Ch. 1 The How of the Market

Consider the question, “Does the market work?” Some would probably answer, with or without qualification, with a “yes.” But most would likely adopt what they might characterize as a skeptical view. Their answer would therefore be in the negative or, if positive, with some type of qualification – “yes, it works if…” or “it works when…”.

Perhaps it is due to political rhetoric that we find the question to have a certain moral or ethical underpinning. Much is blamed on the generic “market,” which probably makes many of us think of the financial markets and hedge funds based on Wall Street in New York City. We have learned to adopt a negative view of “the market,” as opposed to society. The same is true about competition, which we see as a cornerstone of how markets act, as opposed to cooperation. We are inclined to think not in terms of whether to regulate markets, but “how much” or in what manner in order to get out of the market what we want or need. The assumption many of us tend to hold is that the market is dysfunctional in some sense, and this warrants correction from another party—and there is only one other party: political authority. Overall, there is something daunting or unnerving about leaving things to “the market” and therefore lose control.

It can be argued that this type of automatic skepticism, if not an entirely dismissive attitude toward markets, is an indication of the great influence on popular thought by the tradition of economic skepticism going back through centuries and including thinkers like Thomas Robert Malthus, Karl Marx, John Maynard Keynes, and, much more recently, Thomas Piketty. These thinkers share a disbelief in markets and primarily see problems inherent in or resulting from its value-creating and production-coordinating qualities. They assume that “the market” is unable to cope with important challenges and may even, at least to some degree, be the cause of social unrest, tensions, and conflict. Indeed, Marx claimed that there are inherent contradictions in the market system – more specifically, capitalism – such that capitalist competition will “inevitably” lead to crisis. As markets left unregulated and uncontrolled will tend to cause great inequality, social conflict, and ultimately widespread despair, thinkers in this tradition often place their trust in the political apparatus and its powers of coercion to tame market forces and allow society to resist the temptation of economic incentives. This is a fundamentally pessimistic view of humanity, which assumes that people left to their own devices will not engage in peaceful exchange for mutual benefit and community-building, but will be at its others’ throats. Unless people are subdued and controlled, they will resort to shortsighted violence and this will soon degenerate into a Hobbesian war of all against all.

But we need not trace the historical or theoretical origins of popular market skepticism. It is sufficient for our purposes to note that “the market” is often used not only to describe the system, and thereby how the economic organism, to borrow Pierre-Joseph Proudhon’s term, actually functions, but comes bundled with a value judgment that often leans toward dislike or pessimism. For this reason, asking the question “Does the market work?” may cloud the fact that we are asking a real and positive question of relevance to how we understand – and can describe – society and humanity. Consider instead the alternative but rather synonymous question “Does the economy work?” This question appears different; it seems purely descriptive and neutral. The economy, as everyone knows, is just what is all around us—it is what we work in, what we shop in, what we benefit from and what we contribute to. There is no value judgment involved and therefore we have no problem adopting a neutral position with regard to describing or attempting to explain the economy. Yet both questions above refer to the same thing: the economic system or organism.

Does it work? Well, it depends on what we mean by “work.” If we by “work” mean that the outcome is of a structure that dovetails with what we would personally prefer, then the answer is probably no. But the proper question is not if the economic system, which hardly exists to please only you, fulfils all your wants and wishes. The question is what it brings about – what is the outcome of the economic system as it is presently structured? If we answer or at least theorize on this question, then we can begin to explain how it works, why it works this specific way, and what it means for us as individuals – and for society and humankind. Then we can also ask how we can improve it, that is how we can get “more” out of it than we do at present. We can also ask what causes its limitations and misallocations, that is why we don’t already get more.

That the economy, and therefore the market, works in one way or the other should be beyond any doubt. It exists, and therefore it must work in some sense of the word. The reason this question is misunderstood and often answered in a highly emotional manner is that we commonly take a normative position with respect to the market, and then over-politicize the question. So we look at the outcome of the market and compare it with our personal preference or maximum – how we conceive of the most perfect of all worlds, our utopia – and blame the difference on “the market.” But the question of whether the market “works” is really about understanding the functioning of the processes that make up the economic organism; it is the question of how it works, not whether we like the specific outcome – or the structure thereof – that it currently generates. In other words, it is a question about how well we understand the market as a process, which is a necessary precondition for assessing the outcome and, more importantly, figuring out how we get what we get and why we don’t get more.

What we will do in this chapter, therefore, is look at how the market works. Whether this means that it really does work, in the normative sense, is something the reader will have to decide for him- or herself. This latter question, by the way, depends ultimately on what the market, or more specifically how it is perceived, is compared to. It raises the question of whether this benchmark is itself realistic and realizable. Very often, a normative assessment of the market is based on a comparison with some utopia, that is a flawless and unrealistic imagined alternative, rather than the reality of other system practices. Our task here is not to make inadmissible comparisons such as this, or even to make a comparison between the market system and alternative systems. Rather, the purpose of this discussion is to produce an understanding of how the market functions. The normative assessment of whether this is an attractive or ethical system is left to the reader.

What Constitutes the Market

What we mean by a market can be described by its smallest component: the exchange. A market economy is then an overall system that allows for and indeed is composed of any and all exchanges that are considered legitimate. But to see how this is the case, we must first elaborate on what we mean by exchange. And before then, we should discuss what the motivations for individuals to engage in exchange are.

Simply put, an exchange is composed of at a minimum two individuals exchanging something that is valuable for something else that is also valuable. If they do so voluntarily, by which we mean that no one is using or threatening to use physical force against one of them in order to engage in the exchange, then it follows that they are both made better off. How so? Because if they did not believe that they were better off by carrying out the exchange, then they wouldn’t choose to do so. This is the case because value is fundamentally subjective: how you value something is not necessarily identical to how I value this something or how someone else values it. So it can be the case that I value something you have more than what I have to offer in exchange and, at the same time, you value what I have more than what you have to offer. If this is the case, then we might choose to exchange those somethings. And as a result, we both get what we desire more highly – that is, what we value more – and we’re better off for it. At least, this is the case unless there is fraud involved, which is a deceitful way of making something appear as more valuable than it actually is.

If both individuals involved in an exchange refrain from coercion and fraudulent behavior – that is, it is voluntary – then this exchange constitutes value creation because they are both better off by doing the exchange than not. The exchange is therefore a necessary component of economic growth. All exchanges taken together constitute, as a composite that abstracts from the specifics of each individual exchange, “the market.”

But there is of course more to the market than simply exchanging stuff that we already have on hand with people that happen to cross our path. For instance, it is often the case that in order to get into a position where a specific exchange is possible, one will first need to make other exchanges or engage in production. This fact is the essence of Say’s Law, after the French economist Jean-Baptiste Say (1767–1832), who was among the first to express this rather obvious truth. Despite being superficially obvious, the Law is important to understand both exchange and markets. In part, this is because it points to the importance of time and therefore the temporal aspect of economic action: some things must happen before other things are possible. And in order to get something specific that you desire, you must first make sure to have something that the person who has it in his or her possession desires even more. After all, we already saw how voluntary, and by this we mean mutually beneficial, exchanges are possible only when each party has something that the other party values more highly (which is the same thing as saying that he or she finds it more desirable).

With production arises a number of issues that make markets the very complex organisms they typically are in modern, advanced economies.[i] One important such issue is the uncertainty that production necessarily entails, since it is impossible to know how the produced good will be received when it is finally available. With time, things change. Among those things that change over time are people’s preferences – something a person values in the present may not be valued in the future. Perhaps the particular want that gave rise to the valuation has been satisfied in some other way, or the person has simply changed his or her mind for no particular reason. Undertaking production therefore comes at very high risk of missing the market, since the producer might be producing something that turns out to not be desirable when it is finished.

The problem is exacerbated by the fact that any costs of production are typically incurred in the present, and they must consequently be covered prior to completion of the production process and the final sale of the good – and whether or not the production turns out to be successful. Someone has to cover those expenses and face the risk of not being able to cover them with the anticipated (that is, hoped-for) future revenue if the good cannot be sold. This task of bearing the uncertainty of production is what we refer to as entrepreneurship: entrepreneurs choose the type of production that they judge has the greatest chance to meet the approval of consumers at the time it is finalized, and they therefore reap the reward if successful (earn a profit) and take full responsibility if it fails (suffer a loss).

As entrepreneurs are the residual claimants of uncertain business undertakings, which means they get to keep any profits that remain after all costs have been covered, there is a strong economic incentive for those with an entrepreneurial bent to attempt to produce something that consumers will value very highly. After all, if consumers value the product very highly they are willing to pay a high price, which makes it easier for the entrepreneur to cover the necessary expenses to carry out the production process and to earn a return. This simple driving force is what makes entrepreneurs willing to undertake highly uncertain and innovative projects – because they believe that what they will be able to offer will warrant a high price. In other words, if they are able to accurately predict (which amounts to estimating what consumers value, and how highly, based on the entrepreneur’s idiosyncratic understanding for what people desire as well as what wants other entrepreneurs may be able to satisfy) the future market, and align their efforts with this imagined future, they will be mightily rewarded. Such entrepreneurship is the driving force of the market, and profit is the economic driving force of the entrepreneur.

It follows from this understanding of the entrepreneur that entrepreneurs do not only compete with each other for opportunities to exchange with consumers – but for the resources used in production. As resources are scarce, “the market” is engaged in a complex system to establish the trade-offs between different uses of resources. Steel, for instance, can be used to produce hammers and stoves and automobiles and intercontinental missiles, for instance. And steel can be used to produce a great number of things that we are presently unaware of. The question is then how we can decide how to best use the limited quantity of steel that we have available. In other words, how do we get most value out of the little steel we have?

This question is answered by letting entrepreneurs risk their capital in free enterprise and therefore compete with each other for the steel (really, for all resources that can be used productively). By doing this, and therefore by bidding over one another to acquire the limited resources that are available, entrepreneurs guide production overall. They bid for resources using the capital they have at hand, whether their own or borrowed, and bid as highly as they can while still estimating that their venture will earn a profit. Those who aren’t very good at estimating what consumers will want and how much they will want it, and therefore the prices they are willing to pay, lose their investment. Those who are better at imagining what will be profitable get more capital and can therefore expand their business, start new businesses, and invest in innovations that can provide value in the future. This “weeding out” of entrepreneurs with poor judgment, and the rewarding of those with better judgment, amounts to a discovery process: over time, society overall discovers better, more valuable ways to use resources in production. In other words, we become more prosperous.

As entrepreneurs engage in this bidding for resources, they collectively determine how each resource should be valued relative other resources. The result of this process is market prices for all resources that approximate their social valuation in production. Prices don’t reflect how efficiently resources are used in the present, but how efficiently they could be used – both in the present and in the imagined future. If entrepreneurs anticipate that they will be able to use steel in much more profitable ways in the future, they will bid much more highly for steel and therefore the price of steel will go up. So the price reflects the value that entrepreneurs anticipate the resource could have in production aimed at satisfying future consumers; in this sense, prices tend to approximate the social – that is, everybody in a whole society combined – good or value of the resource and thereby how consumers will want it to be used.

These prices, while determined by entrepreneurs, also guide entrepreneurs when they try to estimate whether a new venture could turn out to be profitable: if its production process depends on using resources with relatively high prices, the chances of earning a profit are slimmer than if it can be realized using relatively cheap resources. So as entrepreneurs bid for the resources they need to produce products that they think they can sell at profitable prices in the future, they establish prices that reveal a social valuation of the resources – and this, in turn, provides entrepreneurs with an incentive to use the resources of lesser value. The cheaper – that is, by entrepreneurs deemed less desirable – resources can more easily allow the entrepreneur to earn a profit, which means there is reason to think hard whether the cheaper resources cannot be used instead of the more expensive ones.

Entrepreneurs, in other words, constantly consider trade-offs and “what if” questions: what if, instead of relying on expensive steel, a production process can be established using a much cheaper resource – for example, wood? Of course, using wood instead of steel would change the production process, and probably the product too, which means the entrepreneur must change the whole calculus and estimate what profit could be earned from this other, alternative production process. So while there is a trade-off between resources, there is also a trade-off between production processes and between different variations of the end product. The entrepreneur chooses the combination that he or she judges will maximize the chance for profit, which is what will provide the highest value to consumers – by using the lowest-valued resources possible.

Note that this is all based on simple exchange of goods for mutual benefit. But by allowing entrepreneurs to act on their beliefs about what will or could be, and allowing them to reap any benefits thereof, we have explained an economic production apparatus that amounts to an advanced economy engaged in future-oriented production. With production, the potential to generate real value increases exponentially as compared to the simple, production-less exchanges we started out with. Of course, the production apparatus established by entrepreneurs in their quest for profits also increases the risk for errors, since time is now a production factor. With only exchanges in the present, time has little impact on economic life except for the time needed to search for the best possible exchange. But with production, resources are acquired and used in the present so that entrepreneurs can produce a good to sell in the future. Time therefore becomes a factor of production and a scarce resource, since any entrepreneur chooses between different uses for it: production of different products using production processes of different lengths. The capital used in a production process awaiting its completion and final sale of the produced good consequently constitutes a cost: it could be used in numerous other ways, which means sorter production processes – that is, those that use less time from beginning to end – would allow for using the capital in more projects in any given time period.

This cost is the economic cost. It applies to any resource and amounts to the benefit that could be generated had the resource not been used in the way it presently is. In other words, the cost of using something in a specific manner in a specific production process is the opportunity foregone – whatever valuable alternative way in which the resource could have been used. This true economic cost – opportunity cost – signifies the fundamental trade-off and therefore the choice that was made between all possible valuable opportunities.

Messy, Approximate, and in Progress

The previous section established the fundamentals of economy and how we can conceive of it in terms of its fundamental component: voluntary exchange. But it does not follow from the discussion how to properly assess the market and its function, or establish whether it can be improved. One can easily conceive of the system of production-for-exchange as either maximizing or not, that is, as optimal or suboptimal. To reiterate the question that we asked above, does the market work?

This question unfortunately has no clear answer. The reason for this is that we must first figure out what is the proper benchmark to compare the market to. From the point of view of modern mainstream economics, and specifically their model of perfect competition, an economy is efficient if there are no remaining gains from trade and that each resource is therefore put to its maximizing use. In other words, each resource is used in such a way that the value it creates exceeds its opportunity cost: there are no better alternative uses available. The economy is in a state of equilibrium, where actions are not taken for the simple reason that any action can only cause a reduction in total value. The whole economy is maximized.

This also means that there can be no movement and also no growth, since there are no more opportunities for improvement. Whether consumers are fully content or not, they cannot by any action be made better off. Consequently, the market is in a fixed and maximizing state. As such, there is no production undertaken that has not yet been finalized and the goods sold, because if this were the case then it is easy to see that the resources currently bound in a production process – which does not yet satisfy any want, but aims toward future satisfaction – could have been used in a better way simply by directly satisfying a want, any want, in the present. It is difficult to see any similarity between this economic state and the market described above or experienced in our everyday lives. Rather than a fixed state, the market as we know it includes – if it is not primarily composed of – productive efforts by entrepreneurs and their business firms, which means it is in constant movement, and always aiming for value creation to be realized – if all goes well – at some future point in time. This view of the market as something “in progress” follows directly from our definition of production above: production is how entrepreneurs create something that consumers find valuable enough to engage in exchange. Whenever this is the case, the market cannot ever be in a maximizing state and this means that an assessment of any temporary state of the market – a snapshot, as it were, taken at a specific point in time – must necessarily be inefficient as compared to a hypothesized full utilization of resources (where none of them can be used in a more valuable way in that specific moment).

In other words, the real market – an economy engaged in production – cannot be anything like the mathematical models we learn in undergraduate and graduate economics courses. Rather than a state, whether this state is efficient (equilibrium) or not (disequilibrium), the market is better seen as a process that is constantly in progress (that is, disequilibrium) toward the realization of some anticipated value attainable through production. The myriad production processes in progress in a market at any time are at different stages, where some have barely begun while others are well underway or nearing completion. And we know from experience that many of these undertakings will fail: while a heuristic, it can be informative to think of production as a discovery process that serves to weed out most attempts. Indeed, most entrepreneurs fail most of the time. It is not easy to accurately imagined and time the market.

Yet entrepreneurs as a group do just that: they imagine what consumers will want and they bring it to them and offer those things for sale in the open market. What amounts to successful entrepreneurship can be one or more of many things: from cutting costs or responding to existing demands via solving problems that seem pervasive to educating consumers in what they should value. Many of our wants are latent and we can neither accurately identify them or imagine how everyday problems – which we may consider to be simple facts of life – could possibly be solved. Yet entrepreneurs can do this: many disruptive technologies change people’s behavior not because they respond to an observed and expressed want, but because they solve a problem that many of us have long stopped considering as a solvable problem. When we are offered the potential solution, we’re made better off because we can change our ways of life: so we change our behavior to one that was not possible while the problem remained.

Entrepreneurship, in other words, is much more than simply responding to an obvious and known shortcoming in the present state of things. Production can disrupt what was considered obvious, natural, and unchangeable by offering something of great value that we as consumers didn’t expect and couldn’t imagine. As we have already adapted our behavior to the way the world works – or the way we thought it worked – the introduction of something that ultimately relieves us of the necessity of certain actions, we swiftly change our behavior to one that is less costly to us or more comfortable.

While this is a good thing, since it improves how consumers can choose to live their lives, it also adds to the uncertainty that entrepreneurs face in production. A disruptive innovation introduced by an entrepreneur can at any moment pull out the rug from under the feet of other entrepreneurs. Consider, for instance, the entrepreneurs involved in production that aimed to make transportation with horse and carriage more comfortable, cheaper, and perhaps faster. Henry Ford’s production of automobiles disrupted transportation by offering a reliable means that didn’t require ownership of and caring for horses. So whoever was involved in production relating to horse breeding, feeding, shoeing, and so on, as well as in the production and servicing of carriages, stables, and whatnot else that contributed to the production of transportation by horse and carriage, saw a rapid decline in market demand for their services. For most of them, this was an utter and complete surprise; many of those who were unprepared undoubtedly lost everything they had invested in their expertise, customer relations, tools, and so forth.

Yet consumers were made much better off.

With respect to historic disruption such as the automobile, powered flight, the smart phone, or even inventing the wheel, the innovation may seem obvious. But just like we cannot foresee – and many of us are unable to even imagine – what will change our lives in the years to come, so these disruptive innovations changed the very basis for entrepreneurs and their business firms. They simply had no idea of what would come or how it would affect people and consumers in general and their business in particular. Consequently, even an already existing and profitable type of business – a so-called “proven” business idea – is a fundamentally uncertain enterprise simply because we cannot trust that things will continue to be the way they have been.

This means it would be outright dangerous, at least from the point of view of economic prosperity and therefore our well-being, to take the present for granted and then, perhaps through state-of-the-art research try to maximize based on what we know. Even if we could get more out of production the way it is currently structured, on a societal or economy-wide level, we cannot know what opportunities for improvement to our lives that we could lose by using existing resources to a greater degree. Indeed, leaving some resources idle is the very reason why some entrepreneurs will be able to use those very resources to produce disruptive innovations that can set in motion a vast process of change that affects everybody’s life. Economic optimization and politically preferred ends such as full employment would, if it is actually achieved, risk undermining the bases for improvements that are yet to be realized – many of which are not even imaginable in the present.

Production is a messy and uncertain business, and it is certainly not optimal. If we take a step back and look at an economy’s production structure as a whole, as an aggregate of all entrepreneurs’ production efforts, it will appear more slow-moving and path dependent. After all, what is a radical change to some individual entrepreneur and that threatens to put his or her firm out of business, may to the overall economy seem like a minor change. Also, on an aggregate level changes seem to fit into the larger picture and we can talk about economic growth overall while abstracting from the demise of hundreds, thousands, or even hundreds of thousands of entrepreneurs who failed to see that a disruptive change was just around the corner. This system-wide analysis has its place and provides important insight into the evolution of an economy. But by aggregating we are likely to also miss important changes and, perhaps more interestingly, how those changes come about and develop over time. Indeed, macro level phenomena are composed of millions of individual choices by entrepreneurs and consumers, all of which is the result of those persons acting in their self-interest and doing subjective cost-benefit analyses with regard to the present and imagined future. In this sense, we’re all entrepreneurs and we all take part in the changes that happen all around us.

[i] For a more in-depth discussion on the problems arising due to production, see e.g. Bylund (2016).