Fundamentals of Market Economies
I did a series on Sapient Governance a while back, by which I meant using the wisdom of nature to fashion a set of mechanisms that would govern human behavior and economic activity. Governance is not just about laws and regulations, but about natural mechanisms like the markets to coordinate how humans interact and exchange the products of their efforts. I used the concept of autopoiesis from biology to demonstrate that there are mechanisms taken from hierarchical control theory that help coordinate work processes within any kind of economy, in nature and in human society.
The point was that markets are mechanisms for coordinating the web of production operations that are distributed throughout the whole system. This is accomplished by variable exchange, by which I mean that messages are exchanged between operational entities that lead to the control of the flow of resources between those parties. This happens within cell metabolism and it happens in the human economies. The details are obviously different, but the purposes and dynamics appear to be pretty much the same. As such they fit into the general theory of systems and systems science should be able to say something useful about markets.
The thesis presented here is that effective markets are local phenomena that can only help coordinate interactions between trading entities that have sufficient information regarding the underlying value of the good or service being traded. Markets cannot solve globally inherent problems. They are incapable of broadcasting sufficient information to all parties and to all levels of participation in large-scale webs of trade. People, not markets, decide on value and when to make exchanges. A market is not more than a mechanism for exchange and can only work if the people involved have insights into the basic work that went into producing the good or service. The modern economy is too diverse, with too much special (and technical) expertise imbued within production processes, and too distributed in space and time for participants to have adequate information on the underlying work value that should form the basis for prices.
The situation is also complicated since modern markets include multiple competing participants. From hierarchical control theory we know that under conditions of competition equitable distributions of resources and built wealth are jeopardized without some form of logistical level coordination. Economies, unlike metabolism in a living cell, are rife with competitive forces. The general belief is that competition is what drives innovation and keeps costs down. While true on the surface, this mechanism depends on complete honesty to withstand the temptation to cheat. Humans are notoriously susceptible to that temptation as has been witnessed most recently in every specialized market in our economy. Currently various legislated rules and regulations along with government agencies (watchdogs) are used to provide a patchwork and mostly band aid approach to logistical control. It can be said that Reagan and Clinton-era deregulations have exposed the weaknesses of unfettered markets to cheating. Clearly markets, left to themselves even a little bit, are incapable of equitable distribution behavior when human participants are the decision makers.
This is particularly cogent in the current age when markets appear to be failing us so blatantly. Today we see that an over-reliance on markets as mediators of transactions has led to massive market failures in housing, securities, and most infamously in so-called financial derivatives. But there is a more subtle way in which over-reliance on market mechanisms in more common transactions has led to dislocations and general failure. The housing market is a prime (not to make a pun) example. The so-called housing bubble has resulted from an inability of buyers and sellers to prudently and properly place a realistic value on properties. A herd mentality took over and everyone was convinced that prices of houses would always go up. People started thinking of their homes as financial investments and, more recently, as automatic teller machines (ATMs) that, as they appreciated on the ‘market’, could be used as collateral for loans to buy other goods. The supposed rising prices of homes (everybody wanted one so the demand was always going to go up) buoyed the general economy in the sense that every time one sold the higher sales price contributed to the gross domestic product (GDP) growth. And as home sales were always going up, so was the GDP. GDP is used as an overall gauge of how well the economy is doing.
The market failed miserably in this case. It failed in the case of financial products called mortgage-backed securities and all sorts of derivative based on mortgages. Even so, many conservative and libertarian voices are calling for freer markets rather than regulations be imposed from the government. Their argument is that the markets in question were never truly free and hence that was the cause of their failures. Basically, the claim is that free markets will solve ALL economic problems. To some that argument sounds reasonable, but as I hope to show, it is fallacious. And, as it turns out, so is the argument that more regulations are needed. At least that argument is fallacious unless one is quite careful to recognize what sorts of regulatory mechanisms actually work; they turn out not to be the usual governmental agency with a stick in its hand. Nature has some answers; logistical control has evolved in biological systems to coordinate operational-level, market-like exchange mechanisms. But economists and politicians never think to look to nature for their policy answers.
In order to understand why markets fail we need to look at how they evolved from the earliest modes of exchange between tribes. Humans evolved a number of mental/moral thinking patterns that enabled such trading. Those thinking patterns help keep trades fair on average by balancing the value placed on one's own efforts and resources versus that the other places on his. Attempts to claim higher value than was warranted were generally easily caught and sanctions against the ‘cheater’ were imposed to punish the attempt (or if the trade was made and found to be wanting afterward). Over time, the evolution of culture, particularly after the advent of agriculture, had a major impact on trading relations and methods. By tracking the changes in dynamics of markets we might hope to see where the limits of market mechanisms lie and understand how it is that markets like the housing one have failed.
I use the word failed advisedly. By failure I mean an inability to keep trades fair and equitable for everyone involved. Libertarians (free market champions in spite of evidence) will argue that the markets did work in that prices corrected after the bubble. But that abstract concept of correction leaves a wake of misery for millions of families as they loose their homes in foreclosures. They bought at the market high and were forced to repay loans on those high prices even as the value of their ‘investment’ tumbled. When some of them lost their jobs, on top of that, they had no recourse but to walk away, losing everything. This is not my idea of a market working. Markets should exist to support human well being. If there are crashes and bubble bursts then that is not working in my book.
So why do markets exist in the first place? A simple answer is that given by Adam Smith in Wealth of Nations, that with many people producing excess goods of one kind, and with that many people needing goods that others have produced, exchanges of value-for-value are inevitable. Each producer is found to be good at what they do, hence the excess, and with many good producers engaged in the enterprise of social living, everyone comes out ahead, compared to if they were to try to produce every necessity on their own. Markets exist to help people fulfill their needs.
Trade: Why Markets Exist and How They Work
In all likelihood you have been to a farmers market, possibly near your home. They are making a revival as a popular place to buy local produce and various trinkets, artwork, furniture, and numerous goods made by local artisans. There is something both exciting and comforting about these markets. Somehow you feel closer to the products by buying directly from the producers. But for most of us city dwellers, we still have no real conception of what went into making the products and have a tendency to pay whatever the posted price is for it. Dealing directly with the producer-vendor we somehow feel we are getting a fair bargain; not paying more than the item is actually worth in terms of the producer's costs and efforts.
As romantic as these farmers markets are to most city dwellers, they are really nothing compared with open-air markets in many rural areas and developing nation towns of the world where producer-vendors are also buyers from other producer-vendors. Open-air markets provide a mechanism for buyers and sellers to exchange goods and services directly from producers to consumers. Even so, these markets generally run on monetary exchanges for goods and services rather than direct barter.
Figure 1. Open-air markets have become popular around the US. In many parts of the world, this is the main kind of market for exchanging goods and services.
The original form of a market was for two or more specialized producer-vendors to negotiate a trade, an exchange of goods/services, in terms of units of one product for units of another. This is bartering. Surprisingly, even though the monetary exchange system has come into dominance throughout the world, there are still many situations (where money is scarce or the economies have been under inflationary stress) where barter is still operative. It is a fallback form of market that people can inherently grasp. It isn't easy to negotiate unit-to-unit exchanges, for example, how many sheep equal one cow? But people have worked out the value-for-value equations many times over and deals can be struck.
Figure 2. The first markets were simple matters of barter exchange of goods and services between two or more producer-vendors. The exchange details (units of one product for units of the other) were negotiated. In the early days when most participants had some idea of what effort and resources went into producing the product they wanted (dashed curved arrows), the relative values of units of products was more easily determined.
The key to barter markets was the degree to which the specialized producer-vendors still had some idea of what kinds of costs the other producer had incurred along with an idea of how much value-added effort he had to put into producing a finished product. A sheep farmer, for example, might have a good idea of the relative value of a cow even though he doesn't raise cattle himself. There are sufficient similarities between cattle and sheep that one can make educated guesses.
This insight into the costs of resources and effort to produce the desired product allowed the negotiations to produce reasonable value-for-value trades. Certainly every trader wants to get the most return for their product and the best price for the other product. So negotiations aren't foregone as to outcome. A lot of human perception, proclivities, and other psychological factors enter into decisions about perceived relative values. The sheep farmer might be desperate for cow milk and give up six sheep one time. But another time the cow farmer may be in need of wool and be willing to take only five sheep in exchange for one cow. It is in this sense that a market is ‘free’. The participants are free to decide based on their own needs and perceptions of relative value. They won't strike a deal unless both are within reasonable range of one another in the needs-value space. But note, it is only possible to have a free market when both participants have relatively reasonable (not perfect) information regarding the costs involved in the work of the other. If one participant feels that the other is trying to gain too much of a ‘profit’, then his sense of fairness can intervene to drive the bargaining toward a more reasonable exchange rate. Or he can walk away in a huff looking for someone who is not trying to steal his shirt.
Barter is not a smooth way to trade because of the problem of differences in discrete unit sizes and the difficulty of deciding how many units of one product are ‘worth’ one unit of another product. Money was invented to smooth out the exchange of goods and services (also see: What is money, really?, a look at the deep relationship between physical money and energy available to do useful work). The invention of money solved quite a few problems in economic exchanges. And it probably helped accelerate the movement toward greater and greater specialization in trades. But both the use of money and increasing specialization probably contributed to an increase in difficulty for markets to work as well as they had under direct barter.
Relative Value and Psychological Factors: Price in a Money-based Market
Over time, and as societies became more reliant on more specialized workers the ability of any one participant to grasp the basics of relative costs/value of the good or service being sold diminished. The cost basis for value added became cloudy. Sellers took to setting prices denominated in the coin of the realm and left it to buyers to decide if the price fairly reflected the underlying value of the product.
By underlying value I mean the sum of resource costs and production effort that went into the production of the good (or service, though these remained more transparent since the work was done on the spot). These represented the basic value added to the resources to make something the customer wanted. Effort has no absolute measure attached to it. For one thing skill has a lot to do with how much effort needs to be applied. A very skilled worker can produce a widget with less effort than an unskilled one. Thus there is a difference in input of energy that a skilled producer might be able to exploit when the customer might have to pay a higher price (because of more effort needed) to a less skilled producer to get the same product. Thus the skilled producer is in a position to demand a price greater than the sum of resource costs and his own effort, reflecting an award for being so efficient — his profit.
Every producer wants profit. This goes back to the early agriculture days when farmers planted more than they would consume so as to have some left over just in case. With grains this is particularly the case since grains can be stored for long periods. Granaries could be built up as a hedge against bad years, source of new seed to expand in future years, or to trade for other food stuffs or trinkets. Profit means you are safer and can do more production in the future, so it is a natural desire to want to make it. In the arena of food, profit means obtaining more energy (and nutrients) in the food than was expended in the effort of growing the food. This is represented as energy returned on energy invested (EROI or EROEI). It is the basis of wealth production.
Now we run into some problems. As shown in the figure below, in a more generalized money-based market with more specialized participants the dynamic begins to change.
Figure 3. Money-based markets with specialized participants have a different dynamic.
In the earlier, simpler, barter-based economy a buyer could make a rough estimate of the relative value of his own efforts compared with those of the sellers. He also had a reasonably good idea about the resource costs compared with his own. The market had a reasonable amount of transparency because the nature of the work being done was not that foreign to all involved. In fact it was probably the case that most participants knew almost exactly what was involved since most were to one degree or another semi-self sufficient. That means they may have actually done the same kind of work. The reason for specialization had a lot to do with relative efficiency and personal preferences. If I have a knack for sheering sheep and like the life of a sheep rancher, and if you like raising cattle and are very good at it, why should both of us do the same work? I could raise a cow or two, but suffer from inefficiencies in doing so. As long as I know I can always buy a cow from you, there is no reason to keep raising a few myself.
As society became more complex, with more specializations, it became difficult to always have insights into what the cost basis of a product might be. It became difficult for buyers to gauge the relative costs and efforts compared with their own labor. As towns grew and tradesmen developed businesses their workers only knew that their labor paid off in a certain amount of cash. The problem was, how much of that earned income cash should they use to buy various commodities in the markets? How could they be sure that the seller was not trying to take advantage of their ignorance of what costs had been incurred and whether the they were just trying to make a larger than fair profit?
Buyers were reduced to having to evaluate the worth of a product on their surficial perceptions of the product itself and an inner sense of how much they needed it. It is hard to say when people started to keep household budgets in any kind of explicit fashion, but I'm pretty sure every buyer did a subconscious calculation to see if the price being demanded squared with the amount of hard earned cash he was willing to part with. Open-air markets today still have that feel about them in that the seller posts a price and the buyers have to decide if that sounds about right. There may still be some room for negotiations — haggling over price — in many situations, even today. But as market sizes grew and additional participants began to enter to fulfill yet newer roles, to facilitate merchandise movement, yet again a new dynamic emerged.
Bear in mind that all the while that marketplaces were evolving, along with societal complexity, one factor that almost no one gave much attention to was actually enabling this change in dynamics. From the time when humans first domesticated fire, their access to sources of exosomatic (outside the body) energy for doing work have been increasing. Humans have been exceedingly good at discovering ways of extracting energy from natural resources, wood, animals, water, wind, and later fossil fuels. They have been incredibly good at finding technological ways to exploit those energy resources to do the work of production. And they have been exceedingly good at inventing new products that could be built using the new technologies.
Increasing flows of energy allowed humans to engage in ever increasing forms of commerce, including long distance trading. It allowed increasing specialization or rather allowed the increase in complexity that demanded greater specialization (division of labor) in order to produce most efficiently. Markets were now not so much a place, in the village or town, but a network of relations across a city and even between regions. Markets became more abstract in the sense that they existed in the minds of participants more than in one specific location. They were real enough in terms of goods and services being traded for cash and even promises to pay cash at a later time.
Markets were working. In spite of a loss of transparency — buyers knowing what basic values accrued to products and services — markets seemed to flourish and serve the basic purpose of making peoples' lives better. Here we have a mystery. If buyers were increasingly unable to work out subconsciously what something was worth in terms of the effort and resource costs that went into it, then how could fair deals still be struck. The answer is found in the increasing entry into markets of numerous producers vying for the same customers. As the populations of towns increased the tendency for numerous individuals to develop similar skills and produce similar products increased as well. Since all needed to eat, they strove to produce at a cost that could be reflected in a good price for the buyer.
The simple answer to what kept markets working for so long is that more sellers competed for the same buyers' coins. Competition drove producers to strive for best prices. On the other hand, where competition was stifled, sellers could set prices based more on what they thought the buyers would be dumb enough to pay. Monopolies have been considered a bad thing by economists because they can charge whatever they like, and if they are in the business of producing some essential product or service, they can really mop up the profits.
How competition kept markets honest is a great story. It is one that conservatives love to tell over and over. And, for the most part it is true. But once again, there was a deeper factor that was at work, unrecognized by market observers. While competition was a necessary condition for market success it was hardly sufficient. What was going on behind it all was the continuing increase in energy flow enabling the increase in availability of work opportunities. As long as everyone could get access to energy (labor and machines) the impetus behind market success in making life better for all, or at least most, was at play. At the dawn of the industrial revolution energy flow was abundant (with the rise of coal) and so was the resultant wealth. The notion that a rising tide lifts all ships took hold and the belief that markets were the engines of wealth production (a la Smith's invisible hand) became the zeitgeist of the age.
Those who took an interest in economic activity as a subject to study for its own value looked for causal models of why the market worked so marvelously to produce the results of wealth production. In competition and its underlying mechanisms they found their proximal causes. And that story has stuck ever since. Too bad they didn't look deep enough. Here are a few mythic tales.
Production Efficiencies, Economies of Scale, and “Features”
Whereas in older versions of markets the willingness of a buyer to purchase goods for money often involved trust that came from dealing with a few, historically reliable vendors who one felt were honest in setting their desired price, as more roles for market participants evolved, it became difficult for buyers to be certain they were getting good deals. This left buyers with having to judge relative value based mostly on their ability to pay, on their budget.
As mentioned above, some producers were more skilled at producing their products than others. Skill and finding ways to lower input costs had a direct impact on profits. Perhaps many different producers were attempting to sell their goods to the same population of buyers. Another mythic story has it that producers, eager to out compete the others funded innovation, invention, and technology that reduced costs and allowed them to pass those savings on to customers. As with all myths there is some truth to this one. But as with the whole story of competition, this one needs closer scrutiny. Underlying the ability to innovate is the fact that abundant, cheap energy allowed the possibility for innovations to occur. First, by the fact that energy was so cheap, firms could afford to invest some profits in R&D efforts to find innovations. Second, those innovations invariably involved the use of energy-using machines that could translate power into useful work at production rates that beat human labor. Again, energy being cheap allowed the trade off between machines and labor to favor machines. Economists had long measured production efficiency in terms of labor dollars used per unit of production. They did not worry about machine (physical) efficiency because it simply didn't matter except in the way it allowed the reduction in labor costs. Increasing labor efficiency translated into a competitive advantage to those firms that could employ innovative technologies. They gained greater control over their profit potential by charging just under what other producers in the market were charging but not necessarily as low as their cost savings would have permitted.
There is an irony in the use of machines and cheap energy to substitute for human labor. In 1865 William Stanley Jevons observed a paradox (now called Jevons' Paradox) in noting that as a work process (e.g. mining coal) became more ‘efficient’ by virtue of using machines to increase production, instead of simply being happy with the reduction in labor at a given production rate, the tendency was to increase production (and consumption). As the steam engine made it possible to mine more coal (by pumping water out of the mines), using coal as its fuel, industry simply absorbed the increased availability and the industrial revolution was off and running. The reason for this paradox is simple. It involves the thought that ‘efficiency’ is measured in terms of classical economics inputs, labor, capital, land. Energy costs went down because coal became more abundant and thus cheaper to buy. By economic measures this meant that the energy inputs (measured in monetary terms) became relatively insignificant as inputs, hence the process appeared to be more efficient. Had anyone thought about it, however, they would have realized that from an energy standpoint it wasn't efficient at all. A lump of coal can do a lot more work per unit time than a human or even a horse because it is energy dense and burns at a high temperature compared with its surroundings. But the early steam engines were very inefficient from the physical viewpoint. Since the demand for coal rose dramatically with the evolution of the Industrial Revolution, the water could not be pumped out fast enough to allow deeper mining. This fact spurred the innovation, for example the Watt engine improved performance over the Newcomen engine, that would lead to higher true machine efficiency (and help in the science of thermodynamics) and, thus, reinforce the cycle. Of course, the big fallacy in this innovation story is that it could go on forever. Coal was a finite resource and by the mid 1800s Great Britain felt that fact rather fiercely. Fortunately there was another form of fossil fuel that could replace many applications of coal just starting to be produced in large quantities. Oil would keep the engines of industry running, especially with regards to transportation. Nevertheless, the finiteness of coal should have been a warning that allowing the effects of Jevons' observation to go unchecked would one day cause serious effects in the economy. Yet, at the time, oil seemed to be incredibly abundant, so much so that I suspect the majority thought it was infinite.
Yet another factor is lauded as a means to compete more effectively and that is the idea that when you buy, say component parts for your product, in large quantities, you can negotiate better deals on per unit costs. This leads to lower costs in the product and an ability to further increase profits and/or pass on savings to customers. Either way it leads to competitive advantage. Here is an incentive to grow the business so as to be in a position to buy those large quantities. Other production factors can also benefit from size. Henry Ford discovered that mass production in assembly lines generated greater savings and gave him a great advantage.
But Ford may have missed the boat on another factor that leads to higher competitiveness. He mandated that all Model T's would be black since that allowed for great savings when it came to paint costs. What he didn't get is that people also value unique features that seem to give products more bang for the buck. Given two products with exactly the same function, people will pay more for the one that does it with a little more style. It is human nature, of course. But it is just one more way in which the underlying true value of a product can be obfuscated.
All of these factors tend to hide real costs from the buyer's observation. As a result who can actually say what something as complicated as an automobile is worth compared to the basic needs for its functionality. And that is what leads to value-for-value trade problems. How much is a house worth? The answer is whatever someone is willing to pay for it. In other words we will let competition and the markets decide on value and not worry about real costs (including external costs such as environmental degradation). The markets will decide rather than humans.
Competition Keeps Markets Honest
The beauty of a competitive marketplace is that if you, as a buyer, don't like the price or quality at one vendor's stand, you can shop around till you find a deal more to your liking. Competition is viewed as a good thing in markets. Competition keeps prices down and quality high, or so the story goes. Indeed the general belief is that competition drives innovation and pushes prices downward by finding cost savings as discussed above. The Walmart phenomenon is supposed to be, by free market advocates, the latest, and perhaps most prominent, example of this effect. Walmart (formerly Wal-Mart) is hailed by libertarians as a prime example of innovation in supply chain management in order to offer American shoppers great prices. The details of how those innovations work have come under heavy criticisms, however, since they use their economies of scale to squeeze profits from suppliers and drive wages down.
In fact, competition gets cutthroat and dirty. It can, and has forced companies to do dishonest things in order to win the approval of customers and, in the case of publicly traded stock companies, shareholders. When that happens, companies can turn decidedly dishonest. Once again this is a function of transparency. In the first markets I could walk by the cow farmer's place and see his operation and have a sense of his methods, etc. Today nobody (and it seems that includes some CEOs) has a good sense of operations of other companies. As the saying goes, we're better off not knowing how they make sausage. But then how do we judge the intrinsic value of the products they make?
We've always believed that growth in the economy meant continuing expansion of opportunities for accumulating wealth. And while energy flows were increasing that was basically true. If the size of the game pot is growing and everybody gets a fair shot at winning then it doesn't have to be a zero sum kind of game. The problem is we are now entering a period in which energy flows are going to be forever shrinking until we reach a lower level of flows from alternative energy sources. That level will be much lower than we are used to. So the game pot is shrinking. And when it is shrinking and everyone playing is used to being able to get more of a growing pot, what do we do? We beg, borrow, and steal. Which is exactly what you are seeing in today's developed economies. The stealing is starting to get more favor from corporate America, it seems.
Competition was a useful factor in promoting innovation and keeping companies honest when products were simpler and more directed at basic functionality. It was also workable as long as energy flows were increasing. But now competition is probably past its usefulness as a market mechanism for producing equitable distribution of wealth. Indeed, under current conditions, anything that promotes and sustains competition is simply hastening the demise of the economy due to rampant dishonesty needed to keep up the guise of successful production.
When and Why Markets Fail
My thesis has been that markets are only just a mechanism for allowing the exchange of value-for-value in a localized transaction and work only when both parties to a trade have adequate information regarding the intrinsic value of the product being traded. In a money economy the value of cash ought to be related to a standard unit of work (energy) so that its value is known to all. Of course, thanks to Milton Friedman money is now just another commodity the purchasing power of which varies idiosyncratically with market perceptions. The other half of the trade, a product or service, needs to have a transparent intrinsic value as well.
Markets will fail to provide an adequate mechanism for achieving global equitable distribution when these conditions are not met. And it is easy to show how they are not met in today's complex economic system. But moreover, the argument goes on to claim that these conditions can never be met because opacity is intrinsic to complexity. It is a human decision maker who must, in the end, evaluate the worth of a product, and in our complex economy with complex products that ability is minimized to a point that ordinary buyers cannot really know what the value of something is, other than their estimate of what it will do for them. This is especially true and amplified in consumer market products where motivations to buy include psychological factors like social status and sexual attraction. Thus, merely adding governmental regulation on top of an already flawed mechanism will do little to correct the situation.
Markets have been failing in every quarter. We need to understand why and develop better coordination controls that will help achieve equitable distribution without the distortions that too many politically-based policies inevitably introduce.
What is Something Worth?
Markets fail when buyers consistently fail to assess the worth of products so as to make informed decisions on buying from one producer versus another. Judgments of worth are based on two components. One is a perception of what the product will do for the buyer, its functionality or utility. Note that this need not be a rational judgment. In fact, as noted above, many judgments of value are based on emotional effects rather than utility in the traditional economic sense. One of the major flaws of modern neoclassical economic theory has been the rational agent or Homo economus making sound judgments before buying. Fortunately many contemporary economists have realized this flaw and the field of behavioral economics is using experimental psychology to figure out a better model of purchasing agents.
The other factor involves having a sense of how much something costs the producer to produce and how much value-added effort the producer expended in the process. We humans have a built-in sense of fairness that dictates our feelings about exchanges. Tit-for-tat is the default position with some variance on either side, but not a lot. If we feel someone is selling us something that cost them very little but are asking a large price, we would generally not buy it. Along with our emotional desire, which may override our sense of the unfairness aspect if we perceive the object to be of unusually high impact on our well being, we formulate a subconscious sense of value or what something is worth. And then if the price is right...
What happens when you have no way of knowing what the intrinsic or cost-based value of a product is? How do you formulate a judgment? All the average buyer can do is judge based on superficial appearances. If a car looks racier and sexier than others, does that mean it has a higher intrinsic value? Did the manufacturer expend more effort and pay more for parts? How would you know? You might, if your rational side is in control, go to a quality reporting source like Consumer Reports, which makes an attempt to test products in the consumer markets, to see if they think the car has high intrinsic value.
The traditional model for prices in markets is based on the classic supply-demand relation in economics. As mentioned before the right price is what buyers are willing to pay for something. The playoff between supply and demand (the aggregates of what producers put on the market and of buyers of those goods) determines the average price. If demand goes up due to buyers perceiving more use of the product, then at a given level of supply the price will be pushed upward to reflect it. At some higher price, demand will stabilize and a new equilibrium will obtain. So the theory goes that the market will decide the price and all buyers have to do is decide if they can afford the product at whatever price has been set.
All well and good, perhaps, except for those products that buyers perceive are worth far more (that is they are willing to pay much higher prices for) than they really are intrinsically. This is what creates bubbles in markets. Without a baseline in intrinsic value buyers cannot judge the worth of a product and can only base their buying decisions on their emotion-based want and what the going price in the market appears to be. And depending on supply, buyers become competitors trying to out bid one another.
The intrinsic value of a product depends on costs that the producer paid for components, labor, overhead properly allocated, and fixed capital properly depreciated. If the prices of all of these items were similarly based on intrinsic costs then the cost-value aggregation would be recursively applied all the way down the supply chain and the cost build up would reflect true costs. But buyers of components have the same problem that buyers of consumer goods have in not having insights into those intrinsic costs. In an economic system where information on costs of inputs is considered proprietary it is in the interest of suppliers to keep it that way. Thus one never knows if the price being paid reflects a real value or if it is just where the market happens to be taking us.
Sellers have an incentive to keep the market opaque (or what they call ‘proprietary’). In the name of profit they will always seek ways to cut costs without necessarily passing the savings on to buyers. Even Walmart, after squeezing suppliers through threats of taking their business elsewhere doesn't always and immediately pass the lower costs on to customers unless they are being threatened by their competition. The game of capitalism is to maximize profits and thus shareholder equity. Never let that be forgotten.
Unfettered Competition in a Non-Growing Real Asset Economy
The timing of market failures is another big question. From the above we can imagine how market bubbles get started and inflated because of a lack of value sense among buyers. They are too easily caught up in a herd mentality and the self reinforcing feedback loop where seeing prices escalate, they feel a sense of panic that they need to bid the price up further to beat out the competition.
It turns out that as long as buyers are generally making more income over time (or believing they will in the future) and there are ever more buyers entering the markets over time, the economic measure of the market (not its intrinsic aggregate value) can rise without seeming to cause too much of a problem. These conditions are met as long as the economic system in which the particular market is embedded is growing. The housing market in the US and earlier in Japan are examples. And that condition had been met as long as energy flow was increasing throughout much of history. But starting around the early 1970s things started to change. Energy flow was still growing but at a slower pace each period. It had entered the top part of an ‘S’-shaped curve. This is the point beyond which the marginal return on energy (and money) invested in getting more gross energy out of the ground went into serious decline*. And as economists are fond of reminding us, such conditions cause a decline in period to period profit growth.
When the rate of marginal energy return started to diminish the real work that needed to be done to support the production of real (actual physical) wealth began to diminish as well. Almost nobody noticed because nobody paid attention to net energy and its role in production. The energy inputs to production are relatively small for any one firm, so the marginally rising costs of those inputs could be easily ignored. Nor were they paying attention to the declining growth rate of real assets. Instead financial wizards had started to push financial ‘instruments’ and ‘products’ onto the financial markets. Ordinary people started thinking of their homes as investment that paid dividends. Everyone was fooled into believing the economy was still growing over the last several decades The sales of these products and consumer goods based on money borrowed from supposedly appreciating asset values fluffed up the GDP. Indeed the demand for services in the artificially buoyed economy led to the creation of many jobs. All of which led economists to declare the economy healthy.
In reality it was moribund. Real wealth was being produced at declining rates. What was being called real wealth, trinkets and toys made in China, further enhanced the illusion that our material wealth was expanding. Behind the scenes, as is now painfully obvious, governments ignored important infrastructure investment letting entropy work its will on bridges and power grids were not upgraded to deal with the growing demand. We let slide the deep basis of society and the economy for superficial and illusory marks of a healthy economy. We, in the west, shipped manufacturing and other jobs off to Asia because it was expedient and supported maintaining the bottom line. Of course a few companies that could not sweep their cost structures under the Asian rug were stuck looking for another way out through creative bookkeeping. Companies did what they had to to keep the illusion of America and the other OECD countries as economic engines producing wealth, when in fact it was producing hot air to pump into the bubbles.
Without real growth in the real asset base, especially when there is growth in population, you will find that markets will crash and fail at the slightest provocation — call it the trigger effect. One little hitch and a bubble or two will bust and bring the whole edifice down with it. That is what we are witnessing now.
Put simply, markets fail when they (or to be more correct, their participants) cannot adapt to the realities of changed conditions with respect to energy flows. Reduce the net energy input per unit of time and the markets will first try to compensate with superficial and hollow fluff transactions (that presumably do not require large amounts of energy in order to be carried out, just a computer and some creativity). By ignoring infrastructure, and by companies ignoring investment in R&D, and by families and governments ignoring savings, we could hide a considerable amount of sin under the bed, at least for a while. But eventually it catches up. People respond to and make attempts to adapt to changes in profits, period-over-period. But profits are but a pale reflection of the underlying reality of energy flow. Moreover, the method of response, the reaction to boost profits by whatever means available, turns out to be counter to the logic of declining energy flows. The latter demands doing less real work, whereas the logic of profits demands doing anything that makes it seem as if profits are still expanding. And you can't have it both ways.
The failure of markets means that many buyers and sellers will not be treated with equitable distribution. In one sense one might say it is equitable that people loose their equity because they simply got greedy or selfish and wanted more than the underlying value in the market could bear. They got what they deserved. However, for every one hundred or more losers there were a few winners who were just as greedy or selfish, but also lucky in their timing.
When Markets Work For the Good of Humanity
Should markets serve humanity or should humanity serve markets? It seems that as things stand today we have accepted as the answer to that question the latter. By elevating the market mechanism to an almighty level as solver of all problems we have subjugated our humanity to serve them. We have lost sight of the purpose of trade that evolved from ancient times. Our blind faith in markets to resolve all economic (and as it turns out political) issues is a malaise.
Yet we have seen that at an appropriate scale a market does, indeed, solve a fundamental economic problem.
The take-home lesson in all of this is that markets are legitimate mechanisms for facilitating exchanges of goods and services and providing information regarding the need for specific kinds of wealth production, a fundamental objective of capitalism. But they only work when all participants have sufficient value information with which to judge the efficacy of transactions. Information has become increasingly hard to come by in today's complex and highly distributed economy. Products are so complex that the general buyer cannot judge the intrinsic value reliably. Competition for buyers and among buyers for products with such bad information resources leads to distortions and bubbles that eventually burst, hurting the last ones into the fray. But even with bubbles and lost presumed assets when they burst, as long as the underlying real economy was growing by producing ever more physical assets of real economic worth (not just trinkets and toys) the pain could be absorbed and eventually forgotten. The problem now is that the production of real assets is starting to decline and we are entering a period of diminishing growth because we have diminishing net energy available to do the work. Markets cannot solve this problem because it is a real physical constraint. For example, the rising price of, say, oil will not result in more investments in substitute fuels (like corn ethanol) or alternative energy sources like solar or wind, because these latter are not actually physically viable substitutes. They do not have the energy density potential that fossil fuels have, and on top of that, the energy capture and conversion capital needed to make them work at all is based on using fossil fuels to build them. If the price of fossil fuels goes up with reduction in supply, so does the cost of alternative energy capital. No market can change basic physics.
Transparency in the work that was accomplished in producing goods and services to be sold in a money-based market kept sellers honest. Basic fairness kept sellers from trying to cheat and extract a higher than necessary profit. Competition in markets is workable when there are few participants whose behavior is observable by all other participants. If a good is scarce and there is competition among buyers, social mores can operate to make sure the goods go to those who can make best use of them. When the competition is among sellers to sell a good, it acts to motivate sellers to produce the best quality good most efficiently so as to pass on savings.
But perhaps most important of all, markets work when the scale is local and all of the parameters are accessible by human participants. Once markets get too large, and complicated, all of the above factors are negated. While it is true that local exchanges can still proceed as if a market is local (e.g. between any two vendors/buyers in a supply chain), the large-scale result is not the simple sum of all the local two-party exchanges that it seems.
To summarize, markets work when:
- Buyers have adequate information
- Sellers are restricted to reasonable profit margins
- Competition among buyers is regulated to assure best uses
- Competition among sellers is regulated to assure non-overuse of resources
- Not expected to provide coordination over larger scales (smaller is better)
- The system as a whole is either in steady-state or growing.
Expecting markets to solve economic problems when any of these conditions are violated (as is the case in our current global economies) is folly.
Hierarchical Control Theory and Market Coordination
Using markets to help coordinate the equitable distribution of wealth is not, however, a lost cause. Markets have such wonderful properties when properly implemented that it would be silly to abandon them completely. The question is, what sort of meta mechanism would allow markets to do what they are good at while keeping them from violating the above considerations? That is where hierarchical control theory might serve. The issue is one of logistics. How do we move resources to the points of use where they will benefit the majority of the people most of the time?
Applying hierarchical control theoretic approaches actually suggests a straightforward and relatively simple solution (see Figure 4 below). For each local market, provide a monitor function that keeps track of the seller's value added by monitoring actual costs. In practical terms this would involve opening the managerial accounting books to an agency that is tasked with summarizing the data and providing it to the customers. Note that there is no ‘regulation’ involved in this operation, in the typical sense of government regulation. The monitor has no authority to force the seller to do anything. Its only responsibility is to provide buyers (or potential buyers) with value information so that they are in a position to make an informed decision. This simple act will help keep sellers honest. Buyers can decide for themselves how important it is to their interests to buy regardless of how much profit the seller might be trying to make.
The monitor function will, of course, have to be certain it is collecting real data and not just fluff that the seller is putting out. It will have to monitor its own monitoring function and assure its own veracity. But these are not difficult conditions to meet. Internal auditing is a well established process for commerce.
Figure 4. Monitored markets help provide information feedback to buyers to ensure transparency regarding intrinsic value.
Of course, monitoring may not be sufficient when human actors are involved. Cheaters are almost certainly going to emerge over time. In that case some form of enforcement of rules must be a part of the process. There must be a way for the monitoring function to detect cheating and to pass this information on to an enforcement agency that has access to appropriate sanctions to cause the seller to conform to social norms. But such a type of coercion is not the main point of a hierarchical control system. It is a last resort put in place to compensate for some unfortunate human weaknesses.
Figure 5. In the event that monitors detect cheating some form of rule enforcement is needed to cause the seller into conformance with social norms.
Local market coordination is not the last word. Every buyer can be a seller to someone else further down a supply chain. Thus the scale and scope of markets can be much broader than simple markets such as the open air form. In this case the coordination control provided by the monitor/enforcer will not suffice. Hierarchical control shows us that a higher level coordination function is required to ensure the inter-market (i.e. supply chain) function smoothly. Figure 6 shows this from a macroscopic view.
Before the libertarians scream out about ‘planned’ economies, note that this level of coordination is established after the market network is formed in practice. That is, the supply chain is emergent from the needs of the society; the coordination control is established a posteriori to assist the smooth functioning. The details of how this is accomplished will need to be the subject of another whole essay. The point here is that such a level of coordination is needed to ensure the smooth function of a collection of local market mechanisms.
Figure 6. Assuming that local markets have coordination as in Fig. 5, more complex markets (e.g. a supply chain) require another, higher level of coordination. The blue ovals represent local coordination as above. The purple oval, the coordinator is a much more complex function that attempts to balance resource inputs and various outputs such that the whole market achieves an optimal performance.
We, that is our current markets and governance systems (e.g. EPA, Federal Reserve, and Federal Trade Commission are examples), already try to accomplish this task of providing logistical control, but we do it blindly without really understanding what we are doing. The way these agencies come into existence is more from reaction to a market failure than from forethought. Such systems have been cobbled together without much of an overarching theory. And that is why our current market systems regulatory approaches fail so badly. We do not use understanding of hierarchical control as it works in nature to design and operate adequate coordination mechanisms in our market economies. We try to implement something that seems appropriate (through our policy development mechanisms which are anything but rational approaches as currently constituted), but these are more often band aid approaches. Mostly we implement regulatory agencies which invariably trigger reactionary responses from the libertarians. Much as I hate to admit it, the libertarians, while mindlessly doing so, are actually responding correctly to a fallacious approach on the part of progressives. Blind regulatory agency is not the way to achieve hierarchical management of complex markets that might otherwise provide valuable distribution of resources. We need to approach this from the standpoint of understanding reality. That is not a currently popular approach, unfortunately.
But, as I hope I have established, neither are simple minded free markets the solution. I take my lessons from nature. It turns out that the hierarchical control architecture that I have pointed to for markets is a main feature of the success of living systems. We can actually see this at work in, for example, the metabolism of living cells and the energy flows of ecosystems. The science is well known though still complicated. It is not something that one could expect lawyers to grasp until they had some education in physiology and/or systems ecology. Or, better yet, if they were educated in systems science and then looked at social systems as living organisms!
Markets are useful in solving some very local problems regarding trade. They do not fail when properly applied to local conditions. But they are not panaceas to all economic problems. The American way is to assume they are panaceas and this is now proving disastrous to not only the American, but the world economies that have tried to emulate the US. Several economies, e.g. the Chinese, are mixes of command (regulatory a priori) and market-based. They are showing variable degrees of success in terms of providing equitable distribution of wealth. They are not pure capitalism, which has demonstrated its inability to grasp the issues of environment, but neither are they pure planned economies such as was practiced in the former USSR. It remains to be seen if they will grasp the importance of balancing the market (local) mechanisms with the social (global) mechanisms of hierarchical management. Unfortunately, ultimately, it depends of human judgment. Long-time readers will know that I have a great deal of skepticism about that!
The day that a policy maker understands what autopoiesis is will be the day that I have hope that we might achieve an economic model that will benefit humanity as it should. Living systems evolved the capacity to have wonderfully regulated economies a long time ago. We humans could benefit tremendously by learning the lessons of nature.
* Energy return on energy invested (EROI) for oil started to take a nose dive when off-shore drilling and other hostile environment operations (e.g. North Slope of Alaska) started to become larger factors in the domestic supply of oil. The kinds of physical facilities you need to go after this remote oil are substantially more than that needed to drill and pump conventional land-based wells.