Ch. 4 Unbeatable, Imperfect Markets

Production, as we saw in the previous chapters, is undertaken for two reasons and, as it turns out, with two very different implications. First, production can be undertaken with the intention of making possible immediate and personal consumption; it is, in essence, the means by which individuals manage to survive in a world that doesn’t exist solely for their own benefit. Such production is akin to what the shipwrecked Robinson Crusoe, to borrow the main character from the 1719 novel by Daniel Defoe, would necessarily spend his time doing – it is focused on survival and living day to day. Without engaging in production, Robinson would starve to death. To survive, though he leads a lonesome life, he will need to produce the foodstuffs necessary. Thus, he spends his time finding and picking berries, edible leaves, coconuts and such things. He might attempt to fish or catch animals to eat. It is likely that he will spend most of his time trying to find enough food to survive; he leads a very poor life, especially when considered from the perspective of the modern world. Robinson’s existence is hand-to-mouth and it is unlikely that he will be able to save or find time for leisure. Nevertheless, his best option is to keep producing.

Even if we add other people to this situation, such as the equally fictional Friday, this doesn’t change the situation much with respect to production. Whereas some tasks are easier for two people than for one (such as moving timber or large rocks, hunting prey, picking berries, and so on) simply because it includes more man power, the types of production they can undertake together is also more plentiful than what Robinson can do alone. For instance, two people can do things that one person simply cannot. Robinson and Friday may furthermore feel more secure together, and are probably better off by cooperating in other ways than simply doubling the man power when carrying out the same tasks as Robinson spent his time doing alone. For instance, they can divide tasks between themselves, which would allow them to focus on their respective responsibilities, develop specific skills that help them carry out those tasks, and perhaps even develop simple tools to assist them. Such simple division of labor increases their chances of survival, and might even award them some leisure time.

They nevertheless lead a life that is similar, at least in terms of production and material comfort, to that of the nomadic people living in the historic Stone Age. Even if Robinson and Friday are joined by several other people, they would still produce to satisfy their own need for consumption – they would produce in order to survive even if they now would tend to produce different things (so some hunt, others fish, yet others collect nuts and berries, and so on). Through living in and producing for their community, they would collectively be able to produce a surplus and thus reach a greater level of comfort and prosperity, which might be well beyond what is required for survival. So they’re probably not starving, but may even find time for a little leisure. Yet whereas producing in a small group for the group’s own benefit, with joint ownership (if any) and communal sharing of what is produced, makes for a richer and more plentiful life than that of the lone, autonomous “noble savage,” it is not a scalable model of production as it is still intended for direct consumption and therefore sustenance for the group.

The larger the group gets, and therefore the more manpower it has, the greater the problem of figuring out who does what and, consequently, what’s a fair and just distribution of what’s been produced. Imagine there is a group of well over a hundred people living together. Even if they are able to lead relatively comfortable lives – relative to Robinson being alone, that is – due to the sheer manpower involved in finding sustenance, the problems of dividing the fruits of their combined labor would tend to increase in both number and magnitude. After a bad day or week, who decides who gets to eat and who doesn’t? There are collective action problems involved in larger groups, which give rise to frictions and problems such as free-riding.[1] This, in turn, provides the group with an incentive for centralizing decision-making or finding ways of overriding the individual will (such as majority rule through voting), and with collective decision-making comes bureaucracy for control and management – in other words: politics.

There may be ways for groups to overcome such issues through forming institutions and a culture that sets limits to what is morally and ethically permissible. An obvious “solution” to the large-group problems of collective decision-making is to simply not allow the group to grow too large. However the group manages to handle these issues, the second type of production – intended for indirect consumption – offers a solution. As we will see, scalable production is attainable through specialization and division of labor, which in turn is facilitated by markets.

The relevant production for our purposes is market-based in the sense discussed in previous chapters, in which production primarily aims to satisfy one’s own wants indirectly. This separation of production and consumption, with respect to what the individual him- or herself consumes, has several positive effects on production in the economy. First, it makes it possible to invest one’s time and effort where it is most useful or produces most output rather than where one has wants that need to be satisfied. Where Robinson Crusoe needed to pick, collect or catch the food he needed to eat, market-based production can make available a wide variety of foods even to those who aren’t involved in its production. What this means is that you can work full time on engineering or in an automobile factory, where neither of which may have much to do with food production, yet still have access to plenty of foods. Second, the separation of production and consumption brings about a greater variety and increased appeal of goods produced and offered for consumption because what drives their salability is the ability to satisfy remaining wants (that is, unsatisfied wants, either because existing production quantity is insufficient to satisfy existing wants or because those wants have not yet been discovered) as well as their attractiveness in the eyes of consumers, both of which are incentives for product differentiation. But most importantly, the separation of production and consumption leads to social cooperation through markets. Such cooperation is much less prone to have the problems that we saw could arise in groups producing for their own consumption, because it develops and evolves through bottom-up emergence. It is also a much more scalable model that allows for more economic production and, consequently, affluence.

Production: Smith, Ricardo, and Schumpeter

We saw examples of producing for indirect consumption in the previous chapters, where each of our friends focused on producing a single good that they didn’t intend primarily for their own consumption (such as Adele and her apple orchard). In comparison to the self-sustaining production of Robinson Crusoe or the communes discussed above, each person’s labor is released from the necessity to produce to satisfy their immediate need for consumption. For instance, had Robinson had access to a market on the island where he is stranded he could simply have focused on producing any one good that he believes would be salable in that market in order to then use the proceeds to acquire what he needs or wants to consume from other sellers. In other words, in such a situation he can rely on both his observation of what people reveal as highly demanded in that market (that is, what they’re currently buying at relatively high prices), his understanding for what people will find valuable (that is, goods or services he thinks will better serve consumers), and his own abilities (that is, what he’s good at producing). And based on these things, and anything else that he considers relevant, he can choose to focus his efforts on the production of one or a couple specific goods. This means major savings in effort and time used in production for Robinson as well as for everybody else producing for this market.

Another way of expressing this is to say that actors in a market benefit individually and collectively from specializing. Scottish “father” of economics Adam Smith noted in his 18th century magnum opus Wealth of Nations that specializing through the division of labor, that is by concentrating on a specific trade or specific tasks within a production process, offers three primary benefits: it saves time because each worker no longer needs to switch between different task, workers develop expertise by repetition which further increases their productivity, and it allows for automation through the development of capital because single tasks tend to be much simpler than the whole production chain.[2] It is easy to see, even intuitively, that Smith was justified in making this conclusion; specializing through the division of labor produces an absolute advantage in production. Modern studies confirm that so-called multi-tasking can have detrimental effects on productivity and effectiveness[3]; we easily understand that “practice makes perfect” and personal experience that would appear to confirm that this is so; and, finally, the great use of tools, machinery, and robotics in our modern production economy speaks clearly to the productive power of automation.

Add to this situation of specialization the great lesson of comparative advantage offered by the British 19th century economist David Ricardo.[4] While Ricardo’s lesson is often taught and explained as a “two countries, two goods” mathematical exercise, it is a fundamentally important insight that doesn’t actually require math. The essence of the lesson is that specializing in production and then trading for access to the diverse goods produced by everybody else makes each actor and therefore society overall more productive and thus better off. The real takeaway from the comparative advantage doctrine is that even where some producers are inferior in every line of production, it is disastrous to shut them out. In contrast, total production increases if they too specialize in producing what they’re relatively better at – even if others are more productive in absolute terms. So even if it is the case that some productive people are extremely productive in everything they do, they and society overall is better off – in terms of production, at least – if they specialize in producing where they are relatively better and then let those with overall and thus absolute inferior productivity complement society’s production by specializing on what they’re relatively better at. Where this happens, society uses its resources to the highest degree possible – and we therefore get the greatest possible value out of people’s combined efforts.

The absolute and comparative advantages through specialization that Smith and Ricardo teach us don’t reveal the whole picture, however. They don’t include the great advancements possible through innovation. While Smith indeed mentions automation as one of the three reasons for the productive powers of specialization through the division of labor, productive innovations are not limited to automating already existing tasks by developing simple machinery to replace manual labor. As 20th century economist Joseph Schumpeter famously argued, innovations in the form of what he called “new combinations” can take five different forms: new goods (or new quality of goods); new methods of production; opening of new markets; new sources of inputs; and new types of organization.[5]

Smith’s automation through machinery is a subcategory of Schumpeter’s second form of new combination: new methods of production. But new methods of production refers to much more than simply developing tools and machines; it also includes different types of processes, which may include completely different tasks, and different ways of doing things. Also, Schumpeter’s fifth and final point about organization is an important observation that has turned out to be almost prophetic. By organization, Schumpeter means the organization of an industry rather than a single business. In other words, he’s talking about how the production apparatus changes over time, a process that he described as “creative destruction” – that is, a “process of industrial mutation […] that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”[6] What he suggests is that production evolves as new and better ways of producing are introduced into the market and ultimately replace the older and, from the point of view of consumers, less efficient forms. This includes business firms coming and going, entrepreneurs disrupting the market, and with these “revolutionizing” events come changes to the very structure and extent of the market.[7]

Nonetheless, both Smith and Ricardo’s examples point to exchange through trade as a necessary facilitator of specialized production and, consequently, the increased satisfaction of consumer wants. Similarly, Schumpeter notes that the reason innovation can disrupt production in markets is not the innovation itself but what it reveals about possibilities in production. Following a successful innovation, competitive pressures compel existing market producers and nascent entrepreneurs to adopt the better method or suffer losses. In other words, voluntary trade, as we discussed cursorily above, is core to understanding market production – including the productive powers of and social cooperation through decentralized, market-based decision-making. It is also core to this book’s exploration into the real effects of regulation. Indeed, the lessons from Smith, Ricardo, and Schumpeter each offer insights into how we can (and should) extend our market example in chapter 3 to produce a model of advanced production in a more highly specialized market. We’ll look at how their insights contribute to our understanding in the order presented above.

The previous chapter already makes use of the basic division of labor into different specialized employments alongside distinct trades. Indeed, we have each user specializing in a separate trade: Adele as apple-grower, Bart as baker, Becky as nail producer, and so on. We saw how this is more effective in production because each person gets to focus on a specific kind of production, which is exactly what Adam Smith suggested. We also found that the most effective way of serving one’s own interests is by focusing production efforts on serving others. This, of course, brings about, to borrow Smith’s words, “a proportional increase of the productive powers of labour. The separation of different trades and employments from one another, seems to have taken place, in consequence of this advantage.” So to Smith the step from self-sufficiency, where each and every person or family produces what they consume, just like Robinson Crusoe above, to specialization to separate trades is due to the increase in productivity. This may very well be the case, for the three reasons Smith argued makes the division of labor more productive.

But we can also see that while employment in specialized trades like farmer, baker, and blacksmith makes sense and indeed increases productivity, a greater improvement in standard of living is made possible through trade rather than production for consumption in the immediate family or community. Perhaps this is the reason Smith, who suggested that the productivity increase due to specialization under the division of labor is “proportional,” doesn’t linger on specific trades but immediately moves into industrial production. He thereby goes directly from a situation where individuals or groups such as families and small communities produce for their own consumption to a specialized exchange economy with advanced production structures. Even though he calls his example, the pin factory, a “very trifling manufacture” the step from producing for direct consumption to producing for indirect consumption – where satisfaction of one’s true wants is possible through voluntary exchange with other producers – is far from trivial. In fact, if we think logically about the step it appears to something of a “catch 22,” for who would begin producing something that only indirectly satisfies their own wants before there is a market in which to exchange goods? But, at the same time, why would there be a market if everybody produces for their own consumption? This seems like a paradox.

The paradox is probably exaggerated, however, for the simple reason that different families and communities likely have different interests, skills, access to resources, and so on. So there would be a natural variation in what they produce, and there would be both surpluses and shortages that are reasons to seek exchange. For instance, in a dry year the producers of cotton might produce much more than they can or want to use for clothing and other things, so they might seek to exchange their surplus cotton for other goods with families or communities who value the cotton. Some years or seasons – or perhaps due to luck – beaver hunters find and kill plenty of beavers, perhaps so many that they produce hides that they would be willing to use in exchange for other goods. And similar things can be said for other trades.

This means that there can still be markets and market places even though production is primarily undertaken for one’s own, or one’s family’s, consumption. In other words, there is no catch 22 in how markets develop. Rather, the apparent paradox is due to thinking it is necessary for an individual to take the step from production for direct consumption to production for indirect consumption. This is not the case, and history shows that there were plenty of market places and even long-distance trade despite large parts of the population being self-sufficient.

Nevertheless, both the solution to the apparent paradox and the logical leap Smith takes from specialization into trades to a specialized exchange economy, point to the importance if not necessity of exchange as a means to distribute the goods produced: specialized production in separate employments, where the goods produced are not only or primarily for one’s own consumption, necessitates trade. This is what we saw above with Adele’s orchard, which she invested in because she anticipated that it would be a good use of her time – in terms of her ability to satisfy her own needs as a result of first producing for and thus supplying the market with goods that “it” values. In other words, she anticipated that the best way of serving herself was to serve others, and she considered apple-growing to be one of if not the best opportunity for her to do so. Of course, as we also saw, there are many ways in which Adele can establish the orchard and run her apple-growing business. This is core to the Smithian lesson of productivity gained through the division of labor, and to further illustrate this we’ll consider another example that is very similar to the illustration preferred by Smith (the production of pins in a specialized “manufactory”): Becky’s production of three-inch nails.

As with Smith’s original illustration, Becky’s business is also in many respects, as is the case for most of the examples in our simple, small-scale economy, a “very trifling manufacture.” Indeed, as is suggested by the limited scope of our example, Becky is probably doing all the work herself, possibly with an apprentice or two, using simple tools for heating, shaping, and cutting the metal into three-inch nails. However, as Smith teaches us there are productivity gains to further specializing so that different people do different things in her nail-producing workshop: a further division of labor. With greater division of labor comes increased productivity per labor unit, and therefore more “bang for the buck.” In other words, through a more intensive division of labor Becky could get more output per unit of input.

But this suggests important limitations to the possibility of increasing productivity. First, Becky would need to figure out if it is “worth it” in the same sense as Adele had to do in the example above: is it worth the additional investment, and thus the uncertainty of profitability, to take on a number of workers, invest in blast furnaces, and so on? This question hints at the problem of anticipated demand. Even if there were laborers available for Becky to employ, increased productivity per labor unit means little if there is not a sufficiently sized market that can demand the produced goods. In our little economy, this is an obvious limitation: after all, how many nails could she possibly sell to apple-grower Adele, baker Bart, and the others? She could probably sell a few. But how about hundreds of thousands? Probably not. The increased productivity, which really means there are increasing returns to investments in production, means there is less cost to each produced nail (that is, more nails are produced for each unit of input, whether input is labor, materials, or machinery). But lower cost per nail doesn’t mean it makes sense to produce millions or billions or even trillions of nails. It only makes sense if there is a chance of actually selling those nails. So productivity through specialization under the division of labor is mitigated by the size of the actual market, that is the possibility of selling what is produced. Or, as Smith put it, the division of labor is limited by the extent of the market.

So when Becky decides on how many to employ in her nail-producing business, how expensive (and productive) machinery to buy, how large production facility she needs, and so on – that is, the scale of her business – she must anticipate not only whether the goods she intends to produce are valuable to consumers but what quantity would be demanded at what prices. This, in turn, helps her make decisions about the type of production, scale of process, and what magnitude of investments are reasonable. If she anticipates that there is a large untapped market for nails, then she wouldn’t have a problem investing in large-scale production. In fact, she would have to in order to maximize her returns. To put this differently, she cannot afford to produce in smaller quantities if she anticipates that there is sufficient demand. The reason is that with increased investment, which she of course would only take on if she anticipates that it will increase productivity, the return on that investment is higher. Choosing small-scale over large-scale makes no sense if profitability – the percentage return on investment – is increases with the higher investment. The other side of anticipated higher return on large-scale production is that it makes small-scale production relatively more costly. So with increased production, Becky can either increase her profits (if she has sufficient pricing power) or, in a competitive situation, charge lower prices while maintaining a certain level of profitability. Scale can therefore be an advantage to her business as well as consumers. But this requires, of course, that there is sufficient demand, without which the undertaking is useless and she’ll suffer a loss.

If we attempt to look inside Becky’s nail-producing enterprise, or the way it could look, using Smith’s pin factory as a lens, we’ll get an idea of the productive powers of the division of labor within production processes in addition to between employment specific to separate trades. Whereas Smith refers to the specialization through the division of labor into trades as different from similar developments within trades, it is important to note that they are not in principle different. “Dividing” labor presently dedicated to do all the different kinds of operations necessary for self-sufficient production for direct consumption into different trades such as hunter, baker, and blacksmith is not different from dividing the trade of hunting into different trades: trap-maker, spear-maker, trapper, tracker, and so on. The only difference is that we think of hunting, farming, baking and so on as different and naturally separate production processes. But this was not the case when division of labor occurred among self-sufficient individuals or communities – it is only “obvious” with the power of hindsight. Just like it today appears to be a separate trade to be an accountant or manager or welder – all of which are highly specialized trades. All trades, no matter how intensive the specialization, are separated through the division of labor with a single purpose: to bring about increased production for the satisfaction of wants. What this means is that whether we choose to see separate production processes within the market, or instead see the whole market as a production structure dedicated to satisfy a variety of wants, is irrelevant. All production is related and in fact interdependent (as we shall soon see), and specialization through the division of labor is intensified when entrepreneurs find a way of doing so and anticipate that it is “worth it” – that is, when it appears to be profitable.

Becky’s nail-production business could very well have been organized using much more intensive specialization within, as Smith calls it, a “manufactory.” Smith contrasts Becky’s type of business as discussed above (where she works alone or with only little help) with the industrialized process: “in the way in which this business is now carried on [in the “manufactory”], not only the whole work [pin-making] is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades.” Those parts are specific (though not necessarily unique) to the process of pin-making, which itself of course is a specialized process, and labor workers can thereby specialize to carry out one or only a few of those parts. To use specialization through the division of labor within an already specialized process includes separating operations sequentially so that one operation, carried out by one worker, is and must be followed by one other operation, carried out by another worker. This means there is a serial interdependence in the sense that if someone messes up, the whole chain of operations will be affected – not only the separate operation. Or, in Smith’s words, “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, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.”[8]

From the point of view of the community producing for direct consumption, the difference between specializing into trades (Becky produces nails, Bart bakes bread, Adele grows apples, and so on) and specializing even more intensively is not much different. What differs is the nature of what is produced and thus the relationship between the individual worker and his or her work. In a factory, we’d see the connection between a workman and the result of his work become weaker, what Karl Marx referred to as alienation. The connection between one’s production efforts and what is produced is strongest when producing for direct consumption. But even if producing for indirect consumption, for instance when Becky specializes to produce three-inch nails or Adele grows apples, the connection is obvious: a satisfaction in the sense of “I produced this” can be felt with respect to the very thing produced. In other words, there is no alienation, even under intensive specialization.

Interestingly, alienation appears to only occur within “manufactories.” The reason for this is, from our perspective of specialization, that the process carried out is more intensively specialized than general market trade. Becky is not alienated with respect to her production of three-inch nails for the reason that they are nails and therefore separate good, but because they are goods traded in the market. Nails are not consumed as nails, but make inputs in the construction of houses and other things. If Becky had been specialized toward making nails in an economy where nails were not traded as separate goods, which means she would probably be an employee or subcontractor in a house-builder business with in-house production of nails (because they couldn’t be bought in the market), the connection between her labor and the product would be much less obvious and, as a result, she would suffer from alienation.

Interestingly, this addresses the Smithian point, discussed above, about how the division of labor is limited by the extent of the market. Indeed, specialization under the division of labor is not possible in more intensive forms than are already supported by the market. Alienation follows from pushing specialization further so that an integrated process is formed where each specialized operation is entirely interdependent on the other operations in the sequential process. In other words, alienation would only arise in situations with very intensive specialization under the division of labor, that is not in the general market but as “islands of specialization” brought about by entrepreneurs trying to implement what they anticipate to be superior productive solutions (innovations). Such “islands” step outside the extent of the market and therefore appear integrated, and we can refer to them as firms (like the pin factory).[9]

A more pressing concern for our present purposes, however, is how Becky’s nail-producing business relates to Ricardo’s insight about comparative advantage. In other words, how do we put the “right” people to carry out each specialized operation in a production process. To Smith, at least in the example of the pin factory, who does what doesn’t really matter – his example explicitly relies on uneducated workers rather than specific skills, innate or acquired, and thus specifically uses unspecific labor power. Under such circumstances, it is obvious that repetition (on the job training, as it were) will soon lead to increased productivity (what Smith refers to as “dexterity”). His other two reasons why productivity increases through the division of labor are equally easy to see. Using only basic labor power, Smith’s example shows astounding returns to specialization: one workman, he says, “could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty” whereas “ten men … could, when they exerted themselves, … make among them upwards of forty-eight thousand pins in a day.” In other words, working alone each worker cannot make even twenty pins; working together, they make almost five thousand pins each.

Of course, people have different inherent and learned skills. They also have different interests and therefore find it easy to learn different things. Surely this makes a difference in production as well? Of course it does. So when Becky, if we assume that she’ll need to employ a dozen workers in her factory, would benefit from picking hard-working men and women – and then use them in the best possible ways in the production process. She would fit there already existing skills and their interests with the different operations that make up the nail-making process. Needless to say, she’s best off employing the “best” workers out there and then use them where they are most productive. The workers, conversely, are more productive if their skills and work tasks are aligned, and with the increased productivity they are worth a higher wage. This, in effect, is what Ricardo teaches. Even if the workers Becky employs are not productive to the same degree so that some of them, say the newly employed David and Deborah, are so excessively skillful that they are better than for instance Eric and Edda at any and all tasks that need to be carried out in the nail-production process, then the total outcome is better if Becky keeps Eric and Edda employed and use David, Deborah, Eric, and Edda where they are each most productive.

It may not be obvious in Becky’s nail factory because she would likely select the best suited for the job. But if this were not the case, say her business is a family firm and she needs to rely on family members for producing the nails. Some of them would be highly productive whereas others might be lazy, some have plenty of skills and others have only a few. Furthermore, some of them have experiences that make them productive in many types of positions whereas others have neither experience nor interest in working and therefore won’t contribute much to the bottom line. With such a fixed population, Becky would produce more nails by including all of them than not. Obvious? Yes, but it also applies in trade, and that was Ricardo’s point.

Say Becky is an extremely productive individual and that she’s much better than Bart at both making nails and baking bread. So why wouldn’t she produce the nails and bake the bread, and simply exclude Bart? The reason is that they both have limited time and energy, so even if Becky is better at both tasks in absolute terms – or even much better – they’re both better off if Bart is better at baking bread in relative terms. So if Becky can produce a dozen nails in an eight-hour work day (which makes her quite productive, considering Smith’s pin factory example) or bake twenty loaves of bread, and Bart can produce a miserable four nails or bake seven loaves of bread, then they’re both better off specializing and then exchanging with each other to get what they want. We’re not here including the productivity gains from production that we learned from Smith, but treat productivity as though it is unchanging. This is unrealistic, of course, but makes the point clear: even without the benefits of learning, saving from not switching between tasks, and automation, individuals are still better specializing and trading than not.

Using the example above, we can see that Becky is, relatively speaking, more productive when producing nails than when she’s baking bread as compared to Bart. For Becky, the choice for a workday is either twelve nails or twenty loaves of bread, so her productivity ratio nails/bread is 3/5. For Bart, the choice is four nails or seven loaves of bread, making his productivity ratio 4/7. In decimal terms, Becky can produce 0.60 nails for each loaf of bread, and Bart can produce approximately 0.57 nails for each loaf. In other words, Becky has a relative advantage producing nails whereas Bart has a relative advantage producing bread (he can produce fewer nails per loaf than Becky). Another way of looking at this is that to produce a single nail, Becky will have to “give up” (as opportunity cost) one and two-thirds loaf while to Bart, who’s relatively better at baking, producing a nail means he has to give up one and three-quarters loaf. So it is “cheaper” for Becky to produce nails than bread, as compared to Bart. It is similarly “cheaper” for Bart to produce bread than nails, as compared to Becky. So to get as much as possible out of this situation, Becky should do what she’s relatively better at and Bart should, similarly, do what he’s relatively better at. At the end of the day, they can get together and share the dozen nails that Becky produced and the seven loaves of bread that Bart baked.

In the real world, of course, productivity is not a constant. Adam Smith showed this in the discussion above. If we add the Smithian lesson to our Ricardian discussion on what Becky and Bart should do, then it is clear that the relative advantage of Ricardo provides guidance to what is the better starting point in terms of “who does what” – and then, if we add what we learned from Smith, we see that simply by focusing their efforts rather than both Becky and Bart doing both things, we increase productivity even further. If we had more people and let them specialize under the division of labor, then we could see explosive increases in productivity.

But we should add to this picture the lesson we learned from Schumpeter. Whereas Smith includes limited innovation in his discussion on the pin factory, primarily through “automation” of simple tasks by the construction of machinery, this is not what Schumpeter had in mind. Instead, he was talking about revolutionizing innovations that do much more than relieve a worker of his or her simple production task (which, from an economic point of view, means this worker is now a resource available for other productive tasks, and therefore can contribute to economic growth). Schumpeterian innovation changes how production is done, it doesn’t just simplify processes that have already been implemented.

An example of such an innovation would be Henry Ford’s use of the assembly line technique for mass production of standardized automobiles. Prior to this innovation, each shop could produce only one automobile at a time. The production crew was involved in production from beginning to end, since specific tasks need to be carried out in a certain order. Alternatively, an automobile factory could have separate crews focused on one part of the production sequence each, and they would then move from car to car in order to finish the job. The assembly line did two things: it standardized production for both workers and consumers. Workers specialized on certain tasks in the sequence and the car was moved between stations, placed as close as possible, using conveyors. As a result, consumers were offered a standard product.

Whatever our views on assembly line production, it was a vast improvement over the production method used earlier. For this reason, it completely changed the industry and production of automobiles.

As another example, take the printing press. It didn’t change the importance of books as sources for knowledge, but made their production so much more effective and cheap. Rather than reproducing books by hand, the printing press allowed for printing numerous copies at once. This meant new knowledge could be made available to a lot more people a lot quicker; it was therefore easier to educate people and, at the same time, harder for protectors of the status quo to stop new knowledge from spreading. And each book could be made available at a fraction of the price, making advanced knowledge available to more than the elite. This fundamentally changed society and made arbitrary rule much more difficult; the printing press democratized society.

Another effect of the printing press was the new business opportunities through publishing houses, the greatly increased demand for paper to print on, and the circumscribed use for scribes. Productivity in books production of course increased greatly, but an important part of Schumpeterian innovation is the changes caused to other types of production, to what’s being offered to consumers, and how this changes things overall. Schumpeterian innovations revolutionize the market by disrupting it. Much of this is accomplished by finding new ways of satisfying consumers, which reshuffles resources and changes specializations. With the invention of the automobile, transportation became much more reliable and cheaper. But it also meant that factories and workers specialized to horse carriage production were no longer needed; they could instead be used to satisfy other wants. Likewise, the numerous horses used to pull the carriages could be used toward some other end. While the process can be painful for many of those affected, the effect to the economic system is that resources are released from their present occupations and therefore can be put to other and, presumably, better uses elsewhere – the value they were used to create is better generated through the new innovation.

Taken together, we can see the immense productive power available through specialization and innovation, neither of which would be possible without voluntary exchange. Without a separation of production and consumption, specialization under the division of labor couldn’t go very far. Without trade, we cannot take full advantage of relative comparative advantages, as Ricardo teaches. And without trade, a Schumpeterian innovation wouldn’t have much effect, since exchange facilitates the innovation’s revolutionary improvement to the totality of production. Trade, however, is much more than buying goods for consumption. It is the lifeblood of production and the enormously productive powers of decentralized markets.

Production as Social Cooperation

What has so far been said about specialization under the division of labor in production has focused on separate production processes: from what is conceivable as the start of the production process (as when Adele planted the apple trees in her orchard) to its completion by offering consumers a completed good or service (apples). But market production cannot be properly understood as a sequential process, even if we often intuitively think of and may even observe it as such. Rather, production is an intricate network of interconnected and interdependent productive actions and processes that build off and support each other, and that connect all production efforts into what we in a previous chapter referred to as an “economic organism.”

The issue of productive capital is key to understanding how market production is more of an organism than a sequential process. Consider again Adele’s undertaking as apple-grower. We already established that her business, and thus the “separate” production process that it entails, starts with clearing the land and planting seeds or apple trees, and then continues with tending to the trees, picking the apples, and so on. But is this really a separate process? Hardly. And this is obvious from our previous discussion.

Consider Adele’s clearing of the land, which means cutting down trees and thicket. While we would consider both the land and the labor as “original factors” of production, whether or not she does all the work herself or employs helpers, clearing of the land is almost impossible without tools. To cut down trees, remove rocks, and so on, Adele and her helpers will use chainsaws or handsaws, shovels, picks, and possible sledge hammers. As we discussed previously, Adele would consider using excavators and machinery in the stead of some of the labor. All of these tools and machinery constitute capital: they’re produced means of production. In other words, for Adele’s production process to even begin, she first acquires the outputs from other production processes. For each input used in Adele’s apple-growing business there is a separate production process. Indeed, this is the case not only for the tools and machinery used to get started – with different processes for producing the saws, shovels and picks as well as processes for assembling machinery – but also for producing the apple seeds or seedlings she plants, the irrigation system she purchases and installs, the ladders and tools used for pruning the trees, the carts and whatever else she needs for picking and transporting the trees.

Whereas these inputs used by Adele have their own production processes, so do the inputs used in their production processes. The saw-maker, for instance, relies on other entrepreneurs to make the steel and plastic used to make the saws available; moreover, the tools used for shaping the steel into saws, sharpening them, etc. are also inputs that have been produced using other and separate production processes. And so is the case with the buildings used in the production process (the factory or workshop), to store the steel and tools, and so on. Add to this the vehicles used for transportation and delivery, the automobiles used by workers to get to and fro their work in the factory, the heating and ventilation systems along with the electricity and oil or natural gas used to maintain a decent temperature in the factory, and so on. There is, in fact, no end to the number of production processes the tie into and are necessary for Adele’s apple-growing process.

Nevertheless, we can think of production as taking place in “stages” from virgin land and labor to the product offered to consumers. For instance, we can think of the production of automobiles as consisting of the sequential stages mining, smelting, steel-making, and automobile assembly. There are supporting production processes to make these “stages” happen, but they are not core but peripheral to the “flow” of intermediate goods that eventually are offered to consumers in the form of an automobile. In this simple example, the intermediate goods would be iron ore (from mining), iron (from smelting), and steel (from mixing iron and coal). The steel is then used in assembly of automobiles that are the final good.

We can see, then, how we might conceive of the production of each intermediate good as a separate production process, perhaps carried out by a separate business entity or entrepreneur, whereas they combined constitute the “full” process of production necessary automobile manufacturing: from farm to table or, as is here the case, from rock to automobile. Seeing market production as consisting of separate but interdependent “stages” is an important insight that helps us understand the effects of changes in an economy. The reason for this is that the production of one stage, for instance steel production, is not only used as input into automobile production but many other types of production. Indeed, ships, airplanes, railroads, and skyscrapers are all in part produced from steel. But so are machines used in producing them. So the steel produced in the stage adjacent to automobile assembly in our example is used for automobiles as well as in the production of machinery used in the automobile assembly process. Some machinery made using this steel could also be used to assist in mining the iron ore that is eventually turned into steel, for blast furnaces smelting the iron, and in steel production itself. So while for the purpose of automobile production we can conceive of production in stages, what is produced in one stage – for instance, steel – can be used in many other stages, and even in steel production itself.

Steel, of course, is widely used so we would expect steel to be part of numerous types of production. But this is the case only partly because steel has valuable properties, that is that steel can easily be used for many different things. Usefulness is only part of the explanation, however. We can think of other materials that could be used in the place of steel, or perhaps other ways of producing that would not require steel. The reason steel is used is because it is useful and cheap. If steel was sold at the price of gold, then much of the production that presently uses steel would be directed toward using other materials, different processes, and perhaps cease altogether. So we can imagine that if the price of steel suddenly rises, the relative cost of using steel would go up and entrepreneurs would therefore choose to use different (cheaper) materials, different (cheaper) production processes, or go into different lines of business. By seeing production as stages, therefore, we can track the effects of changes as they effect each stage, and then follow how this affects other stages step by step. If we were to think of production as uniform with indistinct operations that cannot easily be separated, we would not be able to track the specific effects brought about by certain changes. For instance, we would not be able to explain why a sudden and substantial increase in the price of steel leads to automobiles made out of plastic or aluminum, why the laying of railroad tracks is slowed down, or why new and different construction techniques for the building of skyscrapers are suddenly adopted.

Seeing production in stages is therefore an important theoretical tool for understanding how production is coordinated in an economy. But this is not necessarily how entrepreneurs see it, and they do not make decisions based on our conceptualization of production stages. Rather, they respond to prices. So when the price of steel suddenly goes through the roof, individual entrepreneurs do not need to know what happened or why the price dramatically increased, they only need to know that it did.[10] And if they believe that it is not simply a temporary effect or fluke, they will adjust how they carry out their production processes based on this information. If they can raise the prices they charge to their customers, they might try doing so. But under competitive pressures, no one wants to be the first to raise prices since this means customers will likely buy from those not raising prices instead. So they will attempt to cut on costs to maintain profitability without raising prices. Part of cutting costs can be to adopt other production processes that don’t require as much steel – or no steel at all. As steel is relatively more expensive than it used to be, these alternative production methods, which used to be costlier than using steel, are now better options. So as entrepreneurs try to tackle the problem of rising steel prices, they attempt to find better ways of producing – and thus production overall is shifted away from the now relatively more expensive steel and toward alternative methods, techniques, and materials.

In a competitive market, this type of adjustment is undertaken all the time – even if specific prices do not suddenly go through the roof. Indeed, entrepreneurs compete by keeping their cost down and by figuring out better production techniques, and will shift their production efforts toward the best possible – at least, the best possible they know about – alternatives. Part of the driving force in this constant and continuous effort is to beat the competition, but part of it is also the chance for profit. By keeping costs down, finding more effective production techniques, or by figuring out more highly valued products to offer to consumers, entrepreneurs can reap profits – by becoming better at satisfying wants. So even without existing competitors, they still have an incentive to improve (though the incentive might not be as strong) for the simple reason that they have a chance of earning higher profits. In this way, production shifts in ways we might not be able to predict. And each shift produces “ripple effects” – like the waves on a pond when a rock is thrown into it – through the stages of production: each change will have some effect on prices, since both demand and supply shifts, and this will in turn cause other entrepreneurs to shift their production. In other words, production in a market is in constant flux. It is never stable.

What holds this organism together is exchange. The constant adjustments or shifts within the market’s entire production apparatus are possible because it is possible to trade. For instance, rapidly increasing steel prices could mean that Adele instead of investing in machinery chooses to hire more labor to satisfy growing demand. Also, she might employ someone dedicated to taking care of and servicing the tools used to prune and tend to her apple trees so that they don’t have to be replaced as often. This constitutes a shift in response to some unknown event that effectuated a sharp rise in steel prices. And Adele’s choice to avoid this added cost that is reflected in higher tools prices, by employing someone to take care of the tools already in use so that they can be used longer, is one of the effects of the change in steel price. But it is not obvious to an observer, and other entrepreneurs may choose different ways to deal with this change.

While Adele’s choice to employ more people – perhaps because she knows someone who is great at taking care of tools – has very little effect on the market overall, how all entrepreneurs combined react to such changes makes a difference. Say many producers are in the same situation as Adele and choose, like she does, to respond to higher steel price, and the resulting higher prices on tools, by employing tools service experts or buying this service from companies offering it. This increased demand for such services causes a shift from tools production to tools service and care. As entrepreneurs choose to no longer invest as much in new tools and instead use those funds to increase the time existing tools can be used, the effect is twofold: producers of tools will find it more difficult to sell tools, which means they will be forced to lower their prices (prices of tools, therefore, go down); and servicers of tools will see a similar increase in their demand, which means they can raise their prices and many of them probably figure it is worthwhile to invest in increased capacity, and so on.

This, in turn, has effects elsewhere in the market. As tools manufacturers cannot sell as many tools as they used to, they will cut back on their operations and thus use less materials. Some of them will move to smaller offices and production plants, and they will buy less steel from steel producers. In other words, the larger offices and plants that are now too large for tools manufacturers will be made available to the tools servicers who experience increased demand. Tools experts previously employed by tools manufacturers are laid off and instead employed by tools servicers. The steel previously demanded by tools manufacturers can be used by entrepreneurs in other industries or types of production. For instance, they may find better uses in tools and machinery used by tools servicers in servicing the tools that were previously sold by the now downsized tool manufacturers.

This will also have an effect on businesses that seem to be more remote from the production and servicing of tools, such as transportation services, heating and cooling for plants (for instance, perhaps manufacturing requires more high-capacity cooling than servicing), fuel used to run the machinery, and so on. It also affects which types of trucks are used for transportation, since tools servicing might need to transport the tools from the customer to the plant and back whereas tools manufacturing only transported them one way. So it may increase the use and therefore value of roads, diners, gas stations. Many of these changes are far from revolutionary, but are only minor increases or decreases. But they are necessary to properly adjust overall production toward where resources are best used. And it follows from entrepreneurs’ anticipation of how they can best satisfy consumers.

In the case of steel prices surging, for whatever reason, Adele chooses to not buy as many tools because the prices of those tools also go up. This is a decision she makes based on her anticipation of how consumers value the apples that she produces. If she would be able to raise prices for apples without consumers shifting their demand to other fruits or edibles, or simply not buying at all, then she might afford to keep buying new tools. But there is no reason why she wouldn’t have already increased her prices if she knew – or at least felt confident – that the market could bear higher prices. Also, there is no reason why she would choose to pay for tools when it is more cost effective to service the tools she already has on hand – why would she accept the higher cost unless it is necessary? Prior to the increase in steel price, Adele considered buying new tools but not investing too much into servicing them was the best investment: it provided most anticipated service to her apple-growing business at the lowest estimated cost. After the price of steel increased, however, the tools became more valuable and thus costlier to replace, which in turn increased the relative value of tools servicing; it suddenly made economic sense to invest in taking care of the tools, so Adele shifted her investment from buying to servicing. She will still buy tools when necessary, only with proper servicing this will not be as often as it used to be.

Only through exchanging with each other can entrepreneurs bring about the changes we’ve seen. In Adele’s case, she now purchases servicing rather than tools; servicing, in turn, uses slightly different resources than manufacturing, which leads to a shift from producing for manufacturing to producing for servicing; and this, in turn, leads to different uses of the resources used for those kinds of production. Very few of these changes are large enough to bring about revolutionary changes to the overall production apparatus, but it is also likely that the change in steel price affects more than tools manufacturing. Entrepreneurs’ everyday decisions, and especially their shifting from one type of operation, along with the inputs and resources used, to another, affect what other entrepreneurs are able to sell and at what prices. If steel prices go up enough, many entrepreneurs in widely different industries that use steel will shy away from using as much as they did – and thus the market for steel shrinks.

“Shying away” from using is here the same thing as not buying as much as before; in other words, the quantity demanded diminishes and steel can therefore be used in greater quantities for more highly valued uses. But note that what is now more highly valued is not necessarily the same as before. While we used the increase in price for a commonly used resource as starting point for our example, it could also be brought about by a shift in how consumers value goods. The economy is endogenous, which means the market adjusts in response to changes that are not external to it: consumers constitute an important part of the market, and it is quite possible that what they demand – that is, what they value – can change for no apparent reason. Entrepreneurs involved in production will need to anticipate and properly adjust their undertakings to this change to not go out of business.

The same is true if an entrepreneur innovates a product previously unseen and therefore not demanded. But offering this new product could educate consumers about their true valuations, and therefore cause a shift in demand. Many “disruptive” innovations do this: they fulfill a demand we as consumers didn’t know that we had. But when we learn about it, we of course update our behavior and buy this more highly valued good or service before what we used to buy. So the market needs to continuously adjust and respond to changes that occur both among consumers and within the different kinds of production being undertaken for their benefit, and no matter where the change originates (some changes can be exogenous to the economy as well, such as changes in weather or climate) it causes a chain reaction within production as entrepreneurs respond to how the change affects their business to the best of their ability.

We can see, then, how market production, even though it is highly decentralized, and spontaneous rather than planned, can be thought of as an organism: all of its parts are interconnected in myriad ways, many of which may not be obvious and may not be explicit, and production overall adjusts to changing conditions automatically because each individual entrepreneur makes decisions and chooses what they anticipate to be their best course of action. This way, and as we discussed in previous chapters with respect to producing one’s ability to consume, market production is undertaken with the purpose to satisfy others’ – consumers’ – real and anticipated wants, an activity that is aligned with the producers’ quest to satisfy their own wants through earning profits that facilitate consumption.

As production becomes increasingly specialized and therefore, through the division of labor, a whole chain of individual producing entrepreneurs is necessary for the production of goods for consumption, the entrepreneurs become dependent upon each other. But they are also freed through this process, since they can rely on other entrepreneurs – the “market,” as it were – to supply the resources, tools, and inputs necessary. As is the case for Adele, she can specialize in apple-growing because many of the resources necessary to establish and tend to an orchard are already available. She can buy from other producing entrepreneurs what she needs to get started with her own production. This means she will not have to start from scratch, and it also means she will not have to acquire complete knowledge. Rather, she can begin with advanced tools and machinery, each of which requires plenty of skills, expertise and capital investment to produce, and therefore need not bother with how they are produced, why they are produced, or if there are better ways of producing them. She can in this sense act as a consumer toward the producing entrepreneurs who precede her in the chain of production activities necessary for Adele’s customers to be offered ripe and sweet apples. Entrepreneurs are therefore engaged in cooperation in the same way cells or organs cooperate and are interdependent in a body, and it is in this sense we can think of the economy as an organism.

As the purpose of entrepreneurs’ undertakings is their own consumption, however indirectly through production that satisfies others’ consumption, they are involved in contributing to the public good of value creation. By serving others, they serve themselves. This “invisible hand” of market production, which auto-adjusts to changing conditions, changing consumer preferences, and discoveries of new products, production techniques, and resources, is made possible because of specialization under the division of labor, competition for profit between producers, and the whole process is facilitated through exchange. So while the production apparatus as a whole is interdependent and organism-like, it actually consists of tiny and separate parts: entrepreneurs and laborers who independently make choices in their own self-interest. Competition between them for the purpose of satisfying consumer wants, which facilitates their own wants satisfaction through consumption, therefore constitutes cooperation: by competing to serve consumers in the best way possible, they cooperate in providing value to consumers.

This being said, the market should not be considered efficient. Rather, it is redundant and every entrepreneurial failure constitutes a loss not only for the entrepreneur him- or herself, but to society as a whole because more wants could have been satisfied. This is why the weeding out of unsuccessful entrepreneurs, and the resultant shifting of productive resources away from the less productive and toward the more productive, is a core part of what makes a functioning market. Without the very real threat of losing what’s been invested, there would be nothing to balance the lure of profits – and the order of the market would consequently fail.

Opportunity Cost and Optionality

What we have established now is the order that arises from a simple insight: that production precedes consumption or, which is another way of saying the same thing, that one must produce in order to consume. In the simplest case, all produce what they themselves consume. But production is much more effective if producers can specialize and thereby develop skills and expertise, make use of machinery, and increase the depth of their knowledge with respect to specific (rather than general) production. We saw how the arguments of Smith, Ricardo, and Schumpeter individually, but more forcefully when used together, show the immense productive powers of decentralized production that utilizes specialization under the division of labor. With increased production, many more wants can be satisfied. And with more wants satisfied, more wants arise as worth satisfying. We say that people’s wants are insatiable, by which we mean that we will never be fully content – there is always something that could be easier, taste better, look more beautiful, and so on. The reason this is the case is because there is a cost to any achieved value. It doesn’t mean that cost and value balance out, but that there is always something given up in order to gain – there is a tradeoff in every choice.

This tradeoff is what economists refer to as opportunity cost: the real cost of any choice is the value of that which is not chosen – because you lose that option when choosing something else. The real cost of a value is therefore the value that is foregone. This is not, of course, production cost. In fact, outlay and expenses for production are practically irrelevant for the opportunity cost of any item. Yet opportunity cost is still core to production decisions.

If Adam has the choice between eating an apple or a pear, then his cost of eating the apple is the pear and the cost of eating the pear is the apple. It doesn’t matter what fruit he actually chooses, but if he chooses the apple we know that he must value it – and the satisfaction he anticipates it will offer him – more highly than the pear. And vice versa. His personal, subjective gain from eating the apple is of course whatever value he gets from eating the apple. But what is more important for our purposes is the economic “profit” of doing so, which is the difference between how he values the apple – which we know must be higher than the pear – and the pear – which we know he values lower, since he didn’t choose it. He had to forego the pear to eat the apple, since he needed to choose between them, and therefore his cost – the loss of satisfaction by choosing the apple – is the anticipated satisfaction gained from eating the pear.

Why is this important? It is important because it indicates people’s true valuations as revealed through their actions, and this is in turn what directs production. Entrepreneurs invest in what they anticipate that consumers will want, but it is unknown whether they are accurate in their anticipations before consumers act. The ultimate outcome of how consumers choose to act generates the profit entrepreneurs earn or loss they suffer. If they accurately anticipate consumer valuation and use resources prudently in producing it, then they will earn profits; and if they don’t, they will lose their investment. The real loss, however, is the value that is forgone – not the prices paid for the resources used to produce that which wasn’t sold. What matters is therefore the relative value of what entrepreneurs do: in order to succeed, they must provide to consumers something that is not only valuable but relatively more valuable than what other entrepreneurs have to offer. If they fail, the real loss is the opportunity cost of their production: the time, skill, and resources used to produce that which was not sold. All resources are scarce, which means we do not at all times have exactly the quantity and quality we want of each resource, which is why we have opportunity costs. The opportunity cost thus indicates what our options are.

Consider an example as illustration of this point. Adam is given an apple. As he didn’t pay for it, he is strictly made better off by the gift. So what should he do with this value that he has received? He could eat it, which would provide him with some sort of satisfaction. Eating the apple is something that he would value. But in order to understand the economic decision of what to do with the apple, we must also consider his options – the opportunity costs of the apple. It is intuitive to conclude that a gift apple is free and thus has no cost. But this is not, strictly speaking, true. Because by choosing to eat the apple, Adam necessarily foregoes other values. What does he forgo? Say that in our little economy, an apple currently trades for the equivalent of three loaves of bread (Bart is willing to exchange a nice apple for three loaves of bread) and a half dozen of three-inch nails (Becky is willing to exchange the apple for a half dozen nails). In other words, even if Adam was given the apple there is an opportunity cost to eating it. This cost can be expressed as three loaves of bread or a half dozen nails. So in order not to miss out on the opportunities available to him, he must consider the tradeoff: apple, three loaves, a half dozen nails. Which is more valuable to him? If eating the apple is more valuable to him than the alternatives presented to him, then he should of course eat it. If not, then he should figure out which option offers him the greatest pleasure and choose that.

This is what economists mean when they say there is no “free lunch.” It may not be possible to resell an offered lunch on the open market, but the time you spend dining could be used in some other way. If you have a job with an hourly salary of $10, for instance, and you could without problem choose to work an additional hour instead of spending the hour on a paid lunch, then the lunch cost you the $10 that you could have earned. The concept of opportunity cost is powerful because it reveals what your real options are, and it also emphasizes what you are truly giving up. Interestingly, the opportunity cost is much greater in a market, because only in markets is it possible to trade what you have to acquire alternatives. As in the case of Adam’s apple, had there been no market – and therefore no market price for the apple he received as gift – he would have been restricted to the uses he could find for the apple: eating it raw, using it to make apple pie, plant it in the ground to grow an apple tree, give it to somebody else who might find it more useful, etc. But because Adam has access to a market, there are many more options available to him, so his opportunity cost increases.

A high opportunity cost for some good or action means there is at least one alternative use that is almost as good. While this could make choosing a bit more difficult, since the alternatives are valued almost the same, it also means that the individual enjoys freedom in the form of optionality: there are alternatives available. As opportunity cost is not only applicable on goods and services, but on any actions and decisions made, we can easily see how high opportunity cost suggests a freedom to choose. Where the opportunity cost is relatively low, meaning the second best alternative is not very valuable as compared to the best, there is no real choice: the one alternative is so much better than all other alternatives that there is no reason to even think about the “alternatives.” Indeed, whereas the choice is still formally a choice, which means it is possible to choose otherwise, it is so obviously the better alternative that the other options do not matter in the individual’s choice calculus.

For this reason, we should in our everyday lives wish to have as high opportunity cost for our choice as possible. We are in fact better off the more highly we value our alternatives ranked second and third and fourth, since it indicates that there are abundant choices we can make that are of similar value – and therefore that people’s differing wants and preferences can be satisfied to a much greater degree than if this were not the case. Unless our wants are unique and even distant from other people’s, the fact that we’re experiencing high opportunity costs means that many variations of our valuation can be satisfied. This means that other people, with similar wants and needs, will find it easier to satisfy their wants too. It also means that should we lose the ability to choose the most highly ranked alternative – because it is lost or destroyed, sold to someone else who is willing and able to pay a higher price, or some other reason – we are not left much worse off. In other words, we can in some sense measure our well-being and prosperity in terms of the opportunity cost we experience in our choices – we’re well off because we must make choices between many similarly valued goods, not between one good and bads.

This does not mean, of course, that the we should consider the opportunity cost itself as something valuable; it is not, since it by definition is the value we do not get. It is valuable to us if we somehow fail to choose the best alternative, and it is valuable because it suggests that there are many similarly valued alternatives available to us. But foregoing a high value is not in itself valuable, so it is a poor decision to choose the second best alternative for the reason that this raises the opportunity cost of the choice beyond the value attained. We should consider the opportunity costs of all available options when making choices so that the outcome is maximized – so that we do not inadvertently miss out on value that is available to us – but not for the purpose of raising the cost. There are always opportunity costs, and the occurrence of high opportunity costs is valuable only because it implies many good alternatives: optionality.

Markets, it follows, tend to empower the individual as they increase optionality in consumption through improved production. By engaging in producing for other people’s consumption, engaging in specialization under the division of labor, exchange, and innovation, overall production is greatly increased. We saw how this was the case in the previous section, and it follows from this that the producing individual’s purchasing power – his or her ability to procure the means to satisfy wants using the value attained through production – is greatly increased through market-based production. By producing more, we can afford to consume more. It also means there are more goods and services offered for our consumption, because by increasing productivity the quantity and variety of offerings that can be made available also increases. By specializing and engaging in market production, therefore, we increase our productivity and that makes us richer, but we also contribute to the vast multitude of goods available for purchase in the market. This too makes us richer: improved and specialized production increases our purchasing power, while other people’s production increases the number of ways we can satisfy our wants – our optionality – and therefore raises our opportunity cost. Part of the “power of the market,” and especially market production, is therefore the freedom that is offered in terms of choices. This is an insight that we will return to throughout the remainder of this book and that will prove important to understanding the concept of the “unrealized.”

Despite this power of the market to generate overall prosperity through production, it would be false to claim that it is a perfect or optimal system. Indeed, we have already noted that entrepreneurs (actually, producers in general) act under the threat of suffering losses if they incorrectly anticipate what consumers demand. This is a necessary implication of not being able to know the future, but it is also one that causes inefficiency: many investments that, with the power of hindsight, should not have been made were made anyway and cause individuals to lose their accumulated funds and society to lose the alternatives that would have existed had they entrepreneurs not erred. Also, the market will not ever fully utilize all the productive resources available toward providing satisfaction in the present, because some of them will necessarily be dedicated to uses in production processes that will be concluded at different points in time. The investments made today for the purpose of offering goods in the future, as Adele’s planting of apple trees or Bart’s building or buying an oven for baking, could also have been used to satisfy wants in the present. So market production will not at any single point in time be “maximized,” because it constitutes a process of a myriad production undertakings that will mature at different times and satisfy different wants. As production takes time, there is always some fraction of productive resources bound in the production for future wants satisfaction.

The unknowability of the future means there is no way around this state of things. There will always be waste and failure and redundancy in market production. Waste will arise due to mistakes and errors; costly failures will be caused by errors as well as because competing entrepreneurs may turn out to be more successful; and redundancy in production is necessary to maintain some degree of flexibility to be able to readjust and therefore salvage production processes in the face of unexpected change. The market system, consequently, is never at any point in time efficient. Yet at the same time, it is unbeatable in its long-term contribution to human well-being through satisfying people’s real wants and needs.



Bylund PL. 2016. The Problem of Production: A New Theory of the Firm. Routledge: Abingdon.

Hayek FAv. 1945. The Use of Knowledge in Society. American Economic Review 35(4): 519-530.

Olson M. 1971. The logic of collective action: Public goods and the theory of groups. Harvard University Press: Cambridge, MA.

Ricardo D. 1817. Principles of political economy and taxation. J. Murray: London.

Rogers R, Monsell S. 1995. The costs of a predictable switch between simple cognitive tasks. Journal of Experimental Psychology: General 124: 207-231.

Rubinstein JS, Meyer DE, Evans JE. 2001. Executive Control of Cognitive Processes in Task Switching. Journal of Experimental Psychology: Human Perception and Performance 27(4): 763-797.

Schumpeter JA. 1934. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle. Harvard University Press: Cambridge, MA.

Schumpeter JA. 1942. Socialism, Capitalism and Democracy. Harper and Bros.: New York, NY.

Smith A. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations.


[1] (Olson, 1971)

[2] See (Smith, 1776)

[3] See for example (Rogers & Monsell, 1995) and (Rubinstein, Meyer, & Evans, 2001)

[4] See (Ricardo, 1817)

[5] See (Schumpeter, 1934)

[6] (Schumpeter, 1942: 83)

[7] See (Bylund, 2016)

[8] (Smith, 1776: 8)

[9] I discuss this phenomenon in detail in (Bylund, 2016)

[10] Hayek discusses this information-bearing quality of prices in production (Hayek, 1945)