Chapter 2: Social Cooperation and the Three M's of the Marketplace

We can never overcome scarcity. But by understanding its implications—opportunity costs, the inevitability of competition and the desirability of cooperation, the need to ration and the importance of choosing at the margin—we can better understand how market economies constantly push back the limits of scarcity.

In a nutshell, market economies succeed because they let us make the best use of the information necessary for social cooperation. They do so by allowing that information to be communicated from those who have it to those best able to act on it, with the messages containing this information motivating people to respond appropriately and providing them with the means to do so. Any successful economy has to be a system of messages, motivation and means. And no economic system incorporates these three M's as effectively as the market economy.

Messages

Only by directing scarce resources into their highest-value uses can an economy prosper. But there are countless uses for resources, differences of opinion about their value in different uses, and shifting conditions that constantly change a resource's relative scarcity and its value in different uses.

Given the complexities, it would be easy to dismiss the goal of making the most valuable use of our resources as a utopian dream. Somehow, people from all over the world would have to be in constant communication. Consumers would have to constantly send messages, to each other and to producers, on the value they place on the various goods and services that can be produced. Producers would have to send messages, to each other and to consumers, on how productively they can use resources to turn out various goods and services. Communications technology is improving dramatically, but surely we'll never reach the point where everyone can be in constant communication with everyone else.

Even if such an amazing communications network were possible, it couldn't ensure that resources flowed to their most valuable uses. People would not only have to be able to communicate with others constantly, they would also have to communicate accurately. If the messages contain distortions on the value of resources and the goods they produce, there is no possibility that the resources will be used to produce the most value.

What hope is there that individuals will resist the temptation to exaggerate the importance of resources in the uses they favor? Improving communication technology is difficult enough. Ensuring accurate communication is even trickier. But as we will see, market prices do a remarkable job of communicating information accurately.

Motivation

Ensuring that the economy makes the best use of its resources requires more than accurate communication. It also requires motivating those best able to respond to that information to do so appropriately. For example, if others inform you that they value a good more than you do, responding appropriately means reducing your consumption so they can increase theirs. Or if consumers inform a producer that the resources he is using would be more valuable in another activity, responding appropriately means using less of those resources (perhaps by going out of business) so producers doing a better job of satisfying consumers can use more.

It's unrealistic, of course, to expect people to be as concerned for others as for themselves, their family members and close friends. Concern for others hardly seems strong, widespread and constant enough to get resources directed into their most valuable uses. Yet in our market economy, we come very close to realizing the type of social cooperation needed to do just that. This cooperation is achieved through market prices.

Means

When people want more of a good, they communicate that through their willingness to pay a higher price for it. The higher price does more than inform producers that more of the good is wanted and motivate them to produce more of it. The higher price results in more revenue, which provides those producing the good with the means to produce more of it.

How It Works

Consider a trip to the grocery store. Everywhere you look are products from around the world—even domestic products require foreign inputs—that are consumed all over the world. Each of them bears a price that communicates information from everyone who contributed to supplying the product and from everyone who consumes it. That price is a message that tells you all you need to know about all those people—almost none of whom you'll ever encounter—to respond appropriately to their various preferences and circumstances, and it motivates you to do so.

For example, the price of bananas—which we'll assume is 49 cents a pound—tells you how much another pound of bananas is worth to other consumers.

If people valued another pound by more than 49 cents, they would buy more, which would drive up the price in the short run (the time over which it is impossible to grow more bananas). If they valued another pound by less than 49 cents, they would buy fewer bananas, which would lower the price (again, in the short run).

Their decision on how many bananas to buy is responsive to this price information and feeds back into that information by affecting the price of bananas. It pays consumers to evaluate the marginal value of bananas to them and then buy bananas only to the point where an additional pound is worth 49 cents.

Assume next that for some reason, people in Asia decide they want to eat more bananas, which raises the price to 68 cents a pound. People elsewhere in the world will respond to this price increase by consuming fewer bananas. How many fewer? Just enough fewer to make the additional bananas Asians want to buy at the higher price available to them.

Few, if any, consumers will know why the price went up. Nor will they know where the bananas they would have consumed at the lower price go. But the higher price tells them all they need to know to harmonize their preferences with those of Asians.The consumers who reduce their consumption cannot be expected to care as much about Asian consumers as they do about themselves. But in response to price communication, they are motivated to act as if they do.

Two-Way Communication
When consumers want more bananas, the resulting price increase communicates that fact to banana producers. Given enough time, producers will respond by investing more, working longer and outbidding competitors for the resources needed to produce more bananas.

These responses all require sacrifice. But as long as the value of the sacrifice necessary to get another pound of bananas into stores (marginal cost) is less than the price (marginal value), more bananas will be provided. Producers are not as concerned for banana consumers around the world as they are for themselves and their loved ones. But in response to price communication, they will act as if they are.

On the other hand, if consumers want fewer bananas, they'll send this message with a drop in price. This will encourage the purchase of bananas that are already available. But because the lower price will not cover the marginal cost of producing as many bananas as before, growers will respond to consumers' message by reducing production, with some of the less productive growers possibly going out of business. Producers will act as if they are saying, "Consumers are telling us they value other things that could be produced with the resources we are using by more than they value bananas. Because of this, we will release some of those resources to those who will use them to provide more benefit to consumers." Banana growers don't reduce their production because they care as much about the interests of consumers as they care about their own. But price signals motivate them to act as if they do.

We not only want producers to consider consumer interests when deciding how many bananas to make available. When consumers decide how many to buy, we want them to consider the sacrifices producers are making to grow bananas and transport them to local stores. And because of the two-way communication of market prices, they will. The price of bananas allows producers to communicate to consumers the cost (sacrifice) of making an additional (marginal) pound available in a way that motivates appropriate responses.

Assume, for example, it is discovered that working on banana plantations increases the chances of developing an uncomfortable skin rash. Wages for workers growing and harvesting bananas will rise to help compensate them for this risk. Of course, this raises the marginal cost of banana production, which will be communicated to consumers with a higher price for bananas.

Although consumers may not know the price increased because of the newly discovered risk to banana workers, the higher price will tell them all they need to know to respond as if they did and as if they were as concerned about the well-being of the workers as they are about their own. Consumers will reduce their consumption of bananas until bananas' marginal value to them increases enough to equal the higher marginal cost of producing them.

The Free Market Economy

The communication and cooperation that take place through market prices are the secret to the superior wealth creation of free market economies. Americans aren't richer than people in other countries because they are smarter or work harder. Our population is composed of people from all over the world, so we certainly aren't smarter than people from other countries. And though most of us work hard, we don't work harder than people elsewhere. We are richer than most people because our economy relies more on market prices to harmonize our diverse talents and aspirations.

Nobody would claim that markets work perfectly. But given the magnitude of the task involved, they work amazingly well. Certainly, no other type of economic system comes close.

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