There is a joke that goes like so. Teach a parrot to say supply and demand, and you have an economist. Economics is all about supply and demand. To understand the market economy, you should know the law of supply and demand. Not surprisingly, this is one of the most important laws in economics, even though this law is often wrong. This law states that the price is where supply and demand are equal. An example of the coffee market can clarify that.
If coffee is free, people might like to drink lots of coffee. But producers cannot make coffee for free. They go bankrupt if coffee is free because they have costs, for instance, employees and equipment. A price of € 3 per kilogramme may not cover all their expenses. Some producers can produce cheaper than others because they have more efficient production facilities. When the price is € 5, a few producers might make a profit and start making coffee.
That may not be enough to satisfy the demand that is out there. The low-cost producers have a limited production capacity. They may come up with 650 kilogrammes of coffee. Consumers might want to gobble up 1,700 kilogrammes if the price is only € 5 per kilogramme. In that case, there would be a shortage of 1,050 kilogrammes. Consumers who fear that they get nothing might offer more money, so the price of coffee rises.
When coffee becomes more expensive, some consumers might not be able to afford coffee. Others may buy less because they have other expenses like beer and milk. On the other hand, some producers can make a profit at this price and start producing. So when the price increases, supply goes up, and demand goes down.
At € 10 per kilogramme, every producer may make a profit, even those with high costs, and producers may come up with 2,000 kilogrammes. Consumers may only buy 600 kilogrammes because it is too expensive, resulting in a surplus of 1,400 kilogrammes. Producers may try to sell their surplus at lower prices before it gets spoiled to recover some of their costs. When prices are lower, consumers are willing to buy more. High-cost producers cannot make a profit and stop making coffee. So when the price decreases, demand goes up, and supply goes down.
The price may settle where supply equals demand. When the price is € 7, producers may make 1,200 kilogrammes, and consumers may gobble up 1,200 kilogrammes. So € 7 per kilogramme could be the price of coffee according to the law of supply and demand. The law often does not work as more issues play a role, but the law suffices for a basic understanding of markets. A graph can illuminate the discussion so far:
The graph shows the quantities of coffee demanded and supplied at different prices. When the price increases, demand goes down, and supply goes up. The downward-sloping black dashed line represents demand. The upward-sloping black line represents supply. If the price is low, the supply is small, and demand is high, leading to a shortage. At € 5, there will be a shortage of 1,050 kilogrammes as demand is 1,700 kilograms while supply is only 650 kilogrammes.
If the price is high, there is little demand and plenty of supply, leading to a surplus. If the price is € 10, there will be a surplus of 1,400 kilograms as supply is 2,000 kilograms and demand is only 600 kilograms. The lines of demand and supply cross at 1,200 kilograms and a price of € 7. Supply and demand match 1,200 kilograms, and € 7 is the price according to the law of supply and demand.
In reality, things often differ a lot from this simple model. There may be different qualities of coffee at their own price. In some markets, there is a lot of competition, and corporations hardly make a profit. Other markets lack competition, and corporations make huge profits. And there hardly ever is an equilibrium as the factors that influence supply, demand, and price constantly change. Nevertheless, simple examples like this one help to explain how a market economy works.
Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.
Making the economy sustainable may require an unprecedented amount of capital in the form of knowledge and outfits like solar panels, sustainable farms and energy-efficient transportation systems. It is hard to imagine that it can be done. And imagining it is still a lot easier than really doing it. It is going to require some economic magic to divert investment capital from destructive activities to the future of humanity. We may need more useful capital and less consumption.
Perhaps the invisible hand can be of some help. It is easier to finance a great endeavour from investments than from taxation because nobody wants to pay taxes but everybody is happy to invest. It is the secret of the success of the European empires that conquered the world after the Middle Ages. England, France, Spain and the Netherlands were much poorer and smaller than China, India or the Ottoman Empire, but they didn’t finance their conquests with taxation, but with the use of investment capital.1
Europe won out because European conquerors took loans from banks and investors to buy ships, cannons, and to pay soldiers. Profits from the new trade routes and colonies enabled them to repay the loans and build trust so they could receive more credit next time.1 The same logic may need to be applied to making the economy sustainable. The challenge is so enormous that it may never be possible to finance it by taxes. Nowadays interest rates are so low because there is plenty of investment capital.
It’s the economy stupid!
It is often argued that the economy is unsustainable because of short-term thinking. The economy must grow in order to have positive returns on investments. And it is believed that returns on investments need to be positive otherwise the economy would collapse. The economic time horizons of individuals are reflected in their time preferences. The time horizon of the economy as a whole is reflected in the interest rate.
The lower the interest rate, the longer the time horizon of the economy could be. The following example from the Strohalm Foundation can illustrate this:
Suppose that a cheap house will last 33 years and costs € 200,000 to build. The yearly cost of the house will be € 6,060 (€ 200,000 divided by 33). A more expensive house costs € 400,000 but will last a hundred years. It will cost only € 4,000 per year. For € 2,060 per year less, you can build a house that lasts three times as long.
After applying for a mortgage the math changes. If the interest rate is 10%, the expensive house will not only cost € 4,000 per year in write-offs, but during the first year there will be an additional interest charge of € 40,000 (10% of € 400,000).
The long-lasting house now costs € 44,000 in the first year. The cheaper house now appears less expensive again. There is a yearly write off of € 6,060 but during the first year there is only € 20,000 in interest charges. Total costs for the first year are only € 26,060. Interest charges make the less durable house cheaper.2
Without interest there is a tendency to select long-term solutions. Interest charges make long-term solutions less economical. Interest promotes a short-term bias in the economy. It may explain why natural resources like rainforests are squandered for short term profits. If interest rates are high, it may be more profitable to cut down a rainforest and to put the proceeds at interest rather than to manage the forest in a sustainable way.
Only, things are not as simple as the example suggests. For example, the building materials of the cheap house might be recycled to build a new house. And technology changes. For example, if cars had been built to last 100 years, most old cars would still be around. This could be a problem as old cars are more polluting and use more fuel. Nevertheless, the example shows that long-term investments can be more attractive when interest rates are lower.
This also applies to investments in renewable energy. For instance, a solar panel that costs € 100, lasts 15 years, and generates € 150 worth in electricity in the course of these 15 years, is feasible at an interest rate of 5% but not at an interest rate of 10%. Many investments in making the economy sustainable may have low returns and are only feasible when interest rates are low. Low and negative interest rates can also deal with low economic growth. That may be needed for living within the limits of the planet.
Living within the limits of the planet
When interest rates are negative, the time horizon of the economy could go to eternity so that it makes sense to invest in making the economy sustainable. A few examples from history can illustrate this. In the Middle Ages some areas in Europe had currencies with a holding fee like Natural Money. As there hardly was economic growth, interest rates were negative. It was the era of Europe’s great cathedrals. These cathedrals were built for eternity. As better investment opportunities were absent, wealthy towns people spent their excess money on cathedrals.3 For similar reasons, the people of Wörgl planted trees as the proceeds of the wood were expected to occur in the distant future.3
A bit of calculus shows why. At an interest rate of 5%, putting € 1 in a bank account turns into € 1,05 after a year, so you would rather have € 1 now than in one year’s time, even when you need the money in one year’s time. That’s because you can put the money on a bank account at interest. At an interest rate of 5%, € 100 in one year’s time is worth € 95.25 now. The distant future has even less value. The same € 100 in one hundred year’s time is worth only € 0.59. And € 100 after 1000 years has no value at all in the present.
At an interest rate of -5%, you would prefer to have the money when you need it, otherwise you would end up with less. At an interest rate of -5%, € 100 in one year’s time would be worth € 105. The same € 100 in one hundred year’s time would be worth € 13,501 now. And € 100 after 1000 years would be worth more than everything there is in the present. Income in the distant future is also very uncertain, so it is unlikely that investors will shift their time horizon to 1,000 years, but this logic may help us to come into terms with the limits our planet poses on human activities.
Living within the limits of the planet may require unprecedented investments in the future. These investments may require low or even negative interest rates as their returns may be low. Only low and negative interest rates can make these investments economical. Everyone who has money to save can help by shifting money from consumption to saving and investing. The more people act like capitalists, the lower interest rates may go, and the more sustainable the economy may become.
Market economies have an invisible friend called the invisible hand. In market economies, goods are distributed without the need for a planning agency. According to Adam Smith, it is as if an invisible hand makes this miracle happen. His critics, for instance, Karl Marx, did not believe in invisible friends. Not surprisingly, Marx also did not believe in God. Smith claimed that if everyone pursues his own interest, the interest of society is often best served. The followers of Marx felt that the state should plan the production and distribution of goods and services.
I’m the invisible man Incredible how you can See right through me
– Queen, The Invisible Man
The following story demonstrates how the invisible hand does its magic. Whether or not it is true does not matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then, Russia did not have a market economy. The mayor received a tour around the city and noticed that no one queued up for bread as everyone did in Moscow. There was an ample supply of bread at affordable prices. Somehow bread was produced in the right quantities for the preferred tastes and supplied at the right places.
The mayor was 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 how much he was planning to make and sell and at what price. A few years later, Russia switched to a market economy.
The individual decisions of bakers and the businesses in the supply chain, for instance, farmers and flour mills, make this miracle happen. They all decide for themselves. If a baker could sell more than he produced, he would miss out on profits. The same is true when he has to throw away bread. And some people are willing to pay more if the bread tastes better. Hence, each baker tries to make the right amount of bread to the tastes people desire. It is in their best interest.
In Russia, the state planned how much of each item a corporation should produce. Corporations could not decide on prices. They received compensation for their costs but could not make a profit. Employees received a fixed salary. Corporations that produced more or better products and their employees did not benefit. Corporations also could not go bankrupt when they did a terrible job. That 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 quite a few people. 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. Economists call them market failures. One can think of the following situations:
We have more desires than our planet can support. A market economy may fulfil those desires at the expense of our future.
Many people cannot make 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 and charge higher prices, most notably if they have no competitors.
Products can cause harm to people or the environment, but producers may not pay these costs themselves. For example, cigarettes cause health costs.
In most countries, governments interfere with the economy to deal with these market failures. These are situations where pursuing personal interests does not bring the best outcome for society. In many democratic countries, public expenses are about 50% of national income. People in these countries probably believe that a market economy does not always work best. In some areas, markets produce extremely poor outcomes, for instance health care.
An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is poor and does not have 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 in the United States.1 Cuba does not spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba appears 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, you may not receive treatment when you cannot afford it because the United States has a market economy. There may be other causes, for example, differences in diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Life in Cuba may be miserable, but healthcare is one of the few things Cuba has organised well.
Successful societies have market economies and governments that organise things that the market fails to do. And a market economy still needs a government to set the rules and 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.
Capital
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 well 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 the 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 when 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]
The Plan For The Future 