The Conclusion of Market System

One of the best-known passages in the Wealth of Nations describes how the pursuit of self-interest leads to social benefit:

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 self-interest. We address ourselves, not to their humanity, but to their self-love.

In retrospect, we see that the imposition of centralised decision-making on an

economy can achieve short-term successes. Among them might be included the

transformation of the Soviet economy under Stalin and the restoration of the

Chinese economy under Mao. But history suggests that the successes of such

centralisation soon reach a limit. The postwar experience of Central Europe

confirms this conclusion. Decades of socialism left this region weakened by

an inefficient allocation of resources, by the erosion of innovation and by

technological obsolescence.

One striking consequence of the neglect of the price system by the socialist

countries was the dramatic contrast between energy consumption patterns in

Eastern and Western Europe. Between 1965 and 1985, the energy intensity of GDP

fell from 0.52 to 0.38 per cent in the West, while actually rising in the East over the

same period from 0.73 to 0.78 per cent._9 Because internal energy prices in the Eastern economies were not set at the prevailing international levels, the increase

in world energy prices in the early and late 1970s, ‘signalling’ the need for energy

conservation, was not transmitted to their firms and consumers. As a result, industrialenergy intensity in the 1990s was five times higher in Poland than in the US,and five times higher in Hungary than in Germany. The high level of energy

intensity not only implied a waste of energy due to underpricing, but also encouraged

the growth of heavy pollution industries and gave insufficient incentives to

the development of less energy-intensive methods of production.

Writing of the contrast between East and West Germany, John Kay has

remarked that:

Whatever the superficial attractions of central direction and control, in practice it literally failed to deliver the goods. The immediate contrast between East and West Germany provided as close to a controlled experiment as social science is ever likely to see. The results of that experiment, and its dramatic end, imply that for the foreseeable future the private value-maximising corporation will be the principal engine of commercial activity in Europe.

The ‘private value-maximising corporation’ is the same as the profit-maximising

firm which determines supply. Given the increasing range and scope of the

market system, it has become more important than ever to understand this

system and the role of the firm in its working.

Where the institutional prerequisites are absent, however, market capitalism

can get a bad name. Essentially, the point is that the free market will not perform

efficiently without moral restraints. A legal system based on the principles of

profit maximisation would deliver little justice. Judges would make judgments on

the basis of the highest bribes. Paradoxically, the market system and the pursuit

of self-interest will operate effectively only when a significant proportion of the

workforce puts duty and propriety ahead of personal advancement and prosperity.

It has often been remarked that the definition of property rights based on the

market system depends precisely on the lack of universality of motivations of the

market system. An efficient economy needs an incorruptible judiciary and civil service. An interesting question is whether the market itself tends to undermine some ofthe values of trust, incorruptibility and restraint which we have identified as

essential to its proper functioning. Evidence from the history of economic development suggests that, while it may be relatively easy to pull down the monolith

of central economic control and to reinstitute private property and free exchange,

it takes longer to develop the cultural and social structures necessary to sustain a

truly successful society.

The efficiency of the market system

In older we defined the concepts of productive efficiency and allocative efficiency,and mentioned that, under certain conditions, the free market could be

shown to bring the economy to an efficient point so defined. The analysis of the

market system in this article enables us to provide an intuitive explanation of

why this might be the case.

Consider, first, the demand curve. It shows how much people are willing to purchase at each price. The person who bought the OQth unit of the good in

Figure 3.10 did so because the utility received from it made it just worth the price OP. The consumer tries to ensure that the extra utility obtained from an additional purchase is proportional to its price. This extra utility is termed marginal utility. When deciding how to allocate our income among competing desirable items, we implicitly compare marginal utility and price. If pears cost twice as much as oranges, we assume that, in a free market, utility-maximising consumers will arrange their purchases so that the marginal utility provided by the last kilogram of pears purchased is double the marginal utility of the last kilogram of oranges. Suppose this condition were breached and the utility of pears were four times the marginal utility of oranges. Then the consumer could add to utility, within a fixed budget, by buying more pears and fewer oranges. The utility maximising assumption will dictate a continuance of this reallocation until the 2:1 ratio is reached. Free market prices reflect marginal utilities.

Next, consider the supply curve, SS. This represents the cost of producing the product. The extra cost of producing the OQth unit of output, otherwise known as its marginal cost, is QS. The supply curve slopes upwards because, in the short run, unit costs are assumed to rise as output increases. Hence, at a higher price it

becomes profitable to produce more output and firms continue producing more

until marginal cost equals that higher price. The connection between costs and

price at firm level will be explained fully. For the present, all we need

to understand is that the supply curve indicates the marginal cost of producing

any given level of output.

This is achieved not because market participants are consciously striving to achieve an efficient outcome in the economist’s sense. Rather, they are being driven by the

desire on the part of consumers to maximise utility and on the part of producers

to maximise profits. We are back to Adam Smith’s ‘invisible hand’, leading

market agents to a socially beneficial outcome which was no part of their original

intention. Competition leads profit-seeking producers to provide what consumers

want to purchase at the lowest possible price. While free market competition

tends to lead the economy towards static efficiency, it also has important

dynamic efficiency effects. Over time, pressures of competition will ensure that

costs are kept to a minimum. A free market with competition gives firms a powerful

incentive to seek more effective ways of producing and distributing their

output, through rationalisation and innovation. For most industries, we think of

this process as involving continuing shifts of the supply curve to the right.

The case for competition and the free market as a generator of economic efficiency is subject to many qualifications. The ‘invisible hand’ is itself in need of

guidance. Discussion on these matters is a live issue as many industrial countries

attempt to become more market-oriented and as countries in transition decide on

the type of market institutions most suited for their needs.

The market system in action

The market system in action

The free market comprises a series of interconnected markets. These markets are

assumed to be highly competitive and to operate free of government interference.

This is an initial simplifying assumption, which will be relaxed in later chapters.

In reality, many markets are subject to monopolistic influences, and government

intervention in the market system is a feature of even the most enthusiastically

capitalist society. Indeed, in some circumstances, such intervention can be shown

to be a necessary condition for achieving economic efficiency. Additionally, we

assume a stable institutional framework of law and order within which market

transactions can be conducted in an orderly and predictable way.

Given these conditions, the market system allocates resources between different

uses and among different people. It acts as an equilibrating mechanism between

supply and demand. Prices act as signals; and the price system is the coordinating

mechanism which ensures that markets ‘clear’, i.e. that supply equals demand in

each market.

The operation of the price system is by no means obvious. The fact that a free

market system works at all may be considered, if one stops to think about it, as

somewhat miraculous. Millions of individual decisions are taken daily in a market

economy by producers and consumers. These decisions are independent and

uncoordinated. Yet, by and large, goods and services are available in the shops to

meet consumer demands as they arise. The market system is the mechanism

which brings this about in an automatic and efficient manner.

The market system

The market system can be sketched by reference to three major markets – the

product market, the labour market and the capital market – and two primary sets

of participants: firms and households  The product market comprises

the markets for individual goods and services; the labour market involves

the buying and selling of labour; and the capital market deals with the lending and

borrowing of capital. Each market involves the participation of firms and households.

Thus, households sell their labour to firms; and, with the salaries so earned,they buy goods and services from firms. Firms produce goods and services byhiring labour and capital from households .Households andfirms also interact on the capital market. If individuals choose not to spend alltheir income, their savings are channelled to firms by intermediaries such asbanks and pension funds. If they choose to spend more than their income, loanswill be supplied by the same intermediaries. The lines in Figure 3.1 run bothways. However, the savings arrow from households to firms is thicker thanthe reverse arrow from firms to households in recognition of the fact that thecorporate sector is the key investor and borrower in an economy. Households aregenerally net suppliers of funds to firms.

This is a much simplified conceptualisation of the market system as we know itin the real world, but it is sufficient to illustrate the strong interconnectionsbetween markets. Households need to sell their labour to firms in order to be ableto buy goods. Unless households spend their incomes on purchases of goods andservices, there will not be any demand for their labour. Or, to take another example, if firms do not invest, there will be no demand for household savings: savings are useful only in so far as there is an investor somewhere ready and willing to use them for investment. Clearly, a mechanism must exist to bring these disparate and independent decisions into equilibrium. A sustained disequilibriumin one part of this closely interconnected market system can have serious repercussions on other parts of the system. The market system is, in other words, a general equilibrium system. If anything goes wrong with the market mechanism, an economy could run into serious trouble.

Two other market participants must be considered – the foreign sector and the

government sector. Firms do not have to sell their entire output to domestic consumers.They also have the option of exporting. Likewise, households can

import goods and services instead of buying the output of domestic firms.

Imports, exports and the foreign trade market are an integral part of an analysis

of the market system. Factors of production such as capital and labour can also

be traded internationally. The rise in global capital mobility, especially between

developed countries, has meant that the domestic economy is no longer

restricted to domestic savings for its supply of investment funds. The foreign

sector has been growing rapidly in relative importance during the postwar

period.

The government is also an important participant in the market. Government

spending amounts to about 40 per cent of total national expenditure in industrial

countries generally and exceeds 50 per cent in a number of European countries.

Sweden’s ratio is 50 per cent Even in an economy as free market-oriented as the US, the government’s share of total spending ratio is 30 per cent .The spending ratio, however, gives only a rough impression of the extent of government influence in the market system. Public intervention takes many forms in addition to government spending. Official regulations impinge on all areas of economic life – planning requirements for new buildings, health and safety regulations and environmental restrictions, for example. State-owned commercial companies are another vehicle of government influence not reflected in the spending:GDP ratio.