This paper was presented to educators, Ministries of Education, and independent teacher unions in Czechoslovakia, Hungary, and Poland in a series of events called the Free Society Seminars conducted in November 1989. The papers were prepared for the American Federation of Teachers' Education for Democracy/ International project, which also organized the seminars. This paper may be reprinted with permission of the AFT International Affairs Department.
Ezra Solomon is Dean Witter Distinguished Professor of Finance and the Graduate School of Business at Stanford University, where he has taught since 1960. Author of three books on finance, he is considered the founder of modern financial management. He was a member of the Council of Economic Advisors under President Richard M. Nixon from 1970-73.
Introduction
What is economics? One may define it as the science that deals with the production, distribution and consumption of commodities (which includes both goods and services). While some argue that it is not a science in the same sense as physics or biology, economics is an important area of the social sciences. And it is more than a dry academic subject: Economics tries to explain how individuals, societies, and nations, are organized to produce goods and services that satisfy human wants and needs. Economics tries to answer the questions: How does an economy work? How can individuals and societies prosper materially and better themselves over time?
Ideas in the field of economics have had profound consequences on human lives. Two currents of ideas have had particular consequence. "Scientific socialism" and "dialectical materialism" were theories that, when taken to their extreme forms and applied, created totalitarian systems of control. Such a system is associated with state control, central planning, and abolishment of most forms if not all forms of private property. In the end, "scientific socialism" in practice resulted in poverty, destruction of natural resources, and technological backwardness. The second main current of ideas and the one which will be discussed in this paper is commonly referred to under the term "free market." These ideas have been associated with the prosperous economies of Western Europe, North America, Japan and now several countries in East Asia.
There are two important aspects of a "free market economy." The first is that it appears to provide the mechanisms and means to achieve a relatively high degree of material wealth and well-being, as well as technological progress. The free market fosters creativity and initiative. The second aspect is that it appears to function best where there is political democracy. Various forms of political dictatorship have not generally produced material wealth for the society as a whole (although they may produce wealth for a group within society). However, there is a general correlation between democracy and prosperous economies.
Why is that so? Perhaps, as some have argued, it is that a "free market economy" or a free economy is most suitable to a free polity, for it allows the broadest scope of liberty in the free exchange of goods and services between individuals and groups. Perhaps, as others have argued, it is that it best suited the religious and cultural temperaments found in countries where democracy evolved. Other theories abound.
Given the experience of "scientific socialism," however, the first explanation has gained wider currency. For it is clear that private property and free markets do limit the power of the state by diffusing its control over the economic lives of the citizenry. Individual liberty in making economic decisions limits the power of the state to control the political lives of the citizenry.
Even in a democracy, however, the state is never withdrawn from economic matters. A legitimately constituted government, functioning with the consent of the governed, makes decisions that affect the economy. The executive branch of government mints coins and issues the national currency; it influences the rate of interest in society and controls the stability of the general price level its. Its Parliaments and legislatures determine taxes imposed on society and how much and for what purposes government spends money and in what areas government encourages individuals to act.
Parliaments and legislatures make laws that regulate economic activity; governments issue decrees that further regulate economic activity. What these decisions and laws are depends upon the many ebbs and flows of an economy and the needs and wants of the citizenry.
Where there is material prosperity, the question also arises: how is income to be distributed? Should the government help to redistribute wealth when a disparity exists between rich and poor? Generally, those countries where a free market economy exists also have various welfare policies that provide income and services to the poor or unemployed. How much and to whom is a continuing and fluctuating question. For in a democratic society the majority may change, new elections may bring new officeholders with different ideas about the role of government.
What is most important to remember in their respects is that the democratic process and the constitutional arrangements that are established in a democracy determine the role and scope of the state (or central government) in economic affairs.
This makes it all the more important that the citizens become educated about economics. For ultimately they who determine economics in a democracy and a free society.
The Market System
The present paper describes the various ideas that explain how a free market system works both in theory and practice, as well as their history in Western Europe and the United states. It is neither a thorough explication nor a complete history. There are many theoretical textbooks and histories that provide a more thorough and detailed description. What we hope this paper provides is a useful introductory resource for those whose knowledge or experience in economics is limited.
Some of the ideas and terms used are the subject of great controversy and ideological debate. Indeed, one's views about the market system is often reflected in the terms that are used to refer to it. Thus, a review of some of these terms is a useful starting point, for they emphasize different aspects of a market system and different ways in which a market system works:
- Free enterprise system: The emphasis of this term is on the freedom of individuals to start a new firm in any legal industry of their choice, to compete against other firms in the industry, to keep the profits they earn or to absorb any losses they may suffer.
- Laissez-faire system (from the French words meaning "allow to do"): This term describes the belief that in a market economy, government intervention in the economic affairs of individuals and of society should be kept to a bare minimum.
- Capitalism: This label is both historical and economic in nature. In the first sense it describes the emergence and growth of the free market system from (approximately) 200 years ago, i.e. after feudalism and the pre-capitalist system of mercantilism. In the economic sense it emphasizes the important process of capital accumulation, whereby capital is used in the process of production to generate a surplus (over and above the immediate consumption needs of society), which surplus is then reinvested to increase the stock of capital and thus to increase production still further and so on for a long period of time. By contrast other "systems" (such as existed in Ancient Egypt or Imperial Rome) used whatever surpluses their economies could generate not to add to the stock of productive capital, but mainly for such non-productive forms as pyramids, temples or vast military machines!
- Free Economy: This term perhaps avoids some of the ideological connotations that "free market" or "capitalism" often carries. One advantage of this term is that it may be used with the term free society to describe a system in which the free and open exchange of goods and services between individuals is seen as enhancing political liberty.
- The market system is sometimes called the Adam smith or Smithian System. -- a fitting tribute to the first "market" economist. Smith's great book The Wealth of Nations was published in 1776, just as modern industrial capitalism was beginning. It provided the first insights into how such a system would work and why it would work more efficiently than any alternative system. Although the many technical advances made in economic theory over the past 200 years have transformed the subject, smith's original insights are still as relevant today as they were in 1776.
Adam Smith and The Invisible Hand
The central economic question then and now can be stated as follows: Absent some sort of overall central planning or direction, how can a society of millions of individuals acting as consumers find the goods and services they want in a market place that is supplied by the same millions of individuals acting as producers and working for millions of firms?
Surely the result would be chaos.
Adam Smith's argument that such a free market economy would work smoothly was based on three key insights:
- If an exchange between two parties is voluntary, it will not take place unless both parties believe they will benefit from it. [A rational human being will not exchange money for something he doesn't want or need; a rational human being will not sell something that results in his losing money. Benefit should be and is mutual, for the self-interest of one party is served through the self-interest of the second party.]
- In a free and competitive market, voluntary transactions between many buyers and sellers, each acting entirely in his or her self interest, would also make everyone better off. The individual consumer would buy just what he wanted from the range of commodities available to him; he would sell his services as a producer (or as an owner of other productive resources) in whatever way maximized his satisfaction and income; each firm would buy or rent productive services in order to maximize its efficiency and hence its net gain (or profit) from production and sale to consumers. In the process market prices for products and factors of production (labor, land, or capital) would emerge and change as conditions changed. Those changes in relative prices would in turn generate changes in the behavior of consumers and producers.
- Changes in relative prices generated by the interaction of supply and demand for products and for factors of production would automatically serve to co-ordinate the activity of millions or tens of millions of people (each seeking only his own self-interest) with greater efficiency and far better results than any central planning body could. Smith's description of how the price-system, given competition and freedom of choice, solves the economic problem without conscious direction runs as follows:
Every individual endeavors to employ his capital so that its produce may be of greatest value. He generally neither pretends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain. And he is led, as if by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it.
The Role of Prices
The invisible hand works through the price system. A modern industrial economy produces literally millions of products and services each of which has a money price. [A ton of a certain type of steel has a certain price; a pound of meat another price; and so on.] These millions of prices can be observed as many more millions of relative prices. Relative prices is what describes how individual consumers choose to spend their limited budgets. The true cost of any one purchase of product X implies a-non-purchase of product Y and vice-versa.
With a given amount of money, an individual chooses to buy certain types of foods and not others, depending upon the price and the amount of money the individual has. In a monogamous society, the choice of a spouse means not choosing all of the other possible alternatives. In an economy, it is such choices that people make which create the real costs, or the relative price.
This brings us to the fundamental economic problem: Limited resources have to be allocated among many competing uses. The statement is true for individuals, for families and for entire societies. What, how and for whom should limited resources be allocated?
The function of the price system -- i.e. the entire set of millions of relative prices -- is to provide information to buyers, sellers and producers more efficiently than can be achieved otherwise. [The other main alternative to the price system thus far has been state-controlled pricing. This system did not provide any information about real costs. In fact, the state could not know the real cost: it set prices arbitrarily.]
In a free market, any single individual does not have to worry about the entire range of relative prices in order to function effectively. Individuals and individual firms need to follow and understand only the prices and relative prices of those products and services that are significant to them as either buyers or sellers. [A pig farmer, for example, is primarily concerned about the price of land, interest rates that banks may charge, the price of food, or the relative price of other meats. He is not concerned with the price of a steel mill or iron ore.] However, for society as a whole, the pricing system in a free competitive market provides an accurate guide to all three questions that all societies must answer:
- What products will be produced and in what quantities?
- How will they be produced.
- For whom will they be produced.
The what question. Modern industrial societies are capable of producing literally millions of different goods and different services. Because productive resources are limited, everybody's wants cannot be satisfied. How should the production mix be determined and who should make these decisions?
The how question. Once the decisions on what to produce have been made, the system has to provide a way of deciding on what combinations of the various "factors of production" will be used to produce each item as well as about who should make these decisions.
The "For whom” question. How should the output of society be divided among that society's population? Should individual claims to output depend on the value of individual contributions to output? Or, should claims be independent of contributions? How should government intercede to change the way in which incomes and outputs are distributed?
History tells us that all three questions have been answered in many different ways. As we have noted, for modern industrial economies the two major alternatives have been the free market (capitalist) system and the centrally planned (socialist) system. The two systems differ along three dimensions. In the socialist system the bulk of the decisions on what and how to produce are made by the state; the means of production are also generally owned by the state and central planning generally prevails. By contrast, in the free market system where individual decisions by consumers determine what is produced the means of production are for the most part privately owned and controlled and market processes take the place of central planning.
How Does A Free Market System Adjust
A key concept in economics (borrowed from physics) is that of equilibrium. In economics it refers to a state in which, at existing prices, the demand for products and for the factors of production (remember: labor, land and capital) are just satisfied by their supply.
The concept of supply and demand allows us to analyze how and why a disturbance to a state of equilibrium sets forces in motion that will return the system to a new state of equilibrium. -- [Just as liquid in a glass when disturbed returns to a state of equilibrium or rest.]
Assume that the original equilibrium is disturbed by a change in technology, for example, by the invention of a better or less expensive machine to produce textiles. This invention will induce some producers, seeking their own self interest, to substitute such machines for some previously employed labor. [People who used to work for that textile factory will no longer have a job.] The system is no longer in equilibrium.
But that is not the end of the story. The use of the new machine will increase the productivity of the firm, reduce the cost of producing each unit of the commodity, and increase the firm's capacity to produce more.
With lower costs, a competitive firm can and will lower the price it charges in order to increase both its total share of the textile market and its total profit. The new lower price for this textile will induce consumers to buy more of clothes (in total). Alternatively, it will leave consumers who do not choose to increase their purchases of more clothes to buy more of some other commodity.
In either case the demand for labor will increase again because of the demand for more commodities and thus re-absorb the workers displaced by the original change in technology at the textile plant. In short, the economy will return to a new equilibrium that offers a higher level of total production per worker than existed in the original situation.
Using the kind of logic just illustrated, Adam smith and the classical economists who followed and enriched his arguments, showed how individual self-interest, working through the forces of supp1y, demand and price enables a free-enterprise free-market economy to resolve the basic economic problems> of the total social economy without the aid of any central plan. [Total wealth is increased, and individual wealth is increased. The efficiency of the system is based on self-interest, as Adam smith described in the quotation above. Producers want to earn more profit; consumers want to buy the best products at the best prices possible.]
The Advantages of a Free Market
In addition to showing how a free market economy would work, smith and his successors argued that a market system offered three very important benefits for the society.
First, the consumer rather than the state or its bureaucrats would determine what an economy produces and in what quantities. (This is referred to as consumer sovereignty). It is as if each time a consumer buys a particular product or service he is casting a vote for that product by the use of his money. Clearly it is in the producer's interest to pay close attention to the collective votes cast by the society they serve, [just as candidates for office are concerned with the total number of votes they receive.] This is something that cannot be said of most bureaucracies!
Second, the system would use economic resources more efficiently because it automatically ensures that each factor of production (labor, land and capital) would be utilized at its highest possible value to society i.e. its market value.
Why is the proposition justed stated a correct one? First, look at it from the point of view of the factor of production -- for example individual human beings:
If the "market" offers a person several alternative opportunities to work, would not a rational person who is free to pick the one that suited him best? Generally, the job he would pick would be the job that offered him the highest pay --by definition that would be the job that had the highest market value to society.
Alternatively, let us look at the firm which fulfills that task of using factors of production. Clearly, any firm that tries to use a factor that is worth (and therefore priced at) 10 money units an hour in a productive process in which its contribution is only 5 money units an hour will soon find that it is losing money.
In both situations, pure selfish interest of the worker or the firm, will prevent less than optimal usage.
Finally, without a central planning agency or government telling people what to consume, where to work or what to produce, the free market system offers all citizens a degree of personal freedom that cannot be matched by any centrally dictated economic system. [People are "free to choose": free to buy certain products, free to invest money, and relatively free to seek particular employment or careers.]
The Role of Government in Market Economies
Although Smith was a proponent of a laissez-faire economy -limiting government to a bare minimum -- he did not suggest that there was no role for the national or local government to play. There was a very important -- although confined, in Smith's view -- role for government.
One role was to ensure competition in the marketplace, both in the market for goods and services as well as the market for factors of production (labor, land, and capital).
Competition among producers of a particular product is a critically important element in the proper functioning of a market system, because it leads to the lowest possible price of that product for the consumer. By contrast, if all the producers of a particular product were allowed to get together and agree not to compete with each other, they would essentially become monopolies (meaning a "single" seller) and would be free to set prices for their product; prices that would be well above their true costs.
Because the "self interest" of producers, if uncontrolled by the law, would lead them to "collide" with each other, most market economies have had to enact laws that prevent such collision.
In the U.S. for example, laws enforcing competition and seriously punishing offenders were enacted at the end of the 19th century. These laws are still in force and are actively enforced.
A second role for government was to provide "public goods and services" i.e. goods and services that only a government can provide in a society of free individuals. These include the common defense (military); the administration of law, order and justice; as well as such social goods of the kind that no person or firm would finance because their services would or should be publicly available -- such things as roads and highways, navigational aids and various public facilities.
In the end the role of government would not be limited to these confined areas. Adam Smith's view was laissez-faire; others would argue a different view of government and free markets as the consequences of the industrial revolution were felt. Previously, the role of the state prior to constitutional systems of government was absolute and directed.
The state provided the impetus for much of the economic growth of Europe (for example, through trading companies, financing of shipping expeditions, control over gold and other commodities of exchange, and through military campaigns).
The onset of the free market economy broadened the role of the individual producer, and the individual worker, and thus changed the role of government in the economy. Here, the development of democratic systems of government also contributed heavily to the economic debate. The description below shows some of the ideas at work in the United States. But these ideas would have a similar battle in other countries where the free market took hold, notably in Europe.
The Impact of the Smithian Economy: The Case of the United States
Smith's book was both a revolutionary manifesto and the rationale for the system of free market capitalism that blossomed so well in much of Europe and North America after the Napoleonic War.
As smith predicted, even before the coming industrial age really began, a political-economic system of free markets and free individuals who are freely allowed to specialize in what each does best and who are allowed freely to exchange the products of their work -- all this did lead to impressive economic growth and progress for society as a whole. Such growth was most impressive in countries that adopted or seemed to adopt his ideas.
And it has come to be most notably identified with the United States, where the role and share of the central government in economic affairs (i.e., the government's power over the annual national product) was among the lowest in all the industrial world from 1776 to 1936.
Although the political-economic system practiced in the U.S. prior to 1936 appeared to fit Smith's model closely, the small role played by the federal government in the economy was the result of the u.s. constitution -- man's first and thus far most lasting attempt to define, in writing, the proper relationship between a government and the individuals by whose consent it governed. It is important to review how the U.S. constitution affected the role of government in the economy and how this was interpreted.
Section 8 of Article 1 of that document gives the Congress the power to collect taxes "to pay the debts and provide for the common defense and general welfare of the United States. . ." The very long sentence goes on to explicitly enumerate the specific types of economic and other purposes for which the U.S. Congress could spend money.
In essence it said:
…To regulate commerce with foreign nations and among the states.
…To establish uniform laws on the subject of bankruptcies.
…To coin money, regulate the value thereof and of foreign coin.
…To establish post offices and post-roads (i.e. highways).
…To raise and support armies.
Aside from all the specific items enumerated, was the phrase "to provide for the general welfare" an explicit purpose for which the government could impose and spend taxes? [Could the "general welfare" be interpreted to mean anything that society considered to be in its welfare?] Or, alternatively was "the general welfare" simply meant to describe all of the specific purposes that are explicitly enumerated in the rest of the sentence? This' was no tiny semantic quibble. [It determined whether the individual states could control its own commerce and production.]
On its outcome hung the history of what was to become the world's largest economy.
Debate on the issue was joined in 1791. James Madison, the prototypical conservative, argued for the narrower interpretation [on the grounds that the federal government should have limited powers]; Alexander Hamilton, the prototypical interventionist, argued for the broader interpretation and the much wider spending powers it would give the federal government [on the grounds that this would enhance wealth and production.] Madison won that debate. That outcome did as much as Adam smith's economic philosophy to keep down the role and share of the U.S. government in the economy for the next 140 years.
Although the government did act in many cases (for example - offering land to individuals for sale) and various sorts of welfare legislation were enacted, federal government expenditures "to promote the general welfare" remained insignificant until the 1930's.
In fact, in 1929 total federal spending, including defense expenditures, amounted to just $3 billion or less than 3 percent of U.S. gross national product in that year. All this changed in 1936.
The Free Market and the Keynesian Revolution
The Smithian system has been criticized in two major ways. As Keynes put it in his celebrated 1936 book known as the General Theory:
"The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of income."
The idea that a self-regulating economy would automatically return to a new equilibrium (with reasonably full employment of all productive resouces, including labor) had been challenged early in the history of economics, but each challenge including that by Marx had been shown to be unfounded. Until the 1930's the theory of a self-regulating market economy (and hence a "hands off" policy by government) had been upheld apart from the transitory phenomenon of brief business cycles.
Likewise the fact that different human beings had vastly differing skills and resources and hence earned very unequal shares of the national income in a free market economy was until the 1930's accepted as a small price to be paid for the far greater efficiency of the system. In this perspective, with the growth produced by an efficient market system everybody's income level could rise over time and thus everybody could expect to be absolutely better-off even though inequalities might persist.
After 1929, this was more difficult to argue. The U.S. and other industrial nations fell into a deep and prolonged economic recession from which a spontaneous and automatic recovery as envisaged by the Smithian system did not take place. The recession lasted so long it came to be called a "Depression." In the U.S. the 'dollar value of annual output (the gross national product) fell to one-half its 1929 level by 1933; the rate of unemployment rose to 25 percent of the labor force; half the nation's banks had been closed as insolvent; the unemployment rate averaged 20 percent for the entire decade. [And it was not only in the U.S. Such prolonged economic distress resulted in political turmoil throughout Europe. The collapse of the Weimer Republic of Germany is of course the leading example in Europe. The question arose: How to set things right again? But the first issue was a theoretical one: Why had things gone wrong?
Keynes' General Theory provided an explanation for what had happened: According to Keynes, Smith's laissez-faire no-intervention economy worked well for most of the time but not all the time. At particular times such as the early 1930's, a lack of aggregate demand in society could cause supply to fall; that fall in turn would reduce the level of employment and people's incomes, leading to a further fall in aggregate demand and so on in a vicious spiral. To use our earlier analogy, when a glass of water is tipped over, the subsequent "equilibrium" is found at a much lower level.
Keynes conclusion was that the self-equilibrating mechanism of a market economy could fail and that when it failed the only available cure for the disease of a downward spiraling economy was for the Central government to intervene with the express intent of raising aggregate demand artificially.
This could be done either by raising government spending sharply (without raising tax rates) or by cutting tax-rates (without reducing spending) or by both means. In short, the government would run a deliberate deficit in its budget (financed by borrowing) in order to stimulate demand.