The ABC of a Market Economy

There are basically only two ways in which economic life can be organized. The first is by the voluntary choice of families and individuals and by voluntary cooperation. This arrangement has come to be known as the free market. The other is by the orders of a dictator. This is a command economy. In its more extreme form, when an organized state expropriates the means of production, it is called socialism or communism. Economic life must be primarily organized by one system or the other.

It can, of course, be a mixture, as it unfortunately is in most nations today. But the mixture tends to be unstable. If it is a mixture of a free and a coerced economy the coerced section tends constantly to increase.

One qualification needs to be emphasized. A “free” market does not mean and has never meant that everybody is free to do as he likes. Since time immemorial mankind has operated under a rule of law, written or unwritten. Under a market system as any other, people are forbidden to kill, molest, rob, libel or otherwise intentionally injure each other. Otherwise free choice and all other individual freedoms would be impossible. But an economic system must be dominantly either a free or a command system. 

Ever since the introduction and spread of Marxism the great majority of people who publicly discuss economic issues have been confused.  Recently a very eminent person was quoted as denouncing economic systems that respond “only to the forces of the market place,” and are governed “by the profit motive of the few rather than the needs of the many.” He warned that such a system could put “the world’s food supply into even greater jeopardy.”

The sincerity of these remarks is beyond question. But they show how phrases can betray us. We have come to think of “the profit motive” as a narrowly selfish drive confined to a small group of the already-rich whose profit comes at the expense of everybody else. But in its widest sense the profit-motive is one that all of us share and must share. It is our universal motive to make conditions more satisfactory for ourselves and our families. It is the motive of self-preservation. It is the motive of the father who is not only trying to feed and house himself but his wife and his children, and to make the economic conditions of his whole family, if possible, constantly better. It is the dominant motive of all productive activity.

Voluntary Cooperation

This motive is often called “selfish.” No doubt in part it is. But it is hard to see how mankind (or any animal species) could have survived without a minimum of selfishness. The individual must make sure he himself survives before the species can survive. And the so-called profit motive itself is seldom solely selfish.

In a primitive society the “unit” is seldom the individual but the family, or even the clan. Division of labor begins within the family. The father hunts or plants and harvests crops; the mother cooks and bears and nurses children; the children collect firewood, and so forth. In the clan or the wider group there is even more minute subdivision and specialization of labor. There are farmers, carpenters, plumbers, architects, tailors, barbers, doctors, lawyers, clergymen, and so ad infinitum. They supply each other by exchanging their services. Because of his specialization, production increases more than proportionately to numbers; it becomes incredibly efficient and expert. There develops an immense system of voluntary productive cooperation and voluntary exchange.

Each of us is free (within certain limits) to choose the occupation in which he himself specializes. And in selecting this he is guided by the relative rewards in this occupation, by its relative ease or difficulty, pleasantness or unpleasantness, and the special gifts, skills, and training it requires. His rewards are decided by how highly other people value his services.

Free-Market Economy

This immense cooperative system is known as a free-market economy. It was not consciously planned by anybody. It evolved. It is not perfect, in the sense that it leads to the maximum possible balanced production and/or distributes its rewards and penalties in exact proportion to the economic deserts of each of us. But this could not be expected of any economic “system.” The fate of each of us is always affected by the accidents and catastrophes as well as the blessings of nature—by rainfall, earthquakes, tornadoes, hurricanes, or what not. A flood or a drought may wipe out half a crop, bringing disaster to those growers directly hit by it, and perhaps record-high prices and profits to the growers who were spared. And no system can overcome the shortcomings of the human beings that operate it—the relative ignorance, ineptitude, or sheer bad luck of some of us, the lack of perfect foresight or omniscience on the part of all of us.

But the ups and downs of the market economy tend to be self correcting. Over-production of automobiles or apartments will lead to fewer of them being produced the following year. A short crop of corn or wheat will cause more of that crop to be planted the following season. Even before there were government statistics, producers were guided by relative prices and profits. Production will tend to be constantly more efficient because the less efficient producers will tend to be weeded out and the more efficient will be encouraged to expand output. The people who recognize the merits of this system call it the market economy or free enterprise. The people who want to abolish it have called it—since the publication of The Communist Manifesto in 1848—capitalism. The name was intended to discredit it—to imply that it was a system developed for and by the “capitalists”—by definition the disgustingly rich who used their capital to enslave and “exploit” the “workers.”

The whole process was grossly distorted. The enterpriser was putting his accumulated savings at risk at what he hoped was an opportunity. He had no prior assurance of success. He had to offer the going wage or better to attract workers from their existing employments. Where the more successful enterprisers were, the higher wages also tended to be. Marx talked as if the success of every new business undertaking was a certainty, and not a sheer gamble. This resulted in his condemning the enterpriser for his very risk-taking and venturesomeness. Marx took profits for granted. He seemed to assume that wealth could never be honestly earned by successful risk-taking but had to be inherited. He ignored the record of constant business failures.

But the label “capitalism” did pay unintended tribute to one of the system’s supreme merits. By providing rewards to some of the people who risked investing their capital, it kept putting into the hands of the workers more and constantly better tools to increase per capita production more and more. The system of private property and capitalism is the most productive system that has ever existed.

The Communist Manifesto was an appeal to “the masses” to envy and hate the rich. It told them that their only salvation was to “expropriate the expropriators,” to destroy capitalism root and branch by violent revolution. Marx attempted a rationalization of this course, built upon what he saw as inevitable deductions from a doctrine of Ricardo. That doctrine was in error; in Marx’s hands the error became fateful. Ricardo concluded that all value was created by “labor” (which might almost be true if one counted labor from the begin ning of time—all the labor of everybody that went into the production of houses, land clearing, grading, plowing, and the creation of factories, tools and machines. But Marx chose to use the term as applying only to current labor, and the labor only of hired employees. This completely ignored the contribution of capital tools, the foresight or luck of investors, the skill of management, and many other factors.

The Errors of Marx

The theoretical errors of Marx have since been exposed by a score of brilliant writers. In fact, his preposterous conclusions could also have been proved wrong even at the time Das Kapital appeared by a patient examination of the available contemporary knowledge of incomes, payrolls and profits.

But the day of organized, abundant, and even “official” statistics had not yet come. To cite only one of the figures we now know: In the ten years from 1969 to 1978, inclusive, American “nonfinancial” corporations were paying their employees an average of 90.2 percent of the combined total available for division between the two groups, and only 9.8 percent to their stockholders. The latter figure refers to profits after taxes. But only about half of this amount—4.1 percent—was on the average of those ten years paid out in dividends. (These figures compared with public-opinion polls taken at the time which  showed a consensus of most Americans that corporate employees got only 25 percent of the total available for division and the stockholders 75 percent.)

Yet the fierce diatribes of Marx and Engels led to the Russian Revolution of 1917, the slaughter of tens of thousands, the conquest and communization by Russia of some half dozen neighboring countries, and the development and production of nuclear weapons that threaten the very survival of mankind. 

Economically, communism has proved a complete disaster. Not only has it failed to improve the welfare of the masses; it has appallingly depressed it. Before its revolution, the great annual problem of Russia was to find sufficient foreign markets for its crop surpluses. Today its problem is to import and pay for less than adequate foodstuffs.

Yet The Communist Manifesto and the quantity of socialist propaganda which it inspired continue to exert immense influence. Even many of those who profess themselves, quite sincerely, to be violently “anticommunist,” feel that the most effective way to combat communism is to make concessions to it. Some of them accept socialism itself—but “peaceful” socialism—as the only cure for the “evils” of capitalism. Others agree that socialism in a pure form is undesirable, but that the alleged “evils” of capitalism are real—that it lacks “compassion,” that it does not provide a “safety net” for the poor and unfortunate; that it does not redistribute the wealth “justly”—in a word, that it fails to provide “social justice.”

And all these criticisms take for granted that there is a class of people, our officeholders, or at least other politicians whom we could elect in their place, who could set this all right if they had the will to do so. 
And most of our politicians have been promising to do exactly that for the last half century.

The trouble is that their attempted legislative remedies turn out to be systematically wrong.

It is complained that prices are too high. A law is passed forbidding them to go higher. The result is that fewer and fewer items are produced, or that black markets develop. The law is ignored, or finally repealed.

It is said that rents are too high. Rent ceilings are imposed. New apartments cease to be built, or at least fewer of them. Old apartment buildings stand vacant, and fall into decay. Higher rents are eventually legally allowed, but they are practically always set below what market rates would be. The result is that tenants, in whose supposed interest the rent controls were imposed, eventually suffer as a body even more than landlords, because there is a chronic shortage of housing. Wages are supposed to be too low. Minimum wages are fixed. The result is that teenagers, and especially black teenagers, are thrown out of work and on the relief rolls. The law encourages strong unions and compels employers to “bargain collectively” with them. The result is often excessive wage-rates, and a chronic amount of unemployed.

Unemployment relief and Social Security schemes are put into effect to provide “safety nets.” This reduces the urgency for the unemployed to find new or better-paid work and reduces their incentive to look. Unemployment payments, Social Security and other such safety nets continue to grow. To pay for these, taxes are increased. But they do not raise the expected revenue because the taxation itself, reducing profit incentives and increasing losses, reduces enterprise and production. The spending and safety nets are increased. Deficit spending appears and increases. Inflation appears, demoralizing production further. Sad to relate, these consequences have appeared in country after country. It is hard to find a single country today that has not become a bankrupt Welfare State, its currency constantly depreciating. Nobody has the courage to suggest dismantling it or to propose reducing its handouts or safety nets to affordable levels. Instead the remedy proposed everywhere is to “tax-the-rich” (which turns out everywhere to include the middle-classes) still more, and to redistribute the wealth.

Guided by Profit

Let us return to our point of beginning. The eminent person that I quoted then is mistaken when he tells us that we are governed by the profit-motive of the few rather than the needs of the many. The profit motive is simply the name for the practically universal motive of all men and all families—the motive to survive and to improve one’s condition. Some of us are more successful at this effort than others. But it is precisely the profit-motive of the many that must be our main reliance for supplying the needs of the many.

It is strange that so little recognition is given to the fact that a man cannot grow richer without making others richer, whether that is his intent or not. If he invests and starts a new and successful business, he must hire an increasing number of workers, and raise wages by his own increased demand. He is supplying his customers either with a better product than they had before, or as good a product at a cheaper price, in which case they have more money left to buy other things. Even if he uses his own receipts only to increase his own consumer demand, he helps provide more employment or higher pay; but if he reinvests his profits to increase the output of his business, he directly provides more employment, more production, more goods. 

So let us be thankful for the successful profit-motive in others. Of course, none of us should respond “only to the forces of the market place.” Fortunately few of us do. Americans are not only among the richest people in the world today but among the most generous. It is only when each of us has provided for more than his own needs that he can acquire a surplus to help meet the needs of others. Voluntary cooperation is the key.

[From the February 1985 issue of The Freeman. Excerpted from The Wisdom of Henry Hazlitt]