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Our invisible friend


18 December 2021 (latest revision: 1 January 2022)


 
The Invisible Hand
The Invisible Hand
 


Market economy


Market economies have an invisible friend called the invisible hand. In market economies, goods are distributed without a planning agency. According to Adam Smith, it is as if an invisible hand makes this miracle happen. His critics, for instance Karl Marx, did not believe in invisible friends. Not surprisingly, Marx also did not believe in God. Smith claimed that if everyone pursues his own interest, the interest of society is often best served. The followers of Marx felt that the state should plan the production and distribution of goods and services.

The following story demonstrates how the invisible hand does its magic. Whether or not it is true does not matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then, Russia did not have a market economy. The mayor received a tour around the city and noticed that no one queued up for bread as everyone did in Moscow. There was an ample supply of bread at affordable prices. Somehow bread was produced in the right quantities in the preferred tastes and supplied at the right places.

The mayor was amazed about this feat, so he said to his hosts, “Back in Moscow our finest minds work day and night on the bread supply and yet there are long queues everywhere. Who is in charge of the supply of bread in London? I want to meet him!” Of course, no one was in charge. That’s the secret of the market economy. Every baker decided how much he was planning to make and sell and at what price. A few years later, Russia switched to a market economy.

The individual decisions of bakers and the businesses in the supply chain, for instance, farmers and flour mills, make this miracle happen. They all decide for themselves. If a baker could sell more than he produced, he would miss out on profits. The same is true when he has to throw away bread. And some people are willing to pay more if the bread tastes better. Hence, each baker tries to make the right amount of bread in the tastes people desire. It is in their best interest.

In Russia, the state planned how much a corporation should produce of every item. Corporations could not decide about prices. They received compensation for their costs but could not make a profit. Employees received a fixed salary. Corporations that produced more or better products and their employees did not benefit. Corporations also could not go bankrupt when they did a terrible job. That resulted in poor quality products, a shortage of nearly everything and even outright famine from time to time.


It does not always work out well


This miracle has enchanted quite a few people. They believe that everything will turn out fine if only markets can do their job. But there are many instances where a market economy does not produce a good outcome for society. Economists call them market failures. One can think of the following situations:
  • We have more desires than our planet can support. A market economy may fulfil those desires at the expense of our future.
  • Many people cannot make a living in the market economy, for instance, because they lack the skills or have little bargaining power.
  • Corporations use lobbyists and bribe politicians to pass legislation that favours them.
  • A government may be a more efficient producer of products that do not benefit from competition, for instance, roads and the power grid.
  • Corporations may abuse their power and charge higher prices, most notably if they have no competitors.
  • Products can cause harm to people or the environment, but producers may not pay these costs themselves. For example, cigarettes cause health costs.

  • In most countries, governments interfere with the economy to deal with these market failures. These are situations where pursuing personal interests does not bring the best outcome for society. In many democratic countries, public expenses are about 50% of national income. People in these countries probably believe that a market economy does not always work best. In some areas, markets produce extremely poor outcomes, for instance health care.

    An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is poor and does not have a market economy. The United States spends more on health care than any other country in the world. Every possible treatment is available in the United States. Still, in more than 40 countries, people live longer than in the United States.1 Cuba does not spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba appears efficient compared to healthcare in the United States. How can this be?

    The available treatments in Cuba are free for everyone. In the United States, you may not receive treatment when you cannot afford it because the United States has a market economy. There may be other causes, for example, differences in the diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Life in Cuba may be miserable, but healthcare is one of the few things Cuba has organised well.

    Successful societies have market economies and governments that organise things that the market fails to do. And a market economy still needs a government to set the rules and enforce them. Governments of successful societies aim at making the market economy work better where it is beneficial for society and constraining it where it does more harm than good.

    Featured image: Our invisible friend photographed in the moorlands near Nijverdal. Jürgen Eissink (2018). Wikimedia Commons. Public Domain.

    1. Life expectancy per country 2017. World Population Review.