The free market system in social context

Before proceeding further, however, it is useful to consider the institutional conditions needed if the market system is to operate efficiently. These conditions are easy to take for granted, but the transition from socialism to a market system in many countries has shown just how important the social context of the market can be.

First, the price system presupposes a stable and reliable medium of exchange. This implies the existence of a secure and widely acceptable currency. A monetary

economy differs from a barter economy in that it allows exchange to occur even

in the absence of a coincidence of wants between the buyer and the seller. For

example, a car worker can sell labour to the employer in return for money, which

can then be spent on goods and services at the individual’s discretion. By contrast,

exchange will take place in a barter economy only if someone is willing to

take exactly what another has to offer – one needs what is called in the jargon a

double coincidence of wants. Also, if the general money price level is rising rapidly

and unpredictably, people get confused about the real price level and are unable

to distinguish between an absolute rise and a relative rise in the price of a good

they are interested in trading. Rapid price changes involve great uncertainty._

Second, there must be full information. The market cannot work well if

consumers are ignorant of the qualities of the good or service being purchased –

lack of such knowledge explains why so much of the health service has been

taken over by the state and why there is such intensive regulation of the banking

and insurance industries.

Third, competition is needed in order to ensure that

firms respond quickly and efficiently to price signals and that best production

techniques are utilised and waste avoided.

Fourth, we need strong institutions, in particular the institution of private property

and a legal framework. At one time, proponents of market socialism believed

that market mechanisms could apply while retaining state ownership. But experience

showed that this was not a practical proposition. Bureaucrats ‘bargaining’

with other people’s goods and services will rarely act in the same manner as consumers and producers would in a free market. Individuals will save only if there is

a real prospect of their being able to use their savings at a later date as they wish.

Entrepreneurs will invest only if the profits they earn can be retained, either to

reinvest or to pass on to future generations – or even to ‘waste’ on luxuries.

Private property is needed if the investment and saving decisions of the market

system are to be efficient. In addition to private property, one needs a broad legal

framework covering bankruptcy, competition law and contract enforcement.

Limited liability, patents and the public company are examples of legal constructs

which have exercised enormous influence on the process of industrial development.

Without them, the market system as we know it today could not have developed.