The complexity of the process cannot be overstated. The retailers, wholesalers, bottlers, pulp manufacturers, and orange growers will not be the only producers to experience sudden and unexpected demand for their products, initiated by the increased demand for orange juice at the retail level. It is difficult if not impossible to trace all of the individuals and industries involved in bringing additional supplies of juice to consumers at the local grocery store. The producers of orange pulp, for instance, may have to purchase new machines if they wish to increase production. This will increase demand for such machines and thus their price, which in turn will lead manufacturers of the machines to increase production. The machine-manufacturers may have to hire additional labor to do so, as will the orange growers and pulp producers, who will need additional workers to plant and pick the oranges and process the pulp. The increased demand for workers will put upward pressure on the price of labor; wages relating to employment in the orange-juice industry will increase to attract the workers needed to meet the increased demand for the final product. Firms that make plastic jugs will similarly experience an unexpected increase in demand for their product, which in turn will increase demand for the chemicals used in the production of plastic. The same will hold true for firms that produce paper labels; firms that make the ink used to print the paper labels and the glue that attaches them to the jug; firms that produce the wood pulp used to make the paper labels; transportation firms that carry the juice to the retail stores; manufacturers of tires used on such trucks; producers of the rubber used as an input for tires; tool makers who produce the machines necessary for juice processing; machinists who operate them, and so on. It is scarcely possible for the human mind to identify all of the thousands if not millions of people who will ultimately be involved in the seemingly simple act of increasing the supply of orange juice at the local grocery store.
Moreover, the knowledge required to initiate and guide the market process is minimal and spontaneously transmitted to all relevant parties. For instance, none of the individuals and firms involved in the production process need know anything about the newly discovered benefits of orange juice. The market process efficiently summarizes all knowledge relevant to their activities in the abstract symbol of a “price.” The only information needed by individual producers is that the price of their particular good or service, for whatever reason, has increased. The increase in the price of their particular product, whether orange pulp, trucking services, manual labor, processing of chemicals for plastic, and so on, means a potential increase in the profitability of their individual activity. Their self-interested desire to earn greater income leads them to take precisely the action the market “requests.” The ultimate result of the intricate process will be an increased supply of orange juice at the retail stores, precisely as demanded by consumers. Along with the essential preconditions of the market previously discussed, all that is required to achieve such a result is the spontaneous transmission of the information condensed in relative prices, information accumulated and transmitted through individual acts of buying and selling, and the fact that human nature is so constituted that, ceteris paribus, every person would prefer a higher to a lower income.[14]
Surplus and Shortage
The next issue to consider is how market forces lead to the production not only of more orange juice but the correct quantity of orange juice, that is, the amount consumers actually wish to purchase, no more and no less. More formally stated, the issue is how market forces prevent surplus (quantity supplied exceeds consumer demand) and shortage (quantity supplied insufficient to meet consumer demand). The market, as we shall see, is self-regulating in this regard as in others. In the long run, the spontaneous forces of the market tend toward the elimination of both surplus and shortage and this without need for intervention of authority. The market process will lead spontaneously not only to production of more orange juice, as demanded, but also in the quantity demanded by consumers.
To explain this aspect of the market process, it is necessary to introduce a formal economic term, what economists refer to as a “normal rate of return.”[15] Profit and loss are calculated, of course, by subtracting total costs of production from total revenue (earnings received from sales). The “normal rate of return” is the percentage of profit an investor expects to earn (“return on investment”) by investing his capital (savings) in a relatively risk-free asset, such as a bank certificate of deposit or a stable and mature industry not experiencing growth or decline. The normal rate of return can vary across industries. Over time, however, the rate of return within various industries tends to stabilize—to become the “normal” return expected from investing in a particular business or industry. In our example, prior to the unexpected increase in demand for orange juice, investors in the production of orange juice earned more or less the same rate of return, the “normal rate” for investment in the long-established and stable orange-juice industry. The sudden change in demand, however, led to upward pressure on prices of goods and services related to orange-juice production, price movements that changed—increased—the rate of return on investment in the orange-juice industry. As we have seen, in the short run, producers in every firm directly or indirectly involved in the production of the final retail good, orange juice, experience a rise in the price of their respective products. This means that their profits will rise and thus the rate of return on investment in their firms will rise. The fortunate producers and investors who initially experience an unexpected increase in demand for their products will, in the short run, earn a greater-than-normal return. In everyday language, they are now earning greater profits than before. Such economic actors are in an enviable position, but their good fortune is transitory. Such short-run effects will not endure over the long run.
In every developed market economy, people seek profitable opportunities for investment. Capitalist investors want to earn the maximum possible rate of return, and they scour the earth looking for the best—most profitable—investment opportunities. They are guided in such investment decisions by the price system. In our example, the increased profitability of investment in the orange-juice industry will quickly become public knowledge, entering the social process through changes in the structure of relative prices. Investors will compare the now-higher rate of return in the orange-juice industry with rates of return in other industries. They learn that investment in orange juice and related industries is now more profitable than investment in industries that have not experienced a comparable rise in demand. We have seen that all producers involved in the orange-juice industry have experienced increased profitability due to the increase in demand for their products, which means they are temporarily earning higher-than-normal rates of return. Other investors will want a share of this newly enlarged pie. Capital resources will flow into production of orange juice and related industries, eventually resulting in the production of more orange juice (as well as more oranges, pulp machines, plastic jugs, and so on).
Such investment is motivated, once again, by the self-interested desire for profit. Once again, however, it is also precisely what is desired from the point of view of consumers and society as a whole. The market process was set in motion precisely because consumers want more orange juice than formerly, and this requires that scarce resources be directed or redirected toward its production. Over time, the market responds by increasing investment in the orange-juice industry through the lure of potentially increased profit, thereby increasing the supply of the juice and necessary inputs.
Such an increase in investment and supply, however, is not infinite. It is safe to assume that demand will eventually stabilize at the point where enough orange juice is produced to satisfy the desires of all market participants. As supply increases over time, in conjunction with stable demand, the price of orange juice and related factors will tend to fall from their initial high (ceteris paribus, an increase in supply leads to a decrease in price). As such prices begin to fall, so does the rate of retu
rn on their production. Additional resources will continue to be invested in orange-juice production so long as the rate of return in that industry remains above the normal rate. As more and more supply enters the market, however, enticed by the above-normal rates of return, the price of orange juice and its inputs will continue to decline. Additional investment in orange-juice production will ultimately cease when prices fall to such a level that investors earn no more than the normal rate of return. The orange-juice industry will stabilize at this point. The final result of the market process will be an increased supply of orange juice, in more or less the correct quantity relative to demand, and at the lowest price necessary to produce it. All consumers who want orange juice will be able to purchase it; there will be no shortage. Sellers will not be saddled with lakes of orange juice they cannot sell; there will be no surplus. If a shortage should exist (demand exceeds supply), prices will rise and producers, in pursuit of profit, will be led to increase production, as discussed. If a surplus should exist (supply exceeds demand), prices will fall, and producers, aiming to minimize their losses, will be led to cut back on production. The self-regulating forces intrinsic to the market spontaneously tend toward elimination of both shortage and surplus.
Such, then, is the market process, the manner in which the market operates over time to adjust production to consumer demand and with the least possible waste of scarce resources. It should again be emphasized that the entire chain of events proceeds spontaneously, that is, without the conscious oversight or direction of any central authority. There is no need for a government “czar” to direct the orange-juice industry to meet the increase in demand. Each and every individual and firm involved is led to do precisely what it should do by pursuing individual self-interest, secured by property rights and guided by the movement of relative prices. Prices tell the producers what to produce—the orange juice the consumers urgently want, reflected in the increase in its price. Prices also tell producers how to efficiently produce the orange juice and related factors. In determining the best, most economic, way of producing an item, producers calculate their costs in terms of prevailing market prices. In order to increase their profitability, they will strive to use the lowest-priced inputs whenever possible. No one has to force them to conserve scarce resources; it is in their own interest to do so, since their profit depends in part on their costs of production. Moreover, all producers in a market economy seek to reduce the price of their good or service so far as possible; ceteris paribus, the lower the final price, the greater the demand for their product.
That is only to say that the market process is characterized by competition. Market competition, contrary to popular misconception, does not involve battle or conflict. Competition among producers serves both society in general and the consumer in particular. The threat to a firm’s profitability posed by the superior skill of existing competitors or potential entrance of new competitors ensures that any producer not utilizing least-cost methods of production, in service of actual consumer needs and wants, will be challenged by another firm that does so. A producer who faces competition from a rival who can produce the same good at lower cost, or a higher quality good at the same cost, will lose customers and sales, and perhaps be forced out of business. Market competition ensures that consumers do not have to settle for inferior goods or pay more for a good or service than is necessary to produce it. It further serves to ensure that scarce resources are used as efficiently as possible, an outcome that benefits not only consumers but society as a whole. All that is required is that potential competitors are free to enter or exit a given industry at will.
Finally, the price system also facilitates resolution of the third aspect of the economic problem: the problem of “distribution”—who is to receive the fruits of production. We have seen that in a market economy, the goods and services produced will be obtained by those persons willing to pay the highest price for them or, in venues that do not permit competitive bidding, by those willing to pay the price asked by the seller. No one is forced to purchase or prohibited from purchasing an item legally for sale in the market. Each individual evaluates the asking price of a good or service and decides for himself whether, in his own subjective judgment, the item is worth the price. That is only to say that in a market economy, individual consumers themselves solve the problem of distribution; they themselves determine “who gets what.” Indeed the very concept of economic “distribution” of goods and services is meaningless within a market economy. The concept of “distribution” of course implies a “distributor,” that is, an agent capable of conscious selection or choice. In a market economy, however, no one “distributes” any economic good to anyone (with the possible exception of intra-familial relations).[16] As will be further discussed in the following chapter, the concept of economic distribution is only meaningful within a planned or command economy controlled and directed by centralized political authority, for instance, communist and quasi-communist forms of economic organization. In a capitalist or market economy, on the contrary, no central authority consciously or deliberately “distributes” material goods or services to any particular person or group, that is, no governmental administrator decides which particular members of society shall receive which particular fruits of production. In a market order, each individual decides for himself.
The Invisible Hand
In 1776 Adam Smith published his seminal treatise on the operation of the market system, An Inquiry into the Nature and Causes of the Wealth of Nations. Among other major contributions, Smith highlighted the remarkable self-regulating and self-coordinating aspects of the market process, encapsulated in his celebrated metaphor of the “Invisible Hand.” We have seen how the guidance of prices permits human beings to employ scarce resources efficiently and toward production of items most highly valued by consumers. Smith perceived a further beneficent feature of the market process. As he observed the daily interaction of buyers and sellers in his small Scottish town, he was struck by the fact that market participants, as previously noted, were led, in their own self-interest, unintentionally and simultaneously to serve both their fellows’ interests and those of society as a whole, and this without any explicit direction from authority. The market order thus seemed to him marked by Providence, guided by an “invisible hand” that spontaneously produces harmony of interest among buyers and sellers as an unintended consequence of their individually self-interested motivations and actions.
Smith further perceived that the market system is not only efficient, rational, and conducive of interpersonal harmony but also commendable in a moral sense. More specifically, it provides the additional moral benefit of transforming or channeling purely self-regarding interests into actions beneficial to others. A market economy particularly serves to restrain the human propensity for selfishness—the tendency to consider only one’s self and one’s personal well-being and not also the wellbeing of others. Smith, like the American Founders, accepted human nature as it is. Neither he nor the Americans dreamed of attempting the impossible—transforming human beings into angels or selfless “servants of Humanity.” Human nature was regarded as given and fixed. Human beings are constitutionally self-directing and self-regarding, and this is not subject to change. “Self-interest rightly understood,” as Tocqueville later expressed the general idea, is a sure spring of human action—a core motivation of every human being—and rightly so.[17] Human beings always strive to pursue their own purposes and further their own wellbeing, and there is nothing intrinsically immoral about that fact. Smith’s great discovery, however, was that individual self-interest, while inevitable, can also be made to serve the interest and wellbeing of other human beings, a harmony spontaneously achieved through the “invisible hand” of the market.
It is thus ironic that one of the chief moral allegations raised against capitalism in subsequent centuries is its purported encouragement of “selfishness.” Modern society is saturated with caricatures of the market economy drawn by its enem
ies. Most Americans, for instance, are familiar with the figures of the heartless “capitalist pig” and “fat cats” of Wall Street motivated solely by greedy and selfish desire for personal profit and gain. The anti-capitalist animus conveyed by such images is a commonplace of modern culture at least since the time of Karl Marx. The irony stems from the fact that early theorists of the market, including Smith, regarded capitalism not as conducive to selfishness but rather ameliorative of that moral propensity. One of the special virtues of the market, Smith suggests, is precisely its ability to restrain the human propensity for selfishness while, moreover, simultaneously channeling selfish motives into actions that enhance the wellbeing of other persons.
The following example will illustrate the manner by which the market yields such a moral benefit. Imagine a young man contemplating his life plan, searching for a way to achieve happiness for himself and perhaps also his loved ones. The young man, like most persons, will be confronted by the need to earn a living. Everyone understands that fulfillment of their values requires certain material means; it is difficult to live a happy life if continually on the verge of starvation. Unless a person has inherited significant wealth, his attention is thus immediately drawn to choice of profession. Human beings, moreover, desire more than mere survival; they further want to thrive and flourish. They seek not only to earn an income but also a trade or profession that will allow pursuit of personal interests and propensities, development of their unique potential. Human beings are not interchangeable cogs in a wheel, but individuals who vary widely in values, abilities, and interests. They will generally consider such personal characteristics in light of their potential ability to obtain a source of income.
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