CHAPTER 3

The Ideal Free-Market System

The fundamental threat to freedom is power to coerce, be it in the hands of a monarch, a dictator, an oligarchy, or a momentary majority. The preservation of freedom requires the elimination of such concentration of power to the fullest possible extent and the dispersal and distribution of whatever power cannot be eliminated—a system of checks and balances. By removing the organization of economic activity from the control of political authority, the market eliminates this source of coercive power. It enables economic strength to be a check to political power rather than a reinforcement.

—Milton Friedman, Capitalism and Freedom

 

 

 

 

 

In Chapter 2 we noted that, for a free-market system to function, a society must promote freedom for people to broadly pursue their interests, protect private property rights, and enforce the rule of law that protects the life and liberty of everyone regardless of their wealth or status. As institutions evolve to advance these goals, a free-market system can then prosper. For example, the development of the limited-liability corporation, and of markets for trading stocks and bonds, were enormously important to capital formation and to the free-market process for allocating resources to their best uses.

The free-market system is built on matching success or failure in serving customers with rewards or losses. Government actions, by way of bailouts or protective tariffs, interfere with that reward system and lead to an inefficient allocation of resources. Firms that are woefully short of the skills necessary for providing value to customers at competitive prices need to greatly improve; or they should go bankrupt so their resources and employees can be shifted to more productive activities.

COMPONENTS OF A FREE-MARKET SYSTEM

Let’s analyze what a free-market system is and how it delivers value to consumers. ¹ We can begin at the lower-left box of Figure 3.1.

Economic progress starts with, and grows from, a society’s capital base. Capital is embodied knowledge of what has been learned in the past that is useful for producing what consumers want in the future. Capital can be classified as tangible (buildings, machines, roads, etc.) or intangible (codified knowledge, tacit skills [Leonard and Swap, 2004], and methods used for acquiring new knowledge).

Voluntary exchange occurs when people willingly exchange goods and services with others to improve their condition. When exchanges are voluntary, both parties benefit, giving up something they value less in order to gain something they value more. Exchanges can be by barter or by money, immediate (retail sales) or involve commitments over time (insurance, investments). Voluntary exchange is a prerequisite for sustained wealth creation.

FIGURE 3.1 Free-Market System Focused on Consumers

Voluntary exchange creates opportunities for specialization. That is, individuals specialize in producing goods and services at a “low” cost due to their skill and efficiency. They trade those for desired goods and services that would be “high” cost for them to produce. The more capital a society has and the more opportunities for voluntary exchange that exist (the breadth and depth of markets), the more specialization can take place. People can avoid being hunters and farmers out of necessity, and instead can pursue work that offers the best opportunities for generating income and job satisfaction. Combining one’s specialized labor with capital increases productivity, that is, creates greater useful output for the same hours worked.

Market pricing is essential for both parties to benefit from voluntary exchange. Prices communicate information. Price signals coordinate action by providing profit incentives to effectively allocate and use resources (Hayek, 1945). Business enterprises respond to the profit incentive and act with the expectation of earning economic profit by efficiently providing products and services in amounts that “the market” wants. Over the long term, the bigger the gain in profits, the more value-added has been delivered to customers. Price controls, rent controls, and a variety of government subsidies distort the market’s price signals and lead to inefficiencies for the many, while transferring wealth to a favored few.

Profit incentives drive resource allocation as firms adjust to current market prices and expectations of future prices. Based on their existing knowledge, it is not always obvious to firms ’ top decision makers how to best use resources or how to develop new, innovative ways to better meet customer needs. That often entails experimentation, which necessarily implies failure as well as success. Markets facilitate the discovery of new ways to serve customers. Experimentation is as critical to sustained economic progress as it is to the growth of knowledge in the physical sciences. The success (or failure) of business experiments can be judged by their effect on firms ’ profits.

Firms continually aim to surpass competitors, better serve customers, and earn additional profits. If they fail to exploit new ideas, technology, or the myriad ways of improving processes, their efficiency declines compared to the competition. Then they lose customers, which results in lower profits or actual losses. As the following quote brings to life, the status quo is never a long-term, viable option:

My central contention here is that what differentiates the prototype capitalist economy most sharply from all other economic systems is free-market pressures that force firms into a continuing process of innovation, because it becomes a matter of life and death for many of them. The static efficiency properties that are stressed by standard welfare economics are emphatically not the most important qualities of capitalist economies. Rather, what is clear to historians and laypersons alike is that capitalism is unique in the extraordinary growth record it has been able to achieve; in its recurring industrial revolutions that have produced an outpouring of material wealth unlike anything previously seen in human history. Moreover, it seems indisputable that innovation accounts for much of this enviable growth record. But what attributes of capitalism are responsible for this dramatic superiority in its record of innovation? The answer I propose here is that in key parts of the economy the prime weapon of competition is not price but innovation . . . . The result is a ferocious arms race among the firms in the most rapidly evolving sectors of the economy, with innovation as the prime weapon.

(Baumol, 2002, pp. viii-ix, italics in the original)

 

The hallmark of a free market is competition among business firms. Customers benefit through lower prices than otherwise would prevail and in particular, as noted by William Baumol in the above quote, through continuous innovation that leads to improved products and services.

How does competition weed out inefficient firms? The stock market is an especially illuminating lens by which to observe market discipline. If a firm steadfastly fails to earn the opportunity cost of capital, its stock price suffers. Then, there is pressure to hire new management, which often jettisons old business strategies, downsizes, fires employees, and refocuses the firm ’s resources. At times, failing businesses (especially small firms) can quickly go bankrupt. Less apparent to the general public is that the harsh punishment administered by the market creates new job opportunities as resources flow to other firms that are better skilled at efficiently providing value.

Although wealth is created by this constant cycling of resources from less-efficient to more-efficient firms, this process is invisible to the general public. In contrast, the negatives are narrowly focused and highly visible to the public (closed operations, workers fired, communities harmed). The public’s perception tends to be heavily influenced by general media reports that myopically sensationalize the negative cost of adapting to change (e.g., outsourcing) and totally ignore the long-term benefits.

Voluntary exchange, specialization, price signals, profits, and competition all generate and help disperse new knowledge about consumer wants, the best ways to meet those wants, and investment opportunities. In a competitive free market, there is not only continual innovation and the generation of new knowledge, but also a rapid and widespread dissemination and practical application of that knowledge as firms, investors, and consumers respond to it. Markets, which on their surface seem to be about material goods, are actually mostly about ideas and knowledge.

New knowledge created by market processes encourages, directs, and rewards new investment in the creation of and delivery of goods and services. New investment flows into the capital base, which then accelerates mutually beneficial voluntary exchanges and sets off another round of the wealth-creation cycle.

Consider, for a moment, the absence of one or more of the basic prerequisites to a free-market system, and consider how much investment there would be: in a lawless society?; in one that fails to provide for and protect an individual’s property rights?; if the corporate form of business organization did not exist?; if there were no existing market mechanism for readily buying and selling stocks and bonds? With an effectively functioning free market, investments offer the opportunity for financial rewards while automatically increasing the capital base, and sowing the seeds for future increases in productivity and in the standard of living.

CONSUMER WEALTH, PRODUCER WEALTH, AND COMPETITION

One obvious and common way to assess consumer wealth is to visit a country and observe the living conditions there. Alternatively, a more quantitative way is to tabulate people’s net worth and estimate the value of their human capital (knowledge and skills). But to understand the process of how wealth is created, one needs to analyze how firms enable consumers to buy more of what they want at a lower price (e.g., computing power) and to receive higher-quality goods and services (automobile travel compared to traveling on horses). Figure 3.2 shows the connection between consumer wealth and producer wealth.

The back-and-forth arrow in Figure 3.2 connects Consumer Wealth and Producer Wealth. This is because employees working at firms receive paychecks, and at the same time are consumers. Moreover, their consumer wealth is partly comprised of stock and debt ownership of firms through 401(k)s and other forms of saving and investing. The arrow is also a reminder of the cause-and-effect complexity of a global system of wealth creation.

FIGURE 3.2 Consumer Wealth and Producer Wealth

As to a global economy, how often have we heard politicians say that we must get better at competing for jobs in the global marketplace, and here is the plan for doing so? And that plan entails all sorts of imposed distortions to the market system that either interfere with voluntary exchange, or grant some sort of anticompetitive advantage to businesses with political clout.

A plausible case can be made that the “competition for jobs” issue is better analyzed as “competition for capital” (Rutledge, 2008). High corporate tax rates lower firms’ after-tax returns on capital. The United States has one of the highest corporate tax rates among the more developed countries. Making matters worse, the complexity of the corporate tax code is mindboggling. It is an open invitation for unproductive entrepreneurial activity and massive lobbying that distorts the free-market system. The return to investors gets reduced even further by taxes on interest, dividends, and capital gains.

In an interconnected global economy, all else equal, capital seeks out the highest expected returns, net of all taxes. When financial capital flows into a particular country to fund business expansion, employees in that country get better tools and knowhow to become more productive. Increased productivity is the key to higher wages and expanded employment opportunities. The CEO of FedEx, which has 290,000 employees, has noted that about 70 percent of the return from their capital expenditures in equipment, planes, computer systems and the like is realized by employees in the form of higher wages as their productivity rises (Moore, 2008).

EFFICIENTLY PROVIDING WHAT CONSUMERS WANT

Understanding the wealth-creation process has implications for government policymakers, business leaders, and investors. The message put in the briefest way is: Give top priority to consumers. The best way to accomplish this is through a free-market system that has a high degree of competition with a minimum of government interference that distorts the competitive playing field.

Particularly insightful empirical work on comparisons of wealth creation across countries is summarized in The Power of Productivity by William W. Lewis (2004). He headed up a large-scale, 12-year study by the McKinsey Global Institute that analyzed industry productivity across 13 countries. The data from this unique, bottom-up, field research revealed the critical importance of competition to economic performance.

This research pointed out that zoning laws, exclusion of foreign competition, government subsidies, tax burdens that promote an underground (informal) economy to the detriment of legitimate companies, and assorted government favors to special interests all work to preserve inefficiency with higher prices and lower quality for consumers. Inefficient firms continue their wasteful ways because the rules of the game minimize competition from efficient firms.

For example, small retailers in Japan have been protected through zoning laws and government subsidies. This contrasts with the extremely efficient Japanese industries that compete globally (e.g., autos, electronics). Small Japanese retailers are quite inefficient. In the United States, in contrast, Wal-Mart has spurred productivity increases throughout the retail industry, including its suppliers. Brazil has an exceedingly large underground economy that pays no taxes and is also quite inefficient. But the much more efficient Brazilian companies in the formal sector are hit with a heavy tax burden. This interferes with the competitive process and makes it difficult for the tax-paying formal sector to take market share away from the tax-free, informal sector.

The short-term impact of increased competition would cause problems for inefficient firms and their employees, but would improve the standard of living for consumers in general. After an adjustment period, employees would be better off as firms adapt and resources shift to more skilled firms.

The absence of a systems mindset can easily result in shortsighted thinking, and lead to bad decisions. Interfering with competition to keep wages high and employment temporarily up at inefficient firms may appear to help employees; but that comes at a high cost to others and, in the long run, is not sustainable.

Recall that one of the bullet points under the “Actions and Consequences” component of the PAK Loop in Chapter 1 states that cause and effect have both time and spatial lags. This is at the heart of the dilemma in which people benefit enormously from free-market capitalism; but the needed allocation adjustments can temporarily result in an unstable and insecure environment for those affected. On the surface, the system appears not to be working to many hardworking and capable people who have been fired.

To avoid excessive regulations and gain widespread support for free-market capitalism, we need sustained and robust economic growth that reduces the political incentive to “fix” the economy with programs that distort the basic function of consumer choice and competition. In this regard, two private-sector proposals, discussed in later chapters, merit consideration.

The first proposal is to accelerate implementation of lean management geared toward providing high value to customers while continually purging waste. This is often talked about by CEOs and boards of directors, but companies rarely achieve, on a sustained basis, anywhere near the extraordinary productivity of Toyota, whose Toyota Production System pioneered lean principles.

A particularly important part of lean management is the continual mentoring of employees to improve their problem-solving skills. As lean firms adapt to new business opportunities, employees are better equipped to transition to different jobs due to highly developed, general-purpose problem-solving skills that are integral to a lean business culture. Chapter 6 reviews lean principles and the issues involved when companies decide to make a lean transformation.

The second proposal addresses the situation in which insufficiently skilled CEOs are retained for many years by underperforming boards of directors. Often, these boards are comprised of directors whose membership on the board is due to their personal relationship with the CEO.

The public, in general, and shareholders in particular, are rightfully angered by the enormous compensation, including golden parachutes, received by underperforming CEOs upon termination (Bebchuk and Fried, 2004). At the level of the firm, stability and employment security could be greatly improved by a process that upgrades the quality of board oversight so that boards effectively monitor the development of a lean culture attuned to long-term wealth creation and led by highly skilled CEOs.

Ineffective board oversight is manifested by CEOs who run inefficient operations typically with a “grow-the-business” mindset that is disconnected from economic efficiency and wealth-creation principles. Chapter 7 describes a market-based approach for improving corporate governance. Importantly, the proposed solution avoids heavy-handed government intervention that could easily produce unintended bad consequences. The reasoning behind this initiative is rooted in a sound understanding of how wealth is created. The starting point is the firms’ competitive life cycle, which is explained in detail and illustrated with company examples in the next chapter.

Summary of Key Ideas

• Critics of free-market capitalism tend to lack an understanding of the synergistic operation of the components of a free-market system (Figure 3.1). Critics assert that they occupy the moral high ground because of their opposition to greed and excessive profits. That this assertion is false is demonstrated by the significantly higher levels of per-capita income, life expectancy, education, and democracy for those societies that more closely embrace free-market principles.

• Business firms are the key to a free-market system that benefits consumers through efficiency and innovation in delivering products and services. A deeper understanding of the economy from a bottom-up perspective of business firms by public policymakers (and the voters who elect them) should lead to legislation and regulations that are decidedly more pro-wealth creation.

• Knowledge growth and wealth creation are opposite sides of the same coin. In a competitive, free-market system, innovation, as noted by William Baumol, becomes a matter of life and death for many firms. Managements of firms that gain competitive advantage typically have orchestrated fast and effective learning throughout their organizations so that innovation becomes part of the firm ’s culture.

• In a global economy, competition is clearly seen as intense for products and services. Not nearly as visible is the competition for capital, in which investors seek the highest expected returns adjusted for taxes and risk. Tax rates on businesses and investors are crucial determinants of the return on capital. This impacts the amount of new investments made, which affects productivity and job growth.