Free Markets – Part 4

Mutually beneficial transactions aided by price signals.

Continuing this essay series on Milton Friedman’s book on free markets called Free to Choose, this essay explores his description of how the free market is a series of millions and millions of mutually beneficial transactions aided by price signals.

Friedman writes:

The key insight of Adam Smith’s Wealth of Nations [1776] is misleadingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it. Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another. This key insight is obvious for a simple exchange between two individuals. It is far more difficult to understand how it can enable people living all over the world to cooperate to promote their separate interests. The price system is the mechanism that performs this task without central direction, without requiring people to speak to one another or to like one another. When you buy your pencil or your daily bread, you don’t know whether the pencil was made or the wheat was grown by a white man or a black man, by a Chinese or an Indian. As a result, the price system enables people to cooperate peacefully in one phase of their life while each one goes about his own business in respect of everything else. Adam Smith’s flash of genius was his recognition that the prices that emerged from voluntary transactions between buyers and sellers—for short, in a free market—could coordinate the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off. It was a startling idea then, and it remains one today, that economic order can emerge as the unintended consequence of the actions of many people, each seeking his own interest.

Friedman then describes the function of prices:

Prices … transmit information; second, they provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes …

Regarding the transmission of information:

Suppose that, for whatever reason, there is an increased demand for lead pencils—perhaps because a baby boom increases school enrollment. Retail stores will find that they are selling more pencils. They will order more pencils from their wholesalers. The wholesalers will order more pencils from the manufacturers. The manufacturers will order more wood, more brass, more graphite—all the varied products used to make a pencil. In order to induce their suppliers to produce more of these items, they will have to offer higher prices for them. The higher prices will induce the suppliers to increase their work force to be able to meet the higher demand. To get more workers they will have to offer higher wages or better working conditions. In this way ripples spread out over ever widening circles, transmitting the information to people all over the world that there is a greater demand for pencils … The price system transmits only the important information and only to the people who need to know. The producers of wood, for example, do not have to know whether the demand for pencils has gone up because of a baby boom or because 14,000 more government forms have to be filled out in pencil. They don’t even have to know that the demand for pencils has gone up. They need to know only that someone is willing to pay more for wood. There is a revolution in some remote country that is a major producer of copper, or there is a disruption of copper production for some other reason. The current price of copper will shoot up at once. To find out how long knowledgeable people expect the supplies of copper to be affected, you need merely examine the prices for future delivery on the same page. Suppose that a forest fire or strike reduces the availability of wood. The price of wood will go up. That will tell the manufacturer of pencils that it will pay him to use less wood, and it will not pay him to produce as many pencils as before unless he can sell them for a higher price. The smaller production of pencils will enable the retailer to charge a higher price, and the higher price will inform the final user that it will pay him to wear his pencil down to a shorter stub before he discards it, or shift to a mechanical pencil. Again, he doesn’t need to know why the pencil has become more expensive, only that it has. Anything that prevents prices from expressing freely the conditions of demand or supply interferes with the transmission of accurate information.

Friedman explains how prices send the signals that produce incentives:

We have discussed the incentive effect so far in terms of producers and consumers. But it also operates with respect to workers and owners of other productive resources. A higher demand for wood will tend to produce a higher wage for loggers. This is a signal that labor of that type is in greater demand than before. The higher wage gives workers an incentive to act on that information. Some workers who were indifferent about being loggers or doing something else may now choose to become loggers. More young people entering the labor market may become loggers. Here, too, interference by government, through minimum wages, for example, or by trade unions, through restricting entry, may distort the information transmitted or may prevent individuals from freely acting on that information.

Friedman explains how capital accumulates not just in the means of production, but also in human beings:

In countries like the United States the major productive resource is personal productive capacity—what economists call “human capital.” Something like three-quarters of all income generated in the United States through market transactions takes the form of the compensation of employees (wages and salaries plus supplements), and about half the rest takes the form of the income of proprietors of farms and nonfarm enterprises, which is a mixture of payment for personal services and for owned capital. The accumulation of physical capital—of factories, mines, office buildings, shopping centers; highways, railroads, airports, cars, trucks, planes, ships; dams, refineries, power plants; houses, refrigerators, washing machines, and so on and on in endless variety—has played an essential role in economic growth. Without that accumulation the kind of economic growth that we have enjoyed could never have occurred. Without the maintenance of inherited capital the gains made by one generation would be dissipated by the next. But the accumulation of human capital—in the form of increased knowledge and skills and improved health and longevity—has also played an essential role. And the two have reinforced one another. The physical capital enabled people to be far more productive by providing them with the tools to work with. And the capacity of people to invent new forms of physical capital, to learn how to use and get the most out of physical capital, and to organize the use of both physical and human capital on a larger and larger scale enabled the physical capital to be more productive.

Friedman points out that life involves chance, but chance that can be ameliorated with choice:

The amount of each kind of resource each of us owns is partly the result of chance, partly of choice by ourselves or others. Chance determines our genes and through them affects our physical and mental capacities. Chance determines the kind of family and cultural environment into which we are born and as a result our opportunities to develop our physical and mental capacity. Chance determines also other resources we may inherit from our parents or other benefactors. Chance may destroy or enhance the resources we start with. But choice also plays an important role. Our decisions about how to use our resources, whether to work hard or take it easy, to enter one occupation or another, to engage in one venture or another, to save or spend—these may determine whether we dissipate our resources or improve and add to them. Similar decisions by our parents, by other benefactors, by millions of people who may have no direct connection with us will affect our inheritance. The price that the market sets on the services of our resources is similarly affected by a bewildering mixture of chance and choice. Frank Sinatra’s voice was highly valued in twentieth-century United States. Would it have been highly valued in twentieth-century India, if he had happened to be born and to live there? Skill as a hunter and trapper had a high value in eighteenth- and nineteenth-century America, a much lower value in twentieth-century America. But the price we receive for the services of our resources through the market also depends on our own choices—where we choose to settle, how we choose to use those resources, to whom we choose to sell their services, and so on.

Friedman points out that envy and dissatisfaction are inevitable in any society. The question is only whether government rulers — or the impersonal forces of the free market — should distribute that envy and dissatisfaction:

In every society, however it is organized, there is always dissatisfaction with the distribution of income. All of us find it hard to understand why we should receive less than others who seem no more deserving—or why we should be receiving more than so many others whose needs seem as great and whose deserts seem no less. In a command system envy and dissatisfaction are directed at the rulers. In a free market system they are directed at the market. One result has been an attempt to separate this function of the price system—distributing income—from its other functions—transmitting information and providing incentives. Much government activity during recent decades in the United States and other countries that rely predominantly on the market has been directed at altering the distribution of income generated by the market in order to produce a different and more equal distribution of income. However we might wish it otherwise, it simply is not possible to use prices to transmit information and provide an incentive to act on that information without using prices also to affect, even if not completely determine, the distribution of income. If what a person gets does not depend on the price he receives for the services of his resources, what incentive does he have to seek out information on prices or to act on the basis of that information? If Red Adair’s income would be the same whether or not he performs the dangerous task of capping a runaway oil well, why should he undertake the dangerous task? If your income will be the same whether you work hard or not, why should you work hard? If there is no reward for accumulating capital, why should anyone postpone to a later date what he could enjoy now? Why save? How would the existing physical capital ever have been built up by the voluntary restraint of individuals? If there is no reward for maintaining capital, why should people not dissipate any capital which they have either accumulated or inherited? If prices are prevented from affecting the distribution of income, they cannot be used for other purposes. The only alternative is command. Some authority would have to decide who should produce what and how much. Some authority would have to decide who should sweep the streets and who manage the factory, who should be the policeman and who the physician. When everybody owns something, nobody owns it, and nobody has a direct interest in maintaining or improving its condition. That is why buildings in the Soviet Union—like public housing in the United States—look decrepit within a year or two of their construction.

Friedman then describes his understanding of the proper role of government:

Where does government enter into the picture? To some extent government is a form of voluntary cooperation, a way in which people choose to achieve some of their objectives through governmental entities because they believe that is the most effective means of achieving them. But government is more than that. It is also the agency that is widely regarded as having a monopoly on the legitimate use of force or the threat of force as the means through which some of us can legitimately impose restraints through force upon others of us. In a society whose participants desire to achieve the greatest possible freedom to choose as individuals, as families, as members of voluntary groups, as citizens of an organized government, what role should be assigned to government? It is not easy to improve on the answer that Adam Smith gave to this question two hundred years ago: All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society. According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society. The first two duties are clear and straightforward: the protection of individuals in the society from coercion whether it comes from outside or from their fellow citizens. Unless there is such protection, we are not really free to choose. The armed robber’s “Your money or your life” offers me a choice, but no one would describe it as a free choice or the subsequent exchange as voluntary. Military and police forces are required to prevent coercion from without and within. They do not always succeed and the power they possess is sometimes used for very different purposes. A major problem in achieving and preserving a free society is precisely how to assure that coercive powers granted to government in order to preserve freedom are limited to that function and are kept from becoming a threat to freedom. The founders of our country wrestled with that problem in drawing up the Constitution. Adam Smith’s second duty goes beyond the narrow police function of protecting people from physical coercion; it includes “an exact administration of justice.” No voluntary exchange that is at all complicated or extends over any considerable period of time can be free from ambiguity. There is not enough fine print in the world to specify in advance every contingency that might arise and to describe precisely the obligations of the various parties to the exchange in each case. There must be some way to mediate disputes … [T]he court of last resort is provided by the governmental judicial system.

Friedman explains why Adam Smith’s suggestion that the government can properly administer “public works” and “public institutions” is more problematic:

Adam Smith’s third duty raises the most troublesome issues … If it is difficult for private parties to identify who imposes costs or benefits on whom, it is difficult for government to do so. As a result a government attempt to rectify the situation may very well end up making matters worse rather than better … We should develop the practice of examining both the benefits and the costs of proposed government interventions and require a very clear balance of benefits over costs before adopting them. This course of action is recommended not only by the difficulty of assessing the hidden costs of government intervention but also by another consideration. Experience shows that once government undertakes an activity, it is seldom terminated. The activity may not live up to expectation but that is more likely to lead to its expansion, to its being granted a larger budget, than to its curtailment or abolition.

Friedman sees a role for government in providing some degree of aid to those who are not reasonably considered capable of supporting themselves:

A fourth duty of government that Adam Smith did not explicitly mention is the duty to protect members of the community who cannot be regarded as “responsible” individuals. Like Adam Smith’s third duty, this one, too, is susceptible of great abuse. Yet it cannot be avoided. Freedom is a tenable objective only for responsible individuals. We do not believe in freedom for madmen or children. We must somehow draw a line between responsible individuals and others … We cannot categorically reject paternalism for those whom we consider as not responsible. For children we assign responsibility in the first instance to parents. The family, rather than the individual, has always been and remains today the basic building block of our society … We believe, and with good reason, that parents have more interest in their children than anyone else and can be relied on to protect them and to assure their development into responsible adults. However, we do not believe in the right of the parents to do whatever they will with their children—to beat them, murder them, or sell them into slavery.

As Friedman writes:

Our society is what we make it. We can shape our institutions. Physical and human characteristics limit the alternatives available to us. But none prevents us, if we will, from building a society that relies primarily on voluntary cooperation to organize both economic and other activity, a society that preserves and expands human freedom, that keeps government in its place, keeping it our servant and not letting it become our master.

In the next essay in this series, we’ll explore Friedman’s discussion of the dangers posed to personal freedom in America today by the growth of government over the last century.