Market Theory Made Easy: Part 2

Entrepreneurship and Innovation

In Part I we looked at a certain world without uncertainty, yet this is not the world in which we live. No one knows whether or not a productive process will really yield a profit because no one can be certain what consumers will demand in the future. We call the people who take risks by starting and funding businesses “Entrepreneurs”. They are the movers and shakers of the market economy.

The market economy naturally attracts wise entrepreneurs and effective innovators. While above we have shown how efficient entrepreneurs can decrease profits and put an end to waste; they can also bring new products to the market and ensure that future goods are provided in necessary quantities. If an entrepreneur designs a new product that people would buy then he can make a profit by producing this new good. By producing and providing these goods the entrepreneur fulfills the desires of others and improves the quality of their lives. The same is true for what quantity of existing goods or future goods should be brought to the market. How much of a certain good will people want in the future? If it’s less than is currently expected then an entrepreneur can make a profit by increasing his output to sell these goods in the future. If demand really falls in the future than people currently expect then an entrepreneur can avoid losses by decreasing his production

It’s important to see that what we have outlined above is a very risky endeavor. It’s often difficult to know what we will want in the future, let alone what thousands of other people will desire. For this reason entrepreneurship is both very risky and very important. If production did not change as demand and technological abilities changed then the quality of service provided to consumers would be continuously decreasing. If entrepreneurs have used their funds wisely and correctly anticipate what people want then they will receive a profit, but if they have improperly anticipated future events and then they will experience losses. Speculation, estimation, and anticipation of future events are what drive the market, and it’s essential that entrepreneurs freely face the full brunt of their profits and their losses so that the best entrepreneurs can continue to invest, while their inefficient counterparts are weeded out. The profits and losses sustained by previous entrepreneurs are also an indicator to current entrepreneurs that they should engage in similar behavior. For instance, if a new electronic gadget fails, then this indicates to me that I shouldn’t make something similar to it.

Entrepreneurs assume the role of liability and risk in the market economy, for if the company fails then it is the entrepreneur who is financially ruined and has to deal with all outstanding debts. Profits are the opposite of losses, and the entrepreneur is responsible for both. Nonetheless, it is ultimately the consumer who is the master of the market economy. Although entrepreneurs directly organize the market economy, they must ultimately guide production towards what consumers demand or else these entrepreneurs will experience losses and be replaced by others more willing and able to produce in line with consumer preference.

Capital Goods and Savings

We outlined what capital goods are and some major factors that determine how these goods are priced in the first part of this series. It is important to see that capital is extremely important to the market economy because it increases the quantity of goods which can be produced in the economy. In the absence of the great factories, tools, and materials which make up developed economies we would all be as impoverished as the most primitive ape. Therefor it’s important to understand how capital is accumulated. “Capital accumulation” is jargon for producing capital goods like tools and factories that allow us to produce more in the future.

Private ownership of capital means that the owners of capital receive income off of their productive property. This is important because capital is often expensive and requires a long-term investment. If I have to pay thirty dollars for a hammer and it makes a product worth five dollars a year, then I’d have to wait for a whole six years before I would start making money off that hammer. Long-term private ownership provides an incentive to produce capital goods which require a long period to pay off. Capitalists, the owners of capital, also have a clear reason to take care of their capital goods and to make sure that they last for a long time. This is also true of natural resources and land. Property rights over productive inputs must be ensured so that firms don’t squander them. If I’m afraid a machine I currently own will be confiscated in future, then I probably won’t care how quickly I wear it down because I will want to sell as much product from the machine as I can right now, rather than losing the machine before I could get any more money off it. Long-term private ownership brings about investment and higher output over time. When private property of productive inputs is threatened capital is wasted, land is polluted, and future production possibilities are sacrificed as entrepreneurs scamper to get whatever profits they can while they can.

Savings and the interest rate play an essential role in capital accumulation. The interest rate is a percentage of an initial amount of money which has to be paid back over a period of time. If I borrow a dollar from you at an interest rate of five percent annually then I have to pay you a dollar and five cents in a year. The rate of interest indirectly signals to producers the value of another major productive input: time itself. If I were to plan a massive super factory that would give me profits of forty percent over the price of inputs, but it took thirty years to build, then even though this would certainly increase productivity it probably wouldn’t be worth producing because of the value of all the productive opportunities foregone in the time it took to make the factory. The interest rate conveys societies’ “time preference”, how greatly present goods are desired over future goods. Do you prefer a dollar today or two dollars tomorrow? The lower the interest rate the “lower” the time preference, the less society cares whether projects take a long period of time to produce. Since money is practically universally desired more presently than in the future, the interest rate conveys this by making a project more expensive the longer it takes to complete. A project that costs fifty dollars over ten years will accumulate much more overall cost due to interest payments than one that requires 50 dollars over one year. If the rate of interest were exactly zero, and it was never expected to change, then as long as I was doing something which would result in profit, then it wouldn’t matter if it took a million years to happen, I’d just have to pay you back after this time was done. The zero rate of interest would imply that society has no time preference, the market is perfectly neutral as to whether something is produced in the future or currently. If you had no time preference then you would be indifferent if you lent out a dollar today as long as you got the dollar back at any time in the future.

Therefore the lower the interest rate the more capital will be accumulated. There are two reasons for this. Firstly capital takes time to produce. A factories and railroads don’t simply pop into existence, they take a long period of time to be made. If the interest rate is lower, then the costs go down for longer-term projects, and so more capital can be produced, increasing the productivity of society. Secondly a lower interest rate also makes some current projects more valuable. If a certain productive endeavor only took a year to complete, but the expected profit was only 2 percent, then the year it would take to produce wouldn’t be profitable if the interest rate were 3 percent. If the interest rate fell to 1 percent it would then be profitable and more capital would be produced even in that short-term project. Low interest rates promote large expansion of capital goods because they decrease the costs of producing over time.

The importance of savings should be obvious. In order to invest we made first save. If everyone were to just spend money, rather than investing it, then the whole productive system would eventually fall apart as the interest rate skyrocketed, old machines broke down from wear and tear, and “non-durable” capital like wooden boards and thread couldn’t be replaced since, even though they are used up quickly, it takes a decent period of time to produce them. If no one saved and invested money then only the swiftest and most productive of endeavors would be produced. Investment paves the road to a better future. Through investing in capital goods now a larger quantity and higher quality of consumer goods can be produced in the future. Lowering the interest rate increases capital accumulation, and by saving rather than consuming, by expressing a lower time preference, society lowers the interest rate.

Government and the Economy

The government can pass laws that directly affect the functioning of the market economy or it can spend money that alters the market economy in other ways. For instance the government could pass a law saying what price people could sell cake at, or the government could state that certain goods can only be made in certain ways. Alternatively the government could buy up a large amount of cakes, or subsidize cake producers. Whenever you hear economists talk about “intervention” by the government, they are talking about government spending or passing laws that affect the economy. All of these things affect how producers and consumers act. Intervention is usually justified by fixing flaws in the market economy.

Unfortunately, intervention usually makes people worse off. This is usually going to be true for two reasons. We have already shown that the market is a system that is based around mutual benefit and that it arranges itself in such a way that the most efficient producers are always rewarded, leading to increased productivity over time, all based around what people actually want and are willing to pay for. Failures in this system are relatively rare, and are usually (although not always) so small that the government often has a very hard time pinpointing them and fixing them. This means that whenever the government tries to interfere with the market it is likely to interfere with how efficient firms are, or it will prevent people from buying goods which they would really like to buy. The government gets in the way of the generally efficient market economy. The second reason state intervention is generally negative is that the government itself is generally inefficient. The government doesn’t need to efficiently serve the consumer, since no one can compete with the government, nor can the efficiency at satisfying consumer desires be expressed through profits and losses.

Let’s display an example of the negative effects of government intervention by examining the effects of the most well-intentioned of interventions: banning child labor in poor countries. This would at first appear to be a very well-intentioned and wise choice. Many places in the third world provide awful conditions for children to work and at very low wages, so surely the government would generally make people better off by banning this practice. The truth is the intervention would make things worse. The families of these children are usually struggling as it is, and without the pay from the child labor many families would probably go hungry. The law hasn’t fixed what caused the need for child labor in the first place: the overwhelming poverty in the third world. Therefore both the children and parents will just be even further impoverished. Another awful effect of this is the alternative some children will have to adopt. In poor countries an appallingly common alternative to factory work for children is prostitution or sex slavery, a blatantly more awful alternative. This is a case where well intentioned government action has awful consequences.

A much milder, but still very important example of bad effects of government intervention can be found in the minimum wage. The minimum wage increases the wage low-skilled workers are paid. As we have stated above, all things in the market economy are priced at the level they are for a reason. If wages for very unskilled labor are at wage X then this is most likely because wage X is about the same amount of money which the worker adds to production. If you say to entrepreneurs “you must pay a higher amount in wages”, then they aren’t going to employ the same amount of workers at the higher wages because this would lose them money. If a tool adds a dollars’ worth of output in what you’re making then you will pay up to a dollar for it. If the government tells you that you have to pay two dollars for the tool then you aren’t going to lose a dollar by buying it, you’re not going to buy it at all. This means that many lower skilled workers won’t be able to find work, they’ll be out of a job and unemployed. This is especially unfortunate for low-skilled workers who are especially in need of the money. It’s important to note that the minimum wage doesn’t just hurt the workers who are unemployed, but it hurts everyone involved. Consumers now have to pay higher prices, since the cheapest production option, low skilled labor, is now unemployable, and the producer will likely see slightly lower profits too.

These are just two examples of how well intentioned government interventions can lead to awful side effects that harm everyone involved with the intervention. The market is generally quite an intelligent, efficient, and positive system, so direct action in the economy usually disrupts this order and make things worse.

The government doesn’t need to preserve resources since no one in the government owns those resources. Tax money is unusable by the government except for its own pet projects, so it has no reason not to squander tax money. The government has another inherent problem: How much should it spend? The government could probably bring the crime rate down to about zero if it had about five cops wandering around each city block, but this would cost an absurd amount of money, so how much should the government spend? All answers are entirely arbitrary, but no matter how it’s decided you’re forced to pay whatever the government tells you whether you like it or not. This means that while the market has a very clear goal to work towards, profit, the government is fumbling in the dark by comparison. The market can look at demand for its product, and derive its own demand for productive factors from here, since consumers are the ultimate masters of the market economy. Meanwhile while the government has nothing to look at to judge the extent and quality of its services, it simply acts arbitrarily.

The government also has a very big problem in how its leaders are appointed. Democracy, while historically being the best form of government, suffers from the problem that each person only gets one vote, the very essence of the system. While in very small situations this isn’t a big deal, in larger situations it means that voters have very little reason to be educated on issues. Even a relatively small election in modern America, say an election with fifty thousand voters, suffers from this problem. No one would deny that what the government is doing is extremely important, but if you only have a one in fifty thousand chance of being the deciding vote, then how long are you really going to spend looking into the issues? Even if you do, many people won’t and don’t. Many people are stupid, closed minded, or gullible, and this means that they are prone to vote unwisely. People are also unable to show how much they prefer something. You vote for one candidate or another, you cannot show how much you prefer one candidate or how much you prefer certain policies, unlike the market economy where you display (in an admittedly rudimentary manner) how much you prefer something.

We can see then that the government is likely not only to disturb the market economy from its positive and naturally occurring state, but also to introduce a whole host of new problems of its own. This is why economists tend to be very skeptical of government intervention

Conclusion

The market economy is a system of production which aligns itself to consumer demand. It produces what people want at relatively low prices, it rewards innovators and those who predict future conditions well, and it ensures a system in which capital can be accumulated which leads to a better standard of living for everyone in society. Rather than being arbitrary, both levels of pay and the prices of productive inputs are based off of the demand of consumers, and they are constantly being driven towards their real values by entrepreneurs. When the government interferes with matters it tends to bring about negative consequences, both because it disrupts this order of the market, and because it has a poor incentive structure which makes it generally inefficient.

Hopefully this exposition gives a brief, but extensive introduction into market theory. There is always much more to learn, however. Nonetheless I hope that it becomes obvious that economics, instead of being complicated and nonsensical, is actually quite logical. Jargon which seems quite scary, really just describes fairly simple, but important, human activities.