Consider the possibility, however, that the student actually possesses knowledge relevant to the task at hand. Perhaps he knows that another professor previously distributed the same article and that fifty extra copies already exist for the taking. In the situation under discussion, such knowledge is utterly wasted, lost to the social or economic process. The student under command is constrained to follow the specific orders of the professor which, under the circumstances, proves wasteful and irrational; scarce resources are needlessly used to produce copies that already exist. Such is wrong from an economic point of view, both for the particular organization, the university, and society at large. The resources used to produce the fifty unnecessary copies could rather have been used to meet other needs and wants, either within the university or elsewhere. Such waste of knowledge and resources, however, is a predictable outcome of the type of rule employed in this situation, a specific command or directive. We have seen that any and every command necessarily embodies only the limited knowledge of the commander. In the present case, the professor’s limited knowledge led to a needless waste of resources which could have been avoided if the student had been permitted to contribute his personal knowledge toward accomplishing his assigned goal (acquiring the fifty copies). Such could only have been achieved, however, by permitting him a greater measure of self-direction than is possible under command.
Our example is merely a particular instance of a more general problem arising from order produced by command: the inevitable restriction of knowledge involved in such a technique, a restriction proportionate to the degree of specificity involved in a directive. The more specific a directive, the more knowledge is restricted to that possessed by the issuer. The more general a directive, on the other hand, the greater the possibility of utilizing knowledge wider than that possessed by the issuer. The professor in the present example could have avoided the negative outcome by giving the student more general instructions, telling him, for instance, simply to obtain fifty copies of the article, leaving aside specification of the means he must employ in achieving that end. The advantage of utilizing a more general directive is that it leaves the student free to personally devise the means of realizing the given end. In our case, he would have been free to use his knowledge of the existence of the fifty copies to meet the directive, eliminating the unnecessary waste involved in producing the extra copies as ordered.
We have repeatedly emphasized that the economic problem is ultimately a knowledge problem. An understanding of the different kinds of rules and order in society leads to the recognition that its solution involves the ordering of human action by the widespread use of general rules rather than commands or directives of authority. Only a society governed by the rule of law proper—the enforcement of general rules possessing the attributes described in a previous volume—is capable of potentially eliciting and utilizing all the economically relevant knowledge and information possessed by all its members, even the least among them. A society ordered by commands and directives, on the other hand, necessarily restricts the knowledge brought to bear on the solution of the economic problem to that possessed by those who devise the commands and directives. The problems that arise from employing human directives in place of general rules are identical to those that arise from attempts to order a society’s economic arrangements by means of deliberate direction by political authority rather than the spontaneous ordering forces of the market. A market economy, and the coordination of individual pursuits in a free society more generally, is necessarily ordered not by commands or directives of government (a planned or command economy) but rather impersonal general rules of conduct applicable to all persons, that is, the rule of law.
In conclusion, the coordination of human activity by means of general rules of law is among the chief reasons for the manifest superiority of capitalism over socialism and other forms of planned economy. It is superior precisely because it is ordered not by conscious central direction involving personal command or human directive but rather impersonal rules. A society ordered by general rules of conduct encourages the emergence and utilization of far greater knowledge than is possible in any order fashioned by specific directives of authority. Individuals in a market economy are not forced to obey authoritative commands but rather permitted to “use their own knowledge for their own purposes,” within the limits of law that merely restricts but does not compel action. Accordingly, every individual, whatever his social or economic position, is able to contribute all his many kinds of knowledge—technical, tacit, and the all-important fleeting knowledge of time, place, and circumstance—toward solution of the overarching economic problem confronting every society.
Order achieved by the observance of general rules has the further benefit of encouraging not only discovery and utilization of knowledge but also more flexible adaptation to the ever-changing and unanticipated circumstances of existence. Moreover, and not least of its many advantages, only an economic order achieved on the basis of general rules of law permits the exercise of individual freedom; order achieved by command, by definition, eliminates the capacity for voluntary choice. Such are the reasons—the superior knowledge informing decisions regarding both production and consumption and the ability flexibly to adapt to the flux of circumstance—why the spontaneous order of the market has been more successful in solving the economic problem than any other form of economic organization heretofore discovered.
The great modern competitor to capitalism has of course been the planned or command economy of communism and its variants. A planned economy, by definition, attempts to consciously and deliberately order economic activity across society by conscious human design, the technique of organization. Centralized planning necessarily relies upon command and directive, which means that it necessarily rests upon the inevitably limited knowledge possessed by the planners, usually politically appointed directors, managers, or other bureaucrats. Insofar as the economic problem is ultimately a knowledge problem, such a fact has tremendous consequences for the ability of any planned or command economy to achieve a rational, let alone optimal, allocation of resources. Such is evident not only in consideration of the various epistemological issues under discussion but also historical experience—the universal failure of collectivized economies to achieve the prosperity and plenty promised by their designers. We return to a discussion of the problems inherent to all forms of planned economy in a subsequent chapter.
Seven
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Capitalism: The Market Process
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The price system is an evolved medium of communication . . . a language of a kind. —F.A. Hayek
Underlying most arguments against the free market is a lack of belief in freedom itself. —Milton Friedman
Every functioning society exhibits some orderly pattern of activities. In the absence of order existence would be chaos, and no one could go about their daily affairs or satisfy even basic needs. In modern American society each person pursues his individual aims within a comprehensive order that most people take more or less for granted, namely, the set of abstract social relations called “the market.”[8] Although many persons are not consciously aware of its existence, the smooth functioning of the overarching or background market order is crucial to the realization of every person’s plans. The spontaneous order of the market is not of course a concrete entity that can be seen or touched. It is rather an abstract or intangible order that manifests as the matching or coincidence of expectations and plans across individuals who are necessarily ignorant of most of the factors that influence the success of their personal plans. Members of a geographically extensive social order such as American society know little if anything of either the concrete circumstances prevailing throughout society (such as conditions of “supply” and “demand”) or the concrete aims pursued by their (mostly unknown) fellows. Such knowledge, however, is crucial to the realization
of any individual’s plans and goals, involving as it does the availability of the material resources required for their fulfillment.
Such inevitable facts of modern social existence raise several interesting questions. First, how do strangers who possess no explicit knowledge of their fellows’ concrete needs and wants nevertheless manage to provide the means—the material goods and services—required to fulfill them? How is the evident order each person experiences in the course of a day generated and maintained even though most persons are only tacitly aware of its existence and do not deliberately aim to produce it? More concretely, why can every American confidently assume he can purchase a loaf of bread at the local grocery store whenever he so desires? He can do so because contemporary American society largely secures the abstract or general conditions that allow the activities of millions of persons—buyers and sellers who do not and cannot know one another’s concrete circumstances and intentions—to “dovetail” or mesh rather than come into conflict. He can do so because American society is ordered by the widespread observance of certain general rules, perceptual, behavioral, moral, and legal, that structure the spontaneous ordering process called the market.
The Ordering Principle of the Market
The market comprises a complex of social relations, institutions, and practices that may be regarded as historically developed solutions to the economic or knowledge problem as described—how to elicit, utilize, and coordinate relevant economic knowledge, explicit, tacit, and fleeting, most of which is necessarily fragmented and dispersed among the numerous members of any complex society. Capitalism, as we have seen, goes by many names: free enterprise, the market economy, system, order, process, and so on. Perhaps the most accurate of all such descriptions, however, is the term preferred by Nobel Laureate economist F. A. Hayek and other economists associated with the so-called Austrian school, namely, the “price system.” Such a designation highlights the all-important function of prices in a market economy, especially their role in the social transmission of relevant economic knowledge and information. Hayek underscores that function by characterizing the market or price system as essentially an evolved “information system,” “medium of communicati[on],” or “system of telecommunications.”[9]
The vast majority of market participants are relatively blind to the crucial function of prices in a capitalist economy. Their interest in prices is typically limited to the affordability of various needed or desired goods and services. Market prices, however, bear significance far beyond such individual concerns, constituting, indeed, the very linchpin of capitalist economic arrangements. Comprehension of the crucial role played by prices in a market economy begins with a discussion of the nature and meaning of a “price.” A price is an abstract symbol—a language of a kind—that embodies or summarizes knowledge and information garnered by means of the transpersonal social process conventionally termed the market. More particularly, the prevailing structure of relative prices in a market economy indicates the relative scarcity or abundance of resources available for production and consumption at any point in time. Such knowledge, collectively acquired via the actions of market participants, transcends the knowledge available to any individual human mind, which is constitutionally incapable of mastering the infinite concrete complexity of the social environment.
The price system represents a culturally evolved adaptation to such irremediable limits of the human mind, one made possible by the mind’s ability to employ abstract thought and symbols (such as a “price”). The ability to read and speak the abstract language of prices permits human beings to navigate in a world of scarce resources and unimaginable concrete intricacy. Such an ability, as mentioned, permits individuals to bypass their irremediable ignorance of the innumerable facts upon which the success of their individual plans inevitably depends, namely, the concrete or material circumstances prevailing throughout society and indeed the world. Prices are indispensable guides to human action, one that each person, whether as producer or consumer, relies upon on a daily basis. Only the guidance provided by the prevailing structure of relative prices permits individuals to orient their actions in a way that coordinates or meshes with the actions of the millions and billions of other individuals with whom he must share the scarce resources of the earth and who also plan to utilize them in fulfillment of their purposes. In the absence of an accurate structure of relative prices, human beings would have no means of knowing whether their personal plans and goals are consistent with the plans and goals simultaneously pursued by their fellow human beings. Without the guidance of prices, human beings would have no way of knowing whether the (scarce) resources requisite to fulfillment of their myriad personal plans are actually available for use.
The information conveyed by relative prices, moreover, is crucial not only to solving the economic problem, both individually and socially, but also to the exercise of individual freedom. The prevailing structure of relative prices in a market economy, as said, indicates the relative scarcity or abundance of resources available for production and consumption. Without the guiding function of prices, individuals could not know how to employ their productive efforts (contribute to “supply”) in a manner compatible with the plans and actions, the needs and desires, of other human beings (“demand”). In the absence of an accurate structure of relative prices, production, which of course is essential to human survival, could not be undertaken on a voluntary basis but would have to be directed by command.[10]
Capital
The next task is to examine more closely the actual process by which capitalism or the price system leads toward solution of the economic problem in practice. Analysis of the market process must first address the problem of production; there can be no distribution or consumption of what has not yet been produced. We have seen that the nature of things—the inescapable fact of limited resources or scarcity—forces upon every society the question of choice: someone must decide, in the first instance, what is to be produced, and how. In a market economy, that function is performed by private individuals (business owners, entrepreneurs) and groups of voluntarily associated individuals (business firms, corporations). Individuals, either singly or jointly, decide to employ their personal resources—their “capital”—in the production of goods and services that they believe will be desired by other people—the potential consumers or buyers of their goods and services. In the formal language of economics, producers generate “supply” and consumers generate “demand.”[11]
Capitalism, of course, derives its name from the essential role of capital in its manner of operation. The concept of economic capital is perhaps most readily grasped by perceiving its identity with “savings” employed or “invested” in the production of goods and services. Capital initially arises from an individual’s ability to produce more than he or she needs for subsistence. The “capitalist” is the person who not only manages to raise his production above subsistence level but further decides to “save” and then “invest” such savings in the production of a good or service.[12]
To simplify matters, consider the hypothetical situation of Robinson Crusoe alone on his desert island. Crusoe, like every human being, is confronted by the economic problem arising from scarcity. He must thus decide how he is to employ his personally limited resources, which in his case largely consist of labor and time, to meet his needs. He must first of all decide what to produce, and how. Suppose he identifies food as his most urgent need and decides to spend his time and labor attempting to catch a fish. We shall assume that, after some practice, he manages to catch a fish and, further, that he requires one fish per day to survive. Day after day he successfully catches a fish and thus is able to sustain his existence.
Suppose that one day, however, Crusoe manages to catch two fish. Such a seemingly simple if fortunate event will have significant bearing on Crusoe’s prospects—it raises the possibility of capitalist development on his little island. Such development is not certain but rather will depend on Crusoe’s n
ext decision: whether immediately to feast on the two fish or instead delay his gratification and save the second fish for the following day’s meal. If he decides immediately to consume both fish, potential capitalist development is halted in its tracks. On the next day, Crusoe is “back to Go,” that is, he must continue to expend all his resources, his labor and time, in the attempt to catch the daily fish he needs for survival. If, however, Crusoe is more self-disciplined and far-sighted, he will choose not to eat the second fish but rather save it. In that event, he begins to build his “capital” (savings), thereby enlarging the personal resources—the time and labor—he has at his disposal. On the following day, he will not have to use all his limited resources to catch a fish, as was the case up to this point. His decision to save the second fish means that he can now “invest” the time and labor he would normally expend toward catching his daily fish toward production of another good, that is, satisfaction of another need.
If he is truly wise, moreover, Crusoe will choose to invest his savings (capital) in the production of what economists call “producer” goods, that is, goods such as tools that are not suitable for immediate consumption but rather useful in the production of consumption goods. If Crusoe is a good capitalist, then, he will use the time and labor he has gained by delaying consumption of the second fish to, say, scour the island for material suitable for building a net. He cannot consume the net, but it will greatly facilitate his attempts to catch (consumable) fish in the future. Suppose, then, that Crusoe uses his savings—his additional time and labor—to build a net and manages on the following day to catch half a dozen fish with his new tool. He is now well on the way to even further capitalist development. The net, the tool, has enormously increased the productivity of his labor, and he reaps the benefits of such productivity as additional “wealth,” in his case, additional time and labor. Now released from the daily necessity of catching a fish, Crusoe can employ such resources in the production of yet other goods that will further improve his condition, perhaps shelter, clothing, and so on. By choosing to save the second fish—the fruit of production beyond his subsistence needs—and further choosing to invest the additional time and labor so gained in the production of a non-consumable tool, Crusoe has increased his wealth and wellbeing. Indeed he has become a successful capitalist.
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