How Markets Solve The Basic Economic Problems

In a country like the United States, most economic questions are resolved through the market, so we begin our systematic study there. Who solves the three basic questions-how, what, and for whom-in a market economy? You may be surprised to learn that no individual or organization is consciously concerned with the triad of economic problems. Rather, millions of businesses and consumers interact through markets to set prices and outputs.

To see how remarkable this fact is, consider the city of New York. Without a constant flow of goods in and out of the city, it would be on the verge of starvation within a week. A wide variety of the right kinds and amounts of food is required. From the surrounding counties, from 50 states, and from the far corners of the world, goods have been traveling for days and months with New York as their destination.

How is it that 10 million people are able to sleep easily at night, without living in mortal terror of a breakdown in the elaborate economic processes upon which the city’s existence depends? The surprise is that all these economic activities are undertaken without coercion or centralized direction by anybody.

Everyone in the United States notices how much the government does to control economic activity: it legislates police protection, speed limits, antipollution laws, minimum wages, taxation, national defense, drug prohibitions, highway construction, and so forth. But we often overlook how much of our ordinary economic life proceeds without government intervention.

Thousands of commodities are produced by millions of people, willingly, without central direction or master plan.

Not Chaos but Economic Order 

Before they have studied the way the market works, most people see only a jumble of different firms and products. People seldom stop to wonder how it is that food is produced in the right amounts, gets transported to the right place, and arrives in a palatable form at the dinner table. But a close look at the example of New York is convincing proof that a market system is not a system of chaos and anarchy. A market system contains an internal logic. It works.

A market economy is an elaborate mechanism for unconscious coordination of people, activities, and businesses through a system of prices and markets. It is a communication device for pooling the knowledge and actions of millions of diverse individuals. With, out a central intelligence, it solves a problem that today’s largest computer could not solve, involving millions of unknown variables and relations.

Nobody designed it, and like human society, it is changing. But it does meet the first test of any social organization-it can survive.

History’s most dramatic example of the importance of the market economy came in West Germany after World War II. In 1947, production and consumption had dropped to a low level. Neither bombing damage nor postwar reparation payments could account for this breakdown. Paralysis 0f the market mechanism was clearly to blame. Price controls and overarching government regulation hobbled markets. Money was worthless; factories closed down for lack of materials; trains could not run for lack of coal; coal could not be mined because miners were hungry; miners were hungry because peasants would not sell food for money and no industrial goods were available for them to purchase in return. Markets were not functioning properly. People could not buy what they needed or sell what they produced at free-market prices.

Then in I948, the government freed prices from controls and introduced a new currency, quickly putting the market mechanism back into effective operation. Very quickly production and consumption soared; once again what, how, and for whom were lacing resolved by markets and prices. People called it “an economic miracle,” but in fact the recovery was largely the result of a smoothly running market mechanism.

The fact to emphasize is that markets are performing similar miracles around us all the time-if only we look around and alert ourselves to the everyday functioning of the market mechanism. So central are markets to the high levels of output of a capitalist economy that history often witnesses political crises when the market mechanism breaks down. Indeed, a revolutionary out to destroy Western democracies could ask for nothing better than a galloping inflation or depression to paralyze markets and produce political chaos.

THE MARKET MECHANISM 

Just how does the market mechanism go about determining wages, prices, outputs, and other economic variables? We can describe its workings easily.

Originally, a market meant a place where goods were bought and sold. Economic histories of the Middle Ages record that market stalls-filled with slabs of butter, pyramids of cheese, wet fish, and heaps of vegetables-would form the commercial centers of villages and towns.1 Today, important markets include the Chicago Board of Trade, where oil, wheat, and other commodities are traded, and the New York Stock Exchange, where titles to ownership of the largest American firms are bought and sold.

Market transactions are often made over the telephone or electronically (as for many financial transactions), and sometimes markets are not centrally organized but operate through individuals buying and selling a house or a car.

A market is an arrangement by which buyers and sellers of a commodity interact to determine its price and quantity. 

In a market system, everything has a price-each commodity and each service. Even the different kinds of human labor have prices, namely, wage rates. We receive income for what we sell, and we use this income to buy what we want.


Moreover, prices provide important signals to market participants. If consumers want more of any good-say, wheat-a flood of new orders will be placed for it. As buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration out a limited supply. And the higher price will encourage greater wheat production.

On the other hand, what if a commodity such as cars becomes overstocked at the going market price? Sellers will lower car prices in their rush to unload unwanted models. At the lower price, more consumers will want cars, and producers will want to produce fewer cars. As a result, a balance (or equilibrium) between buyers and sellers (or what the next Chapter and Part Four will call an “equilibrium of supply and demand”) will be restored.

What is true of the markets for consumer goods is also true of markets for factors of production. Recall that a factor of production is an input into the productive process-one of the classical tn'ad of land, labor, and capital. If computer programmers rather than typists are needed, job opportunities will be more favorable in the computing field. The price of computer programmers (their hourly wage) will tend to rise, and that of typists will tend to fall. The shift in relative wages will cause a shift of workers into the growing occupation.

Solution to the Three Problems 

What happens when we put all the different markets together-wheat, cars, land, labor, capital, and everything else? These form a market mechanism that grinds out an equilibrium of prices and production.

By matching sellers and buyers (supply and demand) in each of these markets, a market economy solves our three problems simultaneously. Here are the bare outlines of such a market equilibrium.

1. What things will be produced is determined by the dollar votes of consumers--not every 2 or 4 years at the polls, but every day in their decisions to purchase this item instead of that one. The money that they pay into business cash registers ultimately provides the payrolls, rents, and dividends that consumers, as employees, receive as income.

Firms in turn are driven by the desire for profits-profits being net revenues or the difference between total sales and total costs. Firms are lured into production of goods in high demand by the high profits there, leaving behind areas of low profits.

2. How things are produced is determined by the competition among different producers. The best way for producers to meet price competition and maximize profits is to keep costs at a minimum by adopting the most efficient methods of production. Producers a, Spurred on by the lure of profit--the production method that is cheapest at any one time will displace a more costly method.

History is filled with examples of how more efficient and lower-cost technologies replaced more expensive ones. Steam engines displaced horses because steam was cheaper per unit of useful work. Diesel and electric locomotives replaced coal-driven ones because of the higher efficiency of the new technologies. In the 1990s, glass fibers and lightwave communications will displace Alexander Graham Bell’s traditional copper telephone lines.

We can see the same phenomenon across nations. Bob Smith farms extensively, with much American land relative to each hour of labor. Pierre Reny farms intensively, using much labor to each hectare of French land.

Who makes sure that these how decisions reflect the fact that land is scarcer in France than in America? Is it Congress? The National Assembly? The United Nations? Of course not.

The price system is society’s signaling device. It tells farmer Smith that he should farm extensively by presenting him with a high ratio of wage rates to land rents. Peasant Reny, on the other hand, faces a low wage/rent ratio and uses more labor per unit of land than does Smith. By looking at price signals, farmers, firms, and other producers can choose the most appropriate technique of production.

3. For whom things are produced is determined by supply and demand in the markets for factors of production. Factor markets determine the wage rates, land rents, interest rates, and profits-such prices being termed factor prices. By adding up all the revenues from factors we can calculate people’s incomes. The distribution of income among the population is thus determined by the amounts of factors (personhours, acres, etc.) owned and the prices of the factors (wage rates, land rents, etc.).

Be warned, however, that there are also important extra-market influences that affect the resulting distribution of income. This distribution is highly dependent upon the ownership of property, upon acquired or inherited abilities, upon luck, and upon the presence or absence of racial and gender discrimination.

Who Rules? 

Who is in charge of a market economy? If we look beyond the details, we see that the economy is ultimately ruled by two monarchs: consumers and technology. Consumers direct by their innate or learned tastes. as expressed in their dollar votes, the ultimate uses to which society’s resources are channeled. They pick the point on the production-possibility frontier.

But the available resources place a fundamental constraint on consumers. The economy cannot go outside its PPF. You can fly to London, but there are no flights to Mars. An economy’s resources, along with the available science and technology, limit the places where consumers can put their dollar votes.

In other words, consumers are not the dictators in deciding what goods should be produced. Consumer demand has to dovetail with business supply of goods. Businesses set their prices based on production costs-moving into areas with high profits and leaving unprofitable sectors. So business cost and supply decisions, along with consumer demand, do help to determine what. Just as a broker may help arrange a match between buyer and seller, markets act as the go-betweens who reconcile the consumer’s tastes with technology’s limitations.

It is important to see the role of profits in guiding the market mechanism. Profits provide the rewards and penalties for businesses. Profits lead firms to enter areas where consumers want more goods, to leave areas where consumers want fewer goods, and to use the most efficient (or least costly) techniques of production.

Like a master using carrots and kicks to coax a donkey forward, the market system deals out profits and losses to get how, what, and for whom decided.

A Picture of Prices and Markets

We can picture the circular flow of economic life as shown in Figure 3-1. This provides an overview of how market prices reconcile household transactions with business needs. Note two different kinds of markets: one set for outputs like tea and shoes and the second for inputs like land and labor. Further see how decisions are made by two different entities, households and businesses.

Households buy goods and sell factors of production; businesses sell goods and buy factors of production. Households use their income from sale of inputs such as labor and property to buy goods; businesses base their prices of goods on the costs of labor and property. Prices in goods markets are set to balance consumer demand with business supply; prices in factor markets are set to balance household supply with business demands.

All this sounds complicated. But it is just this intricate web of interdependent supplies and demands through which the prices in a market mechanism solve the how, what, and for whom. A few minutes spent studying Figure 3-1 now will pay many dividends later in furthering your understanding of the workings of a market economy.

The Invisible Hand and “Perfect Competition” 

Adam Smith, whose The Wealth of Nations (1776) is the germinal book of modem economics, was thrilled by his recognition of an order in the economic system. Smith proclaimed the principle of the “invisible hand.” This principle holds that every individual, in selfishly pursuing only his or her personal good, is led, as if by an invisible hand, to achieve the best good for all. Smith held that, in this best of all possible worlds, any government interference with free competition is almost certain to be injurious. (Reread carefully this chapter’s introductory quotation.)

The invisible-hand doctrine is a concept for explaining why the outcome of a market mechanism looks so orderly. Smith’s insight about the guiding function of the market mechanism has inspired modern economists-both the admirers and the critics of capitalism. After two centuries of experience and thought, however, we now recognize the scope and realistic limitations of this doctrine. We know that the market sometimes lets us down, that there are “market failures,” and that markets do not always lead to the most efficient outcome. One of the major market failures, whose consequences will run as a the e through this book, is imperfect competition.