Part 1 of A Discussion of Thomas D. Simpson’s Capitalism versus Socialism Chapter 2 “Market-Based Systems”
If we are going to compare the four economic systems, we need to first define and understand each one of them. This is the chapter that focuses on market-based systems.
While the title of the book is “Capitalism versus Socialism,” Simpson prefers the term “market-based system” over capitalism as he explained earlier that Marx coined the term as an insult.
Simpson notes that the US has always had a market-based system and is one most readers have had first-hand experience with so he is starting with it as the benchmark to compare to the other systems. (p. 26)
Thus, this is a chapter that lays out the economic principles that underlie a market-based system.
Welcome to a crash course in microeconomics!
A market based system is one in which buyers and sellers interact, be it in the market for goods and services, such as milk or hair styling, or the market for labor, such as auto mechanics or web designers. A market can be highly organized and centralized, as with the New York Stock Exchange, which trades stocks, or it can be fragmented and informal, as with the local market for lawn care. (p. 27)
Competition is a key factor in a well-functioning market-based system: firms enter and exit the market in reaction to changes in demand and supply that cause prices to change and thus their profits. (p. 28)
To the extent that there are barriers to entry that limit competition in some industries, the market-based system will fall short of its ideal.
Prices serve as signals to buyers who will react to conserve resources that are in short supply when prices rise without them even knowing the reasons.
At the same time, higher prices encourage suppliers to produce more if they can in pursuit of profits. Profits, like prices, are a signal that helps producers decide how to use our scarce resources.
The good news is the market-based system encourages innovation and efficient use of our resources so labor productivity rises, that is, more output per person.
This increase in “the size of the pie” is why a market-based system is not zero-sum, where one person’s gain is another’s loss. (p. 29)
The value of extra output that they’re responsible for typically exceeds the extra profit they receive, meaning they also have added something that benefits other. (p. 29)
Thus, profit-seeking is a good thing that guides suppliers to make more of what the buyers want and to do so efficiently and innovatively increases profits for themselves.
Leonard Read who founded FEE wrote a famous essay illustrating the amazingly complex interdependence in the market system that leads to the betterment of all in his essay from the 1950’s titled, “I, Pencil” that you can watch a version of in this video if you are interested.
This interdependence works without anyone in charge, which is the meaning behind the metaphor of the Invisible Hand attributed to Adam Smith.
People are motivated by their self-interest, not just in market based systems but in any system. The reason the market based system results in higher standards of living than other systems is the Invisible Hand directs this self-interest into the most productive uses.
Note self-interest is not a synonym for greed. We assume people will take actions that make them better off, or at least not worse off, but that does not mean they have no care of others. Greed goes farther assuming people are fine with harm to others and society.
[Self-interest] can be viewed to be similar to the way that we respond to pangs of hunger to ensure that our bodies get essential nourishment or how we respond to pain, which alerts us that something is wrong with our body and requires prompt attention. In other words, self-interest is to greed as ordinary hunger pangs is to gluttony.(p. 31)
Another way to put it is self-interest is a virtue but if you take it too far it becomes the vice of greed. All virtues are considered to be in the middle of two vices: the vice of it missing and the vice of it taken too far.
As each person seeks his self-interest, he is motivated to work to produce a good or service someone will pay for so he can earn money. This means he needs to care about the quality of what he is producing, how he treats anyone who works for him, and how he treats customers if he wants to stay in business.
Ultimately, the invisible hand takes self-interest and transforms it into service because the only way to get what you want (money) is to provide a good or service someone wants to pay for.
People tend to have more negative connotations to the words capitalism and competition, and yet these competitive forces turn self-interest into serving others.
Peter Foster’s book explored this hostility towards capitalism that many seem to harbor at some level.
As people and businesses seek to minimize costs to maximize profits, they are guided into specialization. Some people are better at some things than others. I like writing and teaching. You might like construction programming or accounting.
If I focus on teaching, I still need food, clothes, and all the other goods and services. In a market economy, we can each specialize in the area we choose and use the money we earn to buy the things we need. We do not have to be self-sufficient.
This specialization in things we are comparatively better at actually increases total production for society creating more output that can then be traded. We all end up better off following specialization and comparative advantage.
One of the amazing features of the Invisible Hand is how resources are allocated without anyone in charge.
People, however, instinctively feel like someone has to be in charge and are uneasy with this concept.
However, the reality is a central planner cannot possibly do as well as the Invisible Hand in a competitive market.
F. A. Hayek captured this in his writing on the knowledge problem.
Imagine being in charge of an economy. You have to decide how much wheat should be grown so there is enough flour to produce enough bread each day. This is the problem the USSR struggled with resulting in the common experience of waiting in lines for bread and other items.
Planners are missing a key feature of the market system: prices as signals. When planners decide how much of something needs to be produced, they are also assigning a price, but it more likely than not will not be the market equilibrium price. And even if they got it right, factors change all the time and then the price will be wrong.
Prices that are too low lead to shortages. If you do not have a price system in place to correct shortages, you are left with other ways to allocate the goods, such as waiting in line.
Imagine this scenario: the newest fad is the bread diet. (Yeah, I wish). All of a sudden, the demand for bread rises. Stores have trouble keeping it on the shelf. They reach out to more bakers to get more bread who will raise prices in the face of this demand.
The bakers reach out to get more flour whose price will also rise in the face of this higher demand. Ultimately this increases the demand for wheat, whose price then rises.
Farmers can see the price of wheat is higher. They don’t need to know why, but they will shift their crops in the direction of more wheat in response. And that is the response that was needed given this change in demand.
This knowledge about the change in consumers’ preferences in just one market can not be known by the planners, and then you have to expand that across all products.
Demand and supply change all the time in ways the planners cannot know. Prices hold all that information in them — without you knowing why the price has gone up, you can respond appropriately.
This is how the market-based system can solve the knowledge problem in a way planners cannot as Hayek describes:
The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction.
This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or “normal” level. From F. A. Hayek’s The Use of Knowledge in Society
Conclusion
This is a good overview of the key features of the market-based system and how it works. Next blog we will look at how well it fits with the biblical worldview including the role of work inherent to the system.
From there we can look at some of the common criticisms of the system. Also, we can look at the impact when the system does not match its ideals of complete competition or perfect information.
Reference: Simpson, Thomas. D., 2020. “Market-Based Systems,” Chapter 2 of Capitalism versus Socialism, Thomasdsimpson.com.
