Free Market Pricing
Free Market Pricing
- Basic Economics Explained in Everyday Language
- The Case for a Market-Based Economy
- Misapplication of Theoretical Conclusions in Real-World Situations
Everything has a cost. There simply is not enough of everything to satisfy all of the wants and needs that exist in the world. In other words, the world does not contain an endless supply of everything. Consumers must choose among all of their available options in order to decide what to do with their limited budgets. Producers (businesses) must consider what consumers want and the costs of their resources to determine what, and how much, to produce.
The next three (short) paragraphs include the basic theory of free markets. If you only read that far, you will come away with a basic understanding of the theory of the free market system (capitalism). If you read through to the end, you will come away with a basic understanding of some of the differences between the theory and real-world applications, as well as the some of the important differences between capitalism and socialism.
Consumers will tend to purchase more of something if the cost of that something decreases relative to their other options. Producers will tend to produce more of something if they can receive a higher price for selling, within the framework of their cost structure. Consumers can also purchase more things if they can increase their budgets – they have an incentive to increase job skills and contribute to production. Producers have an incentive to innovate in order to attract more business from consumers. Consumers will use their budgets in such a way as to get as much satisfaction as possible; producers will determine what to sell in such a way as to maximize their profits.
Since consumers want to pay the smallest price possible and producers want to sell for the highest price possible, the amount that actually gets traded would be the quantity where the price that consumers are willing and able to pay matches the price that produces are willing and able to sell for. This is the basic concept of the free market system: demand equals supply. The price that equates demand with supply is the equilibrium, or market price.
The beauty of this system is in its efficiency. Competition means that only the most efficient producers will survive. What gets produced depends on what consumers demand. Everything is done voluntarily. Each party to each transaction is entering into it voluntarily. Whoever decides to opt out voluntarily does so. If the price is too high for a particular consumer, that consumer will simply choose not to participate in that particular market and use the budget for something else. If the price is too low, then it won’t get produced. Only when the demand and supply are equal will the resources of both consumers and producers be used efficiently.
The major drawback for a socialist system is that resources will not be used efficiently, resulting in an inefficient quantity or quality of goods and services being produced. Efficient markets require that all costs be factored into the voluntary decisions to buy and sell. But by definition, a socialist system includes costs that cannot be accurately calculated. By definition, a socialist system is one in which the government owns some or all of the factors of production: the land where the production takes place, including the natural resources on the land, the equipment, machinery, and raw materials that have been previously produced but are used in the production process, and/or the labor of the employees. All of these have costs because there are many options for their use. While the resources are being used for a specific activity, they are not available to be used for a different activity. Whatever value is placed on the best alternative activity then becomes the true cost of the use of resources. Determining whether they are getting put to use most efficiently requires knowing what their costs are. In a market (capitalist) economy, each of these resources has its own market to determine their efficient price. In a socialist economy, some or all of these resources will not have a market to determine their efficient price. Instead, the government sets the price or provides the resources for “free”. For the overall economy to optimize its growth potential, and for maximizing the standard of living for the population – efficient production and pricing are necessary. That is why you will see that economic systems which are mostly capitalistic tend to have higher long-term economic growth, with more consumer choices and higher standards of living, than economic systems which are mostly socialist.
Perhaps you already understand all of this. Perhaps it means that you know more about economics than you thought you did. This truth is somewhat paradoxical, however. The above explanation makes sense, but what it doesn’t say is that it is all based on certain assumptions. The explanation is theoretical, and the real world does not provide a perfect match for the theory. Often, people who take economics classes forget about the underlying assumptions and end up drawing the wrong conclusions about the real-world economy. Many people draw conclusions based on the outcome of a theoretical model for perfectly free markets. Indeed, in many cases the theoretical model of perfect competition is an underlying assumption behind other theoretical economic models – but perfectly free markets do not exist in the real world.
Economists use assumptions in order to isolate specific relationships to study. But when those relationships are applied to the real world, the isolating assumptions have to be lifted. That is where the complexity of the study of economics comes into play: knowing what the assumptions are, knowing what makes them unrealistic, and understanding the different relationships that are changed because the assumptions are not realistic. The study of economics involves many different concepts. An understanding of the basics of each of these concepts would be required in order to have a full understanding of how different economic activities are interrelated. Applying this understanding to each situation or policy option on an individual basis, without resorting to sweeping generalizations, is required in order to thoroughly analyze the potential economic impact in each case.
Economics is logical, but the conclusions are only valid if all of the assumptions hold true. Economics can be practical, but this requires an understanding of what happens when isolated assumptions are lifted, which in turn requires an understanding of many different concepts in economics – opportunity cost, market structures, elasticity, market failure, factors of supply and demand, avoiding the fallacy of composition, marginal propensity to consume, trade and trade restrictions, symmetrical information, monetary policy, fiscal policy, business cycles, financial markets, automatic stabilizers, and the like – all concepts which are introduced in a typical Econ 101 class. It should be noted that we have a rather extensive economic history to guide us. If you are making a case for a particular policy, the historical record should back up your conclusions. Even if you accept the fact that unrelated circumstances may have altered specific historical outcomes, the historical record should be extensive enough so that in the big picture, a pattern will have emerged which supports your position. If not, then there is probably something wrong with the reasoning behind your position.
Being both logical and practical with economics is not easy to do. People at all levels of knowledge of economics have been known to form real-world conclusions on the basis of theoretical conclusions, without accounting for the isolating assumptions. Very often, partisan advocates don’t even try, in spite of their influence and prominence.
Here is a tip that might help you to decide if your conclusions regarding economic issues and economic policy are based on the real-world application of economic principles, or are instead based on unrealistic assumptions from theory. Ask yourself the following questions:
Can you explain both why and how a particular policy or economic relationship, the actual process, leads to your personal conclusions? Have you thought through the process of how things work, who would be affected, what the likely outcomes would be, without the need to cite some theory? Does the “big picture” historical record support your position? If so, you are on the right track. But if the reasoning behind your position is along the lines of “that’s how the system works” or “this is the best solution because economic theory says so, and therefore I won’t consider any alternatives”, without having anything more substantive to back up your position, then you are likely basing your arguments on unrealistic assumptions.
Free markets may not exist in their purest form, but there are varying degrees of them. Generalizations, then, can be made based on concepts like “mostly free” or “mostly not free” markets. That means that the concept of free markets can be discussed in real-world terms. In the absence of purely free markets, inefficiency is always present to some degree. Inefficiency is why we have economic peaks and valleys, and a big reason why the economy is never in a state of equilibrium.
Another important point that I want to make involves the difference between the real world of economics and the political rhetoric. I mentioned above that “economic systems that are mostly capitalistic tend to have higher long-term economic growth, with more consumer choices and higher standards of living, than economic systems which are mostly socialist”. This is true, based on economic principles as well as world history. However, it holds true because of a specific feature in the definition of socialism, yet much of the political rhetoric is based on a different definition – a definition for which this conclusion does not hold true. A number of logical fallacies are committed with this rhetoric.
Socialism: A system of government or collective ownership of the factors of production (land, labor, capital).
That is the definition of socialism. A socialist or mostly socialist economy would have all or some of the factors of production being owned by the government, distorting or eliminating the market value of these factors. The rhetoric that any government involvement equates to socialism does not fit the definition, and does not fit the real world conclusions about growth, choices, and the standard of living. If the government doesn’t control the resources, it isn’t socialism. The idea that any government involvement equates to socialism not only uses an incorrect definition of socialism, it also uses faulty logic.
The negative connotations resulting from this illogical misuse of the terminology is often a deliberate attempt to avoid a rational discussion. A government is at the very heart of an organized society. Without government, the market system as we know it could not exist. Instead, we would have pure anarchy, a system in which the strongest have the ability and a motive to destroy everybody else economically. Such a system is the opposite extreme of a free market economy. In short, the government by its very existence creates every type of economic system other than pure anarchy. The government’s existence allows the businesses to exist, and provides a means for customers and businesses to get together. The government provides the framework and the rules for which society works. Markets are inefficient and less than perfectly-free due to the nature of society, not simply a result of government involvement. Without government setting the rules, there can be no free markets.
Free markets are characterized by the free exchange of goods and services, with each party in each transaction having equal market power, equal knowledge of the benefits and costs involved, and equal ability to say yes or no without feeling pressured or being in a desperate position. Neither side has the upper hand. Free markets are also characterized by having costs paid by those receiving benefits, and having profits received by those who take risks – even if the costs and benefits are social costs and benefits. Inefficiency results when costs are private but benefits are social, for example. Free-market efficiency is not something that occurs when the government simply gets out of the way; free market efficiency is something that can only occur in the presence of government policy designed to work towards that end. It makes no sense at all to automatically assume that every perceived or real problem can be solved simply by eliminating the government from the equation. It also makes no sense at all to assume that free markets will result if government policy is designed to give one side more market power than the other side – sellers over buyers and employers over workers, for example.
The level and type of government involvement could indeed create problems, but it could also eliminate problems. Remember, perfectly-free markets do not exist in the real world. Each situation should be analyzed separately with no preconceived notion that government is always “bad” (or the alternative, always “good”). Such perceived notions are not rational.
Economics is a social science; it is not a science. This is something that even many economists do not want to accept. Many economists like to spend their time accusing other economists of failure to predict certain specific events. I believe it is a mistake to expect anybody to predict specific future outcomes, but it is also a mistake for economists to use faulty reasoning and fail to predict the general outcomes and directions of specific situations. You cannot get perfect predictions, such as with science, when the outcomes depend on the actions and reactions of human beings. People can keep trying if they want, but there will never be an economics school of thought that will create an ability to make predictions with scientific accuracy. Yet if you think of economics as a social science, we are already getting the results we would expect.
Consider this hypothetical case of a psychiatric patient. A psychiatrist analyzes the patient, and reaches the conclusion that the patient is unstable, and if allowed to move about freely is likely to be a danger to society and/or to himself. Now, suppose that this patient does get released, in spite of the psychiatrist’s objections, and he goes out and commits mass murder and suicide. Does it make sense to blame the psychiatrist for what happened because he did not predict the exact time, location, weapon used, and number of victims? Of course you wouldn’t blame the psychiatrist. He did his job as a social scientist. You could have blamed him if he had said that the patient was perfectly harmless, but he did not do that. It’s the same thing with economics. You can’t blame an economist for failing to predict the exact details of what happens, if the specific outcome depends on human actions, but you can blame him for not knowing the general nature and direction that the economy will take as a result of certain policies or certain situations.
A version of this essay is included as a chapter in the book Sanity and Public Policy: Separating Truth from Truisms by Jerry Wyant. This book is available in both paperback and eBook formats.
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