Understanding the foundations (six pillars) of a free market economy should have brought the “big picture” into at least fuzzy focus. In this last lesson, we will paint it more fully and also clarify several aspects of it that are somewhat counterintuitive. We will pay special attention to debunking some of the scurrilous attempts that are regularly made to discredit the free market economic system.
Commodity Substitutes We learned that an increase in the price of a commodity always results in less of it being purchased (and vice versa). Depending upon the commodity, this may be a small or a large change. For example, in the case of a gasoline price increase, part of the reduction may come from drivers simply skipping some less important trips, carpooling or combining errands for greater efficiency.
However, there is another possibility which often can have a larger effect. That is, switching to the use of a substitute. The substitution of 10% ethanol is an example of a direct substitution. There also are lots of indirect substitutes for gasoline. Instead of driving, ride a bicycle or take public transportation instead. Higher gasoline prices may even result in increased sales of hybrid or all-electric vehicles.
There are substitutes for virtually any commodity. One result of this is that nothing happens in isolation. A change in the availability and/or price of one commodity affects others, sometimes in hard-to-predict ways. A major economic event or “shock” in one sector of the economy will ripple into other sectors, sometimes immediately and sometimes after a delay. The price and sales volume of any given commodity can be affected by changes in the price or availability of its substitutes.
An economy is an incredibly complex web of constantly changing and interacting entities, all driven by billions and billions of voluntary exchanges. Each such exchange is based upon the rational self-interest of the participants and must increase the wealth of both. Thus a free market economy will always adapt to changing conditions to maximize the creation of wealth under the new conditions.
It is this complicated mess that macroeconomists attempt to understand and predict. That they frequently fail to get it right is not at all surprising.
That Which Is Seen, and That Which Is Not Seen As has been explained, a free market economy will self-organize and flourish when people are free, honest and peaceful. Such a free market maximizes the creation of wealth. The proper role for a government, then, is to secure citizens’ rights by deterring and punishing those who would engage in fraud or use force on others, and to ensure that all six pillars of a free market economic system remain solidly in place.
Unfortunately, governments seem to have a hard time sticking to their proper role and can’t resist interfering in the economy by applying the only thing a government has: ham-handed force. Examples are excessive taxation (for wealth redistribution schemes, aid programs or myriad other boondoggles), regulations, subsidies, loan guarantees, etc. Yet another disruption is the Federal Reserve manipulating interest rates and inflating the dollar. Interest rates are the price of borrowing money and should be set by marketplace competition. Inflation (or deflation) changes the standard of value and interferes with the ability to plan for the future.
A free market economy is resilient and will find a new equilibrium to optimize wealth creation under new conditions imposed by force. However, the rate of wealth creation will be lower than it would have been without the government meddling. With enough forceful meddling, we approach a command economy and wealth creation really slows to a crawl.
Why does the voting public not object strenuously to governments screwing up the free market? It is because of the aforementioned ignorance of how free markets function, and also an unfortunately misleading phenomenon. Suppose the government levies a tax on “the wealthy” to feed “the poor.” The benefit to the poor is seen by the public as a good thing; the politicians make sure of that. What is not seen is the delayed negative effects from confiscation of taxes that ripple out diffusely through the economy. The nearly invisible bad effects more than offset the good.
A French economist named Frederic Bastiat very clearly explained all of this in two seminal works published in 1850. One was a book titled, The Law. The other was an essay titled That Which Is Seen, and That Which Is Not Seen. These works are easily understandable by anyone and are recommended reading: http://bastiat.org/en/twisatwins.html https://fee.org/media/14951/thelaw.pdf
Businesses and Profits Businesses are created by entrepreneurs for the purpose of providing goods and/or services that people want. A business is the mechanism by which the means to produce the goods or services are assembled, organized and managed; it also facilitates measuring and tracking how well the business is succeeding at its endeavor. Small businesses can be sole proprietorships or partnerships. Large businesses are usually set up as corporations with shareholders as the owners.
Businesses may not engage in fraud and may not use force to compel anyone to do anything. Therefore, a business’ employees work there voluntarily. Each employee and the business believe they are gaining from the employment relationship or it would not happen (or would soon be terminated by one side or the other). Similarly, each customer who purchases the business’ goods or services does so voluntarily. Each customer and the business must believe their wealth is increased or the transaction would not occur.
In a free market economy, businesses must be completely benign entities. Yet, they frequently are characterized as villains. We often hear them referred to as “greedy corporations,” as though that makes them evil. Well, (duh!), of course they are “greedy” and that is a very good thing. The overriding objective and measure of success for any business is to make a profit. Profits are always good for everyone, not just the business.
Consider that a business’ total cost of operations (material, labor, et.) measures the total wealth that it has consumed in creating the goods and services it has sold. The total sales measures how much wealth the business has created. Total sales, minus total cost, equals the profit. Therefore, the profit is the amount of additional wealth that the business has contributed to the economy. Profits contribute to raising everyone’s standard of living!
There is no guarantee that a business will be able to earn a profit. If it does not and instead loses money, the business will be consuming more wealth than it creates and is lowering everyone’s standard of living. That is why it is very important that any business that consistently loses money be forced out of business. That also is why it is folly to subsidize such a business to keep it going! It is an extremely important feature of free market economies that unprofitable businesses are automatically shut down (without the use of any force) so remaining assets can be redeployed to more productive uses.
Most people have an inflated idea of how much profit businesses make. Having something left on the “bottom line” isn’t easy in the face of marketplace competition. On average and in a reasonably good economy, companies are only able to make a profit of about 3.5% of their sales. Of course, the hope/expectation of making a profit is the only incentive that entrepreneurs have to undertake the considerable risk of starting a company. An entrepreneur with a world-beater new idea might be able to make big profits for a few years until competition develops, but there are also plenty of cases where entrepreneurs lose money.
Politicians often beat up on large corporations, claiming they are making huge profits because they are “price gouging” their customers. They complain about, say, a $15 billion profit. Of course, the politicians neglect to mention that the company may have lost almost that amount in an economic downturn year. (Has anyone ever heard a politician urging a company that is losing money to raise its prices?)
As we have learned, prices are set by marketplace competition, so businesses don’t actually have much flexibility to control their prices. If they want to make more money, they must instead work as hard as possible to reduce their costs; reducing costs is overall a more beneficial thing, of course. Since we know that business profits average only about 3.5% of sales, if every business gave up all their profit and cut prices until they just break even, it would mean only a 3.5% average reduction in prices – a far smaller decrease than the politicians would like you to believe. We citizens need to think things through carefully and not fall for ignorant rhetoric.
One final observation: businesses cannot pay taxes. Only people pay taxes. There are always three sets of people associated with any business: its employees, its customers and its owners (or shareholders). When governments levy a tax on businesses, they are using them as tax collectors and hiding the tax from those who actually pay it. When dollars are confiscated from a business, they must pass through to the people connected with that business; either through higher prices for customers, lower wages/benefits for employees, a lower return on the investment of the owners/shareholders, or some combination of all three.
Wealth Distribution The enemies of the free market economic system incessantly criticize it for fostering an unequal distribution of wealth. This is absolutely necessary and required for the proper functioning of a free market economy. It actually is the motive force that drives wealth production. Never apologize for it.
Suppose for the moment that there is an economic system that makes the distribution of wealth substantially equal. (Despite any claims, there is no such system, by the way.) The sixth pillar would be wiped out by such a system. There will be no entrepreneurs. Who would decide to take the considerable risk of investing to create new or better goods and services if there can be no reward for doing so? No one. The “American dream” of becoming wealthy by “building a better mousetrap” would be dead.
Critics say or strongly imply that the wealthy have become wealthy by somehow taking wealth that rightfully belongs to poor people. In a pure free market economy, that is simply not possible. No one can engage in fraud and no one can force anyone else to do anything they do not want to do. The only way to become wealthy is to do a better job than the competition at providing goods and services that other people want and voluntarily purchase. Remember that each such voluntary exchange increases the wealth of both the seller and the buyer. The wealthy get that way by creating new wealth, not by taking existing wealth away from anyone else. They deserve everyone’s admiration and thanks!
Command economies always devolve into a wealthy elite class which calls all the shots backed up by force. They are able to accumulate wealth through the use of force. This leads to people fighting for power instead of peacefully earning their wealth. Production of new wealth is much less, so everyone else is very poor. Essentially, there are just two classes: a very small, very wealthy elite class which wields the power and a large, very poor lower class (virtually no middle class).
By contrast, in a free market economy there is a continuum of wealth, including a large, robust and healthy middle class.
As previously explained, the U.S. does not have a pure free market economy, and unfortunately, there is an accumulation of too much power at the top. “Crony statism” does exist where some are able to hijack government power to unjustly obtain economic advantages and enrich themselves. The enemies of free markets point to such inequities as an argument against free markets when these actually are the things that a pure free market economy would prevent.
A few years ago, it was noticed that the middle class seemed to be shrinking. Some loudly proclaimed, “Our economy is not working for everyone.” “The middle class is taking a beating,” they claimed; presumably falling into poverty. It would have been wise to first look more carefully at the statistics.
In 1967, 53.2% of U.S. households had incomes between $35,000 and $100,000 per year; call them the middle class. By 2016, the middle class had declined to 42.1% of U.S. households. (All data are in terms of 2016 dollars to remove the effects of inflation.) The middle class did shrink, at least over that time frame. We should look at the households with less than $35,000 income to see if they are ending up there.
In 1967, 38.7% of households had incomes below $35,000. However, by 2016, only 30.2% fell into this category. Nope, the middle class surely wasn’t crumbling into the low income group; it was shrinking too.
In 1967, 8.1% of households had $100,000 or more income. By 2016, 27.7% of households were in the high income category. So it looks like the economy actually has been working very well for substantially everyone. Consider this info along with the worldwide data cited at the beginning of Lesson 1.
A question to be asked is, do we want to reduce poverty or do we want to equalize the distribution of wealth? It is not possible to do both. One would hope the choice is to reduce poverty. In that case, people need to stop whining about unequal wealth distribution and start encouraging everyone to take advantage of the many opportunities a free market economy provides to create more wealth for themselves. The sky is the limit.
The Safety Net Another perennial criticism of laissez-faire free market economies is that they do not provide a “safety net.” No matter how many opportunities there may be, there still will always be some small percentage of people who are just not capable of supporting themselves. Most will agree that having some sort of safety net to catch and support such people is preferable to letting them starve in the gutters.
Currently, the safety net is provided by a combination of government programs and private charity. Many believe that government’s involvement is necessary. However, it is highly likely that private charities could do this job better themselves if government force were completely eliminated. There are many powerful reasons, both philosophical and practical, to curtail the use of government force:
- We have learned how the application of government force reduces the rate of wealth creation of the free market economic system. Ending destructive meddling in the economy would increase wealth production, lift more people out of poverty, and reduce the load on the safety net.
- “Forced charity” cannot be called charity at all. Confiscating wealth from those who have earned it and giving it to those who have not earned it is philosophically repugnant; it is purely and simply theft.
- Private charity is more personal and more closely couples donors and beneficiaries. Donors can derive some pleasure from helping others and recipients tend to feel grateful and appreciative. With the government in the middle, donors are no longer donors and instead resent the confiscation of their wealth. Recipients know that benefits received from the impersonal government are not voluntarily offered; feelings of entitlement and victimhood are fostered.
- Private charities are better (than governments) at making sure donations actually are going to those most in need.
- As a practical matter, the “bang for the buck” is incredibly awful for government welfare. On top of apparently inevitable government inefficiency, bloated bureaucracy always grows and controls are poor, leading to WFA (waste, fraud and abuse). A reasonable guesstimate would be that only 25 or 30 cents of each taxpayer dollar actually reaches and helps the intended beneficiaries.
Government is so horribly inefficient and wasteful that, based on this fact alone, it makes no sense at all to have government do anything other than those few things that it absolutely must do, like national defense!
The statistics for private charities are much better. About 70 cents of each donated dollar actually reaches and helps the intended beneficiaries.
Charitable donations during 2021 totaled 485 billion dollars. This total does not include the value of the millions of labor hours that volunteers donated. To achieve the same benefit through the government would require more than 1.2 TRILLION taxpayer dollars.
Bear in mind that Americans donated $485 billion in spite of the fact that governments confiscate more than a third of their earnings as taxes. Donations likely are also somewhat suppressed by the knowledge that plenty of taxpayer dollars are already being spent on welfare by governments. It seems entirely reasonable that private charity could and would provide an adequate safety net if governments stop screwing up the economy, get out of the welfare business and reduce taxes accordingly.