To understand market economies, you need to know about our invisible friend, the invisible hand. Somehow market economies can distribute goods efficiently without anyone planning this. According to the economist Adam Smith it is as if an invisible hand makes this miracle happen. His critics like Karl Marx didn’t believe in invisible friends. Not surprisingly Marx also didn’t believe in God. Smith claimed that if everyone pursues his own personal interest, the interest of society is often best served.
I’m the invisible man
Incredible how you can
See right through me
– Queen, The Invisible Man
The following tale demonstrates how the invisible hand does its magic. Whether or not it is actually true doesn’t really matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then Russia didn’t have a market economy. The mayor received a tour around the city and noticed that no one had to queue up for bread like everyone did in Moscow. There was an ample supply of bread at cheap prices while no bread was thrown away. Somehow bread was produced in the right quantities in the preferred tastes and supplied at the right places.
The mayor was truly amazed about this feat so he said to his hosts: “Back in Moscow our finest minds work day and night on the bread supply and yet there are long queues everywhere. Who is in charge of the supply of bread in London? I want to meet him!” Of course, no-one was in charge. That’s the secret of the market economy. Every baker decided for himself or herself how much he or she was planning to make and sell and at what price. A few years later Russia switched to a market economy.
It is the individual decisions of bakers and the businesses working in the supply chain, for instance farmers and flour mills, that make this miracle happen. They all decide for themselves. If a baker could sell more than is produced he or she would miss out on profits. The same is true when bread is thrown away. And people are willing to pay more if the bread tastes better. Hence, every individual baker will do his or her best to make exactly the right amount of bread in the tastes people desire. It is in their best interest.
In Russia the state planned how much of every item was produced, where these items were shipped and what prices they were sold. Corporations couldn’t decide about prices. They received a compensation for their costs but they weren’t allowed to make a profit. Employees received a fixed salary. If a corporation produced more or better products, it still didn’t make a profit nor did the employees receive higher wages. Corporations also couldn’t go bankrupt when they did a bad job. This resulted in poor quality products, a shortage of nearly everything and even outright famine from time to time.
It doesn’t always work out well
This miracle has enchanted some people to the point that they believe that everything will turn out fine if only markets can do their job. But there are many instances where a market economy doesn’t produce the best outcome for society as a whole. Economists call them market failures. One can think of the following situations:
- People may have far more desires than the planet can support and the market economy may fulfil those desires at the expense of future life on the planet.
- Some people are not able to make in a living in the market economy, for instance because they lack the skills or have little bargaining power.
- Corporations use lobbyists and bribe politicians to pass legislation that favours them.
- A government may be a more efficient producer of products that do not benefit from competition, for instance roads and the power grid.
- Corporations may abuse their power to charge higher prices, most notably if it is hard for competitors to enter the market.
- Some products cause harm to people or the environment but these costs are not paid for by the producers. For example, cigarettes cause health costs.
In most countries governments interfere with the economy in order to deal with market failures. These are situations where pursuing personal interests doesn’t bring the best outcome for society as a whole. What the best outcome is, is sometimes a matter of taste, but often it is obvious. Government intervention can make things even worse, so decisions about interfering are made after weighing benefits and drawbacks. In many democratic countries public expenses are about 50% of national income. People in these countries probably believe that market economy doesn’t always work best.
An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is a poor country without a market economy. The United States spends more on health care than any other country in the world. Every possible treatment is available in the United States. Still, in more than 40 countries people live longer than the United States.1 Cuba doesn’t spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba therefore appears extremely efficient compared to healthcare in the United States. How can this be?
The available treatments in Cuba are free for everyone. In the United States people may not receive treatment when they can’t afford it because the United States has a market economy. There may be other causes too, for example differences in the diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Still, Cuba isn’t a great country to live in. People have been fleeing Cuba for decades and many Cubans moved to the United States. Cuba is a dictatorship and most Cubans are poor. Healthcare is one of the few things Cuba has organised well.
The story about the visit of the mayor of Moscow demonstrates that the invisible hand of the market shouldn’t be ignored. Successful societies have market economies. Many public expenses are paid for by taxes on income generated in market economies. A market economy still needs a government to set the rules and to enforce them. Governments of successful societies aim at making the market economy work better where it is beneficial for society and constraining it where it does more harm than good.
Market economy and capitalism are so closely related that many people believe them to be the same. Capitalism is about capital. Capital consists of the buildings and the machines corporations own, but also the knowledge of how to make products and how to bring them to the market. Knowledge of how to make a film entertaining might be capital for a film company. Networks of customers and suppliers can be capital too if they contribute to the success of a business. The same applies to contracts and brands. For instance, the brand Coca Cola has a lot of value because people are willing to pay more for cola when the logo of Coca Cola is printed on the bottle.
Building capital can be costly but in a market economy the value of capital doesn’t depend on the cost to build it but on the future income it is expected to produce. This can lead to peculiar situations. When investors have no faith in the future of a corporation because it is expected to make losses, the buildings and the machines on their own may be worth more than the corporation as a whole as those buildings and machines could be used by other corporations for more profitable purposes.
In most cases more capital means more wealth because capital produces the things people need or desire. Corporations tend to be more profitable if they fulfil those needs and desires better. Therefore, the value of capital in a market economy often depends on how good it can fulfil the desires of consumers. Investors are willing to invest in corporations that fulfil those needs and desires because they expect to make money by doing so.
It is sometimes argued that when investors are free to invest in the corporations of their choosing, the invisible hand channels investment capital to the most useful corporations because they are the most profitable. That’s why the value of corporations is important in a market economy. Businesses ‘create value’ for investors by making consumers happy. Still, the value of a corporation might not reflect the benefits for society as a whole. For instance, if the profitability of a corporation comes from exploiting people or harming life on the planet, a high value could be a bad sign.
And capital can be useful without being profitable, for instance in the public sector. A hospital in the public sector may have no market value because it doesn’t make a profit but it can be useful nonetheless. Capital in the public sector might even be more valuable than in a market economy. For instance, making hospitals private enterprises for profit might not benefit society as a whole. Hospital care may not improve from competition as it is often best to have one hospital serving a particular area. And patients might receive unnecessary treatments when hospitals can make a profit. Healthcare in the United States may create a lot of value for investors but it doesn’t always benefit the patients.
As there are basically two types of people, capitalists who save and invest and ordinary people who borrow and spend, it is hardly surprising that capitalists tend to be wealthier than ordinary people. Capitalism can create wealth because it is the capitalists who finance the investments in the corporations that make the items ordinary people enjoy, but this wealth is often unevenly distributed. From a moral perspective, it is a problem that poverty still exists while there could be enough for everyone. So the question that still remains is how to make the economy work better for the benefit of all?
Featured image: Our invisible friend photographed in the moorlands near Nijverdal. Jürgen Eissink (2018). Wikimedia Commons. Public Domain.
1. Life expectancy per country 2017. World Population Review. [link]