Need some help understanding the efficiency of the market process . . .

Economics Economics Questions
1

Hello all,

I’m having trouble understanding why Austrian’s say that the free market tends to allocate resources towards consumer’s highest values. It’s easy enough for me to see that intervention can never be said to improve social welfare (because the pareto criterion is violated), but does it necessarily follow that the price system assures the highest values will be met? Price does not equal value, correct?

Consumer demand is a function of subjective valuations AND purchasing power, correct? If that is so, won’t there be a systematic bias of the price system to encourage production for the wants of those consumers with the greatest purchasing power? Empirically we see that resources are not all tied up in luxury goods and many profitable businesses are geared towards meeting poorer consumers’ demands. Can someone help me understand the theoretical reasons why ALL consumers are better off in a free market?

A related claim is that if a particular production process is uneconomical it is wasteful. But, it seems to me this implies utilities on the market can be compared. Transforming a high cost good into a low priced consumer good results in monetary losses, but since consumer utility is subjective, how can we know if there is a net loss of wealth? Isn’t it possible that the low priced consumer good is actually very highly valued but that those who value it are lacking the purchasing power to out-compete others for the resource?

Thanks for the help!

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The market does not lead to perfect efficiency if you allow for redistribution of wealth, but that does not indicate that they market is not the best system for two reasons.

The first is that I do not believe that redistribution of wealth, even if it leads to higher utility, is justified unless it is voluntary (which the market can do quite well). And, if wealth is not redistributed, then the market is perfectly efficient theoretically because it leads to the greatest utility within a fixed income. Alternatively, if wealth is redistributed by some means such as a negative income tax, then the free market still leads to the optimum allocation of goods after taxation.

The second reason comes down to the calculationism: does any means of determining utility other than the market exist? My feeble understanding of the Austrian position is not that the free market is perfect but that it cannot be improved upon.

Keep in mind that increased purchasing power tends to manifest itself in greater quantities and values of goods, rather than higher profits for producers. The manufacturers of luxury items rarely make an extroardinary profit because competition equalizes profits across industries.

4

Purchasing power for an individual is determined by this individual’s total productivity towards the market. The reason Bill Gates has so much purchasing power is because millions of regular people gave him money to use his software. If people with exceptional productivity could not profit fully from this productivity, they would not produce as much. Bill Gates might have retired after selling DOS. Then the supply of goods would be much lesser for everyone, that is to say the regular people who gave Bill Gates his fortune would not have had the benefit of Windows 95.

5

Prices are merely indicators of the relative scarcity of a good.

No. The most efficient way of organizing markets is to give the consumer what they want, which means different markets for different consumers. If one does not provide to poorer consumers they are losing out on profit they could otherwise gain.

Give specific examples of what you mean here.

6

Be wary when judging economics based on measurable economic stats, like income, alone. The praxeological view of the market economy spans every voluntary exchange, even those concerning intangible goods such as respect and friendship. What is not talked about by many economists are the things the rich man has to forgo to become financially wealthy. There are things traded in markets which cannot be measured.

We live in an age (at least in America) where the poor increasingly have cable television, Internet access and reliable transportation. Coincidentally, the two areas where the poor have a hard time keeping up are in health care and education, both largely government-run and managed.

Consumer demand for first-order goods drives the demand for goods of lower orders, meaning that high cost commodity is expensive for a reason - there must be something more valuable to be made from it. All utility is subjective, not just consumer utility. If that expensive commodity suddenly found it was obsolete in the manufacturing of some previously-desired consumer good, it would loose value.

7

Thanks everyone for your replies. I think I have a idea as to the source of my confusion now: from Man, Economy, & State Ch.4 Appendix B:

“Economics has made such extensive use of the term “value” that it would be inexpedient to abandon it now. However, there is un­doubtedly confusion because the term is used in a variety of different ways. It is more important to keep distinct the subjective use of the ­term in the sense of valuation and preference, as against the “objec­tive” use in the sense of purchasing power or price on the market.”

When we say that the market tends to allocate resources towards their most highly “valued” uses it is the second kind of value we mean. We can’t mean the first kind of value because that would imply impermissible inter-personal comparisons of utility.

Sound right?

8

Yes, that sounds right.

Something else to keep in mind:

In your opening post, you asked, “Can someone help me understand the theoretical reasons why ALL consumers are better off in a free market?” No economic system (i.e. market/socialist/interventionist) can allocate goods toward their most highly valued uses in the subjective sense (because interpersonal utility comparisons are not possible). The market allocates goods to their most valued uses in the objective purchasing-power sense. This, however, does not imply that the market leaves poorer consumers “out in the cold” so to speak. Remember that thanks to the market’s ability to determine opportunity costs, economic calculation can take place. Economic calculation allows relevant increases in the capital stock which is the source of society’s increases in productivity. This increase in productivity is what causes the real wages (and thus purchasing power) of labor to rise. Thus, the market economy tends to increase labor’s purchasing power, giving labor more say in what gets produced. Without the increase in productivity provided by the market economy (and not provided by socialism/interventionism), the average laborer’s wages would be much, much lower.

So that is how consumers become better off in a free market.

9

That’s sounds like an interesting theory, but is it really like that?

To be clear, productivity is a characteristic of a person or operational unit. It is a measure of efficiency. So I think one would have to rephrase it:

But this isn’t true either. Purchasing power for an individual depends on the exchangable goods he can offer for what he would like to purchase. At present these exchangable goods are mainly money. But how much money one has doesn’t necessarily depend on the “total productivity (or product) this individual does have towards the market”. There can be other reasons for this as well… Shall we discuss them? I also would add that money is not all that determines the purchasing power of a specific person. There can be other factors as well.