Our discussion so far has established how the economic organism responds to changes both from within and without, and how it encompasses as well as encourages entrepreneurs to find ways to satisfy more highly valued consumer wants. We have also looked at the effects on the functioning of the market when affected by artificial restrictions through policy, and how such influences create distortions in resource allocation as compared to what otherwise would have been – and therefore limits decentralized production efforts throughout the market. We saw how the effect of policy is similar to that of destruction, but without the concomitant change in preferences: policy is a one-sided change, which makes it extra costly.
While distortionary when viewed from the point of view of the unhampered market, and thus costly to society in lost wants satisfaction, policy-based restrictions are not necessarily only or even primarily a cost on society. The reason any policy is introduced is, of course, to attempt to solve one or more problems. If the policy is successful, the value of solving that specific problem should be recorded as a benefit to offset the cost of distortion and loss of productive capacity.
Policy introduces a different problem, however, that we noted briefly in the discussion above on Luke’s attempt to solve the apparent issue of too little bread being produced. Policy tends to solve problems that consumers through their actions have shown are of overall less value than what is provided by the market. As we observed above, Luke considered the supply of bread to be too low and therefore attempted to solve this problem by offering a subsidy. The effect, in this case, was indeed an increased supply of bread – but at the expense of other reduced supply of other goods, which by consumers were more highly valued. Indeed, he shift of resources from the production of three-inch nails as Eric leaves to become a baker, and from apple-growing as Adele similarly leaves her trade to instead bake bread, solves the problem that Luke considered more important – but at the same time means the problems already solved by nail manufacturing and apple-growing become “unsolved.” As Eric and Adele in this example go to different trades, they do so not because they anticipate that they will serve consumers better by doing so. By making the move, they do anticipate their profits to become higher, which in the market signals that one has offered valuable service to consumers, but the profit actually generated by the market – that is, consumers – is in fact lower than in their current professions. If this were not the case, the subsidy would not be needed. The subsidy makes the difference and thus makes baking more profitable. In other words, their move to other occupations – and therefore the economic organism’s overall productive shift from nail manufacturing and apple-growing to baking – is not a move that solves problems that consumers are willing and able to pay for, but solves a problem that Luke is more interested in (too little bread).
Similar to what was the case in chapter 5, in which we discussed the effect of the shopkeeper’s broken window and the “ripple” effects caused through the economy, the policy-induced shift changes consumptive behavior. But, as we noted in the chapter 8, the shift sets other chains of events in motion by shifting production, not – as was the case with the broken window – consumption. When consumption shifts this is an indication of consumers’ value rankings having changed, in this case the shopkeeper values replacing the window pane higher than buying shoes, and when market production shifts it does so in anticipation of shifting consumer demand or an increased ability to satisfy consumer wants. Indeed, we saw in the early chapters of the book that production in the unhampered market facilitates consumption – and that production is undertaken specifically to meet anticipated demand. In other words, production tries to find consumption, and as consumption changes production thus follows.
A policy-induced shift in production is different, since it restricts or distorts wants-satisfying production in order to solve a politically valued problem. Consumers’ preference rankings may not have changed as a result, but what set of goods and services that are made available them have changed. Production does not facilitate consumption, but is restricted from doing so in the way entrepreneurs think proper – this is, after all, the intent and implication of policy – and thus has to choose other, and consequently less valued since the most valued and thus most profitable are chosen first, ways of satisfying consumer wants. This loss of ability to satisfy the more highly valued wants makes consumers as a group worse off as they will be able to satisfy only less highly valued wants. Consumers have different preference rankings, of course, so some of the consumers may be better off while others are worse off, depending on – in our previous example – whether they prefer bread or nails or apples.
We identified the effect of the subsidy on several groups within consumers in chapter 8. In this chapter, we will focus on the effect by policy on individuals’ optionality – the choices that can be made. More importantly, we will discuss what choices cannot be made anymore because the means to make those choices remain unrealized.
Limitations of the Pure Market
We noted in chapter 4 that markets, even when they are not affected or distorted by regulation, are hardly efficient. Part of the reason for this is the ignorance we suffer with regard to the future: we cannot foresee what will be supplied or demanded in the future, and therefore it is impossible to perfectly fit production to the wants and needs that will emerge in the future. This problem is due to consumers’ ignorance of what they will want, which partly depends on what wants they will discover as entrepreneurs make new types of goods and services available, and producers’ ignorance of what they can and should produce, which depends on limited technological knowhow and incomplete understanding of what problems consumers face today and in the future. The latter is also due to the fact that even if the demand situation is perfectly predicted, which is as close to impossible as gets, the supply situation isn’t. Consumer demands are not only dependent on the problems consumers want to solve, but on what problems they have already solved, in the manner they are solved, and what problems consumers anticipated that they will be able to solve – and at what cost. Take a problem like transportation, for instance. It was solved by walking, running, riding horses and carriages before the advent of the automobile and, more importantly, when Henry Ford made the automobile available to a larger share of the population. The automobile proved to be a much more effective (and, which is at least as important, cost effective) solution to the problem of transportation, so this innovation replaced what was previously the obvious and generally accepted solution. With the highway system and improved comfort and speed, automobiles became an even more important solution. This does not mean, of course, that there won’t be an innovation to replace the automobile. So even a solved problem can be solved again, if entrepreneurs find better ways of solving it.
It is quite conceivable that there were innovative entrepreneurs introducing new and better carriages, better and more effective stables and horse-feeding, breeding, and training operations, better horse feed, improved buggy whips, and so on as the automobile was introduced. These innovations are all improvements, and in this sense create value – but they are misaligned and misdirected attempts to create value, since consumers are about to change their behavior with respect to transportation. The market for horse-drawn carriages, horse feed, and buggy whips will shrink dramatically as consumers shift their demand from horse-and-carriage toward automobiles. Entrepreneurs who didn’t see this coming failed because they were competing for a share of a shrinking market. Other entrepreneurs, who anticipated this change much more correctly, may have invested in oil refineries for petroleum production or gas stations or steel plants or rubber ersatz for the production of tires. These undertakings would have been complete and utter failures had the automobile not been invented and adopted by consumers. In other words, to be successful in production, one has to anticipate the supply situation.
The supply situation is less straight-forward than one might think, however. It is obvious that the production of substitutes – like the horse-and-carriage to the automobile – and complements – like gas stations for automobiles – are affected by the supply situation. Without automobiles, producers of horse-drawn carriages would have the whole market – and entrepreneurs establishing gas stations along the roads would be hopelessly malinvested. With automobiles, the situation is quite different. But what about shopping malls? Shopping malls were not possible before automobiles were adopted by the general population and thus had become a common means of transportation. Suddenly it made sense to collect different stores in a single place – located far from the city center. With the automobile, it suddenly became sensible to place housing outside of cities as well, thus creating urban sprawl, giving rise to the phenomenon of commuting to work, making daycares necessary for double income households. One change, therefore, caused numerous adjustments to consumer behavior that triggered responses by entrepreneurs in the market. Many of these responses in turn produced other changes to behavior, which caused other responses, and so on. It is in this highly dynamic, ever-changing situation that entrepreneurs attempt to anticipate whether they and their intended good have a place. Whether they actually do, and can make a profit from it, depends on how both supply and demand evolve between now, that is what is known in the present, and when the good is finally produced and made available to the market.
As the market situation at any point is caused by the interplay of supply and demand, that is by the entrepreneurs’ production undertakings and consumers’ wants, the evolution or process of the market is extremely difficult to foresee. Because of supply and demand are mutually constituting, the economic organism is endogenous, which means the reasons and ways in which it changes over time comes primarily from within. An economy is of course affected also by exogenous changes, that is effects with origins outside the economy such as natural disasters, but the market process is not dependent on but only reacts to such events. While endogeneity means it is very difficult to predict the course of change, it is not random. We have already established that the market consists of production efforts intended to facilitate consumption, which in turn satisfies experienced wants and felt needs, and as such its direction – the market’s progression – is clear: it tends toward the greatest possible want satisfaction, because this is where the profit is.
Progression toward is not the same thing as attainment of the end, however. The market process is always in disequilibrium and thus – for that very reason – inefficient: it is constantly moving towards higher states. Since it is comprised of only decentralized decisions, but those decisions are incentivized by satisfying real wants, the market process typically reaches higher levels of want satisfaction as capital is produced and accumulated, productivity strengthened, and investments made to support innovations that challenge the status quo by offering further improvement. Real economic growth through the satisfaction of a greater number and more urgent wants and needs is accomplished through competition for profit, and the mutual discovery that follows from offering competing products intended toward consumption for given ends, and the absence of artificial barriers to entry.
The reason all wants and needs are not and will never be fully satisfied is a result of human nature and facts of reality. Economics generally assumes that consumer wants are insatiable, which means there is always something that could be made better or improved; we do not live in the garden of Eden, but in a real world of scarcity. And this points to the limitation of economy due to the fact that goods are scarce, which is also the reason there is such a thing as economy. In a world where no resources are scarce, they lose their value. Their value, after all, is imputed from their contribution to satisfying real wants – but if all wants are being satisfied, which is the implication of all resources existing in abundance (that is, they’re non-scarce), then there is no choice toward which want they should satisfy and, as a result, nothing has a cost. Without cost, then, resources aren’t valued. The economic organism responds to changes, but its main feat is to produce ever greater satisfaction of wants and thus limit the effects of scarcity on people’s lives. We see this lessening of scarcity in the form of increased convenience and comfort in our daily lives – that is, our standard of living increases as our wants are being satisfied.
While the effects of scarcity diminish with innovations and increased productivity, it cannot be fully abolished. It is conceivable to eventually reach a level of prosperity where everybody can afford whatever stuff and gadgets they could wish for. But even in this situation, some wants remain to be discovered as entrepreneurs offer new types of goods and services that shatter consumers’ ignorance about their real wants and preferences. Also, time and space cannot ever be anything but scarce for a living being: even if we live forever and have colonized the universe, it is still the case that we cannot do everything we would like at every moment. We cannot eat and sleep at the same time, for instance. This is due to time and space limitations that amount to scarcity: had we had non-scarce access to both time and space, we could do both – and all other things we would like – at the same time. Scarcity in the colloquial sense can be abolished, but not in the sense that makes economy irrelevant: the choice will always be there, and the choice necessarily means choosing something over something else – the choice has an opportunity cost. This cost indicates the presence of scarcity, and the only way of lessening it is by economizing – that is, by finding out how to better use existing resources, and thus to allocate resources toward more highly valued uses. This is what is done “automatically” in the market, since production precedes and facilitates consumption and because specialized production for the benefit of others is a more effective way of gaining the means to satisfy one’s own wants.
What this means is that the market, when left to its own devices – and thus unaffected by imposed restrictions or large-scale destruction – tends to reach higher levels of want satisfaction by developing the means necessary. Why? Because a situation where the chooser has one highly valued alternative and all other alternative are of significantly lower value is an opportunity for profit. If the problem to be solved is shared by more people, the fact that there is only one solution – or only one provider of solutions – means their profits are likely higher than the market average. After all, consider a situation where a person is looking for transportation across the Missouri plain from St. Louis to Kansas City and there are only a few alternatives available: walking, traveling by horse and carriage, or taking the train. The entrepreneur operating the train can, because the train is the much faster and more comfortable means of transportation, charge a high price. This is the obverse of a situation without optionality: the higher price can be charged because travelers value taking the train so much more than the other means available. So from the travelers’ perspective, the situation is one where the opportunity cost of taking the train is low, meaning the value anticipated from walking and traveling the distance by horse and carriage is significantly lower than riding in a train car. As the train entrepreneur offers a much higher value, he or she can benefit by charging a higher price.
But this is also an incentive for other entrepreneurs to develop competing means of transportation that provides them with a share of the profit. They can build railroads or roads or fly the 250 miles between the two cities, all of which would make them able to compete for the profit – by offering consumers value that is at least as high as is already offered. And by adding to the supply of highly valued transportation services between St. Louis and Kansas City, the number of similarly valued alternative means of transportation that consumers can choose from – their optionality – increases. It also means the opportunity cost of the choice increases because the value foregone by, for instance, choosing to drive on the newly constructed highway instead of riding the train is much higher than the value forgone when choosing to travel by train before the highway was constructed (that is, the value of walking or traveling by horse and carriage).
We discussed this in chapter 4, where we noted that a relatively high opportunity cost implies real optionality: a situation where choosing takes place between several alternatives of similar value to the chooser. Because entrepreneurs compete for profit by satisfying consumer wants, they individually attempt to outdo the competition by adopting productive innovations and, as a group, attempt to keep up with the front runners. The result is continuous progress and, which is another way of saying the same thing, higher levels of want satisfaction.
Innovations that reshape the market, or even create new markets, are still always in some sense improvements of what already exists. This may sound paradoxical, but the explanation is simple: an entrepreneur who innovates a new type of good, previously never imagined, will still rely on the existing production apparatus to implement this innovation. Even highly disruptive innovations like the printing press and the Internet built off and therefore improved on what already existed. They use tools, knowledge, and infrastructure in a different way, but these resources are in existence before the innovation can be realized. An innovation that doesn’t build on what already exists would need to not rely on anything at all in existence: no tools, no machines, no materials, no knowledge, and so on that is already in use. Whereas this may be theoretically possible, it is difficult to think of how anyone could imagine an innovation that does not make use of but rather is completely new in every sense and in every part of the production process. It is much easier to use what we know and have than come up with completely different ways and tools. And since the diversity of tools and services and knowledge in an economy’s production apparatus were developed because they are of value in production, it would make very little sense to start anew. So even though the market may be “disrupted,” that is its productive structure and “direction” are changed fundamentally by the introduction of a previously unseen and unimagined product or service, there is continuity. An economy’s productive achievement is cumulative – innovations build on some of the previous successes but challenge others. They must, since not building on what already exists is too limiting: it would be like becoming the entrepreneurial equivalent of the shipwrecked Robinson Crusoe, and we have already established that specializing is an important means to become more productive.
This means there is a boundary to what is possible in the market, since each person in his or her endeavors is limited by what already exists and adding to it by challenging parts of it or the way some resources are put to use. In other words, even innovative super-entrepreneurs cannot go too far from what already exists, because doing so would make their attempts incompatible with all the means of production existing and created in the market – and this would make them as inefficient as the unspecialized, self-sustaining Robinson Crusoe. It is not a means toward success, but a sure way of failing and thus losing one’s investment. To be successful, therefore, innovations must break new ground but not go too far: they cannot go so far that they end up being significantly incompatible with the production structure already in existence.
Economic history is littered with examples of innovations that went “too far” in some sense, often because they were before their time – consumers were not ready for the innovation. A recent example is the tablet computing device, which is a modern-day version of the age-old tablet for notetaking. Even so, the success and disruption of the computing market by the release of Apple’s iPad tablet in 2010 was preceded by similar innovations that turned out to be complete failures for the simple reason that the timing was wrong: the MS-DOS-based GRiDPad in 1989, Apple’s Newton in 1993, the Microsoft Tablet PC in 2002, and the Android-based Archos 5 in 2009. The failed attempts at devices introducing tablet computing were different, but were similar to the iPad in their defining characteristics – their failure was to launch too soon.
The boundary is therefore not simply a limitation of what can be produced, that is what tools, machines, techniques, and materials are available, but is also the set by what consumers are willing and able to comprehend as means toward satisfaction. Unless consumers are able to see how a specific good can provide want satisfaction, in whatever form, they will not see it as of value. Where this is the case, the good will not have a price on the market or will only be sellable at such a low price that it fails to cover the costs of production – and therefore the venture fails. This confirms what was stated above about production facilitating consumption as well as being intended to satisfy wants, and that the value of the means of production is imputed from the value contributed to consumers. And if consumers are not convinced of the ability of a new product or service to satisfy real wants, it will have no value – the market is thus, due to this limitation, conservative in its progression.
This also means that the major shortcoming of the economic organism – that it is inefficient, since it does not satisfy all wants – cannot be thought of as valid criticism, since the wants and needs not yet satisfied are either not technologically feasible, not cost efficient and therefore a poor use of resource, or simply have not yet been discovered. Due to these three reasons, a market will never reach a general equilibrium – that is, full contentment will not ever be in reach.
The Pure Economy and the Realized
The previous section focused on the limitations and “inefficiency” of the pure market. This model of economy – the unhampered market process – used in this book differs significantly from what is commonly used to assess the efficiency of economic states. Our focus is the market as an economic organism, a process that is constantly undergoing change brought about by entrepreneurial discoveries, innovations, and investments for profit – indeed, entrepreneurship is the driving force of the market process. This model, as we concluded in the previous section, is not an efficient system in the strict economic sense, that is as compared to the model of perfect competition. The latter assumes, among other things, that actors have perfect information – that we know everything about the present, including what others know, imagine, and plan to do, as well as the future, and therefore can use resources, which are mostly homogeneous (there’s only capital and labor, not different types of tools, machines, expertise) and transactions therefore aren’t very costly, in an optimal, maximizing way. Perfect competition therefore excludes entrepreneurship and change, since they are neither needed nor of value if there is perfect information. Indeed, the very existence of entrepreneurship suggests that the market has not reached full efficiency but is in an inefficient state, because otherwise there would be no (profit) opportunities to better satisfy consumer wants. The model of perfect competition thus – by design – excludes uncertainty and discovery, both by producers and consumers, by assuming that the economy has already reached a state of maximum performance. Improvements cannot be made since the system is without flaws, so entrepreneurs could only – if they acted – cause inefficiencies. Therefore, entrepreneurs have no place and no function in the model.
To assess the functioning of a real or proposed economic system, a model based on foreign or even outrageously unrealistic assumptions is a poor benchmark. All economic systems are necessarily inefficient, since there is no such thing as perfect information. The problem of imperfect information is not a problem that can be solved economically (or in any other way), so critique of any real economic situation based on such assumptions can misdirect our attention to problems that may not be possible to solve – and may actually be unimportant problems. In other words, such a benchmark can potentially do more harm than good for the simple reason that the real problems may become overshadowed by the not-so-real ones. Indeed, the real and solvable problems may seem of only marginal importance or peripheral from the point of view of the “perfect” model, so the focus of improvements may instead fall on what’s either impossible or not a real problem or both. The real is compared with a fantasy world.
The proper benchmark to assess the functioning of real economic systems, such as those including attempted corrective policy or those that include an element of central planning, is a model of the unhampered economy as we have discussed above. This model is realistic in the sense that it does not assume actors to be omniscient or motivated only by pecuniary benefits like profits. Instead, the model stresses real issues caused by ignorance and discovery; it places production, entrepreneurship, and uncertainty at the heart of the analysis; and it indicates why it is necessary that a society accumulates productive capital to be able to generate higher standards of living – that is, to experience sustainable economic growth. The model also includes a logic by which the market process can be properly understood, and effects consequently traced from causes, which in turn facilitates detailed and exact analysis of the unfolding of events, their consequences, and interactions and interdependencies in the market. This is what we did in previous chapters, where we traced the effects of changes by walking through how one change generates shifts and changes elsewhere, and how those in turn produce a change elsewhere.
What matters to us here is not efficiency of the overall system in an abstract sense, as is the intent of the model of perfect competition, but how the system affects the actors that comprise it. More specifically, we are interested in the extent in which an economy empowers people by producing valuable goods and services – and by offering optionality. The discussion has so far focused on the issue of production, since production is what facilitates consumption and therefore is the means by which actors satisfy real wants – the wants of others, and thereby indirectly their own. Optionality, however, is a matter of independence and autonomy for the individual in a choice situation – it is restricted neither to production nor consumption. An entrepreneur can experience (and thus benefit from) optionality by choosing between several suppliers, inputs, production techniques, locations, expertise of employees, and so on of similar value; likewise, a consumer can experience (and thus benefit from) optionality by choosing between several products and services that equally or to similar extents satisfy a specific want – either perfectly or imperfectly.
The fact that a choice must be made, which implies that at least one alternative option cannot be chosen, does not necessarily indicate a problem. For instance, we can easily think of a person hungry for dessert choosing between different alternative baked goods, ice creams, chocolates, Jell-O, etc. Perhaps this person realizes that he or she does not have room for more than one serving, or maybe they are really hungry for dessert but cannot, for whatever reason, justify taking more than a couple of bites to taste. In both cases, getting all the desserts on the menu is not an option because that does not contribute value – only the first serving does. So the choice is positive in the sense that it entails picking out the one dessert to satisfy the want best, rather than not being able to choose the other desserts. Of course, it may also be the case that this person would like more but cannot afford more than a single serving of dessert. This would seem to be a less positive situation, since the person is primarily choosing which desserts not to order. While this may appear to be more problematic, as we discussed in previous chapters, this really means that our dessert-hungry person was or is not willing to give up what it would cost to buy more than one dessert – because the non-dessert alternatives are worth so much more. Alternatively, not having enough money in one’s pocket to pay for two desserts, even though two (or more) would be preferred, should be a result of previously not having produced sufficient value and therefore not having generated enough buying power – for instance by choosing leisure over labor or failing in one’s entrepreneurial undertaking. The lack of ability to satisfy a want in the present – more than one dessert – is therefore a result of a value achieved in the past – leisure instead of labor. As we noted in chapter 8, there is only voluntary unemployment in an unhampered economy, since there are no restrictions on one’s options except the physically impossible and the willingness and ability to put in the effort.
Actually having the choice, especially if it is a tough one because the alternatives are of similar or equal value, is a luxury. It indicates prosperity. Such a choice situation suggests two things: that very basic needs for one’s survival have been met, that is that a basic standard of living has been accomplished, and that market production offers alternative and competitive solutions to a single problem, which of course also indicates a high standard of living. So finding yourself in the situation where you need to (can) choose between two delicious desserts, and neither appears as the obvious choice, is an indirect measure of wealth since those alternatives – optionality – are made available to you by the combined productive apparatus of the market.
We can therefore assess a market’s performance by looking at the choices people can and might have to make – and especially the options they’re presented with in the choice situation. Societies with abundant choices are, all other things equal, more prosperous than those that offer very few real alternatives and thus limited optionality. Though this is an indirect measure of prosperity, it tells a story of how well people are doing within an economic system. It is very difficult to measure directly, since it isn’t possible to see how people value the alternatives – we can only see what they end up choosing. We can potentially list the contents of a person’s choice set, that is the number of possible options, but whether they are similarly valued or very far apart in terms of the person’s actual valuation is hidden to the observer. This valuation that the chooser makes in that moment is not simply a ranking of the options presented in the present, but is also affected by anticipations of what options may be made available later on – and the value they will present at that future time. The choice is also tainted by the perceived cost of already exerted effort, that is the labor already invested in production to facilitate the choice of means for consumption, even though this cost – from an economic perspective – is sunk and therefore irrelevant. In other words, it is impossible to separate the individual’s choice at any moment in time from both the situation’s temporal and spatial context: what happened before and is anticipated will happen, and what the options actually perceived by the person are.
The good news is that we don’t have to put together a complete picture of the choice situation in order to analyze it. Instead, we can return to the logic above and look at what alternatives are realized in a certain economic system – and by walking through the logic we can trace what goes wrong in the systems that offer very limited choice situations. The question we ask is thus: compared to what options could reasonably be available or even expected, how many – and which ones – are made available in this specific economic system?
To answer the question, we must first establish a baseline, and therefore analyze the options realized in an unhampered market. This is, as we noted above, the model that is unbeatable in terms of value creation and, therefore, the one that should present individual actors with the better and more numerous alternatives in choice situations. It is theoretically possible, of course, that we can, when walking through the logic of different economic systems, find a system that is better at providing individuals with alternatives in every choice situation than the unhampered market. The discovery of such a system, and how it is or can be structured, would be a very important finding indeed. The working hypothesis (though it is actually of little importance), considering what we have learned above, is however that the unhampered market would maximizing in terms of optionality due to its matchless ability to create real value.
Consider again our chain of events from chapter 5, but this time we add our friends from the discussion on production and market responses, and add their consumptive behaviors, to get a fuller picture. As we argued in the very beginning, production facilitates consumption and therefore every consumer is also a producer. There are potential exceptions from this rule, such as small children and sick or disabled adults, who may not be able to produce sufficiently to facilitate their own consumption. But unlike many streamlined models used in economic analysis, the model of the unhampered market process is compatible with treating individuals as embedded in a context such as community and not simply instants of the economic caricature homo economicus, who responds atomistically and only to pecuniary benefits. Individuals are social beings and are always embedded in a social context, which means it is possible to survive and lead a good life even if you are a small child, sick, or disabled. We should note that the fact that production facilitates consumption doesn’t mean “everyone for his or her own” without exception. But it is nevertheless true that even if an individual doesn’t produce the value that facilitates what he or she consumes, someone has – it is impossible to consume what has not been produce. This allows for some redistribution between individuals – through community pooling of resources, joint savings initiatives such as workers’ unemployment or health care funds, or simple charity – and this suggests a simple and down-to-earth solution to both temporary and permanent economic setbacks. However, it is not possible for a whole society or community to consume more than they have produced. It is thus not possible for a population to live beyond their means, which suggests a limit to how many net consumers, as compared to net producers, can be supported over time. To live beyond one’s means, to consume more than what is produced, means that one’s savings (if any) are depleted and then accumulated capital is consumed, which in turn inhibits productivity. It is not a sustainable state of affairs and therefore requires a swift solution: either by increasing production to a level that at least equals consumption, or decrease consumption to no more than the level as production. This rule applies to both individuals and communities.
Let’s revisit our little society to illustrate the complexity of the economic organism. Adele is, as she was from the very beginning, an apple-grower, Adam produces and sells soft drinks, Becky is the nail smith, Bart and Bob are both bakers, and Fred is a construction worker. The others have found their way from previous employment into roles from our discussion on the seen and the unseen in chapter 5, as well as some additional roles: Charles is now a shop keeper, David and Deborah are both farmers, Eric is a cattle breeder, and Edda is a hunter. Also, the previously underemployed Gina, Gordon, and Gregory have found new occupations: Gina combines her part-time employment for Fred with making ice cream, Gordon competes with Gina’s business and is a full time ice cream maker, and Gregory has become a cattle breeder. In all, this little society consists of 14 people, all of whom are engaged in specialized production to facilitate their consumption. None of them produce exactly and only what they themselves use, which means whether or not the 14 members constitute a community (or several communities), the society as a whole is engaged in social cooperation through the division of labor.
The degree of optionality experienced by the population is realized because the producers create and offer goods and services valued by others in exchange for goods they themselves value. This optionality is evident both in production and consumption, and is increased by having higher purchasing power. Indeed, the richer a person is – that is the more capital he or she has accumulated through working and saving – the more wants can be satisfied at will in the market and, consequently, the less restrictive are the asking prices for the desired goods and services. To put it differently, with greater purchasing power there are more options available within a price range that can be afforded as well as considered worth it. This is a simple conclusion that is valid in our model as well as in our everyday lives: with more money, we can afford to buy goods in greater quantities and also goods that are sold at a higher price. Optionality, therefore, is partly a function of one’s purchasing power, which in an unhampered economy is a result of one’s contribution to satisfying the wants of others. It is also partly a function of the success of others in producing goods and services that we find of value and therefore worth acquiring, which in turn increases those producers’ purchasing power and thus optionality.
Of course, as this little society is indeed little, we cannot expect a huge number of choices – after all, there are only 14 people to produce and consume so it wouldn’t be possible for them to produce hundreds or thousands of different products and services. We will therefore look at purchasing power as a proxy for optionality. We will also look at the effects of a change, since this is where the results are most easily recognizable.
To illustrate our baseline, we will start with a seemingly well-functioning unhampered market and walk through the effects of a change. So our starting point is as described above: 14 fully employed people working in specialized trades. In this example, Gregory the ice cream maker was rather recently married to Deborah the farmer, and they live together in the small hut that makes the farm (as this is a rather small and limitedly developed economy, they all live in huts rather than houses). They’ve just learned that Deborah is expecting their first child, so they need to add a nursery to the hut. Fred the construction worker advises them to instead consider tearing down the hut and replacing it with a house. It will be more work and a little more expensive, but it will keep the whole family warm during cold winter nights and protect them and their belongings from rain and humidity – thereby saving them money over time. It could also provide Gregory with a shop for ice cream production and sales, right next to where Deborah keeps her cows and therefore with excellent access to fresh milk, which would make his life a whole lot easier and probably increase his business. A house will also provide them with enough space to have a nursery and a guest room, and they wouldn’t need to add more rooms for future additions to the family. Gregory and Deborah are immediately sold on the idea, and start working on the plans with Fred – and Gina, working part time as Fred’s assistant, helps as well.
At about this time same time, Gordon the cattle breeder decides to contact Fred and ask if he could build him a house. Gordon doesn’t have a dwelling of his own, so has been sleeping in Bart’s bakery at night. Even though the bakery is nice and warm – and Bart is kind enough to allow him to live there at no cost for as long as he’d like – the very early mornings (Bart starts baking around 3 am to have fresh breakfast bread for sale) and constant smell of bread are beginning to become more than a nuisance. Also, he doesn’t want to be more of a problem to Bart than he already has been, so he has been trying to save as much as possible of his earnings from the cattle with a house of his own in sight. When Gordon sells his next couple of full-grown cows, he anticipates to have enough saved to buy a house. So after watering his cows in the early evening, he takes a walk to Fred’s hut to discuss this matter with him. But when he gets there, Fred already has visitors – and he is halfway through drafting blueprints together with Gregory and Deborah, and Gina is there too cheering them on. Gordon quickly realizes that there is no way Fred will be able to help him build his house. At least not until he is done with Gregory and Deborah’s house, which would be at least a year from now.
Realizing there is no way he can live with the early mornings and constant bread smell for another year – or maybe even two – Gordon decides to look for alternatives. He knows Edda, who earns a living by hunting, is very handy, so he contacts her to inquire about the possibility that she would be able to build him a house. Surprisingly, she accepts. She’s been considering other trades for a while, and while she makes a decent living off hunting she realizes that she would easily make more in construction – and working on Gordon’s house is a great way to get started and get a reputation as quality builder. So she gladly accepts.
As the two construction projects begin, the demand for Becky’s three-inch nails sky-rockets. She has a hard time to keep up, and thus raises prices to lessen demand somewhat and provide her with a profit. Bob notices this drastic increase in profitability from nail manufacturing, and as he has played with metals as a hobby (he made his own steel oven, for instance) he can easily switch from baking to nail manufacturing. He anticipates that he’ll be able to get enough of a market share to make a nice profit in excess of what he’s making as a baker, so he eagerly closes his bakery and starts working on nails.
Also, the demand for building materials increases as the two major construction projects pick up. Previously, Fred has, with the help of Gina, visited a nearby forest to cut down the trees necessary for the huts he was building. But for houses, timber isn’t enough – he (and Edda, of course) needs planks. Making planks out of timber is time-consuming and adds a lot of time to building the houses, so Fred talks with Adam the soft drink maker about possibly making planks for him. Adam has been struggling with selling his sodas ever since it became fashionable among the men in our little society to adopt a low-carb, high-fat diet, so he doesn’t need much time to consider shifting. He lives by a forest with very tall and straight pine trees that he could use. Learning about Edda’s new line of business and her contract with Gordon, he talks with her about supplying her as well. She’s thrilled to not have to make planks herself, so even before Adam starts his new line of business he has two customers signed up for large quantities of planks.
The result so far is a shift toward house-building, caused by Deborah, Gordon, and Gregory’s revealed preferences for houses. To satisfy the demand for houses, Edda was attracted from hunting to the more highly valued work in construction, Bob went into nail production from his previous trade as a baker, and Adam was attracted from soft drink making to plank production. Each shift implies an increased value-creating capability in the economy, since Edda, Bob, and Adam contribute greater value in their new positions than previously. As such, they are also made better off themselves, so their respective purchasing powers increase. The same is true for Becky, who was able to make more profits in her line of business because of the greater demand (at least until she started facing Bob as competition), and Bart, who is the only remaining baker, can sell more bread or raise the price – or both. And, of course, Fred, who landed a much greater project than he had previously. It is also anticipated that the output and quality of ice cream will increase when Gordon establishes his production in the new house; this too is a value created.
The losses, or the opportunity cost for the little society, is the loss of game as they’re now out of a hunter, the loss of one of two bakers, and the loss of soft drink production. The opportunity to buy game meat, cheap bread, and soft drinks are now unrealized options – they cannot be chosen. Each of these lost choices, however, are the result of productive activities being replaced by other types of production that produce more value in the eyes of consumers.
In terms of optionality in production, house construction has become a longer process because Adam is now specialized in plank production and both Fred and Edda therefore have the choice to build using timber they gather themselves or build using planks – that they either produce themselves or purchase from Adam. Fred and Edda also have the choice to buy nails from either Becky or Bob, whereas they used to be dependent on Becky’s ability and willingness to spend time in the forge. Also, as both Fred and Edda now offer construction services, there is greater optionality for anyone interested in building a new house or hut, or perhaps just getting an addition to their existing dwelling. Of course, the losses also affect optionality: it is no longer possible to buy sugary soft drinks, the price of bread has gone up, and buying game meat is not an option anymore. On the other hand, the quantity and variety of ice cream is likely to increase.
While what’s been stated summarizes the supply situation, that is production, we have not considered the effects that the shifting prices might have on consumptive patterns. For instance, it is quite possible that Adele the apple grower gets a share of Bart’s increased profits. It is also likely that Eric and Gregory, the society’s cattle breeders, will experience increased demand and therefore, potentially, higher profitability. Why? Because when Bart increases his prices as he is the sole baker, those who used to buy bread may choose other types of food: apples and beef, for instance. While apples and beef aren’t perfect substitutes to bread, they are close enough to be considered – depending on how much Bart anticipates that he can charge for bread.
Just like we’ve shown in previous chapters, a change has ripple effects throughout the market and thereby adjusts to the new situation by reallocating productive resources toward production of the most highly valued goods and services. What was discussed here is the addition of more highly valued production, which causes shifts throughout the economy – all of them caused by more valuable options being made available: Edda acted on the opportunity to better serve consumers by shifting her efforts from hunting to house building; Bob similarly gave up baking to produce nails, and Adam quit making soft drinks to instead create a new trade: plank production. While these and the other changes are all important to understand, our intent here is to use this as a benchmark when we now turn toward assessing the effects of regulation.
The Unrealized in the Regulated Economy
Let us now turn toward analyzing the same development as above but on an economy that is regulated. We use the same starting point as above, with our 14 specialized producers and the added demand for houses, but this time we also have Luke the policy-maker and his private subsidy, paid from his personal wealth and intended to increase the production of bread. In this market, therefore, Bart and Bob – our bakers – already benefit from the subsidy by being slightly more profitable than they were in the example above. Rather than work through the effects of introducing a subsidy, as we did in chapter 8, we assume that it is already in place and that what we see is therefore the structure of the market after the effects of the subsidy have played out. The market starting point, when Gregory and Deborah go to visit Fred to discuss construction of their house (and Gordon soon does the same), is thus the exact same as above in terms of the structure of production. But with a subsidy supporting Bart and Bob’s bakeries.
As was the case in the previous section, Gregory and Deborah, our expecting couple, visit Fred to have him build their new house. Slightly thereafter, Gordon visits Fred only to learn that he will need to find another builder. Also as in the previous section, Gordon makes an offer to Edda that she gladly accepts, with the result that Edda shifts her efforts from hunting toward construction. Edda and Fred, our two house-builders, get started on their projects and, just like before, convince Adam to give up soda production for the new trade of plank master to supply both of their businesses with the proper materials. So far the effects remain the same as in the example above.
Due to the increased demand for resources going into the construction of houses, Becky’s business as a nail smith is blooming. She raises prices because the demand is overwhelming, and the increased profitability that the higher prices provides makes it easier to put in the necessary hours. Also, with higher prices, both Edda and Fred are more careful with the nails they purchase – so they won’t waste as many. At this point, in the previous section, Bob was attracted from bread-baking by the higher anticipated profits in nail production, which increased the supply and thus made house-building easier and a less costly endeavor. Now, however, since both Bart and Bob benefit from Luke’s subsidy, it would take very high profits in nail-making to lure Bob into that line of business. It turns out that the profitability that Becky enjoys is not sufficient for Bob to leave his subsidized bakery to produce nails.
The result of this is that the houses become much more expensive than was previously the case, which of course affects both Edda and Fred in their undertakings as well as any continued efforts as builders. Edda, as we know, is hoping the house she’s building for Gordon will be the start of a career as builder, but with the high prices for nails – profits that go directly into Becky’s pockets – it is no longer as clear whether this may be possible. Edda and Fred will also, because of the higher price of three-inch nails, try out other methods than nailing the planks together. For instance, they might experiment with different types of glue, special cutting of the planks and timber to make them fit together without adhesives, or simply tie the planks together using string. Some of these methods are poor solutions that would not have been considered at a lower price for nails, whereas others were previously anticipated to be too costly – that is, they could not sufficiently contribute to satisfying consumer wants, and were therefore poor uses of available resources – to consider. With the much higher price for nails as Becky is the sole supplier – a monopolist – these methods are no longer out of reach. The implication, as we have learned in previous chapters, is that house-building – the type of production preferred by consumers – becomes less efficient as it now requires more resources to complete such projects. To put it in much more briefly, the little society gets less house construction as Becky enjoys artificially high profits. The profits are artificial, of course, because without the subsidy of baking Bob would have chosen to go into nail manufacturing, which would have increased supply and decreased price, which in turn would have provided the society with more housing.
But the effects don’t end with these indirect but still easily recognizable implications of Luke’s subsidy in support of baking. As Bart and Bob are partly supported by the subsidy, they have comparatively little incentive to produce a quantity demanded by consumers. They also have less incentive to put in long hours to meet spikes in demand or try new techniques or different types of bread. In other words, baking as a protected trade is less innovative and less efficient than it otherwise would have been. It is also more profitable because of the subsidy, so Bart and Bob are comparatively more wealthy than they otherwise would have been. Bob, as we noted, makes enough money to not want to shift into nail manufacturing. Bart, on the other hand, makes a decent living as it is, partly because of the subsidy, but had there not been a subsidy he would be the only baker – and could possibly make more money. So even though baking is a protected business and those in that line of business profit from it, the effects are not the same: Bob earns more than he otherwise would, even including his alternative income as a nail smith in the unhampered market, whereas Bart actually makes less because baking is less efficient because of the subsidy – and because it keeps Bob in baking bread.
As both of them are still in bread baking, their combined output is likely higher than the quantity supplied by Bart after Bob decides to become a nail smith. The higher quantity suggests a lower price, and the subsidy certainly makes a lower price possible as it covers the bakers’ actual costs. For this reason, the increase in demanded quantities of apples and beef that we saw in the previous section do not happen. This opportunity for Adele, Eric, and Gregory to expand or refine their businesses simply isn’t realized. They remain unaffected by the boom in house construction, except for the higher price of nails were they to require nails for some project, whereas they would otherwise be winners. Their standard of living is therefore, relative to what otherwise would have been the case, lower – and so is their purchasing power.
Furthermore, as Bob does not become a nail smith, which increases the price of nails and therefore the cost of building, it may be the case that for instance Gordon no longer has enough capital to contract with Edda. So he must postpone his house-building plans and continues to live in Bart’s bakery while saving for his dream house. Say that he needs to save for another year and a half to be able to afford the more expensive (but otherwise the same) house. This means Fred may no longer be busy building for Deborah and Gregory, but could take on Gordon’s house as well. And if this is so, then Edda may never get the chance to move into house building. Instead, that value ends up in Fred’s hands as the only builder in our little society. In fact, the higher cost of building may also lead to Deborah and Gregory choosing to build a slightly smaller house than they would otherwise have preferred because they get less house for their money.
The result of the subsidy, then, is higher profits for Bob without moving into nail manufacturing, higher profits for Becky in her established line of work, and higher profits for Fred. But the result is also the loss of those opportunities that would otherwise have been realized: Edda, who will then remain a hunter; Adele, Eric, and Gregory, who won’t get a share of the increased profit from demand shifting away from bread; Bart, to the degree he would have earned more as a monopolist baker than a subsidy-supported competitor; and Adam, if his specialization into plank making cannot be supported with only Fred as builder. They are all losers as the opportunities they had been offered in an unhampered market by the boom in house construction are not realized.
These effects are all caused by the added subsidy but not by adding the subsidy itself. Note that we used the same starting point when walking through the economic changes, with the only difference being that baking was a fully market-based business in the baseline (the previous section) but subsidized in the discussion in this section. We did not consider the distortive effects of adding the subsidy, but focused on tracing the effects of having a subsidy in place when other change occurs. What we find when comparing to the baseline – the unhampered market – is that simply having a subsidy in place creates a plethora of deviations, each of which having an effect on people’s lives. There are both winners and losers, but we should keep in mind that even though we tracked the different effects and found both who benefits and who is set back by what remains unrealized there is one difference that is economy-wide: the impact of implementing the subsidy. We left that out, since we walked through that logic in a previous chapter. But it should be noted that this society with a subsidy is comparatively less well off than the society without a subsidy. The problems that we saw appear when the market with a subsidy responds to change – primarily through the opportunities, both in production and consumption, that remain unrealized – are an additional burden. The overall cost is higher.
We could add to this picture the type of regulation that was discussed in chapter 7. For instance, Luke’s dislike for soot emitted from nail manufacturing and therefore the legal requirement to have tall chimneys on all forges. If we would walk through the logic following a boom in housing demand where Luke has already regulated against low-chimney forges, we would find that the cost of construction would be much higher since the regulation increases the cost to producing nails. The result is a higher barrier for Bob to enter the nail-producing business since he would expect lower profits if making the shift. With this regulation and the subsidy, the price of nails would need to increase a great deal to incentivize Bob to leave his subsidy-protected occupation as baker for the regulation-burdened occupation as nail smith. As these barriers exist, Becky would be able to charge an even higher price (though not so high that Bob makes the shift), which increases the cost of house building. There is now no chance at all that we would see Adam move into plank making, which will remain an unrealized trade, and Edda would continue as a hunter. Overall, even less value would be created in the society and the inhabitants’ combined standard of living will as a consequence not increase as much as it otherwise would have. This, of course, means they have fewer opportunities to make different choices, fewer alternatives will be made available, and they will likely work longer hours to reach the standard of living they otherwise would have enjoyed.
We could also add taxation to this picture in order to finance the subsidy. If Luke either didn’t get his hefty inheritance or simply isn’t interested in paying for the subsidy himself. He is, after all, a policy-maker and doesn’t have to foot the bill himself – he can with simple means push the cost onto others. So Luke, who has regulated the chimney height on forges and thereby increased the costs on nail production, and has introduced a subsidy in support of bread production, also introduces a tax to pay for the subsidy. He decides on a 5% tax on all profits, applicable for all businesses, which he thinks should be enough to pay for the subsidy as well as the cost – his own salary – of weeding through subsidy applications and inspecting chimneys. This tax makes any business 5% more costly, since only 95% of any profit earned can be used. This raises the bar for any investment to become profitable, and entrepreneurs would therefore tend to invest less often and they would also not invest in technology, production, and so on that is sufficiently profitable in itself but falls below the threshold because of the tax. Each investment, even those with anticipated very high profits, become riskier due to the added cost. As a consequence, the economy will develop at a much slower pace and with less value creation there is as greater risk for distortive effects: the number of opportunities that will never be realized – the unrealized – increases with the artificial burdens on economic action.
Bylund, P. L. (2016). The Problem of Production: A New Theory of the Firm. Abingdon: Routledge.
 How this can be accomplished is discussed in (Bylund, 2016)
 The perceptive reader notices that this affirms what was stated in previous chapters about the economy’s endogeneity: none of the variables mentioned are exogenous or even with an exogenous cause.