Ch. 10, Policy Implications

The discussion in previous chapters drafted a way of thinking about the dynamic market process that includes both within-market equilibration and disequilibrating market-making through imitating productive innovation. We saw that it is necessary to implement original productive innovations through a firm, even though it is conceived of not as a means to but as the outcome of such implementation. In other words, we observe a firm as an ‘island of specialisation’ because the implementation of a novel innovation by necessity appears both integrated, due to the strict productive interdependence that can lead to failure through incompleteness, and distinct from the market. The firm therefore emerges as a phenomenon with a specific economic function: to establish production outside the extent of the existing market and therefore out of the price mechanism’s reach. It has a limited life span and is in its basic form a temporary presence on the market landscape limited by the degree that the firm’s accomplished profitability induces competitive imitation. As the market extent expands through competitive imitation and market-making, the firm’s economic rationale diminishes and eventually vanishes.

Chapter 9 connected this micro-level firm-forming process with the macro-level market process for economic development and growth. The firm, as we here see it, is the means by which the market expands by adopting more intensive specialisation under the divisions of labour and capital. Other market action, primarily in the form of ‘Kirznerian’ entrepreneurship through arbitrage, is limited by the extent of the market, just as Adam Smith noted. This limitation also applies to the division of labour to the degree it is utilised and applied in market-based production. The economic function of the firm explicitly challenges this limitation by attempting to implement productive innovations that rely on – or compose – more intensive specialisation. As a result, the market is in constant flux not only because of necessary adjustments of market production to changes but also in terms of equilibrating arbitrage and disequilibrating expansion. The latter changes the conditions for resource utilisation and market production, which shifts the efficient end state and thereby changes the former.

This suggests the market as a system is equipped to deal with changes on several levels, of both endogenous and exogenous origin. Changing consumer preferences alert entrepreneurs by resulting in shortages and surpluses in certain lines of production and therefore increased profits and losses, respectively. This incentivises entrepreneurs to reallocate resources to their more profitable uses and thereby change relative prices that effectuate further arbitrage. The market in that way responds to change ‘spontaneously’ in such a way that the newly revealed errors in the market’s present resource allocation are corrected. Other changes, including the discovery or innovation of new types of production and products that expand the extent of the market, bring about similar responses through individual entrepreneurs acting to capture profits. By doing so, they realign production with real, effective demand. The market can in this sense be thought of as an economic organism, an order that emerges from decentralised voluntary agreement and contract, which ‘automatically’ adapts to change: it is continuously progressing and thus may not be allocatively efficient, which is a static concept, but is adaptively efficient.[i] This suggests the tendency of the macro-level market process is equilibrating.

The functioning of the market system facilitates that the ‘best possible’ use of the resources at hand is achieved, or in any case approached, through the continuous adjustments made to the overall productive apparatus. This means the market is quite resilient to obstruction in the same way a river can ‘deal with’ a large rock placed in its way: it finds the path of least resistance around it, even if this path is not immediately or easily accessible. Of course, just like the river’s flow is affected by a rock placed in its way, whether large or small, the market system’s effectiveness in satisfying consumer wants is inhibited if subjected to obstruction. A natural disaster or other types of damage done to an economy’s productive apparatus necessitates that capital resources are reproduced and production processes re-established – or that they are replaced by those better suited to the new market setting – which changes relative prices. To the extent that resources have been destroyed or made unusable, remaining resources will be reallocated toward the best possible overall solution. This new productive solution, however, will because of the damage and the loss of resources be of overall lesser value than the productive apparatus that would otherwise have remained intact. Destruction does not create value, even if it paves way for production that was not previously considered.

As the market is in a constant flux and subject to never-ceasing changes, there is no way of accurately evaluating the mechanism or calculating its overall efficiency. The only way to assess the functioning of a market process is through estimating its value-creating capabilities in comparison with plausible alternatives. As the properly decentralized market consists only of the individual or collaborate actions of entrepreneurs and other actors, who always aim to do more from the point of view of their subjective evaluation of the particular situation and their judgment about future conditions, and since profits are generated through satisfying real wants, through a process of time-consuming production, the unhampered market economy must be unbeatable in terms of resource allocation through the price mechanism. There are no realistic counterfactuals that can possibly achieve more than the market process, which is both equilibrating and expanding, with the limited resources available in a dynamic world. The only way of accurately appraising the performance of the market is to allow entrepreneurial projects and investments, as well as competitive discovery process, to play out. This, of course, implies that the market process reaches its state of rest or equilibrium, which should never be the case.[ii]

We can theoretically construct a more efficient, that is higher-performing, counterfactual to the market process only by disregarding the shortcomings of man, for instance by assuming planning and direction by an omniscient benevolent dictator. But omniscience is not sufficient; it is necessary to also assume omnipotence, since even an initially flawlessly planned production process must be continuously adapted and adjusted to changing circumstances not to become hopelessly misaligned and maladapted. Therefore, even if the market is obstructed, as the rock placed in the river’s way, it is still the best means of organising production – and more so as time progresses and change predominates. The ‘invisible hand’ works because it consists of a myriad visible actions that react to the change within their specific local settings, responsive to and affecting the relevant prices throughout the market. This generates a coordinated response from the bottom up, and reallocates resources toward better uses.

In order to find the best response to exogenous change from the top down, as though with a single mind, one must exercise perfect foresight regarding the courses of action as well as have sufficient influence to prepare for and direct productive resources accordingly. Yet even if this were possible, and all the knowledge necessary for perfect adjustment available, the collective discovery process through innovation and competitive imitation cannot be directed. Mises showed that this is the case in a powerful argument for the market economy based on private ownership,[iii] and what we’ve learned in previous chapters about the dynamic complexity of the market process reinforces this argument. Indeed, the continuous expansion of the market’s extent adds a complexity on a different level, which is usually overlooked in attempts to outline a planned order that outdoes the market. As we’ve seen, the discovery process of the market is not only open-ended in terms of being unknown, but is unknowable since what is to be discovered is generated through repeated implementation and continuous experimenting. It is not only the case that there are a multitude possible better ways of producing, but they need to be figured out over time within a constantly changing market context. Adaptation and adjustment are ongoing in both the existing production apparatus and during the implementation of future production.

The question then becomes one of whether existing institutions support or hamper the market exchange that is at the heart of the bottom-up adaptation and adjustment process. Pure market institutions emerge spontaneously through market action, but can they be strengthened or supported by institutional design? This is where public policy comes in.

It needs scarcely be argued that policy can and does affect the workings of the market process and thereby affects also the outcome. To again use the market process as a river metaphor, we can think of policy as a rock either placed in or taken out of the river’s way. In the former case, it is a hindrance to the natural flow of the market, which has consequences for what is produced and how. It will also affect the value generated through the market process by affecting its overall performance. But it is not necessary that the rock is simply placed to stop or slow down the flow of the river, it can also be used as a means to force the flow in certain directions and thereby – if successful – attain certain political goals. The latter case can, from the perspective of aiming to direct the market process toward certain ends, be seen as the other side of the coin. By clearing the river’s path, the flow can potentially be ‘improved’ in the sense of becoming more steady and targeted.

What is relevant for our purposes is not the effect of policy on the market process per se, however, but how and in what ways it affects and, to the extent possible, can be used to produce certain desirable outcomes. Our perspective focuses specifically on the firm as an ‘island of specialisation’ that revolutionizes the market structure by inciting entrepreneurial imitation and a competitive discovery process, which emanates in the expansion of the limits of the market. As the market’s extent is expanded, and it thus becomes equipped to deal with more intensive specialisation that facilitates increased productivity – creatively destroying the old, as it were – the economy ‘grows’ and can produce greater value. From this perspective, policy could, depending on its specific aims, attempt to increase or decrease the overall frequency of firm formation – or direct it toward certain industries or market segments for particular or local effects. In other words, the question asked here is: how can public policy affect the formation of firms? The particular cases we will discuss are attempts to specifically change the direction or speed of the market process by using policy to manipulate the frequency of innovation, either across the board or targeted toward certain parts of the market. There are two means available for policy-makers to effectuate such change: raising barriers (regulation, taxation, and prohibition) and lowering barriers (deregulating or subsidising markets, actions, or actors).

Using policy to direct firm formation

Consider as point of departure for the discussion in this and subsequent sections of the chapter a market impacted by different kinds of regulation, taxation and so on to a degree that these measures do not significantly suppress market exchange or expansion. Assume furthermore that the effect of existing policy can, for our purposes, be considered neutral across the market landscape. In other words, we assume a market, under some type of modern government, that is fully functioning despite effects of different forms of political regulation. From this situation, government can take further measures to either stimulate or discourage innovation. Both types of measures can be used to produce an overall effect, that is to bring about faster or slower economic growth overall, or to steer the market one way or the other through producing a limited, localised effect. The latter simply targets the effects of the former type of measures to affect the specific parts of or activities in a market or industry that are preferred from a political point of view.

Innovation can be stimulated through tax exemptions for research and development or the creation of new firms, investments in education, and establishing government-funded business incubators and accelerations as well as innovation and research centres, and providing funding for research. It can be disincentivised by added taxes and fees on businesses, introducing restricting regulation, licensing and certification and other legal requirements, and outright prohibition of business. All of these measures, and the ones not mentioned here, can also be used in targeted efforts to politically steer the direction of the market process.

If the political leadership believes the economy is ‘overheating’ in the sense of growing ‘too fast’, and that this poses a threat based on for example environmental concerns or increased risk of social conflict, policy measures can be taken aiming at slowing down the overall growth rate. From our perspective, such measures would attempt to raise barriers for entrepreneurs to implement new innovations outside the extent of the market as well as for entrepreneurs striving to compete with original firms through emulation and competitive discovery.

Long-term cooling down measures could make it harder to do research or make it costly or difficult to form new firms, hire labour to carry out tasks not traded in the market, and so on. A possible measure along these lines and with a similar effect would be to legally require a bidding procedure with multiple buyers and sellers prior to any contractual commitments. This would effectively put an end to the formation of new firms, since, as we have seen throughout this book, the firm can be conceived of as production coordinated where there is a lack of market. Consequently, bidding is impossible for the implementation process of new productive innovation – the formation of firms therefore also becomes impossible within the framework of the law.

Short-term measures include efforts to tax or by other means regulate novelty and originality. Alternatively, policy can subsidise the status quo, both directly through granting specific privileges to existing market actors and indirectly through institutional support and infrastructure investments, and thereby make novelty relatively more expensive by making established market production less costly.

These policy measures, whether aimed to stimulate or discourage the formation of firms, must do so by either making it cheaper or more costly to produce or implement productive innovations. They can thereby influence the frequency of future firm formation. However, as the frequency depends ultimately on how entrepreneurs perceive the value of their imagined productive innovations, which informs their decisions to attempt implementation, the frequencies – both with and without policy measures – are uncertain. It also means the effect of policy on the future frequency of firm formation is unpredictable, since, in the case of stimulation, the perceived value of the policy is subjective and therefore vary across entrepreneurs. In certain situations, stimulation that entails only a minor improvement, monetarily speaking, could bring about a major shift in entrepreneurs’ valuation of opportunities. The opposite may also be true, where a policy change expected to have a major effect may only marginally affect firm formation frequency.

Policy effects are also subject to what Robert Higgs terms ‘regime uncertainty’[iv], or the trust entrepreneurs have in the political system and institutions of the market. According to Higgs’ analysis, entrepreneurs’ expectations about changes to the institutional setting for market action, or the ‘rules of the game’, have a significant effect on their decisions to invest. If entrepreneurs distrust the intentions of policy-makers and believe that policy will soon change for the worse, that enforcement will be to the detriment of business, or that policy measures will be interpreted increasingly unfavourably (and perhaps unpredictably), they will refrain from investing. Stimulating policy may therefore have an effect that is opposite to the intended: entrepreneurs may refrain from forming new firms despite stimulating policy because they distrust policy-makers. This suggests that there is fundamental uncertainty to using policy to bring about specific changes to the frequency of entrepreneurship. The real outcome, especially the magnitude of policy effects, is fundamentally unknown.

In addition to using policy to change the overall frequency of firm formation, whether to ‘cool down’ rapid economic activity or to stimulate economic growth, policy-makers may find a certain sector of the economy especially beneficial and tailor policy measures to stimulate innovation specifically in this area. For instance, responding to political pressure or a perceived opportunity for growth in the widgets-producing sector that is left unexploited, policy can be designed to incentivise entrepreneurial investments supporting only the production of widgets. By incentivising activity in widget production, policy-makers can create artificial profit opportunities that attract entrepreneurs and labour from other sectors of the market. Policy can also increase the firm formation frequency by lowering the costs of implementing productive innovations that relate to development or production of widgets. This can be done in a variety ways, for example through subsidies, tax deductions, monopoly rights, or public matching of private investments.

As the size of the market (not to be confused with the market’s extent) at any point in time is relatively fixed, such policy measures in effect bring about a redistribution of entrepreneurial action by directing entrepreneurs toward certain industries or tasks through changing the incentive structure of the market. The precision of such measures is necessarily limited, since all that can be expected by such policies is an increase or decrease, respectively. The magnitudes of the change cannot be accurately predicted, and, as we saw above, the effect may be unexpected. So policy remains a very blunt instrument for establishing a preferred market structure. One can as easily overshoot as undershoot the targeted frequency, and due to unknown factors that also influence entrepreneurs’ decisions, such as regime uncertainty, some policies can even backfire and produce a situation that is worse from the point of view of the end aimed for.

The seen, the unseen, and the unrealised

We have already seen that policy is a blunt tool with unpredictable outcomes, and the result can sometimes be the very opposite of what was intended and expected. Policy measures have uncertain outcomes because the economic system is constantly in flux and its structure and progress is effectuated on dispersed, decentralised decision-making. In other words, the exact path of the market process is impossible to foresee.

Furthermore, as the economy is in many respects a closed system there are always two sides to any coin. As we noted above, policy that aims to stimulate the production of widgets cannot do so without at the same time discouraging other production. Also, even if we for a moment disregard the special role of policy in the market, any local increase in economic activity is made possible only through a shift from one sector to another. An increase in the production of widgets, which depends on the use of scarce resources, means that the inflow of resources are taken from elsewhere where there then is necessarily less left. As we saw in a previous chapter, the price mechanism steers the market process by bringing about resource allocations that are better compatible with value-creating production. Policy can do no different, which means any policy measure taken to either stimulate or discourage certain activity has a corresponding opposite effect elsewhere. Stimulating firm formation, therefore, means a shift in resource allocation. Whether or not policy directly shifts resources from one market sector to another, resources are shifted by entrepreneurs from market production to establishing new productive innovations. What is produced in the market will therefore need to produce with less.

This other side of the coin is what the French economist Frédéric Bastiat termed the ‘unseen’ and forms the basic lesson of the parable of the broken window[v]. In Bastiat’s example, the breaking of a window is identified to lead to beneficial economic activity as replacing it creates new income for the glazier, who can then spend the money to purchase other goods, hire more people, etc. However, notes Bastiat, this is only the ‘seen’. What is ‘unseen’ is what the money used to replace the broken window had otherwise been used for. This economic activity is lost when the owner of the window reprioritises between ends in order to instead replace the broken window. Whereas replacing the broken window constitutes a net income for the glazier it is an added cost for the owner of the window. But it is a net loss from the point of view of the economy, since the ‘unseen’ activity – the value-creating activities that would have taken place instead of replacing the broken window – is lost.

In a dynamic market process there is more to the story than the ‘seen’ and ‘unseen’. As the market extent expands through implementation of productive innovation, any loss of productive activity, such as the ‘unseen’ economic activity that will now not occur, ultimately slows down the progress of the market process. A broken window is ultimately a lost resource, which could (and probably would) have played a part in supporting the formation of new firms, the emulation of the original innovation, or the arbitrage activities of entrepreneurs within the extent of the market. The investment necessary to implement a productive innovation is made based on the accumulated capital in an economy, which is made available to the capitalist-entrepreneur either through accumulating profits of exchange or borrowing in financial markets. In both cases, the availability of productive resources in the market is a prerequisite for investment. An unavoidable result of the loss of a resources is therefore the limiting effect it has on the expansion of the market, and therefore the intensification of specialisation through the division of labour. Market progress is slowed down, which means less wealth is produced.

The same effect is noticeable where the course of the market process is forced in a different direction than we would otherwise have seen. Any direction other than that brought about by actors aiming to profit from serving real consumer wants is suboptimal as the most eagerly held wants will not be satisfied or at least not satisfied as soon. We have already seen that the market process functions even in the face of exogenous shocks, arbitrary or ad hoc restrictions, and under other far from optimal conditions. It is therefore the case that the new direction will also produce value – but through satisfying other wants. As these wants are not those voluntarily chosen by consumers expressing their urgency for want satisfaction by increasing their willingness to pay or producers selecting the most valued use of resources, they are necessarily of comparatively lesser value. The market process will therefore progress more slowly in terms of wealth creation in the new direction, which is the one that appears as most value-creating after the rock was placed in its path. The direction of the market process without the rock in its path, assuming it was indeed a different path, would be superior but is no longer possible.

It follows that while policy can be used to pursue specific social or political ends that are deemed unlikely to be attained if the market is not directed, such measures are not only uncertain but ultimately slows down the overall progression of the market process. As the market process slows down, the economy will become less specialised and for this reason less productive than would otherwise have been the case. It therefore produces less value. Policy-makers always face the trade-off between the estimated political or social value of the policy and the loss of value-creation due to the hampered or ‘redirected’ market process.

The loss of value created as the market process is forced in a new direction is not easily measurable. A direct consequence of redirecting the market process is the loss of productivity through innovation and specialisation, which can be expressed in terms of consumptive power. Yet the primary value of the progression of the market process, and thereby the extension of the market’s extent, is not the increased quality or lower price of goods and services offered. Rather, the value is primarily structural in the sense that the market with a lower frequency of firm formation will more slowly adopt a greater division of labour, which suggests two consequences of major import to market actors. First, new and more productive tasks and processes remain unrealised and therefore labourers stay relatively unproductive. This means they not only earn relatively lower wages, but also that the new and ‘better’ jobs, saleable skills, and market positions that would have emerged will not do so. And second, the choice set of available consumer products and services is limited as new offerings will not come to be. These effects on both production and consumption, which constitute a loss of value through limiting the alternatives available in choice situations, make both producers and consumers worse off. They lose potentially more valuable options and therefore cannot maximise their welfare to the degree they otherwise would have; they also lose the freedom to choose between a wide range of products and services as well as market activities as the choice set is restricted through the hampered market process. The ‘unrealised’ has a significantly impoverishing effect on the welfare of an economy and its actors.

Empowering markets through policy

Despite the mounting and immeasurable cost of the ‘unrealised’, policy is oftentimes used with the intention to increase economic growth. As growth is achieved through the progression of the market process and expansion of the market, this natural tendency can be strengthened by subsidising or otherwise stimulating the adoption rate of productive innovation. This was mentioned above as increasing the frequency of firm formation, and is primarily possible through removing the ‘rocks’ that block the path of the market process or that force it in a comparatively suboptimal direction. Such policy measures are targeted to facilitate market exchange and increase the adoption of productive innovations by bringing about lower costs of transacting or limiting the uncertainty of entrepreneurial endeavours by providing supporting and reliable institutions. Growth-increasing measures should to be effective target enabling or empowering the market to ‘break free’ from its limiting extent – the specialisation deadlock – by removing obstacles and lowering costs of entrepreneurship.

However, policy has historically been used by governments to instead increase the productivity of the labour force and support businesses under the guise of fighting unemployment. In order to achieve the former, massive public investments in (higher) education can stimulate an increase in the level of education and therefore the productive knowledge of common workers. Countries like Sweden invested early in providing public general education, followed by public higher education, in order to make the work force more productive and thereby raise their relative value in international production. Whereas such investments have diminishing marginal returns, since going from illiterate to literate or from a few years of education to high school degree raises one’s productivity more than going from high school degree to university degree, they are also primarily statistical measures. Education in itself, even if we assume that education is a proper proxy for knowledge and skills of workers, does not necessarily raise the productivity of a specific individual, whereas the educational level of the work force is strongly correlated with the latter’s productivity. For any individual to become more employable or productive in the market, it is necessary that education efforts strengthen the particular individual with respect to existing skills, interests, market position, and local demand in the production structure. Education will only have value to an individual within a production system if it contributes specifically to that individual’s productivity, whereas education that is not particularly suited to this individual’s situation is at best a waste of time.

For the statistical work force the issue may appear differently, however, since neither workers nor education is treated specifically. In other words, investing in education to make an illiterate work force literate would seem to boost productivity, especially if the increase is relative other countries or markets and therefore can increase the inflow of capital investments. Yet the real effect is that specific skills were added through specific education, and that this raised the individual worker’s productivity. The higher the education added the more specific it is, and this requires better matching between, on the one hand, the individual and their skills, interests, and opportunities, and, on the other hand, the form and topic of the educational effort.

In addition to productivity-enhancing measures that target workers specifically, policy measures can be taken to support businesses by establishing a ‘business friendly’ political climate with supporting institutions and well-functioning infrastructure that lowers the cost of transacting. Such measures aim to lower barriers for exchange, which can thereby increase the frequency of market exchanges and consequently speed up the equilibration process within a market. Barriers can consist of any types of costs to carry out exchanges, from difficulty to discover relevant market prices across a varied market landscape to costs of transportation over spatial distances. Governments attempt to lower such barriers by establishing regulation and industry standards, and investing in infrastructure and technology. A national public road system and therefore an implicit subsidy of road transportation, as is also often the case with railroads, is a common means by which policy is used to ‘tie together’ distant parts of the same country and boost domestic trade.

These types of stimulating policy, both of which are very common in policy all over the world, target primarily the existing market. While they can have an indirect effect on the frequency of attempts to implement productive innovations through firm formation, the policy measures are highly inefficient to this end. One reason is that policy-makers are at least as unable to foresee where productive innovations may be successful as market actors, and therefore efforts to stimulate firm formation are necessarily unguided or, at best, based on hunches. It is quite impossible to predict where entrepreneurs will imagine ways to improve production processes or new products to be offered in the market place, and it should be excessively difficult to predict what supporting measures would stimulate entrepreneurs to take such actions – and take the right ones. Even if this were possible, the how, when, and in what way the market can, will, or should be extended is neither known nor knowable. It will be figured out as a joint effort when entrepreneurs engage in competitive discovery to improve on the original productive innovation.

But firm formation itself can of course be supported through different kinds of subsidies or by easing the regulatory burden on doing business. The danger here is that while this type of policy measures may increase the frequency of entrepreneurs attempting to form firms as ‘islands of specialisation’, there is no saying whether these entrepreneurial endeavors are the proper ones. Indeed, by lowering the threshold or even covering part of the cost for entrepreneurial enterprises, policies intended to stimulation economic growth may increase overall uncertainty by attracting a number of hotheads and adventurers. As their implementations of potentially productive innovations claims resources that would otherwise have been used elsewhere, primarily in productive efforts, the net effect of poorly designed policy can be capital-consuming and therefore lead to lower standard of living.

[i] For more on adaptive efficiency, see D. C. North, ‘Institutions and a Transaction-Cost Theory of Exchange’, in Alt and Shepsle (eds), Institutions and a Transaction-Cost Theory of Exchange (New York: Cambridge University Press, 1990), pp. 182-194, P. Moran and S. Ghoshal, ‘Markets, Firms, and the Process of Economic Development’, The Academy of Management Review, 24:3 (1999), pp. 390-412.

[ii] Schumpeter makes a similar point, stating that ‘Since we are dealing with a process whose every element takes considerable time in revealing its true features and ultimate effects, there is no point in appraising the performance of that process ex visu of a given point of time; we must judge its performance over time, as it unfolds through decades or centuries’. J. A. Schumpeter, Socialism, Capitalism and Democracy (New York, NY: Harper and Bros., 1942), p. 83.

[iii] See L. v. Mises, ‘Economic Calculation In The Socialist Commonwealth’, in Hayek (ed) Economic Calculation In The Socialist Commonwealth (London: George Routledge & Sons, 1935), pp. 87-130.

[iv] R. Higgs, ‘Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War’, The Independent Review, 1:4 (1997), pp. 561-590.

[v] F. Bastiat, That Which Is Seen, and That Which Is Not Seen. An Economic Essay (1850) (World Library Classics, 2010).