In the face of such irremediable limits to human knowledge, members of society must nevertheless determine which resources are available for production, and in what quantity. They must further determine which goods and services to produce with such resources and, finally, who should receive them, who stands in greatest need or want. Such determinations can only be made rationally and efficiently upon the basis of all relevant knowledge—the actual availability of resources (“supply”) and the actual needs and wants of human beings (“demand”). In the absence of such accurate knowledge, a society runs the risk of misallocating resources, that is, wasting scarce resources through either inefficient production or production of goods and services that people do not need or want. Such misallocation is inimical to human welfare; the wasted resources could rather be used to fulfill the real and yet-unsatisfied needs and wants of human beings. In the absence of accurate knowledge, moreover, those who plan for production run the risk not only of waste and inefficiency but also failure to produce goods and services that people do in fact need and want, such as the cat food in the present example. Such problems can only be avoided if producers are able to obtain knowledge of the actual availability of resources and the actual needs and desires of those who will consume the fruits of production. The economic problem, as repeatedly emphasized, is ultimately a knowledge problem.
In conclusion, the optimum solution to the economic problem arising from the fact of scarcity depends on the ability to employ the maximum knowledge possessed by members of society. Such knowledge is not only systematic, technical, and explicit but also tacit, fleeting, and dispersed. The maximal utilization of knowledge cannot be achieved by relying solely on the possession of explicit knowledge because such is only a fraction of the knowledge requisite to solution of the economic problem. Much if not most economically relevant knowledge exists only as tacit or implicit knowledge, and, moreover, relates to fleeting and contingent circumstances. No individual can consciously articulate or transmit the entire body of knowledge that he relies upon in navigating daily activities; the individual mind always possesses, and acts upon, greater knowledge than it can consciously access. The inherent limits to the human mind in the face of the concrete complexity of existence means that the knowledge required to solve the economic problem cannot be acquired by any individual or group of individuals, no matter their brilliance or power. No human being does or can possess the capacity to assess or survey every aspect of the immeasurably intricate and ever-changing world. Such irremediable epistemological facts lead to the realization that a wise or rational utilization of the earth’s scarce resources cannot be achieved by exclusive reliance on human or personal intellect or will. The solution of the economic problem requires, on the contrary, a supra-rational or supra-personal process that bypasses or transcends the inherent limits of the human mind. The market process—capitalism—is precisely such a process. Inescapable epistemological facts—the complexity of human knowledge in conjunction with the constitutional limits of the human mind—render the “automatic” or spontaneous coordination of human action achieved by the impersonal and supra-rational market process far superior to any method of coordination based on conscious human direction or centralized planning.
Essential Conditions of a Market Economy
Having explored certain epistemological issues inseparable from the question of rational economic order, we next turn to an examination of the actual process whereby capitalism facilitates solution of the economic problem. We begin with a discussion of the three essential conditions presupposed by, and crucial to the operation of, any market economy, namely, private property, the rule of law, and mutual trust among participants. The market does not operate in a vacuum but rather within a requisite moral, legal, and social framework. The first requirement of a capitalist economy, as the textbook definition makes clear, is the institution of private property—the legal recognition and enforcement of individual property rights. A right to private property, as previously noted, is most usefully regarded as a decision right. An individual, for instance, who holds a property right in an automobile is morally and legally entitled to decide how that automobile is to be employed. He may choose to leave it sitting in a garage, drive it himself, allow another to drive it, sell or destroy it, and so on. Whatever his choice, his property right in the vehicle legally forbids anyone else to employ it without his permission. It is his, which means that he and he alone decides if and how the automobile, his property, is to be employed; neither other private persons nor the government has anything to say in the matter.[3] The same applies to every other entity regarded as private property. Whoever holds title to property, whatever its nature, holds the ultimate right to decide how that possession is to be employed. That right may be qualified by the bounds of law or governmental regulation (e.g., speed limits) but the essential point remains—only the individual who possesses the property right in an entity is entitled to direct its usage. In a pure or ideal free-market economy, all resources, material and immaterial, belong to, and are thus under the direction of, particular private individuals—those who possess the corresponding property right. The security of private property rights is the first crucial condition or prerequisite of a market system.
The second essential precondition of a market order is the existence of the rule of law. The rule of law, discussed in Volume I, establishes an abstract or general legal framework that all persons, including the government, are required to honor in pursuit of their purposes. The rule of law does not concern the ends or goals of human action but rather restricts the means that may be employed in pursuit of such goals. It further provides a framework that secures individual expectations. The establishment of law, as we recall, stabilizes certain features of the environment in a manner that permits individuals more accurately to anticipate certain consequences of their actions. A law prohibiting theft, for instance, permits individuals to rest more or less secure in the expectation that their personal possessions will not be taken from them without their consent. It also informs would-be thieves of the consequence of stealing; if the law is consistently enforced, they can be secure in the expectation that such action will be punished. The protection of private property rights is of course a particular aspect of the general rule of law. Property rights particularly secure the right-holder’s expectation that he will be permitted to direct the use of his personal possessions.
Further rules especially relevant to a market economy include contract law and legal prohibition of force and fraud. The enforcement of contract law secures the expectation that all parties to a contract will honor their contractual obligations. Such enhanced certainty facilitates trade and commerce insofar as people are more willing to engage in contractual business relationships if they are certain that contractual agreements will be legally enforced. The handshake of a “gentleman’s agreement” is one thing, protection by the full force of law another. Similarly, the legal prohibition of fraud increases the level of trust that buyers can place in the claims of various sellers. Sellers in a market economy are not permitted to lie to or otherwise deliberately deceive their customers regarding the good or service offered and will be punished by law if they do so. Such, again, facilitates trade by securing the buyer’s expectation that the good or service he purchases will actually be as advertised. Last but not least, the prohibition of force in market exchange secures the high value of individual freedom. No one, buyer or seller, is permitted to employ coercion toward achievement of his economic ends. No buyer may legally be forced to purchase any particular good or service, and no seller may legally be forced to produce or sell any particular service. The prohibition of coercive force ensures that all economic transactions in a market economy (the “free market”) are indeed free, that is, voluntary.
The rule of law, then, is crucial to the operation of a market economy. It serves to ensure that market participants will conduct their affairs in an ethical or just manner (no force, fraud, or theft). It further provides
a level of certainty that permits individuals to plan their lives with greater rationality and foresight, with greater knowledge of the consequences of their choices, than is possible in its absence. Such certainty applies to the actions not only of other private individuals but also government. Legal protection of property rights, for instance, assures the individual that the government will not confiscate his resources. He can be certain that any wages, salary, or profits he earns will remain under his own direction and plan his personal economic efforts accordingly.
Tax legislation, as we have seen, serves a similar function. Legislation that establishes fixed tax rates permits individuals to know in advance precisely how much of their income they will be permitted to retain. Such knowledge will factor into many of their personal economic plans and decisions. An individual who desires greater income, for instance, may consider working overtime or taking on a second job. The law informs him in advance of the amount of such additional income he can expect to pay in taxes, information that enables him better to determine whether supplementary employment is worth the effort. Individuals will reach different conclusions, in line with their personal circumstances and values, as to the desirability of additional employment under current tax law. The essential element has nevertheless been achieved, that is, individuals know with certainty the consequences of their decisions and can thus make informed and rational choices, secure in their expectation of retaining a known percentage of any additional income earned. A further example is the recent legislation that requires all employers to provide health insurance to their employees. Both the moral grounds and economic desirability of such legislation may be in question, but it nevertheless provides the security of expectation essential to the operation of the market process. Employers will take the additional cost of health insurance into account each time they consider hiring a new employee. So long as the legislation remains in place and is consistently enforced, they know with certainty the costs involved in expanding their work force and can thus make a rational calculation of whether or not such would serve the interest of the firm.
The rule of law, then, is an essential precondition of a market economy, providing a framework of known and stable rules that every person can depend upon in devising his personal plans. By attaching various known consequences to certain actions, the rule of law provides, again, a “man-made” element of certainty, thereby allowing individuals to formulate personal plans more rationally and confidently than they could in its absence.[4] The security of expectation established by the rule of law facilitates not only the rational development of individual economic plans but also coordination of the simultaneous plans pursued by the millions of individuals who constitute modern society. It is as indispensable to a developed market economy as the institution of private property, itself protected by the rule of law.
The third condition essential for the operation of the market process may be called mutual trust among participants. Trust in this regard refers to the expectation that social interaction will be governed in accord with customary moral rules and standards, allowing members of society to depend upon and predict the behavior of their fellows to a considerable extent. Mutual trust, based on a common observance of shared (unwritten) moral values and rules, serves a function similar to the formal rule of law, that is, allows people to plan and carry out their plans with a greater degree of certainty than would be possible in its absence. Trust so conceived plays a crucial if implicit role in a market-based society such as the United States.
To perceive its significance to the market process, consider a routine practice such as the consumption of electricity provided by a local utility company. Every month most Americans receive a bill that typically reflects the amount of electricity consumed within the residence over the previous month. The utility companies throughout the nation implicitly trust that the vast majority of their millions of customers will in fact pay for the electricity they have used. They typically do not require payment in advance of service but rather trust their customers to honor their financial obligations. Of course the provider of electricity is also protected by the rule of law and has legal recourse in the event of nonpayment. Such legal remedies, however, are reserved for the exceptions to the rule, for those relatively few customers who do not meet their contractual obligations. The courts would be overwhelmed if providers had to sue all or most of their customers to obtain payment for services rendered. The utility companies would also be overwhelmed and unable to operate in the normal manner. Their smooth operation depends, in part, on trust, the expectation that most customers will behave honorably—in accord with received moral norms—and pay their bills. Or consider the situation of an individual who accepts a position with a new employer. Normally a new employee must work several weeks before receiving a paycheck. He trusts that the employer will actually live up to his obligation to pay him for work performed, that the employer will behave decently and honorably. He trusts, in other words, that the employer will observe the implicit rules of just conduct characteristic of the traditional American ethos, which include the moral obligation of an employer to pay an employee for actual work performed. Employers, like utility customers, are also legally obligated to pay for services rendered, but it would be impossible to enforce such law if most employers engaged in unethical behavior and violated their obligation to do so.
All forms of social intercourse involve implicit, tacit, or unspoken ethical rules that everyone counts on their fellows to observe. Such unwritten rules and customs regulate human behavior in every society on earth, varying in accord with its particular cultural and ethical tradition. The implicit moral ethos underlying American social order derives from its particular cultural and religious tradition, namely, the Judeo-Christian or Western ethos that prohibits killing, stealing, lying, breaking promises, and so on. The American people have come to expect such behavior as normal or natural, and it is inseparable from their customary way of life. Such time-honored ethical norms are expected to apply not only within immediate personal relations but impersonal legal, political, and economic relations as well. Traditional American order, including its traditional economic order, depends upon the widespread practice of such customary moral rules, ultimately derived from its religious and cultural inheritance and crucial to the vitality of its characteristic institutions and culture.
A key element of the vibrant market economy historically characteristic of American society, then, is the mutual social trust that emerged from its widespread embrace of Judeo-Christian norms. Such an achievement is the fruit of a particular culture and civilization, Western civilization, and not a universal or permanent aspect of culture in general. Societies that developed on the basis of other moral and cultural traditions certainly possess characteristic and implicit moral and social norms but these may differ substantively from the particular standards crucial to the functioning of a market economy. Such societies may thus lack the requisite moral and cultural preconditions of a market economy—commitment to private property and the rule of law and the ethical norms implicitly governing market exchange. Capitalist economic arrangements are not an autonomous or isolated aspect of a social order but rather dependent on a particular cultural and moral ethos. Western capitalist institutions grew from soil prepared by Judeo-Christian values and presuppositions and cannot simply be transplanted or grafted onto societies that lack the requisite moral, legal, and cultural framework.
Indeed, some observers fear that Western society, including American society, is itself gradually destroying the so-called “moral capital” that nourished its growth over the course of millennia. “Moral capital” in this context refers to the explicit and implicit values, chiefly of biblical inspiration, that definitively shaped the development of Western or Judeo-Christian civilization. The free society, including its economic dimension, capitalism, owes an incalculable debt to the fund of spiritual values invested, so to speak, in its growth. The ongoing erosion of traditional spiritual and religious va
lues—the “moral capital” of Western development—is thus of great significance for the vitality, indeed the preservation, not only of capitalist economic order but traditional American order more generally, including its central value of individual freedom.[5] This important and complex topic—the relation of the free society to its spiritual, religious, and moral heritage—will be extensively explored in Volume III of this study, The Rise and Fall of Freedom.
Having identified the three essential conditions or prerequisites of a market or capitalist economy—recognition and protection of individual property rights; enforcement of the rule of law, including prohibition against force, fraud, and theft; and mutual trust among participants—we turn to examine certain other concepts and theoretical constructs central to economic reasoning and practice. Such considerations, in conjunction with the market preconditions and epistemological constraints previously discussed, will leave us prepared to explore the actual operation of the market process, how is, how the market solves the economic problem in practice.
Subjective Value
An appreciation of the market process begins with recognition that individuals vary greatly in their values, needs, desires, tastes, and preferences. In the formal language of economics, every individual is said to possess a unique scale of values and preferences, a unique ranking of the particular goods and services personally most valuable or important to that individual. If readers of this book were asked to list the ten particular goods or services they personally regard as most important to their welfare, they would no doubt produce as many different lists as there are readers. We are discussing in this context economic goods—items that can be bought and sold on the market. Many personal and social values are certainly desirable “goods,” for instance, friendship, love, and justice, but they are not economic goods—goods that can be obtained for a price on the market. Nor may individual rankings contain such generic items as “food, clothing, and shelter.” Individuals never desire “food,” which is a merely nominal term referring to an abstract category of items suitable for the nourishment of human beings, animals, and even plants. They rather desire particular kinds of food that suit their individual tastes—McDonald’s French fries or celery sticks, ice cream or tofu. Obviously each individual has decided preferences in this regard that are greatly at odds with the preferences of other individuals. In the same way, individuals never desire “clothing” but rather a Perry Ellis cashmere coat or an L.L. Bean hunting jacket, a straw sunhat or a wool skull cap. The particular items of clothing desired by consumers vary dramatically from person to person, depending on age, place of residence, career, the wardrobe a person already possesses, and a host of other factors too numerous to list. Indeed, they vary for a particular individual over time; the clothing desired by Jane the teenager is rarely identical to that desired by Jane the mother or grandmother. “Shelter” varies in the same manner and for the same reasons, from a pup tent erected under a public bridge to a mansion on Palm Beach. People do not want “shelter” but particular and individual forms that suit their needs, tastes, and also their budgets. With such considerations in mind, it is more or less certain that the top ten items on each reader’s list of preferences will be unique and particular to each individual reader. It would be astonishing to find even two individuals with identical lists, let alone the more than three hundred million individuals comprised by modern American society.
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