Market Theory Made Easy: Part 1

Introduction and Purpose

This is an attempt to provide a simple, but extensive introduction to economics and market theory for anyone who is new to the subject or who is trying to better understand the Austrian approach to economics. I also hope that it will also prove useful for anyone who could use a refreshing run through of market theory. I will use as little jargon as possible, since scholarly terms often do more to confuse non-economists than to educate them. Whenever I feel that I have to use jargon I will define the terms in question as simply and clearly as possible. Hopefully this article succeeds in explaining market theory in a straightforward and helpful way. I have arranged this article according to the general subjects it covers; I have also divided it into the more basic (the first post) and more advanced material (the second post) for the sake of space.

Let’s begin

What are Markets and why do they exist?

The market process is the outcome of free individuals trying to improve their lives through exchange. Since people believe their lives can be made better off by obtaining goods and by receiving the benefits of certain services, humans engage in trade. This is our first case of jargon. When economists say “goods and services” they mean something which is abstract but simple. Goods are usually physical things, or things which are at least tangible, like a pencil or an application on a smartphone. Services are usually one-time things which a person does for someone else. For instance if someone fixes your car, or if I play you a piece of music, then this is something which I have done for you. It is not something physical that I gave to you.

A fully free market can only truly emerge if person and property are respected. If individuals and their property can be manipulated then they are not entirely free to do things in the way they see fit. We will discuss the effects which this has on the economy later. All this means that on the free market no one is allowed to force someone else into an exchange, nor to take their property. If you buy a cake from me, it is not because the government, a thug, or anyone else forces you to buy it, it is merely because you feel the desire to buy my cake. Because of this we know that all exchanges must benefit both people who are involved. We know this since no one can ever purposefully do something that they don’t want to do. Someone can do something while in a delusional state, or when they’re highly emotional, but this is the same as saying that people can make mistakes. While this is obviously true, it cannot change the fact that if someone makes an exchange they have to believe that the exchange is beneficial at the moment of the exchange. Even if you are mad and hit someone who you’d rather not harm, you still had to have thought for at least an instant that this would somehow benefit you. However, the decisions people make in the economy are usually much more logical than the preceding example.

In modern markets people exchange money in return for goods and services. Money obtains its value almost exclusively because it can be exchanged for other things. A dollar is not really piece of paper to most people, instead it’s half a carton of eggs, it’s a newspaper, it’s one hundredth of a cellphone. Through trade markets come into existence, that’s all a market is: a system in which people voluntarily exchange goods and services. The way in which you live and practically every material comfort that you enjoy (including the computer on which you are reading this post) is the result of functional markets.

When we look at markets we call the individual or group exchanging money for a good the buyer or the consumer, while the individual or group exchanging a good for money the seller or producer. These terms are slightly inaccurate, however, since there is little point in obtaining money except to eventually exchange it for other goods. The producer is driven ultimately (once again, there are a handful of exceptions) by his desire to experience the benefits of goods and services provided on the market by other producers, and so on. This means that when all is said and done the seller is really just as much a consumer as his customer is. This means that the market acts as a great bringer of peace and mutual well being. It aligns the interests of everyone insofar as they are willing to accept the rules of the market: non-violence towards other people. In order to have my needs met I must meet your needs, and you must have met someone else’s needs, and so on. No longer, as in many non-market societies do I need to use force against you to obtain what I want, but instead I can do so in such a way that makes us both better off.

The producer is made into the voluntary servant of the consumer. While all producers desire money (if they didn’t they would not be exchanging goods for money!) not every consumer will desire a good or service just because a producer is offering it. Therefore the producer must fulfill the desires of the consumer if he is to receive money. This is why many economists relate the market as being a “consumer’s democracy”; because things are produced according to what consumers desire. If I were to write scribbles on a piece of paper and try to sell it, I would fail utterly as a producer. I must make what people want at the lowest price possible or else people will either purchase similar goods from other producers, or they will simply not pay for the type of good that I have made at all. Producers must make what consumers want and try to satisfy their desires at every turn, or else the producers will not be able to maximize their money income.

Before we move on to our next section we should reinforce what makes a market. All that is necessary for markets to come about are property rights and the will to exchange. I have to be able to own cabbages before I can sell them to you, and you have to want to buy my cabbages before an exchange can take place. From here cabbages and all other goods in the economy are produced at the lowest price at which they can be provided.

Many people attack the market because it promotes “greed”, but we see that nothing could be further from the truth. Wanting a good life for yourself is not especially greedy, nor is the market an especially selfish system in and of itself. We don’t know why you want to maximize your income, perhaps you want a nice new car, perhaps you want to provide the best life you can for your family, or maybe you want to help the poor. A perfectly altruistic man would be happy to engage in the market system as a producer because all he is doing as a producer is providing for others. The market system works in a world of angels or a world of demons (so long as non-agression can actually be maintained in the latter world). In a world of angels people will produce in the market to make sure that they are producing what others want, and they will be happy to give up large amounts of their own income to others. In the world of demons people will have to provide for others, whether they want to or not, so as to maximize their own incomes and have their own wants fulfilled. The market is neutral to greed, and it works just as well whether or not material greed is the primary motivation for human action.

This fact alone would appear to make the market a very positive system from the point of view of peace, prosperity, and mutual aid, since in the market it almost always makes more sense to work together in exchange and cooperation, rather than through theft and violence.

The Factors of Production and Competition

“The factors of production”, “productive inputs”, or “productive factors”, give us another example of the sort of scary jargon which drives people away from economics. All these terms mean are: “The things people use to produce goods”. These are divided into three broad categories: Land, labor, and capital.

Land is beyond the scope of our analysis here, just suffice it to say that it’s a little more complicated and broad than just your yard out back. With this said it’s obvious we need land to produce things and that different plots of land provide different valuable properties. For instance some land is especially fertile and therefore good for farming, while some lands has valuable natural resources like gold and iron under it. Labor includes all the productive work which people do. Moving boxes around is labor, and so is the work put in by engineers working to designing things like cars. Finally, capital goods are goods which are made because they can be used to produced final products, also known as consumer’s goods (consumer’s goods are merely the things which are actually sold to consumers on the market like a magazine or piece of fruit). Capital goods consist of things like machines, which are made so that they in turn can produce other goods. Capital goods also include of things like wooden boards which are cut out of trees. No one desires a wooden board, but they do desire what can be cut out of the board. These three factors of production are what drive the productive process. Everything that you enjoy can ultimately be attributed by the productive power of these three components.

First we will talk about labor. Labor is ultimately subject to “the division of labor”. This is simply a term which describes something that everyone knows about and almost everyone engages in: becoming specialized in in doing a specific job. It is the living embodiment of the cooperation which we spoke of in the previous section. A construction worker is skilled in just that; construction work. The construction worker probably knows little about painting or the production of electronics, so he specializes in construction work while other people specialize in making electronics. If something can be done more efficiently through specialization and having engineers, hard laborers, and salespeople all work together (and it almost always is) then they will work together to produce the good since it means that all the laborers can obtain a higher income as more of the product is sold at a lower price, increasing total revenue. The efficiency of the division of labor increases how much is produced in general and what everyone receives. If no one were to specialize then very few goods could be produced on the market. Just imagine trying to make your own car. The feat sounds as ridiculous as it actually is. Not only would the process be stupefyingly expensive and time consuming, but it might actually be impossible. By specializing your labor you can quickly and easily buy a car at an exceedingly small fraction of the cost it would have taken you to produce said car.

On the market labor is valued like any other productive input; it’s value comes from what it produces. If someone is working for you to make candy, then what is important is not how much money you make off of the candy, but how much money the person you have hired has made for you. If you hire a hundred people and together they only produce a thousand dollars worth of candy an hour then you can’t afford to pay each person more than ten dollars and hour. Not all types of labor are equally productive. Technicians produce a lot more value in terms of the product than do janitors. Therefore differences in income, and indeed the prices of all productive factors (the income someone receives for work is really just the price a producer has to pay for labor) come about based on what they make. This is known as “derived demand”. Derived demand is a straightforward concept. It means that demand by producers for factors of production doesn’t come from the direct satisfaction provided by that good, but instead it is derived from what that good can produce in terms of the final product of consumer’s goods.

The fact that labor is bought and sold (although really it is rented) just like inhuman things like iron and land is often cited by critics of the market economy to show that producers are cruel and uncaring. This is not the case, however. If I am paying someone more than their labor produces then I’m giving them more than consumers (the real bosses of the market) value his labor. If I were to do this on a mass scale then I would go out of business. Producers are not necessarily being cruel when they trade for labor (we have already stated that the feeling of producers are irrelevant) they are just doing their best to provide what consumers desire.

Derived demand means that the market will allocate labor and all other factors in such a way that the most urgent needs of the consumers are met. As we have stated the more consumers desire something the more they are willing to pay for it. This means that the factors of production will have the highest derived demand in productive processes where consumers are willing to pay more for the final product. For instance if electricians are currently occupied in a productive process which yields twenty dollars per hour per electrician and I start a process which makes twenty five dollars per electrician, then I can afford to bring the electricians to my productive process. I can do this by offering them the higher wage that is the corollary of the increased product they provide for consumers when opposed to the old process.

This also brings about something called “opportunity cost”. While opportunity cost is important to many things in the economy at this point in the discussion it is relevant to factor pricing. In our above case the price, and therefore opportunity cost, of labor in the market for the labor of electricians was twenty dollars. This means that when taking any new job electricians must take into account their oppurtunity cost, what else they could be doing, of their time. If I had only offered them nineteen dollars then electricians wouldn’t come and work for me since they could stay more by taking a twenty dollar job. This means that ultimately, because of opportunity cost as the outcome of derived demand, factors will almost always be used in those areas where they are most highly desired. The derived demand of factors will bid them to their most highly valued spot, and the opportunity cost for the factors which this creates makes sure that they stay there.

The importance of this fact cannot be overstated. It means that the entire market economy is rational and that prices of productive factors are not arbitrary. Instead they are the outcome of how productive the factors themselves are. Laborers make what they make for a reason, and all prices are what they are for a reason, it’s not something which can be manipulated in a willy-nilly fashion. It also gives a very important implication to profits. Profits are an excess of money received as a result of selling a good over the costs of producing that good. If I spend a hundred dollars making something, and I receive a hundred and ten dollars in return, then I have made a profit of ten dollars. If I spend a hundred dollars making something and I sell it for ninety dollars, then I have experienced a net loss of ten dollars. Opportunity cost makes clear the importance and the social function of profits and losses. If I have made a profit then that means that I have used the factors of production in a more productive way than the way in which they were previously being used. If the prices of productive factors were higher than the price of the final output they made for me then this must mean that they could have been used to produce more highly valued consumer’s goods in other areas. Therefore we know that in this case I have wasted the factors by using them to produce the lower-yielding endeavors and that they were more productive where they originally were. On the other hand profits are a sign of more productive use of factors, while losses tell us that the factors have been wasted. Profits and losses play the invaluable role of rewarding efficient producers and punishing less efficient ones.

Finally, a word about competition.

Economists often compare profit opportunities to money sitting on a table. There is no reason to believe that if someone put money on a table in a public place that it would just sit there since there’s an opportunity for someone to just come and pick it up. Similarly if there’s something a profitable project to be invested in then it makes no sense that no one would take this opportunity, and they wouldn’t engage in profit seeking behavior.

More efficient producers will always be looking to enter into markets which are less efficient. If you are making something in a wasteful way, or if you are charging much higher prices for a consumer’s good than what it costs to make that good, then if I’m a smart producer then I can start up my own company and compete with the inefficient producers. If I am as, or more, efficient than you then I will be able to charge a lower price than you do, either because I am indeed more efficient than you, or because I undercut you with my low prices. This means that consumers will buy my good, which is cheaper and your profits go down, while mine are decently sizable. In the end you either you have to become more efficient, decrease your prices, or go out of business. This process means that profits usually fall to a fairly low level, either because new people come in and compete, or a company is afraid that they will, so it makes sense to charge low prices so as to avoid competition. The effect of this is to also ensure that the factors of production are priced to their true value.

This is because the aforementioned process also works in bidding up the prices of the factors of production to their real value. If I enter into the same industry as you then I will also need to bid away the factors of production you are using by offering them something closer to their real value. Even if prices are low if the factors of production aren’t valued at what they produce there will always be the ability for competent producers to come in and compete with their less efficient counterparts. The market constantly work to take money off the table and to ensure that all goods in the economy are being provided as efficiently as possible.

Conclusion

This concludes the first half of our analysis. While we have effectively covered a lot of ground there is still a good deal we have left to do. In particular we have not accounted for the eternal presence of a dynamic and changing economy, what dictates the production of capital, and the effects of government intervention upon the market. We will look to these issues in the next post.

-Neodoxy