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Markets, free-markets, and government
The terms "capitalism", "markets", "free-markets", and "free-enterprise" are often invoked in discussions about the role of government in society, yet they often produce more confusion than enlightenment. The term "capitalism" means different things to different people. People who favor large government think of capitalism as a system where the rich control everything and they acquire that control by bribing politicians (or something resembling that). Those who prefer a limited government think of capitalism as a system where individual engage in voluntary trade with one another, trades that benefit both the buyer and the seller.
The vast majority of economists use the latter definition of capitalism, and so do I, but in this article I avoid the word and rely on the term "markets" instead.
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"Capitalism" is the epithet that 19th-century collectivists foisted on the economic system of private property and the invisible hand. It's a name that wins no friends for the cause of enterprise. A socialist, supposedly, cares for society. A capitalist ostensibly loves only his stocks and steel mills and strikebreakers. The PR battle was almost lost at the naming.
—Grant James. June 9-10, 2012. "A Cure for What Ails Us." The Wall Street Journal. C5. |
A market (without the "free" in front of the word) refers to any environment where people come together to engage in voluntary trade. The stock market is a market. A livestock auction is a market. The food market in a small town may consist of two or three grocery stores, but it is a part of a nationwide food system, and even an international market for food.
A market becomes a free-market when government is active in protecting people's property rights, enforcing contracts, and punishing bad behavior, but does not influence the prices buyers and sellers negotiate, nor restrict their choices. Buyers purchase only what they wish to purchase, at a price they negotiate with the seller. Sellers acts voluntary as well, and this "negotiation" of price can occur indirectly, like when you react to a price in Wal-Mart by purchasing or not purchasing the good. If consumers do not buy a highly-priced item in Wal-Mart, causing Wal-Mart to lower its price, we describe this interaction as a negotiation.
If the government forces you to buy health insurance, yet gives you a choice over whom to purchase insurance from, health insurance is still a market but is no longer considered a free-market. When government subsidizes food production there still exists a market for food, but again, we would not refer to it as a free-market because subsidizes essentially force you to purchase food you would not normally buy.
A free-market is then not a market in the absence of government, as free-markets cannot exist without government, but a market with a good government.
The POW market—a metaphor for all marketsRadford was a prisoner-of-war (POW) during World War II, spending most of his time within one company of 200 prisoners. Rations were provided to them by the Red Cross, and given to each individual in identical food parcels. Among the food items were tinned milk, jam, butter, biscuits, bully, chocolate, sugar, and importantly, cigarettes. The parcels given to each individual was the same, but of course, not every prisoner had the same tastes.
Although certainly appreciative of their parcels, the prisoners sought to improve their food rations by trading the foods they liked the least for foods they liked the most. Fortunately, differences in tastes allowed hundreds of mutually beneficial trades to occur. With every trade, both individuals were better off— else they would not have traded.
Video 1—Hear a World War II POW Express His Gratitude
for Red Cross Rations
At first they traded through barter, where someone who wanted to trade biscuits for chocolate must find someone who wanted to trade chocolate for biscuits. This is referred to as a double-coincidence-of-wants, which naturally made trading rather inefficient. Imagine if you did not have money, but instead had to barter for everything you needed.
To avoid the double-coincidence-of-wants, money was needed, and the POWs developed their own system of money in the form of cigarettes. Cigarettes were an item virtually every prisoner wanted. All cigarettes were alike (and thus of equal value), were durable, and were portable. Now, to trade biscuits for chocolate one only had to find someone who would pay cigarettes for your biscuits (which was easy, since everyone had cigarettes) and another person who would accept cigarettes for chocolate (which was easy, since everyone wanted cigarettes).
Video 2—Red Cross Rations in Movie Stalag 17(S1)
(must use Internet Explorer)
There were even exports and imports. Coffee was relatively cheap in the POW camp, so some prisoners mailed it to black-market cafes in Munich which offerred high prices. Some prisoners received packets of items bought cheaply elsewhere which could be sold for a high price in the camp.
Another market innovation was middlemen. Contrary to the stereotype, middlemen add value to a good by taking it from one person, place, or time and moving it to another with a higher value. If a man makes food more tasty by adding a spice, thereby increasing its value, we believe he should be rewarded. But if a middleman moves watermelons from a region with low prices (due to a surplus) to a region with high prices (due to a shortage), we call him a speculator, which has a negative connotation. Why? The middleman took watermelons from a region with too many and shipped it to a place with too few watermelons. How is that not beneficial to society?
The middlemen in the POW camp spent considerable time learning foods men liked and didn't liked, and would buy certain foods from one person and sell it to another person for a higher price. This is akin to locating a gas station at a busy intersection. This buyer would not have made the purchase if it did not make him better off, and the same goes for the seller, so the middleman profited while also benefitting the buyer and seller. Are wholesalers and food retailers in our modern world any different?(R1)
By trading, and especially by trading with cigarettes as money, the prisoners still had the same total amount of food, but each person's happiness was increased. The prisoners received something for nothing—the hallmark of markets.
How markets work, and why they work wellThe market for food at the POW camp was a real market in that individuals engaged in the voluntary trade of property, yet it can also be used as a metaphor for all markets. For instance, if a cattle producer buys corn to feed cows, and then sells those cows in a market, is that a "good" system? Or, should we prefer something closer to the collective farms in the Soviet Union? We all know the answer, but few of us can explain why.
Russia experienced famines during the days of the Tsar. In fact, those famines were part of the reason the Tsar was killed. The Communist government that replaced the Tsar had even more problems with famine, and part of the reason is that peasant farmers were not allowed to make money from their harvests, so it is not surprising they grew so little.(G1,R2) Markets would have allowed farmers to make money, while competition between farmers would have kept prices low for consumers. The Soviets had little fondness for markets though—to their own detriment.
Figure 1—Famine Resulted From
the Soviet Union's Collective Farms(R2) Soviet collective farm.png)
China was also punished for preventing markets.When Chairman Mao seized power of China in 1949 he began establishing collective farms modeled off those in the Soviet Union. By 1959 millions of Chinese were starving, and so many were too weak to plant crops that the famine continued in 1960 and beyond. Like the Soviet Union, farmers were forced to sell all their crops at very low prices to the government. So low the prices were that peasant farmers had no incentive to plant much, so they did not plant much, which meant there was not much to eat.(S2)
In both the Soviet Union and Communist China scores of people starved because the government would not allow farming to be a profitable business. All they had to do was allow farmers to sell their crops in a market where they negotiated prices with sellers, but they didn't, because they did not how markets work and why they work well. Indeed, China eventually came to understand that wealth cannot be generated in the absence of markets, and today its economy has a large capitalistic component, even though the government itself is communist. Ponder that: even communists today love markets!
This still doesn't tell us why markets work. That explanation is below.
Free-markets—a system of equality (in rules, not outcomes)Free-markets take place in a system of equality for all. This doesn't mean that everyone has the same income as everyone else, for outcomes can be very unequal. Each person is viewed equally in the eyes of the law. A society cannot have both equal rules and equal outcomes; it must choose which one will be given greater priority. In modern, capitalistic democracies, equality of rules is the preferred.
Free-markets—everyone must give to receiveIn the real-world there is a limited amount of resources, so there must be some system for deciding who gets what. Free-markets allow any one person to take a certain amount of resources from society so long as they can return to society something of equal or greater value. This happens all the time in markets because every exchange makes both the buyer and seller better off. In the POW camp both John and Sam are given the same parcels of rations, containing equal foods. John gives Sam milk in exchange for chocolate, and by doing so John took something from society (Sam) and gave something of greater value (Sam makes the exchange because he values milk more). Likewise, Sam took from society (John) and gave something back of greater value (John values chocolate more).
Similar exchanges take place in cattle production. Heather buys $100,000 worth of inputs from society (hay, corn, seed, fuel, etc.) for use in cattle production. Her objective is to make profits, and when she sells the cattle for $150,000 she returnes to society something of greater value—she took $100,000 of inputs and returned more than $150,000 worth of cattle. Note that buyers would not have paid $150,000 if they did not value the cattle more than $150,000, so they benefit also. This was no act of altruism, for Heather earned $50,000 as a reward for her efforts.
A natural consequence is that people can become very rich in a free-market system, but only by providing riches to society. Americans have handed an astounding amount of money over to Bill Gates, but we got something in return. Every person who purchases Microsoft software does so because they value the software more than price. Gates cannot make riches unless we buy he product, but we buy his product only if he gives us something better than his competitors. For every dollar of wealth Gates earns, he gives society riches also. So unless someone earns their wealth dishonestly, they acquire take so much from society because they gave society even more.
For years the U.S. federal government has administered a government-run health program for the elderly, war, and veterans, and typically pays doctors according to the costs the doctors incur. Because the government pays the bills the doctor often treats their patients poorly, providing them poor service and performing unnecessary procedures. In 2012 the government set about correcting this, and began a system where doctors are paid based on the patient's satisfaction with their experiment, as indicated on a post-procedure survey. Patients who rate hospitals poorly cause those hospitals to receive smaller payments for their services. In a way, the government was attempting to do what comes naturally to markets: the more a consumer likes something, the more they will pay. Immediately, hospitals began programs where they taught doctors not to interrupt patients as they spoke, gave nurses mobile phones where their patients could reach them quickly, started providing ESPN on the television, and added wild salmon to their menus. Markets work so well because they require a person to provide value to other people before that person gets paid. Markets allow someone to make money only by enhancing the lives of others.(A1)
Free-markets—using resources to their greatest valueWe can make the previous assertion even more specific. A person is allowed to take resources from society so long as they can return something to society of greater value than anyone else. When Sam is looking to trade his chocolate for milk he seeks the person who can give him the most milk for his chocolate, and if he makes the deal with John it must be because John offered more milk than anyone. When Heather buys $100,000 of inputs it must be because she valued the inputs more than any other potential buyer, but the only reason she would value inputs more than others is if she could create more value from those inputs.
The assumption of no externalitiesThroughout this analysis, it is assumed that no third-party is made better or worse off from the transaction between the buyer and seller. When John and Sam trade, that trade does not affect anyone besides John and Sam. With this assumption, we know that if both John and Sam benefit from a trade, the prisoners as a whole are made better off.
In cases where a firm creates pollution when they produce a good, that pollution affects third-parties and we can no longer say that markets work well. These are the instances when we should consider greater government involvement, but at the same time, involving a bad government can make matters worse.
Hong Kong's GiftOpium was the best thing to happen to Hong Kong. The British Empire had been selling opium it grew in India to China, but in 1839 the Manchu Empire (ruler of China at the time) saw what opium did to its people and ordered a ban on opium imports. Britain would have none of that, and as it waged war and approached Beijing with its cannons—Britain was far mighter than any nation at the time—the Manchus negotiated for peace.
The negotiator on behalf of Queen Victoria was a man named Charles Elliot, and he agreed to peace if China would cede the island of Hong Kong to Britain, which would begin to return it to China in 1997, resulting in a complete handover in 2047.
There was little special about Hong Kong. Queen Victoria was shocked to learn that Elliot settled for so little. The island did have deep channels around it, but no one would have looked at Hong Kong and believed it had the capacity for riches. It was populated by the same people and culture and Hong Kong, so if it had stayed a part of China it would have roughly the same per capita income as the rest of China.(P1)
Although Hong Kong is much wealthier than China today, it isn't because Hong Kong has valuable natural resources, but because the free-market system Britain established was so successful. This system wasn't established immediately. It's foundations were established by Sir Cowperthwaite, who arrived in 1945 and later became the Financial Secretary. Cowperthwaite believed in an economic system with maximum individual freedoms, strong property rights, and a minimalist government. It taxed income at very low rates (15%), refused to subsdize the production of anything, and its regulations on economic activity were tempered by a faithful devotion to free-markets. To many modern-day Libertarians, Hong Kong is one of the very few regions to administer something akin to a Libertarian society.(M1,C1)
In 2012, it was considered the freest nation in the world in terms of economic freedoms. The figure below shows that although Hong Kong is but a small dot on the map, its total income relative to China is surprisingly large. What is more impressive is the per capita income, where Hong Kong overwhelms that of China. The ability of people in Hong Kong to interact with each other in markets for one win-win exchange after another made Hong Kong one of the most successful nations in the world. Had the Opium Wars not occurred, Hong Kong would have remained part of China, would have been strangled by the communism that held mainland China back for so long.
Figure 2—China and Hong Kong(E1) Hong Kong Versus China.jpg)
A picture is worth a thousand words
The ideal experiment for contrasting communism and markets would be to take one region with the same people and culture, split it in half, prohibit any person or good being exchanged, and have one society be a market-based system and the other society communist.
Indeed, that experiment was forced on a region: they are called North and South Korea. The only countries where communism really survives are China, North Korea, Vietnam, and Cuba, though it is hard to call China purely communist, given it now allows its citizens to own property and run businesses for profit. South Korea, on the other hand, flirted with something close to socialism after the Korean War, but has since mimicked America in its reliance on private property and free trade in market. The results are stark, and are best seen in the photo of Korea below. Taken from a satellite at night, the bottom region with all the lights—an accurate sign of economic prosperity—is South Korea. What better indication of the prosperity markets provide?
Figure 2—China and North Korea
From Space Picture of N and S Korea at night (2011).jpg)
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The failures of Communist economic policy had the most tragic consequences in agriculture, the basis of the economy of nearly all countries subjected to Communist rule. The confiscation of private property in land and the collectivization that ensued disrupted traditional rural routines, causing famines of unprecedented dimensions. This happened in the Soviet Union, China, Cambodia, Ethiopia, and North Korea; in each country millions died from man-made starvation. In Communist North Korea as late as the 1990s, a large proportion of children suffered from physical disabilities caused by malnutrition; in the second half of the 1990s, up to 2 million people are estimated to have died of starvation there. Its infant mortality rate is 88 per 1,000 live births, compared to South Korea’s 8, and the life expectancy for males 48.9 years, compared to South Korea’s 70.4. The GDP per capita in the north is $900; in the south, $13,700
—Pipes, Richard. 2001. Communism: A History. Modern Library. |
Our wealth is derived from better technology in free-markets
Markets allow a society to create the greater value from its resources than any other economic system. We have basically the same resources as our grandparents, but we are much richer because our technology allows us to transform those resources to more valuable things, and our economic system rewards innovators. Like you, your grandfather also had natural gas beneath his feet, but didn't have the fracking technology to acquire much of it. That technology was developed not out of love for you or a desire to keep your heating bill low, but out of a pursuit for profits. Markets allow someone who can extract gas cheaper to sell it in the market and make handsome profits, and that is exactly what happened. The inventors of fracking benefitted, but so did everyone in the form of lower energy prices.
Everyone knows that the wealth of the modern, democratic world is derived from science and technology, but we often neglect the role of markets in encouraging innovation and distributing its benefits across the population. These markets allow us to produce a variety and quantity of goods we could never produce ourselves. In fact, we hardly have any idea how most of the goods we consume are made. Just look at a pencil or a smartphone, and think about all the different businesses and people who must cooperate in order to produce that pencil / smartphone, people of varying specialties, industries, regions, ... I could go on and on. They don't work hard and cooperate with each other out of love, though they are mostly loving people, they do so to earn profits, for they acknowledge that they have a moral right for compensation for what they do, and they can only make more money if they produce a better product for you. Self-interest may seem an ignoble emotion, but it leads to magnificent outcomes: like the smartphone. Watch this short video about smartphones, and try to appreciate what wonders the pursuit of profits through markets provides.
Video 3—I, Smartphone
If this description of markets sounds like a series of win-win interactions, you understand markets. When people cooperate through markets, they can only take from others by giving more back. An ancient Roman farmer borrows a bushel of wheat seed, and after the harvest repays the lender more than she borrowed while also keeping some wheat for herself. A Scandinavian fisherman rents a boat, catching enough fish to pay for the rent and make a little profit. Bill Gates borrows obscene amounts of money from investors to develop his software, and the money he makes gives his investors a handsome rate-of-return, enhances the lives of billions of computer users, and makes Gates the richest man in the world.
We must appreciate the role of markets in creating the freest and wealthiest nation on earth. Communist Russian and China failed to understand this, to the determinent of millions. Before the eighteenth century people largely thought there was only way route to riches: to acquire political power and oppress the subjects. That is a zero-sum game, where one person must lose money for another to make money. I don't know about you, but the positive-sum games of markets sounds better to me.
References
(C1) Craig-Bennett. July 19, 2010. "JJ Cowperthwaite and the Hong Kong Economic Miracle." Gwulo: Old Hong Kong. Accessed August 16, 2012 at http://gwulo.com/node/6190.
(A1) Adamy, Janet. October 15, 2012. "U.S. Ties Hospital Payments To Making Patients Happy." The Wall Street Journal. A1.
(E1) The Economist. 2010. Pocket World in Figures. Profile Books Ltd.
(G1) The American Experience. April 11, 2011. The Great Famine. PBS.
(M1) McGurn, William. August 14, 2012. "Go for Bust, Mr. Romney." The Wall Street Journal. A13.
(P1) Paterniti, Michael. June 2012. "Hong Kong: In China's Shadow." National Geographic magazine.
(R1) R.A. Redford. 1945. "The Economic Organisation of a P.O.W. Camp." Economica. 12(48):189-201.
(R2) Picture from YouTube video, "Russian Revolution - Collectivisation," accessed June 6, 2012 at http://www.youtube.com/watch?v=FcumJNNX0qc
(S1) Stalag 17. 1953. Director: Billy Wilder. Writers: Billy Wilder, Edwin Blum, Donald Blevan, and Edmund Trzcinski. Producers: William Schorr and Billy Wilder. Production: Paramount Pictures, et. al.
(52) Standage, Tom. 2009. An Edible History of Humanity. Walker Publishing Company.
