Thursday, February 21, 2008

Invisible Hands & Free Markets

How is value created? The answer is rooted deep in human nature. Austrian economist Ludwig von Mises wrote in his “Human Action: A Treatise on Economics” that there is, inherent, in mankind a drive toward happiness (loosely defined as “having succeeded in attaining his ends”). Given that drive toward the highest degree of happiness, mankind is constantly looking for an attainable alternative to their current condition. That is, they’re looking to trade their current reality for some reasonably attainable BETTER reality—one which will, ultimately, make them happier.

This principle really begins to uncover the answer to the question “how is value created”. At the most fundamental level, value is created through trade.

Some time back, I decided to sell my car. I don’t recall what I had it listed for, but I had a number of offers. One guy offered me $12,000; I turned him down. Why? Because the car was more valuable than $12,000 to me; conversely, the car was LESS valuable than my asking price to him. I ultimately did sell it though-for $14,000 I think. Why? What caused the transaction to take place?

One would assume that he felt the car was worth $14,000, and that I did also, but that would be inaccurate. The truth is, he felt the car was worth MORE than the $14,000 he gave for it; on the other hand, I felt it was worth LESS than $14,000. If this weren’t the case, the trade wouldn’t have happened. Because rational beings only make an exchange when what they are getting is, to them, MORE VALUABLE than what they are giving. He received MORE value from the car than he was receiving from the $14,000 he had in his pocket; I received more value from the $14,000 than I was receiving from the car (you’d agree, by the way, if you’d owned that car).

So then, by virtue of an exchange between rational human beings, additional value was created. Further, the assets in play within that economy (namely the $14,000 and the car) were, through the trade, put to their highest and best use. So value was created not only for the individuals involved in the transaction, but also for the overall economy.

This is the “invisible hand” that Adam Smith, the eighteenth century Scottish philosopher and economist, wrote of. He said, in an oft-quoted passage from his noted work, “The Wealth of Nations”:

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

He postulates that by pursuing our own individual best interests, in a free-market, we will naturally, through trade, arrive at an exchange that will maximize the value attained by all participants. By maximizing our own personal happiness, we, without trying, maximize the overall good to society. That's the invisible hand that brings us to the overall maximum value within an economy, WITHOUT excessive regulatory intervention by a government.

Imagine, then, that in my example, there’d been some regulation that said that used cars of that make and model, for that year, could only be sold for $12,000. Suddenly, the situation changes. Assuming I wish to sell the car, I’m forced to sell it for LESS than I think it’s worth, and the guy that buys it walks away singing. I’m ROBBED of value, and the buyer gets an “obscene” deal on the car.

The idea of a regulation limiting the transfer price a used car is, of course, absurd (or maybe it’s not)—needless to say, it’s not reality. But governments do regularly intervene, and regulate trade (through various means, including tariffs, taxes, monopoly laws, minimum wage and price caps). What is the net affect of an “independent” authority involving itself in trade within an economy?

Consider this: imagine that, in my car sale example, the gentleman who wished to have my vehicle had cash at his disposal, as well as, say, a 9mm Glock pistol (loaded). Further, assume that there was no government authority that imposed a threat of punishment on those who used force, or the threat of force, to take other’s property against their free will. Assuming, again, that individuals are always looking to achieve the highest level of personal happiness (or, to have as much “stuff” in this example), what is the buyer likely to do? He’s as likely to use the gun and take the car for free as he is to pay me the $14,000 that I really require in order to willingly let it go. So in the absence of ANY regulation, we run the risk of allowing “weaker” parties in a transaction to be robbed of any and all value, potentially resulting in a net loss of value to the economy as a whole.

So there exists a need for, at the minimum, a set of societal norms—rules of engagement that provide general boundaries for our actions. Governmental regulation is generally effective at establishing and enforcing these boundaries.

Imagine though that you own a small business. You have a need for a single laborer to perform menial tasks, all manual labor. You place a "Help Wanted" ad in the front window, and in walks a 16 year-old young man.

"I'm looking for work," he says, "and I saw your sign. I'd like the job."

"Certainly," you say. "It's yours if we can make a deal happen. How much would you like to make?"

"Umm...I don't know; how about $5.00 per hour?"

"Perfect! That's exactly what I can afford," you say. "When can you start?"

"Tomorrow," the teen says, as he reaches out to shake your hand.

You shake his hand. As you turn to walk back to your desk, your gaze travels past the State Minimum Wage poster posted on the office bulletin board. Minimum Wage, it says, is now $8.00.

You stop short, and gaze at the poster. The teen is clueless.

"I'm sorry," you say, as you turn back to him, pained expression on his face. "I can't hire you; I can only afford $5.00/hour, and you'll work for that, but the state won't allow you to work for less than $8.00"

He walks away downcast; you scale back business. Neither of you win. You were both WILLING to make the trade, but due to regulatory restrictions, you weren't allowed, and so the net value created was LESS than it would have been were the trade allowed to happen, and not regulated away.

The greater the level of freedom in the marketplace (the lack of regulation), the greater the potential net value created across the marketplace. But there's one additional factor that contributes to overall net value. Choices. A vital element that exists in a true free market is the presence of choices, or options. A seller has multiple potential buyers; a buyer has multiple potential sellers to choose from, and even multiple potential alternative products.

Happiness is truly maximized when one feels as though they've made an equitable trade after evaluating all the options in the market. This is an earmark of a free market, and enable the "invisible hand" to operate most effectively.

The most prosperous economies are those that operate pursuant to the principles of a free-market, and encourage the pursuit of personal prosperity. This environment is most conducive to allowing the "invisible hand" to unwittingly build that individual and collective value across the economy. This is the environment that we must strive to cultivate, both in our national economy, and in our individual business economies. In doing so, we create value.

It is our purpose, to create value. The alternative is to diminish value. The application of human effort and energy enables the creation of value. Diminishing value, then, is tantamount to wasting--or taking--human life.

A prosperous Free Market: it is our purpose; it's our obligation.


Anonymous said...

I have to say I found this post insightful, especially after the quarter fiasco of yesterday :-) Is this the same blogger? A.L.

Mrs. Willman said...

Value is based on the eye of the beholder also, not just that though. If you take your 14,000 dollar car to another country its going to be probably most likely less or a lot less than what our country thinks the value is. And if we take our products to Japan, as our country does on other countries' products, they put tariffs on them so that our price not necessiarly value is jumped up, so that their products have a lower price on them. Our value of minimum wage in California has a different value in Idaho. Which I think is still less than 6.00 dollars an hour. Other countries and states have different values with different beliefs, so I believe with free market causes more competition which causes the value at times to be lower than expected. Look at the Free Trade Agreement.
John W.