In the free-markets, there is no single “authority” setting prices for goods. So, then, how are prices formed for goods in an economy? Prices are formed by the unhindered interaction between businesses and consumers and between businesses themselves. Past prices guide future action of the businessmen who are further affected by the actual prices of factors of production, after production begins. The changes in prices of the factors of production and consumer preference change (market data) in the intervening time influence the degree of success of an entrepreneurial venture. Those market data changes are continuously updated in the “market” through the instrumentality of prices.
Entrepreneurs use prices to assemble the raw materials, capital goods and the labour necessary to enable production. Prices eventually guide the volume and the kind of production in several branches of the economy. The scarcity of natural resources, demand for consumer products, quantity and quality of labour required in different branches of production, preference for certain kinds of goods, seasonality effect on certain types of products or the perishability of some goods, are all factors that eventually get expressed in a single value as prices. Prices are the ultimate carriers of information in markets. Without prices, its smooth functioning is inconceivable.
The most visible element of the “invisible hand” advanced by Adam Smith is the prices of products and factors of production.
Prices are possible because of economic-calculation which is in turn enabled by the use of money as the medium of exchange. Money enables numerical expression of things that are exchanged. Economic-calculation refers to all the monetary calculations performed to undertake profitable production and prudent consumption. This includes savings, prices, margins, wage-rates, costs etc. This is essentially a fundamental feature of the capitalistic system as opposed to a socialistic one.
The process of actual production is common to both capitalism and socialism. Production requires technological planning – technology, not in the sense of information technology, but in the context of the process knowledge necessary to convert factors into products. In a capitalistic system, economic calculations precede production activity. Using price as an input a businessman performs economic calculations to validate the feasibility of venturing into a branch of activity. Consumer good prices and factor prices enter his economic feasibility filter. Note that the availability of prices presupposes the existence of the market for all those items.
In contrast, in a socialistic system, markets don’t exist: all the means of production are owned by the government, as a result, there is no exchange of these goods between private parties. In the absence of such exchange transactions prices don’t form. In the absence of prices, the most advantageous use case of labour time and material resources is not signalled. In the absence of such signalling, an artificial supposition of needs of the society must be arrived at. That job is executed by a few bureaucratic men, who are tasked with the enormous responsibility of determining what inputs and how much inputs must combine under what conditions to produce the kinds of output they think is necessary to keep the economy running.
In that strict socialistic context, the economy is nothing but a physical, technological conversion of materials to products for eventual distribution. But, even in the most socialist countries money exists and commodities and wages are remunerated in money. This is enabled by a sort of pseudo-market for many commodities. Since even the hardened socialistic setup realises that mere knowledge of the technological methods necessary for conversion (of resources to final goods) isn’t sufficient to decide the crucial quesiton of what to produce.
The socialists realise that the apparatus of economic feasibility calculations, available in a capitalistic system, perform a useful function of determining the most advantageous use of men and material. In comparison, the pseudo-prices generated by a limited form of market in the socialistic countries help with that requirement, albeit not in comparable efficiency. These prices are fed into the bureaucratic “engine”, which eventually determine the kind of activities that will be undertaken.
Historically, socialism came into existence by abolishing existing free markets and by consolidated power and decision making. Later, when they set out with plans, they were struck with the question of what to produce and in what quantities. They didn’t have signals that would help them know the things which were in demand and the things that were not. The “vile” markets, they realised, gave prices that were essential for this determination. By allowing small jurisdictions with market-making rights, they presumable could take the “good part” (prices) and leave out the “bad” (inequality, exploitation, class conflict). Then, they could go about force-fitting the production and consumption plans for the rest of the economy based on such price data.
The results of such “experiments” (in the case of erstwhile Soviet Union it was called the "Soviet experiment") were not all too encouraging. For instance, the nail factories tended to meet quotas by shortcut by making a few large nails where many small ones were required. In the case of targets determined in value terms, firms produced costly items regardless of user preference.
Where targets were set in terms of “value-addition” by a firm, the firm would refrain from subcontracting certain operations since the subcontractors were “too efficient”. Instead, the inefficient firm would produce items at higher costs justifying the value-addition targets. Firms seem to be guided by their own self-interests - as it is in any other part of the world.
In Russia, the penalty for an individual firm failing to meet the production target in the exact specification was imprisonment or death. In one such apocryphal incident, the stock of mining equipment produced by a firm was not being delivered to the site, because the equipment was supposed to be painted red, but the firm had only green paint available. While the equipment piled on in its backyard, the much-needed mining activity was halted. The firm’s owner probably thought that waiting for the red paint to arrive was a worthy alternative compared to a visit to the gallows.
The mis-allocation of resources in socialist economies lead to lower standards of living compared to a capitalistic economy. But, through severe censorship, opposing voices are rarely heard under the former system. It’s another thing that, in the capitalistic west, the misguided media and through the falsehoods taught in the education system, more people are now leaning towards socialism in what appears to be a worrying trend.
Articulation and spontaneous order
A fundamental difference between the two systems (capitalistic and socialistic) is the reliance on prices generated by the free markets. In a socialistic system, all the decisions are through articulation, which is the explicit directions regarding the kind of activities allowed to be conducted. The articulation by the experts and bureaucrats substitutes the decisions and choices of millions of people in the economy, namely its consumers and producers.
Further, articulation isn’t subject to changes at the ground level - it is set in the chambers of the expert and has an intransigent quality to it. In the mining equipment example above, to the miners, the colour of the equipment would make no real difference. Yet, the side feature which was artificially articulated carried equal importance compared to a technical feature such as tonnage capacity or its power source (viz., diesel or petrol).
In a system where prices are freely allowed to be formed, there is continuous and incremental signalling between producers and consumers through spontaneous order, that can be barely replicated in a comparative articulated system. We call it spontaneous, because the reactions of consumers and producers at a particular instant in the market are not authoritatively dictated by an external force, but simply by the self-interest, motives, decision and choices at that moment in time, which can neither be articulated beforehand nor such conditions replicated at another moment in time in the future.
In the nail example, among the hundreds of types of screws out there, which one is more demanded at a particular time, is not dictated by an articulated order. But the unceasing interactions between producers and consumers ensure that the incremental production activities are precisely directed towards those screw types most urgently needed. Such spontaneity also ensures that green-painted mining equipment are quickly cleared from the warehouse because users understand that the type of colour is not an essential element in its functioning.
Planners use stale statistics connnected to demand, production, inventory and preferences, that don’t fully reflect the economic trade-offs, changing technology, tastes, diminishing marginal productivity and the diminishing marginal utility of consumers.
Even the best statistics can't match the efficiency of spontaneous order that emerges from allowing the free functioning of markets.
Articulators are essentially chasing a mirage. They seek to objectively define consumer preferences when no such objective criteria can be defined ahead in time by the consumers themselves. Value is always subjective and changes from moment-to-moment.
The sum of the preferences of disparate producers and consumers are so vast and varied that such information can't be captured accurately, even for a moment in time - let alone in the passing of time.
In a full-blown socialist economy, there is a need for detailed articulation spanning all activities. In a capitalist system, where particular branches of economic activity come under regulation (of prices, tariffs, prohibitions), there exists a necessity for articulating the characteristics of the activities of those branches.
The limitations of articulation generalised above, shall apply even to cases where only a partial degree of articulation is deemed necessary.
The results of articulation are evident by the sub-optimal economic output and the undesirable social outcomes - whether in complete articulation of all activities or partial articulation of select activities. We described one such latter instance in the form of the minimum wage laws in an earlier post – The Effect of Minimum Wages on the Economy - which causes sub-optimal economic output. A less-than-optimal social outcome is also seen by imposing restrictions on the age limit for entry into employment (read – Why Apprenticeship is Necessary for Developing Human Capital).
The underlying distinction between articulation and spontaneous systems is the economizing feature of knowledge. In spontaneous systems, each individual has to do with only with a narrow range of specific knowledge. Prices affecting the individual’s interest (the goods he wishes to produce or consume) is enough knowledge which he needs to possess to conduct his affairs profitably. The general knowledge of matters beyond his immediate surrounding could only become a vocational interest. Such general knowledge isn’t necessary for his material well being.
By simply limiting his attention to the incentives (prices) immediately surrounding him, a man could lead a resourceful life - irrespective of his views on general subject matters, however absurd those may be. The economizing feature of capitalistic systems limits the burden of knowledge that each individual must possess to a minimum. This is also a consequence as well a convenience of the ever-continuing division of labour, rendering the circle of competence necessary to flourish narrower by passing of time.
A socialistic system simply cannot succeed in concentrating all the knowledge necessary in the hands of a 'few good men'. When the price for a commodity rises, only spontaneous order ensures individuals purchase a substitute commodity and help the product-market move towards the so-called equilibrium. For goods that are not of every day purchase, special challenges exist. For instance, how many luxury cars and beach homes should the State provide.
In reality, most people aren’t permanently weighing in their heads whether to choose a Porsche Cayenne or an expensive beach home (since many are not so fortuitous enough to make such choice ever in their lifetime), but given one such momentous occasion in their lifetime, it is a certainty that those people will easily cross that chasm of decision making. That is called spontaneous order.
A capitalistic system, allows making such choices easier and more efficiently. In contrast, group of experts constantly making subjective valuations in their heads trying in vain to superimpose such valuation on disparate consumers and producers are bound to fail in their objectives.
Yet, it isn’t just in socialistic economies wherein groups of experts make remote valuations. In capitalistic economies too, there are State interventions in several branches of the economy. This is also a form of articulation with shared characteristics with socialistic economies.
In interventionist capitalistic economies, such articulation takes place in the form of minimum support prices for products, controlling the supply of the mineral resources, fixing wages in different industries, formulating re-distribution (tax) policies, imposing tariffs on imports, encouraging production by providing incentives based on location, aiding particular types of patent registration, owning and operating supposedly essential businesses.
In each of the above instance, the articulator is attempting to define the characteristics of each product, presupposing the elements of contracting between private parties, pretending to know the trade-offs between technology types, and presuming to know the fleeting likes and dislikes of millions of consumers.
Modern economics and policy-making
The top-down trend in articulation in capitalistic economies is particularly being hastened by developments in the field of economics. “Experts” in the field of economics are increasingly using quantitative techniques to explain the phenomenon in economics, like the physical sciences.
For instance, the quantity theory of money (further reading: Understanding Inflation in Greater Detail) suggests that increasing the money supply at specific points in the economic system help create demand for labour. But this is sustainable only as long as the money supply continues to accelerate at a given rate. Eventually, the money supply must stop, lest a spiralling inflation will get out of control. When the money supply stops, the employment levels will revert to its original state.
Debates about unemployment are obfuscated as to its real reasons (further read: Inflation versus Unemployment: The Wrong Debate). Real supply-side frictions are often glossed over in favour of solutions - which carry ostensible political support - for maintaining a high wage-rate and a low unemployment level through inflationary mechanisms. The effects of such policies are perilous, such as in the form of malinvestments in particular sectors, which will take years to unwind.
The mathematization of the field of economics has given an illusion of superior knowledge on the part of a steady stream of egoistic economists. Algebraic equation run on past data does provide useful general patters of the relationship of aggregate variables of the economy. In the absence of such techniques, perhaps knowledge of correlated variables would be absent today.
However the over-use of mathematics in economics has led to the pretense that forward-looking, specific, nominal magnitudes can be extracted from these general patterns and purported to be truths.
Such charlatanism has been going unchecked because mathematical formulae seem to carry a veneer of sophistication. The general patterns are only “general” and the impossibility of articulation of all the characteristics of an evolving economy is never admitted.
In the physical sciences what gets numerically measured, usually, has a functional and influential relationship in the model to other variables. In economics what gets numerically measured usually don’t have any meaningful role in predicting future behaviour. However, today, the march of “articulated” economic knowledge in policymaking is strong and bound to generate greater influence in the future.
The socialization of capitalist economies is happening from within.
Theories that explain phenonemon by pointing to the spontaneous order of markets are unappealing. This is one of the reasons for its lack of place in policy chambers. Also, there is nothing that attracts the politician to such explanations in the absence of potential for weilding control over someone.
An articulated alternative comes with the additional attraction of control of society. Politicians thrive in pretending to solve problems that they help create, extend, solve in small doses and then again appeal to the masses with more articulatory solutions.
The masses are unable to look through all these complex phenomena and rests its faith on the politicians. There is empathy that the elected representative has his limitations in solving “vexing” issues and some are doing their “best” to minimise those problems. The more the elected representative articulates, the more it appeas that he is making "attempts" to solve the problems.
Holding natural rights above everything else
The future generations can only educate themselves about the peculiar characteristics of social sciences of which economics plays an important role. Acknowledging the frailty of the human mind, the limitations of knowledge and the necessary humility are all starting points to arrange society. Personality, liberty and property are the fundamental elements of man’s existence in nature. Intrusion into anyone element necessarily tramples upon another.
Articulations by governments only enriches one’s person, his liberty or his property at the expense of another’s person, liberty and property. Governments simply cannot enrich the person, liberty and property of all individuals at once using the tools of articulation.
(further reading: The Meaning of Freedom)
On the other hand, allowing free exchange enables each citizen to serve one another that he deems best for himself. Those exchanges generate information which are relayed in the form of prices. Price information carries necessary signals to arrange production structure and consumption patterns. It is a tool for “economizing” the otherwise vast knowledge necessary for the interaction of members in a society.
The free exchange, information, and prices happen in spontaneous order. No other single system can substitute such a complex phenomenon through deliberate articulation.