Let’s talk about what the free market is, and isn’t. For some, the phrase conjures up an image of borderline anarchy, of everyone doing what is right in his own eyes, and unrestrained abuses flying in all directions under the guise of freedom. For others, it is contrasted against the image of the breadline or the welfare office, a place of relief from helpless regimentation. If we start at the most basic level of human exchange, the free market merely means that if you and I both have things that the other one wants, no third person comes between us and prevents us from exchanging on whatever terms we both agree to. Neither is it a free market transaction if one of us violently forces the terms on the other against his will; we may agree with distaste, but we voluntarily agree. This simple formula of voluntary agreement is the spring of virtue in all free market systems, and from this humble brick all the monuments of Capitalism are built.
How is it possible that such an obvious little act as voluntarily exchanging the goods you have for those you want become a seed of the truly vast achievements we trace back to it? Let’s say you and I don’t simply have the goods we want to exchange, but do both have the capability to produce a number of things which either or both of us might use. It could be two neighboring farms of differing characters, two companies with differing human and capital resources, or even two prehistoric men who may dedicate their time and effort to any combination of caveman activities such as hunting, constructing shelter, making clothes, seeking fulfillment, etc. The points to recognize are first that the two parties in the exchange are necessarily different: if we both were identical we would be identically able to produce identical outputs, and would have identical resources to do so and thus no incentive to trade. The second point is that once the possibility of benefit by exchange has been recognized by the parties, it begins to shape their decisions; the essential result will be me asking myself, “Will it be easier for me to produce my needed corn myself, or to produce additional pork and trade for it?” And this is a subject I know a great deal about. I know exactly how much I enjoy eating corn, I know exactly how much I hate harvesting it, and I know exactly how much of my resources and effort are consumed in the alternative scheme of producing pigs for trade. This is a simple point but one that ended up being the unexpected scourge of Socialism. Communist planners’ great embarrassment was the huge line of people stretching down a sidewalk, waiting in hopes of receiving say, a refrigerator, while piles of shoes sat in warehouses unused. The Socialist thinks he knows reasonably well how much people like consuming shoes or corn, and he thinks he knows how much effort and resources they are willing to give up to get them. But empirically, his rational efforts have a hilarious history of failure when compared to the seemingly-confused jumble of negotiations that make up shoe sellers and shoe buyers and corn sellers and refrigerator buyers and pork producers all trying to work out among themselves a series of separate bargains. The historical recognition of this is critical: ask anybody who lived in the Eastern Bloc, there is no statistic that can illustrate the failure of central planning as simply as the vast unanimous sigh of relief that came up when Communism lifted off of Europe.
How is this possible? How can a single intelligence, possessing far more information about the economy as a whole than any other, end up producing both shortages and gluts far in excess of those produced by swarms of haggling peasants who know virtually nothing about any goods save the ones they hold and the ones they purchase? The answer is truly fascinating, and is the subject of much excellent work by economists, particularly Friedrich Hayek, who described the price mechanism as a coordinator of the economy. He saw that if a buyer comes to the market to purchase goods, he prioritizes the things he wants to buy vs. the amount of money he is willing to spend. Thus, while in any particular transaction, say, the purchase of pork, he may only be negotiating the price of pork with the butcher, but he is also determining what he is willing to spend on corn. The way he negotiates each bargain signals to the seller how highly he prizes that particular good within the entire market. Thus, if a seller finds many buyers willing to purchase his goods at a high price, it acts as a signal that his goods are dear in comparison to the other available goods. If, on the other hand, he is unable to sell at a high price and is forced to give ground on his negotiations in order to sell his goods at all, it is a signal that his goods are relatively low in the scale of priority. But this supply and demand exchange of signals does not affect mere static actors in a free market. When prices for pork are high, it signals not only those who are selling pork that day, but all who could potentially produce it, that pork is dear. High prices draw new suppliers into the market for a particular good, obviously. They also drive out buyers, as customers who had a relatively low desire for that particular good decide that they would be better off doing without, or purchasing something else.
This pulling-in or driving-out of sellers and buyers is one of the most fundamental ways the free market outperforms the smartest possible central planner. It is not based on statistics or estimates, it really relies on the fact that what a person is willing to give up (pay) in order to receive something is the most accurate measure of how much he values it. If you tried to learn by interrogation how much a man valued an apple, a book of poetry, a claw hammer, and a mousetrap, he could be the most cooperative subject in the world, and still give you a rather vague and useless idea of his estimates of these things. But the decisions he makes in negotiation with sellers work to sharpen his vague opinion, and through the competing upward (from the seller) and downward (from the buyer) pressure on the price, we end up arriving at a number that really does represent the value of the product to the consumer. And by making explicit this number (“The price of pigs today is…”) we make available to others information we barely knew we had ourselves; we make it possible to really precisely know how badly a crowd of people wants bacon. In all the social sciences there is no expression of an internal reality that compares to Price, either in accuracy or publicity. In no other case do we have a numerical yardstick for the desires that exist only inside the minds of of a mass of men. Shakespeare cannot tell us with more fine-grain detail what he thinks of an apple than can a buyer of an apple. And this incredibly expressive act, of agreeing on a price, is the act which produces all the signals that are used by the other buyers and sellers to coordinate their own efforts to provide things that others will want to enjoy.
Thus we see that far from being a confusion, the village market is actually looking through a much clearer lens than is a central economic planner. The Socialist manager is looking at statistics, he is looking at charts and things that somebody has carefully counted and tried to exhaustively research. By comparison, the villagers are looking directly into each others’ hearts. Their data is necessarily less complete in regards to the whole, but in regards to their partner in each transaction, it is tremendously more accurate. And as it turns out, each seller understanding each buyer is infinitely more useful than any one man half-understanding them all. For what is even more remarkable than the penetrating vision of the price system, is its power to marshal the resources of humanity to provide what other humans most desire. Ron Paul describes this function lucidly, contrasted against the error of central planning in a disaster:
In the wake of Hurricane Sandy, the supply of gasoline was greatly disrupted. Many gas stations were unable to pump gas due to a lack of electricity, thus greatly reducing the supply. At the same time demand for gasoline spiked due to the widespread use of generators. Because gas stations were forbidden from raising their prices to meet the increased demand, miles-long lines developed and stations were forced to start limiting the amount of gasoline that individuals could purchase. New Jersey gas stations began to look like Soviet grocery stores.
Had gas stations been allowed to raise their prices to reflect the increased demand for gasoline, only those most in need of gasoline would have purchased gas, while everyone would have economized on their existing supply. But because prices remained lower than they should have been, no one sought to conserve gas. Low prices signaled that gas was in abundant supply, while reality was exactly the opposite, and only those fortunate enough to be at the front of gas lines were able to purchase gas before it sold out. Not surprisingly, a thriving black market developed, with gas offered for up to $20 per gallon.
With price controls in effect, supply shortages were exacerbated. If prices had been allowed to increase to market levels, the profit opportunity would have brought in new supplies from outside the region. As supplies increased, prices gradually would have decreased as supply and demand returned to equilibrium. But with price controls in effect, what company would want to deal with the hassle of shipping gas to a disaster-stricken area with downed power lines and flooded highways when the same profit could be made elsewhere? So instead of gas shipments flooding into the disaster zones, what little gas supply is left is rapidly sold and consumed.
People object to this notion of allowing gas to reach such exorbitant prices, because it initially appears that it will prevent those with limited means from being able to purchase. However, this overlooks two other important points. First, the benefit of an arbitrarily low price is arbitrarily distributed: that is, the little old lady who cannot afford to buy gas at $20 a gallon is no better off under price controls, unless she manages to be first in line. A shortage is a shortage, there is no way to avoid the fact that if we do not have sufficient supply for all needs, some needs will go unsatisfied, price controls or no price controls. The central planner in this case merely converts the market to a lottery, where the first man in line gets all the gas, rather than (as he would put it) the richest man in line. But that brings us to the essential issue of alleviating the original shortage through the coordinating function of the price system. $20 per gallon is a shout for help, sent not through political channels but through economic ones, and the economic shout is actually harder to ignore. Imagine, say, that you lived some miles from the disaster zone that Dr. Paul mentioned. With price controls in effect, you do see the plight of all those people on the news, and you’d certainly like to help them, but even the most noble people can only dedicate their disposable income and their disposable time to the relief effort. You work all week at your job, pay your rent and buy your family groceries, and whatever money is left over you can give to the Red Cross, and whatever time off you have after your work week, you can go volunteer at the relief effort. Most people will do less than this, but virtually none can do more. But consider what Ron Paul was saying about the profit opportunity bringing in new supplies. He is not just referring to the great motivation that high price will provide to the oil companies themselves, who are clearly losing out on sales every day the pumps are shut down, but also you, as a neighbor of the disaster zone. If gas went up to $20 per gallon two towns over, how many people would load up their pickups or rent trailers or do whatever they had to in order to get gas out there and sell it? The supply would be vast. The risks would be worthwhile. The costs of taking time off of work or re-tasking commercial fleets of vehicles to deliver fuel would be obviously justified, in light of the potential returns. With price controls in place, the only resources available to help those in the disaster zone are the time and money people would have spent on leisure, or what they had to spare after looking out for their own families. Without price controls, however, the whole vast machine of the economy, the entire work week, not just the weekend, is redirected into the relief of the terrible need that has provoked the spike in prices. And it has marshaled this massive array of resources and manpower without in the slightest detracting from what voluntary charity can do as well. That is the essential power of the price system: its call never goes unanswered. And thanks to its direct connection to the desires of the heart, the needs it signals are never imaginary. In spite of the police powers which Collectivist states employ, the market not only organizes production more precisely in line with demand than can Collectivist planners, it also brings about this organization more effectively than does the most ruthless police state. Friedrich Hayek, who built and destroyed his career in economics trying to teach the effectiveness of the price system, and its superiority as a coordinator of free agents to the coordination of a planned economy, heaped praise on the price system as if it were a monument of human ingenuity:
The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or “normal” level.
I have deliberately used the word “marvel” to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.
What Hayek is talking about is a more real-world analysis of the economic problem of scarcity. He gives an example earlier in his essay where somewhere in the world, some unknown event has caused tin (chosen at random) to be less available, either because of a mine failure, or the discovery of a new, profitable use, or really anything that will detract from the previous availability of the resource. He emphasizes the fact that though only those immediately concerned (the owners of the failed mine or the new consumers who are buying up all the tin to make better light bulbs, or whatever it may be) are even aware of the circumstances that have reduced the world’s tin supply, the price mechanism transmits a signal to all the users of a resource that effectively influences them to consume less. The lost mine or the tin that has been suddenly bought up to make light bulbs will be expressed in a higher market price for tin. The higher price will drive buyers out of the tin market who find a cheaper alternative for their own use, and an overall economization of tin will result. He wishes us to weigh this result not against the imaginary planned economy of a Collectivist Utopia, but against those on Earth, who have so much difficulty achieving by mandate the kind of reduction of consumption that he describes in the tin scenario.
But why shouldn’t a smart economic planner be able to achieve at least the same results as the archaic price system? At worst, couldn’t he simply imitate the relatively calculable scenario above while at the same time using his control to counter speculative bubbles and the other hazards of Lasseiz-faire? To quote Hayek again:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
Hayek is saying more than that an economic planner needs highly excellent databases of supply and demand, covering the entire world economy in great detail. He is referring to knowing the quickest way to get an eighteen-wheeler around a stopped section of the 91 freeway, or where to get substitute source for specialized parts in an unexpected shortage, etc. Now, today, concentration of this kind of knowledge is actually conceivable through the internet and modern databases, but to implement it involves an implicit limitation of means; a database can only know the way things have been solved in the past, it can never reveal what may be possible through astute problem-solving on the spot, without actually exhaustive knowledge of every mouse-hole and crowbar on the planet. Even more, Hayek is referring to the internal preferences which we saw so sharpened and clarified by the negotiations of the price system; the central planner must not only be clear-minded, he must actually be a mind-reader to know how many shoes the people will wish to consume because consumption is a result of preferences which exist entirely within the mind of the consumer. Thus the Socialist central planner (who controls production) has no means at his disposal to avoid producing either shortages of goods nor wasteful gluts of unwanted goods, because he has abandoned the price system’s marvelous perception of consumer preferences, and instead guides production based on his own knowledge. We can see in this part of the justification of full Communism over Socialism, for the Communist central planner dictates not only what will be produced, but how it will be distributed and consumed. Clearly, however, his planning of production will be just as uncoordinated as that of the Socialist, and his sole advantage is the ability to cover his own tracks by dictating consumption suited to the production he has mandated, however erroneous his mandates may have been. If he forces you to grow too many cabbages, he can at least “correct” this glut, by forcing you to eat them all.