Ch. 8 Attempts to Perfect the Market

So far we’ve noted that unhampered markets function as economic organisms with endogenous causes of growth and respond in a seemingly coordinated manner to changes both from within and without (chapter 4). We have also seen how economic action causes ripple effects through an economy, and how destruction (chapter 5) and even disasters (chapter 6) cause setbacks in terms of value creation but that the economy is still able to respond properly by reallocating resources on the supply side to adjusted value rankings on the demand side. A similar story was told about the effects on the economic organism by regulation of markets through restrictive policy, either as taxation or prohibition, which causes a continued setback by restricting or prohibiting certain types of actions (chapter 7). Throughout this discussion we have explicitly focused on policy as restrictions and so left out policies intended to provide support for certain actions, that is policy that is “nudges” entrepreneurs in what’s considered the “right” (or better) direction by offering extra benefit rather than add penalties for unwanted actions. These positive “nudges” include subsidies and tax deductions and rebates, both of which are intended to make a specific action or class of actions more profitable and thereby have more entrepreneurs choose this course of action – because it, with the subsidy included, appears as a more profitable alternative. If you subsidy something, you generally get more of it.

The previous chapter discussed how policy can be made to indirectly subsidize certain action by adding costs and thereby penalizing all other alternative types of behavior with respect to a certain industry or product. This of course raises the relative value of the preferred action, for instance the production of three-inch nails using chimneys of a certain height, but this does not of course mean that this action becomes profitable. We can think of many examples where a certain type of production is so costly compared to the produced output that they’re hardly profitable on their own, so even if the relative cost of alternative actions is higher this does not mean entrepreneurs are willing to act in this realm. Such claims have been made with respect to for instance solar and wind power, which have been relatively more expensive than alternative sources of electric power, such as nuclear power or coal-burning plants, and at the same time not profitable on their own. Where this is the case, it is no solution to add taxes or other penalties to coal- or oil-burning, nuclear power plants, and the other alternative means for the production of power. The effect of “penalizing” those alternatives would not be a shift of production toward the more preferable (but still not profitable) solar and wind power, but a drop in overall energy production: rather than move into solar and wind power, entrepreneurs would shift their attention towards different industries altogether. Unless the intention is to cut production of energy, this would be a failure of policy. In these situations, using policy to increase the share of energy production that is renewable, such as wind and solar power, it would make sense to use policy to support the preferred behavior by helping to cover part of their cost. In other words, policy is here used to raise this type of economic action financially in absolute terms rather than raise it relative other types by placing costly restrictions on them. The aim and effect of policy, then, is to lower the costs of certain economic actions to thereby make them the better alternative by making them (1) profitable in absolute terms, and (2) less costly relative substitutes.

Impact of Subsidies

Let us again revisit our little society as we did in the previous chapter to illustrate the impact of subsidies – and contrast it with the restrictive regulation discussed previously. We use the same starting point, so the economy’s production apparatus consists of five nail smiths (Becky, David, Deborah, Eric, and Edda), three bakers (Bart, Bob, and Charles), one construction worker (Fred), and one apple-grower (Adele). As before, we also have the city councilman Luke. Rather than regulating to restrict entrepreneurs from certain actions, as we discussed above, imagine that Luke has identified that the society sometimes runs out of bread, that bread prices are a little too high for everyone to afford as much bread as they would like, and so on. Consequently, he wants to make sure that bread production increases and that the price of bread goes down. This could be easily done through decentralized entrepreneurial action, of course, but neither Bart, Bob, nor Charles anticipates increased production to be profitable. That is, after all, the reason they have not already chosen to expand their output. In other words, in our current market situation it doesn’t make sense for them to increase their output, so they refrain from further investments. Luke disagrees with this, and wants to make sure more bread is produced – either by the three existing bakers or by another entrepreneur entering bread production. So he intends to offer a subsidy for bakers. The subsidy needs some sort of basis to target bread production rather than be a general hand-out to anyone producing. For example, Luke can offer payment based on the use of a certain input, for instance wheat flour, so that anyone who uses this input – or perhaps above a certain quantity of it – receives a payment from the government (Luke, that is). Or it can be offered based on output of bread, perhaps of a certain kind or above a certain quantity. Or it can be granted to anyone who is a baker to support their line of business in general.

As a subsidy is an additional income, which is why it provides an incentive. In other words, existing and entrant entrepreneurs will find ways of making sure they get the subsidy and get as much as possible from it as long as doing so is not too costly. So if Luke, for instance, formulates the requirement to receive the subsidy as based on the quantity of flour used, we would likely see an overall increase in the use (or at least purchase) of flour. However, you get what you ask for, and since a subsidy offered for the amount of flour used, this does not necessarily mean more bread is produced: it could also mean more waste, more flour per piece of bread, and perhaps a secondary market where bakers sell excess flour off the books to create an illusion of using a lot of flour (which means getting the subsidy) while they are not. Likewise, if Luke formulates the requirement as a payment based on the number of pieces of bread sold, we should expect Bart, Bob, and Charles to soon figure out that they can get a greater subsidy by making more pieces of but not total volume or weight of bread out of the dough – that is, by selling a larger number of smaller pieces of bread. Specific requirements, as with specific regulation in the previous chapter, constitute specific incentives and would change behavior accordingly.

Considering these potential problems, Luke decides to introduce a subsidy available to any entrepreneur who is solely or primarily in the business of baking and selling bread. By specifying that the business must solely or primarily be in baking, he hopes to avoid anyone acting to take advantage of the subsidy rather than getting into the baking business because it is their most profitable type of production. To make sure that the subsidy is paid only to bakers, he takes on the task of certifying their business himself; so he expects to spend many hours analyzing what entrepreneurs do and how in order to make sure the subsidy is specifically for bakers. And to make sure he targets the right entrepreneurs, he sets up formal rules for how to be considered a baker: he will look at their input costs, their labor hours, and their sales, respectively. Of these three, to be considered a baker and thus eligible for the subsidy, the entrepreneur must have at least 51% of two of the three directly related to baking bread. He also produces a definition of what is to be considered bread and what inputs are considered to be directly for baking. These rules are necessary not to create any grey zones, and therefore facilitate decision-making on his part. So he must create a costly bureaucracy and a separate set of definitions and rules to be able to process applications.

Of course, Luke still wants the subsidy to have an effect by attracting more entrepreneurs into baking, so he must find a balance between making it attractive enough – that is, to push entrepreneurs already considering the bakery business to take the plunge – while not being too attractive – that is, to attract entrepreneurs more interested in cashing in on the subsidy and other types of rent-seeking activities than in actual production – yet at the same time not too costly in terms of fees and time required for applying. He chooses to offer a subsidy of 0.5% of net sales to make baking a bit more profitable, payable every month. And the fee for applying is kept low; he’ll cover most of the cost of bureaucracy himself, so bakers only need to fill out a simple form to make him aware of their business. This means there will be less money available for actual subsidies, but as Luke is wealthy he thinks he will be able to offer enough subsidies to increase bread production for years.

The immediate effect of the subsidy is increased profitability among the existing bakers Bart, Bob, and Charles. After all, they get an additional 0.5% on top of their existing sales, which immediately translates into profits for them. As profits increase, this signals to other entrepreneurs that there may be an opportunity to share those higher profits – which serves as an incentive for others to move into baking. At the same time, however, the incumbent bakers – Bart, Bob, and Charles – may earn profits that exceed their preferred profit levels, which in turn could cause them to cut down on production. The reason for this is that as profits reach a certain level the added value of additional work, or the work already carried out, is of lesser value than the value of the leisure time those entrepreneurs could enjoy instead. Indeed, it is easy to see that Bart, for instance, was perfectly happy with his earned profits, which provided him with a standard of living he finds convenient and satisfying, and therefore that he’d rather work a little less while maintaining this standard than work as much as before while increasing his money income. Consequently, he chooses to limit production and instead spend a few hours every week in the sun relaxing in his hammock, which means total bread output goes down. This, of course, is the exact opposite of what Luke wanted to accomplish with the subsidy. So we can see that in order to produce the intended result – increased bread production – Luke will need to offer a subsidy that is sufficiently high to increase the profitability level among incumbents so much that others enter this line of production.

Let us assume that the 0.5% subsidy on net sales that Luke decided to introduce is sufficient to incentivize at least one entrepreneur to enter the bread-baking business. The most likely entrepreneur to leave his or her current position is the one with the least profitable undertaking, since this entrepreneur would have most to gain. But, in fact, all entrepreneurs with lesser profits anticipate to be better off moving into baking since that will provide them with greater profits. Whether they actually choose to move into baking however depends on their anticipated ability to capture those profits and the cost of making the move; for some entrepreneurs, the cost of shifting away from their current line of business may be prohibitively high. Since these entrepreneurs considering entering baking base their decisions on subjective appraisements of alternatives, which is always the case, it is impossible to tell beforehand how many, and even less which specific, entrepreneurs will make the move. So as long as the increase in profitability that is brought about by the subsidy is high enough, we’ll have an inflow of entrepreneurs – but there’s no saying if this flow will be a drop in the bucket with minor impact on the baking business or an overwhelming wave that completely restructures it. Or somewhere in-between.

The extent of resource reallocation toward bread-baking of course matters, since the impact on other lines of business as well as the output (and thus profitability) of bakers overall depends on the magnitude of the change. So we must keep this in mind when tracing all effects as a change makes ripples through the market: while we cannot tell the extent or magnitude of the change, which means we cannot say exactly what will be the outcome, we can trace the effects in general. In our example, say both Eric and Adele are attracted by the new and higher profitability levels of baking with the subsidy. Eric, who made a decent living as a nail smith, but came nowhere near the profits of Becky who is his superior across the board in that line of business, sees in bread-baking the possibility of increasing his standard of living. Adele, who has experienced a couple of hard years with pests and bad weather, and with this fluctuating and unpredictable prices, is attracted by bread-baking because it is less affected by weather and other exogenous, uncontrollable forces – and would offer a steady stream of income to replace the highly seasonal market for apples.

As Eric the nail smith moves into baking, the supply of nails diminishes and thus Becky, David, Deborah, and Edda, the remaining nail smiths, would be able to either raise their prices or increase their sales even if they don’t change their prices. For example, with Eric still in this line of business, Edda was able to make a living but not much more. She happens to be a terrible sales person, so she was unable to sell her preferred quantity – but she could still sell enough nails to make meager profits, enough to make a living but not to make her rich. With Eric out of the picture, she’s able to sell to more customers, reach her preferred output level and sales, and therefore increase her profits. The same is true for the other nail smiths, who can also increase their sales, however disproportionately. The increase is disproportionate because they have different cost structures – their businesses do not work exactly the same, and therefore reach a productive maximum at different quantities. As we have already seen, Edda’s maximum was at a higher quantity than she was able to sell, which is why she increases her profitability by increasing her sales volume. To Becky, the gain from selling more nails at the cost of putting in more hours is not worth it – she already makes enough money to lead a good life. So she raises the price of her nails, which are generally recognized as being of the highest quality, a little bit. As the quantity demanded in the economy is about the same as before, but the number of suppliers have diminished, Becky is able to sell as many – if not more – nails at the higher price. Her profits increase, and this leads her to decide to take some additional time off – leisure and time with her family is more valuable to her than the additional income from working the same hours as before. So she produces less and chooses to sell at a higher price, while Edda is now able to produce and sell more at a slightly lower price. They can charge different prices because their products – the three-inch nails – are perceived by consumers as of different qualities. David and Deborah follow Becky’s lead and raise their prices a little to increase their profits too. The nail-producing business has therefore changed from a standardized product into two separate quality levels: the higher-price, higher-quality product produced by Becky, David, and Deborah, and the lower-price, lower-quality product supplied by Edda. This change, while it could have happened otherwise, was caused by the subsidy that made Eric leave his trade as a nail smith, which caused a drop in supply and therefore diversification among the remaining nail smiths.

Adele the apple-grower also takes the step to become a baker. As she was the only local producer of apples in our little society, she leaves the market without a source of (locally grown) apples. She only made a meager living off the orchard, so even though she abandons a profit opportunity (for an anticipated better one, due to Luke’s offered subsidy) it is not of sufficient magnitude to attract other entrepreneurs to leave their current trades to become apple-growers. After all, the subsidy for bread-baking means entrepreneurs overall may expect higher profits and they have no reason to choose lower profitability over higher. The result of this, as Adele leaves her orchard, is that consumers will lose the option of purchasing (locally grown) apples. As we know that they previously chose to purchase apples – the reason Adele’s apple-growing business made a profit – even though they had many other alternative ways to spend their money (or not spend them), this is a loss of value: their preferred option is no longer available. So consumer optionality is impacted by Adele’s response to the subsidy of bakers, and because she enters a market with several incumbent entrepreneurs her becoming a baker to supply similar types of bread doesn’t increase consumers’ ability to satisfy different kinds of wants through access to a greater variety of products. They will potentially have more bread to choose from as Adele starts baking aside Bart, Bob, and Charles, but it is safe to say consumers likely consider apples to be a different category of product and therefore offers them a different value. And as apple-growing was a more lucrative business than baking, at least to Adele, it constitutes the better way of satisfying consumer wants. Indeed, we saw in previous chapters how profitability approximates, or at least signals, the real value contributed to consumers. The subsidy, since it attracts entrepreneurs from other types of production, produces a shift in overall market production toward lesser value creation. However, while there is less value created for consumers, the value produced by increased bread-baking is the one that is preferred by Luke the policy-maker: indeed, the reason for the added incentive is that he considered bread-baking an undersupplied and, therefore, by entrepreneurs underappreciated (undervalued) economic activity. The subsidy attracts resources (primarily labor) from other types of production – with the result of Eric leaving the trade of nail smith and Adele her chosen trade as apple-grower. This was after all, though perhaps not these specific effects, the intention: more bread.

The shift in production caused by the subsidy is therefore misaligned with consumers’ revealed preferences through their actual exchanges and actions taken in the market, since they – through entrepreneurs’ productive efforts in anticipation of sales and profit – preferred apples to the increased supply of bread. However, the shift is aligned with Luke’s preference for a greater supply of bread. (We do not know how Luke feels about the loss of local apple production or the change to the production of three-inch nails caused by his subsidy.)

The orchard that Adele carefully established and invested funds in loses its usefulness, at least in its present form, as Adele moves into baking bread. The orchard was valued because it contributed to satisfying consumer wants, and was expected to continue to do so, but as Adele no longer pursues apple-growing and, as a result, apple-growing is no longer a trade in our little society (as there is no one who chooses to take over this line of business), the effect on its value is akin to the forges in chapter 7: the value of the combined resources is lower than the sum of the value of the separate resources. In other words, the only value available from the orchard is the value of its land, the value of the wood (if sold for fuel or carpentry), and so on. The irrigation system loses its value to the degree it cannot be shipped and installed elsewhere or used as materials or parts in support of other production. This loss of value, as was also the case of the forges, is borne by Adele as she moves into bread-baking. But as she is not prohibited from continuing to run the orchard but in fact chooses to do so as the subsidy is introduced, this cost is part of her calculation: indeed, her choice to move into bread-baking suggests that the subsidy, and with it the promise of bread-baking, is sufficient to cover this loss. In other words, Adele anticipates that the profitability of becoming a baker, with the subsidy in place, exceeds the profitability of apple-growing by at least the loss of value by abandoning or finding a secondary use for the orchard. Had the subsidy been lower, this may not have been the case.

Our analysis of this loss of value in the orchard as it is taken out of production is parallel to that of the forges above. But it is not the result of an outright prohibition or an in practice prohibitive regulation-incurred cost, but follows from the subsidy-based “nudge” that changes Adele’s calculation of anticipated value. She’s “lured” to shift her production to another line of business because of the increased profitability brought about by the subsidy. The effect on the specific resource – the orchard – is the same as with what was discussed above, which means the direct cost through loss of market value is borne by the entrepreneur in question whereas the indirect cost, due to the loss of valuable options made available in the market, is borne by the consumers who can no longer make those choices. Indeed, had bread-baking been the better option in terms of value creation, then Adele would have chosen to go into that line of business instead of apple-growing. As she didn’t, and she instead earned sufficient profits to keep her in apple-growing rather than shifting toward baking, it was the more highly valued use of her labor as a productive resource from the point of view of consumers – at least as far as Adele could understand her options and anticipate their profitability. To put it differently, consumers found her efforts more valuable as an apple-grower than as a baker, which is why the former paid better than the latter – and this is also why Adele got into apple-growing and staid in that line of business. The subsidy changed this calculus by adding a benefit to baking that is not provided by consumers through their buying decisions, but an effect specifically caused by the subsidy. This added benefit – the subsidy – is an income made available when engaging specifically in bread-baking and is separate from satisfying consumer wants.

Adele’s move from apple-growing also affects bread production, as was the case with Eric’s taking up baking above, by increasing the supply of bread offered to consumers. This was the intention of Luke’s subsidy, after all, and is also a result of it. With both Eric and Adele adding their breads to the supply and competing for customers, their bidding for sales will force them to lower the price to undercut the incumbent bakers Bart, Bob, and Charles – and the latter are likely forced to follow. This too was the intention of Luke offering the subsidy, since he considered the bread supply too low and bread prices too high in the little society. With lower prices, more consumers are both willing and able to purchase bread. This added sales volume, which is a result of the higher quantity demanded at the lower price, means more consumers – including those who were not willing (or able) to purchase bread at the previous price – have access to bread. But it also means that they do not have access to the apples that they used to be able to choose. Overall, the value offered to consumers is reduced as they as a group placed greater value in Adele’s apples (and Eric’s three-inch nails) than the bread they are now offered.

If we deconstruct the group of consumers to get a more nuanced picture, we can see that consumers indeed are affected by this change in created value – but in different ways. The consumers who preferred to use their funds toward buying apples are now stripped of this alternative, as it is no longer made available to them, and thus have to suffice with something they deem of lower value. This group loses from Luke’s subsidy. The consumers who previously purchased bread at the higher price, that is those who considered bread to be worth more to them than that asking price, can now buy bread at a lower price and thus have funds for other kinds of purchases (or to save for future consumption). This group is made better off. The consumers who previously chose not to buy bread because they were unwilling or unable or both, but who are able to buy bread at the lower price, now gain from the additional available alternative for their purchases: bread at an affordable price. This group also benefits from the subsidy. But there is one other group who is affected by this change in their consumptive behavior, and that follows from the lower price being charged for the bread: the incumbent producers. In our little society, this would be Bart, Bob, and Charles, whose production now generates lower income, which affects their ability (and possibly willingness) to consume. Were they to have employees to assist in baking, these employees would be affected in a similar way (likely by lower wages or cut benefits).

The reader may recall our discussion about the ripple effects that cause changes through the economy due to any choices made, as we discussed following the broken window in chapter 5. This applies here as well as in any other actions taken (or actions not taken), and it too affects consumption patterns. As Adele chooses to close the doors to her apple-growing business, this constitutes a loss of revenue for all entrepreneurs who produce supplies that Adele used when producing apples. This loss of revenue effectuates a reduction in volume and, likely, in profitability, which therefore has an effect on the entrepreneurs’ respective ability to consume. If they have employees, they too are affected either by commanding lower wages or by some of them being left without work. A similar effect strikes any laborers previously in Adele’s employ, who are left without employment and therefore income. Their ability to consume diminishes with their loss of income, and this has an effect elsewhere in the economy depending on their preferences and the previous consumption behavior. All of the entrepreneurs and laborers making a living directly or indirectly from Adele’s apple-growing business face a reduction in income and are therefore lose some or all of their previous ability to consume.

The subsidy therefore creates several winners and losers among consumers. This is different from the market responses to changing economic conditions, whether it is changing consumer preferences, destruction, or productive innovation, because such changes are in response to or happen together with changing consumer valuations. The subsidy, as was the case with different types of regulations in the previous chapter, does not change what consumers actually demand but causes a reallocation of productive resources by changing the conditions of production. We can think of the subsidy as an artificial increase in the profitability of bread-baking; it is artificial as it has no economic origin, but is a policy-created condition. The creation of winners and losers from the shift from nail manufacturing to apple-growing therefore constitutes a redistribution of wealth in our little society: from the losers to the winners.

While we assumed above that the subsidy that Luke offers is a payment made using his personal wealth, this is rarely the case in real economies. We therefore have yet to elaborate on the source of this type of subsidy that brings about the change we’ve already discussed. In the case of a policy-maker’s personal wealth, which in an unhampered market such as our little society’s economic organism must be accumulated from previously undertaken successful entrepreneurship (that is, the successful use of productive resources to satisfy consumer wants), such a subsidy can be considered consumption of capital by the policy-maker. It would then be a use for the sake of satisfying the policy-maker’s own wants, which in Luke’s case would be to see a greater availability of bread. In this case, the effects remain as we have discussed above and it is likely that the policy-maker will, eventually, run out of funds. The subsidy is thus a temporary measure. But even if it is not, it is an influence on production based on consumption of the value that was produced, only without gaining personally in terms of goods and services. If Luke, as a multi-millionaire, chooses to consume this wealth by paying bakers to make more bread available, then this is akin to regular consumption. In fact, one way of understanding the subsidy in terms of consumption is that Luke implicitly picks up the tab for some of the bread sold – 0.5% of the price, to be exact. And this, of course, has an effect on the structure of production as well as prices throughout – as consumer preferences always have.

But, as we noted, this type of charity is rarely the case when governments use subsidies to encourage certain types of behavior. Government is not an economic actor, which the self-made multi-millionaire Luke is, but an exogenous force on the economy. It does not produce using economic means and benefit from sales, but relies on a monopoly of force to make the rules under which entrepreneurs act. For this reason, government cannot offer subsidies to economic actors without first extracting the funds from the economy. This is why we, in a previous chapter, noted that subsidies must follow regulation (taxation, usually). In other words, for our analysis of the effects on the little economy to make sense from the perspective of our modern, real-life markets we would need to first introduce a regulation that redirects funds from production and consumption within the economic organism toward the regulating government, and then add to this the effects of subsidies. In order to add value to an economy, a government must first extract that value. We can see, then, that this would have vast distortive effects on the structure of production in the economy – both through the extraction and the subsequent addition. We can also see that it would be very difficult to trace the real effects, as they cause ripples in numerous stages, throughout a modern and highly complex network of specialized productive efforts throughout the market.

Improving on the Market

What we have seen so far in the previous and this chapter is how the different kinds of regulation affect the market’s allocation of resources, and how this has implications throughout the market especially as relates to its ability to satisfy consumer wants. We will now reiterate a point made in chapter 4 and whether regulations and other coercive measures through policy can be used to improve on the market’s performance and focus in production. As we noted in chapter 4, the market is not efficient in the sense that it can at any point in time be made more effective by putting the available resources into more efficient uses. Indeed, if all resources were dedicated to producing what was requested in the present, society would reach an immediate higher standard of living. Indeed, we stated this in chapter 4: “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.” This means markets aren’t – and cannot be – efficient in an allocative sense at any specific point in time, but must be evaluated over time.[1] The reason is that entrepreneurs accumulate and orchestrate resources to produce in anticipation of creating value for themselves by satisfying consumers’ wants at future points in time. The entrepreneurs do not focus on concluding their efforts at the exact same point in time, and they’re also not always accurate in how they assess, plan and time their undertakings, which is why the market at any moment includes a large number of production processes that have not been completed and certainly have not been optimized to satisfy wants in that specific moment of time.

It is into this highly dynamic and ever changing process, which has no end goal and therefore no aim, that policy is introduced. There can be many reasons for policy, but we will here focus on policy intended to improve the market, its functioning or outcome, in some specific way. Policy can from this perspective be used to “nudge” or otherwise direct entrepreneurs away from or toward specific industries, lines of business, or the production of specific goods and services. Our interest is here the effect on the market overall, and especially how policy affects individuals and groups in society – that is, the people that comprise the economic organism.

In order to improve any process, it must have a purpose or aim against which its performance can be measured. If it doesn’t, then any counterfactual – that is, measuring rod – is arbitrarily chosen. Economists look at the economy as a system that satisfies wants through economic and mutually beneficial actions with the purpose of getting as much as possible out of scarce resources. What matters, of course, is that what we get out of it is something that is of value to us. In other words, economists look at the amount of satisfaction or contentment achieved by markets, and compare markets operating under different institutional settings, markets that utilize different productive structures, and so on. Of course, as we saw above, the problem is how and when to assess the efficiency of the market in using scarce resources to achieve satisfaction. Or, to put it differently, how to say when or if a market is “efficient.” Indeed, as Joseph A. Schumpeter astutely put it, “the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them.”[2] Indeed, as we’ve seen throughout this book, the “administering” of “existing structures” will not be very helpful; instead, we must view the market as an ever changing and open-ended process. We therefore cannot assess the efficiency of markets at any point in time, but must look at the market’s ability to over time find better ways of producing value, adjust to changing conditions, and respond to new or shifting preferences among consumers. Or, in Schumpeter’s terms, to assess the market’s functioning over time in terms of “creative destruction” – how new and better production technologies, organizational structures, and goods and services are introduced and replace those that are less effective. This is what we saw in chapter 4 above, in our discussion about the division of labor, comparative advantage, and innovation.

From our point of view, then, to improve the market a policy must assist in strengthening or achieving what can be referred to adaptive efficiency, that is efficiency in production over time and therefore including the dynamic adjustment to changing conditions, by inducing innovation and facilitate the undertaking of risk and creative activity that help find solutions to problems and thereby create value for society over time.[3] As the market is a process with entrepreneurship as its driving force, the task of policy intended on improving the functioning of the process must be to help entrepreneurs carry out their function. We learned above what entrepreneurs do and how they attempt to accurately anticipate what will be the most highly valued use of resources by seeking profit from satisfy consumers in the best way possible. As acting on anticipation necessarily means bearing the cost of uncertainty, and is an endeavor fraught with mistakes and failures, a possible conclusion is for policy to target reducing the cost of uncertainty. This can be achieved, theoretically speaking, by helping entrepreneurs avoid mistakes or by lessening the burden of uncertainty on the undertaking. The latter would be similar to subsidizing entrepreneurs who undertake pursuing novel ventures or attempt to realize productive innovations in the market. To put it simply, government can incentivize entrepreneurship by covering part of the cost if the entrepreneur fails. This would, as in the example of the baking subsidy above, increase risky undertakings by entrepreneurs, which is not necessarily a productive use of scarce resources. Also, we saw in the discussion above that subsidies imply regulation, primarily in the form of taxation, to cover the cost of the subsidy – and this causes distortions in the economic organism’s ability to satisfy consumers’ wants and needs. The subsidy itself would then “nudge” entrepreneurs toward assuming more risk rather than less, to pursue novelty rather than better uses for or improvements to existing production structures, which could end up being wasteful by redirecting productive resources from wants satisfaction in the present or near future toward a more distant and lesser known future.

A more fruitful aim, it seems, would be to assist entrepreneurs who choose to undertake uncertain projects for profit by helping them avoid mistakes. As the future is uncertain, however, it is impossible for policy to direct entrepreneurs toward the “better” opportunities. Which ones will actually turn out to be the better ones will not be known until after the fact, that is the realization of profits, so this is not a way forward. Instead, to avoid mistakes would likely be a more practical and indirect matter of learning best practices and rules of thumbs for identifying and preparing for problems and errors. It is likely that education can be of assistance here, especially in the sense that education in the real workings of the market, as we have briefly discussed thus far in this book, since it offers the entrepreneurs a framework for thinking about the market and the role of the entrepreneur as embedded in a social and economic situation. Such efforts will not do away with failures, but may reduce them. Yet it is important to note that even such educational and preparatory efforts require resources to be carried out – at a minimum the labor of the educator – that could otherwise be used to directly assist entrepreneurs in their businesses. Like anything else, resources in education have opportunity costs and this reaffirms the points made above. If resources are redirected toward education, formal such or practical on-the-job training, we necessarily forego their alternative best uses. It follows that if those other uses would have contributed to creating more value than education, then this type of policy is not value-maximizing but in fact constitutes poor use of those resources. If it is due to a political decision rather than an entrepreneurial undertaking for personal profit, there is also the risk that the opportunity has not been thoroughly analyzed and that the implementing of the project may be burdened with overhead costs. All of this causes distortions to the market’s ability to satisfy real wants.

We can also think of improvement as attempts to steer market production toward other goals than the “blind” want satisfaction among consumers. For instance, there may be more socially beneficial outcomes, politically identified and preferred, than what the market spontaneously produces. Note that such values, which do not follow from consumers’ actual economic actions and therefore their use of resources in exchange, are necessarily different from what consumers would choose and entrepreneurs anticipate that they value. It places an unreasonable trust in political decision-makers or experts to accurately identify what should be done instead of satisfying consumer wants the way consumers themselves see their wants. It also raises questions about how to define a “social good” and a “social value” that does not emerge from the actions of individuals engaged in social cooperation through production under the division of labor and consumption to satisfy their own wants. To the extent that this is possible, an issue we will not dwell on here, such efforts still fall into one or both of the categories discussed above: regulation that restricts action or subsidies that incentivizes certain action (following regulation). Both necessarily bring about distortions with respect to consumers’ preferred actions.

Nevertheless, policy makers can make use of measures that increase costs for or even prohibit certain actions that are considered socially unfavorable or perhaps destructive. For instance, the outright prohibition of narcotic drugs, often considered a proper policy intended to reduce their use, causes resources and therefore entrepreneurial endeavors to be redirected from the production and distribution of such drugs toward other activities. Policy makers can also rely on subsidies to bring about an increase in politically preferred socially beneficial outcomes. A common such task is to fight unemployment by creating jobs. In our analyses above, we have assumed full employment, but this is hardly ever observed in modern economies. This is problematic since without producing and therefore earning an income, those without income also lose the ability to acquire goods and services necessary to satisfy wants. Unemployment is therefore, as well as for other reasons, considered a social bad that requires a political solution. Political solutions, however, like other actions, use resources and are therefore necessarily burdened with opportunity costs – they cause distortions by taking resources from other uses. Whether fighting unemployment is a social good or bad is not relevant to our discussion here. However, it is relevant to consider the discussions above in light of available resources – how do our examples of entrepreneurship and social cooperation change if there is an unused stock of resources available for use? After all, we assumed full employment, which is why for example Adele’s giving up apple-growing to become a nail smith led to the society losing their supply of locally grown apples. If there are people under- or unemployed, it seems intuitive that they would be able to take over the orchard that Adele leaves behind.

Unemployment in the Market

Unemployment is another way of saying that there is an existing supply of a productive resource that is currently unused, fully or partially. To see how such underutilization of labor affects how we understand the market process, let’s consider a variation of a previous example. To recapitulate, the total production apparatus in our little society consists of five nail smiths (Becky, David, Deborah, Eric, and Edda), three bakers (Bart, Bob, and Charles), one construction worker (Fred), and one apple-grower (Adele). To study the impact of unemployment, we add three underemployed men and women: Gina, Gordon, and Gregory. Gina works part-time with Fred to assist in house building. She specifically is responsible for excavating on construction sites and mixing of the concrete that is then poured as foundation for new buildings. In other words, she does the heavy lifting necessary to get started with construction, while Fred does the rest of the work. As Fred only rarely gets contracts for new construction, Gina only works half as much as she would like to. In other words, she is underemployed but not unemployed. Gordon and Gregory, in contrast, are unemployed.

Before discussing the effects of a change such as the subsidy for bread baking that “lures” Adele to give up on apple-growing, we must ask why it is the case that our three new friends are under- and unemployed. After all, the argument presented in the first few chapters establish that production precedes consumption and, which is necessarily the implication, that in an unhampered market people produce to satisfy their own wants – that is, they work to facilitate their own consumption. To do this, they either produce goods and services that can directly satisfy their own wants or, if that’s anticipated to be a better approach, by producing to satisfy the wants and needs of others, which generates a profit that can indirectly satisfy their own wants. Those who do not produce consequently cannot facilitate consume and thus fail to satisfy their needs and wants. Whatever you consume that you have not produced, directly or indirectly, is necessarily offered to you by someone else and taken out of their belongings, and thus out of what they have produced, and provided without requesting the reciprocal offer of value. It is a charitable contribution – a gift – rather than an exchange, since only one party has value to offer, and consequently the receiving party has little bargaining power. An individual’s independence and sovereignty are in this sense “earned” by engaging in the production of value, particularly highly specialized production in the form of social cooperation through the division of labor.[4]

So far in the discussion our little society has not suffered from a lack of natural resources to sustain its members. While this may seem unrealistic, it is not. The reason is that natural resources are only resources in so far as they are economic resources. The example of crude oil illustrates this point. Before the process of refining oil into petroleum, and the innovation of the internal combustion engine, there was no economic use for oil. It was as much a natural resource as it is today, but was not an economic resource – it had no value in production and couldn’t be consumed. In fact, oil was just a gooey substance that at best was a nuisance but oftentimes incurred a burdensome cost on the poor fellow being so unlucky as to have oil on his or her property. Ranchers raising cattle, for instance, need to dig wells to water the animals when the weather is hot and dry. Striking oil instead of water, which today would be considered good luck and would make you a fortune, was for cattle ranchers the worst kind of luck: it made the newly dug well, and likely any adjacent wells, unusable by poisoning the water – and at the same time making the land unfit for both cattle and crops. Finding oil, therefore, was an additional cost on their business, and as the oil restricted the usefulness of the land – in more than one respect – it also caused a drop in its market value. What this serves to show is that no society runs a risk of running out of economic resources, as the supply of economic resources is limited only by the extent of human ingenuity – the ultimate resource.[5] If the availability of a natural resource that is the basis for a specific economic resource diminishes, the market responds by increasing the price and thereby produces an incentive for alternative means to the same end – or alternative ends altogether. We saw this above when we discussed how an economy responds to destruction and natural disaster, and the same applies when natural resources are used up. As a result, the economic organism does not cease to function but shifts production toward the best uses of the resources available. In other words, the only way Gina, Gordon, and Gregory can be held outside production in the economic organism for any extensive period against their will is if they do not have and cannot gain access to economic resources.

This is however an impossibility, since it is not true that economic resources in the unhampered market are available only to “the rich.” Instead, economic resources – capital – are available for those who will accumulate wealth in the future. This may seem unintuitive, but follows from our discussion above. We argued that prices as well as production undertakings are based on anticipations about the future rather than facts in the past or present. The same is true for the availability of capital for investing in entrepreneurial undertakings. This availability is not dependent on how much value one has already accumulated, which says nothing about one’s future performance, but is rather a function of the anticipated value that one can generate by using a specific resource. As we concluded above, economic resources for entrepreneurial investments are awarded those who are willing to outbid other entrepreneurs for those resources. The same is true for the investment necessary to make a credible bid, which does not need to consist of payment in the present but could include a credit arrangement. In other words, entrepreneurs can offer owners of capital payment of a specific amount at a future time, or part of profits to be earned, for the present use of resources. Whether capital owners, themselves entrepreneurs with past success(es), accept a bid depends on how they subjectively estimate its value and whether it exceeds the value of other bids.

This applies to Gina, Gordon, and Gregory as well, who could compete with other entrepreneurs for economic resources to use in their entrepreneurial undertakings even if they themselves lack capital on hand. But even if we, for the sake of argument, assume that something makes it impossible for them to get access to capital. This can be the case for one of two reasons: either all resources are already occupied in entrepreneurial undertakings of very high anticipated value, or very few economic resources exist in this world. In the former case, this means the economic resources are employed in endeavors that could employ Gina, Gordon, and Gregory and pay them for their supplied labor. It should also be the case, since there is plenty of capital, that their labor is highly productive because of this – and therefore valuable. In the latter case, with very few existing economic resources, the value of our three friends’ labor should be much higher, relatively speaking, simply because there is very little productive capital. They should therefore be able to sell their labor services to assist in production. In both cases, therefore, the conclusion must be the same as with respect to entrepreneurship: there is nothing preventing Gina, Gordon, and Gregory from partaking in production. It may be the case that they do not find sufficient remuneration for their services, that is they’re offered a wage they consider too low, and therefore choose to not work. But that is a choice based on their assessment of alternatives.

This conclusion, that unemployment in the unhampered market is voluntary, may seem crass, but it is the only reasonable conclusion considering our discussion so far. In an economy without artificial restrictions there is only one reason why valuable – that is, productive – resources are not used, and that is because they are anticipated to become of more valuable uses in the future. This is true for Bart when he finds flour at bargain prices and therefore buys to store for baking in the future rather than in the immediate present. It was true for Adele buying tools and machines for her orchard before the apple trees were ready to bear fruit, because she expected them to increase her productivity or solve problems later on. It is true for Becky holding on to part of her stock of three-inch nails because she anticipates the price will rise and that she will then be able to make a greater profit. It is also true for someone like Gordon, who chooses not to become an entrepreneur yet still turns down chances for employment, because he believes better opportunities will present themselves in the future.

But what we have said here is true only in the genuine and thus unhampered market. As we will see in the next chapter, it is not necessarily true in an artificially restricted market.


North DC. 1990. Institutions, Institutional Change and Economic Performance. Cambridge University Press: Cambridge.

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

Simon JL. 1998. The Ultimate Resource 2. Princeton University Press: Princeton, NJ.


[1] Schumpeter notes that “since we’re dealing with a process whose every element takes considerable time in revealing its true features and ultimate effects, there is no point in appraising the performance of that process ex visu of a given point in time; we must judge its performance over time, as it unfolds through decades or centuries. A system – any system, economic or other – that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point of time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance.” (1942: 83)

[2] See (Schumpeter, 1942: 84)

[3] See (North, 1990: 80-82)

[4] We look specifically at the economic implications of production, which is the subject matter for this book. A society may include many other dimensions, such as personal and social ties, including friendships and family, and belonging to a community, in addition to the social cooperation through specialized production that we discuss here.

[5] See (Simon, 1998)