For part 1 of this series, see The Coercive Nature of Law.
Any large society faces the problem of social coordination: how do you get people to work together in a more or less coordinated and harmonious way? After all, the production of pretty much every product we use in our everyday lives requires a very large number of people to work together. There are two fundamental strategies for social coordination: top-down and bottom-up.
In the top-down model, someone is in charge and tells everyone else what to produce and how to go about it. Since it’s impossible for one person to personally supervise more than a couple of people, you need layers of hierarchy. Since the people at the top are human beings just like the rest of us, they will likely put their own interests ahead of the good of society and will probably be susceptible to bribes and other forms of corruption and they are liable to set up the rules in accordance to what best suits them and their friends and family, which may not align with what is best for society. But let’s ignore that for now. Let’s pretend that all the people in charge are righteous, public-spirited, and wise.
Under such assumptions, top-down production would work well enough in a small and simple society of maybe a few hundred people. But when you get to thousands or millions of people, things start to break down because of the incentive problem and the calculation problem.
If you’re the benevolent philosopher king in charge, how do you actually get your subjects to do what you’ve determined is best for society? You can appoint overseers to punish them for straying from your orders or for slacking off, but then you squash creativity and individual effort. You can allow people more freedom in how they can carry out their tasks, but then many of them are likely to not work very hard. You can offer them rewards for doing good work, but then how do you define good work? If you define good work in a nail factory by how many nails they produce, people will only make lots of tiny nails. If you measure the weight of nails instead, they will only make gigantic nails. No matter what kind of measure you use, as soon as you define it as the target and reward or punish people based on it, it will cease to be a good measure. This phenomenon is called Goodhart’s Law.
Even more devastating than the incentive problem covered above is the calculation problem, which was first described by Austrian economist Ludwig von Mises in a 1920 essay. Suppose that you are once again the benevolent philosopher king, but now you’re ruling over a society filled with public-spirited people whose chief goal in life is to do everything they can to improve society. They are just waiting on your word to hear how to best serve their fellow man. What do you tell them?
Let’s say you want to tackle housing. Out of what material do you want to construct your houses? Do you use wood, concrete, bricks, corrugated metal, marble, steel, or something else? You might poll your subjects on how they want their houses to be built, and find out that most of them want houses built of marble. You don’t have enough marble in your kingdom to satisfy everyone, and there are also people who want to use marble for other purposes, such as stonemasons who want to make statues of you. Some people will have to make do with homes of less desired materials, but there also isn’t enough of wood, bricks, steel, or any other material in your kingdom to fulfil everyone’s wishes since people not only generally want large houses, these materials are also used for a myriad of other purposes.
How do you determine whether a particular unit of wood should be used for making houses, furniture, tools, or children’s toys? How do you determine which material or construction process you use if they result in houses which are equally valued by your subjects? To decide these questions, you need some way of calculating costs. You can readily enough determine costs in terms of units of particular goods, or hours worked by particular workers, but you need some sort of accounting unit to compare these disparate costs.
Your centrally planned kingdom does not have a market in these producer goods (since they essentially all belong to you), so you don’t have market prices to guide you. There is no non-arbitrary way of deciding whether a house made of 10 units of wood and 20 units of bricks is cheaper than one made of 20 units of wood and 10 units of bricks. You can just arbitrarily assign prices to these goods, but such made up numbers would not represent the underlying scarcity of the goods in question. The inevitable result would be economic chaos and resource allocation de-coupled from your subjects’ desires and the relative scarcity of different goods. No matter how benevolent your intentions, you just wouldn’t know which goods to produce in what quantities and with which methods.
In the bottom-up model, there is no central planner and the individual members of the the society each have exclusive control over a certain domain (their property) and make economic decisions based on their own values. People can transfer some of their property to another person, which may take the form of a gift or an exchange.
When two people – let’s call them Alice and Bob – agree on an exchange, both Alice and Bob expect to benefit from it – otherwise they wouldn’t have agreed. Because value is subjective and different people value the same good or service differently, it is possible (and indeed likely) for both Alice and Bob to be right in believing the trade to be favourable to them. For now we will assume that the boundaries of property rights are drawn in such a way that an exchange between Alice and Bob only directly affects their own property, and does not improve or damage the property of third parties. The complications introduced when this is not the case (i.e. when there are what economists call externalities) will be discussed in the next post in this series.
This kind of exchange benefits the trading parties and does not harm anyone else, so a society based around individual property rights and voluntary exchanges is highly desirable. Since people get to keep the fruits of their own labour, the incentive problem is solved – if you work diligently at producing goods and services that others value highly, you will be rewarded with receiving more valuable goods in exchange.
The calculation problem is solved through the emergence of market prices. If you want to build a house for yourself and your family, you can see how much the various inputs cost on the market and then you decide based on the prices, your budget, and your preferences. The ingenious thing about market prices is that they solve two hard problems at the same time.
First, they give you a quick summary of the relative scarcities of various goods. If for example a new copper mine is discovered, copper becomes less scarce, but as person not involved in the mining industry, you don’t need to know any of these details. You just see that the price of copper goes down, which gives you all the relevant information.
And second, market prices give people the right incentives to economise on scarce resources. If you’re considering whether to use steel or copper for a particular task and you were previously indifferent between the two metals, a drop in the price of copper means that you’re now likely to use copper. This is means there is now more steel available so that there is enough steel for those uses where steel is preferable.
So much for theory. What about the real world? The two models of organising society described above are ideal types. All real world societies are somewhere in between these extremes. Even a totalitarian socialist dictatorship like North Korea is not organised completely on the top-down model since North Korea has a vibrant black market. Still, looking at how countries countries do depending on where they are on the spectrum between top-down and bottom-up should give us some indication as to whether the theory elaborated above applies to the real world.
A prominent way of measuring where countries lie on this spectrum is the Index of Economic Freedom compiled by the Heritage Foundation and the Wallstreet Journal. In this year’s index, the top five most economically free countries are Hong Kong, Singapore, New Zealand, Switzerland, and Australia. What do all of these have in common? They are prosperous and economically advanced societies. The bottom five countries are Eritrea, Republic of Congo, Cuba, Venezuela, and North Korea. What do all of these have in common? They are poor and and unpleasant countries that few people want to live in if they have the choice.
Nor is this just a matter of cherry-picking. Take a look at the following graphs, which look at the relationship between economic freedom and GDP per capita, adjusted for purchasing power:
Such a strong correlation really speaks for itself. GDP per capita is far from a perfect measure of economic prosperity, and there are problems with adjusting for purchasing power, but given how strong the relationship is, these problems are very minor.
No matter whether we look at it from a theoretical or an empirical perspective, capitalism is undeniably superior to the alternatives. The market economy does have certain flaws, but it is the best shot we have at achieving and preserving prosperity. Next week we will examine whether these flaws justify government involvement in and regulation of the economy.