Whereas in most free market countries, industries encourage the
public to buy more of their products with persuasive advertising and deep
discounts, in socialist countries it is just the opposite. There is usually a
shortage of what the public wants, with long lines, rationing, and waiting
lists. In the United States, for example, the telephone companies urge people
to install a second telephone line, a cellular telephone, television,
broadband, or some other service. In most government owned public telephone
companies elsewhere in the world, customers wait months, or even years, to get
any telephone service at all. A second line is out of the question.

The missing element in these government
run industries is the entrepreneur. Without self interested, profit seeking
entrepreneurs providing competition in a free market, the government owned
industries lack any profit motive. Their costs increase. The industries become
large and inefficient. Without competition, they lose sight of the idea of
pleasing the customers. Politics and the self interest of the managers replace
success in the market as the goal of the enterprise. Most of these government
enterprises are required by law to favor the poor, the unemployed, minorities,
certain locations, or the environment. These political requirements usually
mean that the enterprises are less profitable than private companies.
Furthermore, their managers, with no ownership or stake in the business are not
supposed to make a profit – so they seldom do.

                                      Government: essential to a free market.

The failure of public enterprises should
not obscure the essential role that government plays in a healthy economic
system. Government is essential to maintain law and order. Without government
protection of individual freedom and private property, the industrial
revolution in England would not have been possible, and the economic gains of
the past two hundred years would never have occurred. One has only to look
around the world to see the many places where government does not or cannot
guarantee freedom. In such places, there is little saving and investment going
on. Capital is not being accumulated.

For a free market to exist, government
must protect people from external invasion, and from domestic criminals. It
must provide a court system so that contracts can be enforced, and basic rights
are protected.

                                                         Growth of Production

In the more than two hundred years since
the publication of Adam Smith’s book, there has been an amazing outpouring of
production of goods and services of all kinds in the developed nations of the
world. In these countries today, the average person lives a better lifestyle
than the kings of the world achieved before 1700. Our food, health, education,
houses, transportation, clothing, and leisure are richer and more varied than that
of the Czars of Russia, or the Senators of Rome.

How did all of this come about? How can we
continue our economic success, and avoid the periodic periods of inflation
followed by unemployment which mar our progress? The key to economic growth can
be found in the further development of the division of labor: providing people
with the security and freedom to compete in a free market; to save and invest;
to create capital; to harness the incentive of self interest in the process of
making goods and services for other people.

                                                                     Summary

1. Economics is the study of the actions
of individual people who have their personal intentions and purposes. They act
deliberately to make their situation better for themselves. People learn and
react. Defeated in what they try to do today, they learn what went wrong and
try another idea tomorrow.

2. Looking at the world from the
perspective of the individual people who participate in the market is called
the subjectivist method. Economists use this method to
understand why people take the courses of action that they do.

3. The market is a process whereby human
beings interact each day; they cooperate, work, trade, and compete. Success in
the market is dependent on providing things that other people want.

4. Economists are students of the logic of
human action. They analyze what people will probably do when faced with various
economic opportunities or problems. Unlike a physical science, there are no
constants in economics. Economic laws, therefore, cannot contain mathematical
formulas which are always true, as are the formulas used by physicists and
chemists. Economics is a qualitative not a quantitative discipline.

5. Subjective analysis examines the logic
of human action, assuming that people act to improve their personal situation;
equilibrium analysis assumes that people seek to maximize the utility of their
resources. The results of equilibrium analysis can be determined by a computer;
the subjectivist, however, cannot predict quantitatively what people will do.

6. Actions are taken by individuals, not
groups. Words like the economy, society, the forces of labor, the middle class
may be useful for analysis, but should not be converted in our thinking into
beings that can think and act independently. Thinking this way hinders the
understanding of what is really happening:
individuals not segments of society are acting out of self interest.

7. Adam Smith, in his book The Wealth of Nations in 1776, explained
the division of labor. Economic
progress comes about, he pointed out, when groups of individuals specialize in
one product or service, trading their output with others for what they need. As
a result, a few people working together make more output than all of them could
produce working separately.

8. Mass production of consumer goods was
almost unknown before Smith’s time. It is everywhere today, and is the cause of
the greatest explosion of wealth and improved level of living that the world
has ever known.

9. The entire process is motivated by self
interest. Everyone, thinking only of himself, produces products and services to
sell to others. In the process, as by an invisible hand, each person promotes
the interest of society without meaning to.

10. The division of labor became a
powerful force when there was widespread use of capital in the production
process. Capital consists of man made goods which are used to produce other
goods. Today the average worker is supported by vast amounts of capital, which
makes him very productive.

11. Capital is created by saving and
investment. It is not a homogenous commodity, but is a thousand particular and
special things usually of little use to anyone outside the enterprise for which
it was created.

12. Some countries are rich, and some
poor. The workers in rich countries usually have more capital to work with.
Such capital is accumulated by saving and investing. The Japanese are an
example of a country that grew economically very rapidly by saving about a
third of their income over a period of forty years. Poor countries do very
little saving.

13. The division of labor is successful
because of a free market where goods and services are freely traded for money.
Money serves as a medium of exchange.

14. The market system requires competition
to function properly. Newcomers to the market devise products which are better,
cheaper, or otherwise more desirable. The public shifts to these new products,
forcing the older producers to modernize their products and processes to remain
in business.

15. Growth of production and trade does
not happen automatically. It comes about because individual entrepreneurs assemble
money, capital, workers, and a successful idea to create a profitable
enterprise. The entrepreneur’s success lies in his alertness to opportunities
in the market which others do not see.

16. The history of economics is not the
story of “market forces’, but instead is the history of the actions of
individuals who, motivated by self interest, were alert to opportunities and
took advantage of them.

17. The essential role of the entrepreneur
is shown by the various public enterprises which have been created in countries
throughout the world, which lack entrepreneurs. Such public corporations
usually become large, inefficient, and unprofitable losing sight of service to
the consumer, and producing output that is outmoded and in short supply. In
market economies, enterprises are trying to persuade consumers to buy by
advertising and discounts. In non-market economies, consumers wait in long
lines to get scarce commodities.

18. Government is essential to a free
market system. Without a system of government protection of freedom and private
property, the economic gains of the past two hundred years would never have
occurred. Government must provide a court system so that contracts can be
enforced, and basic rights are protected.

19. Economic analysis began with Adam
Smith, and has evolved over the last two hundred years into several schools
with differing philosophies. The leading schools are Marxists, Keynesians,
Monetarists, Socialists, and Free Market (or Austrian) economists. Although
economics is worldwide, most of the leading economic schools are located today
in the United States.

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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