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wherever a given resource or a given product can be bought in the market

2 See especially pp. 38-43 and pp. 250-259.
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 303


at one price and sold again for a higher price. We have seen that the
more general kind of profit possibility”where a producer sells his product
for a sum exceeding his costs of production”also can be viewed, as being
created by the existence of two prices for the "same" economic good. In
such cases the producer bought resources for one sum and resold them (as
a finished product) for a greater sum. A possibility for profit exists wher-
ever there is a price discrepancy, even if its existence is unknown. The
price an entrepreneur pays for any resource reflects the highest value placed
by other entrepreneurs upon the productive contributions they believe
the resource can render at the relevant margins”at least insofar as they
are aware of the current price of the resource. If other entrepreneurs
believed they could derive a higher market value from the productive con-
tribution of an additional unit of the resource, their competition would
tend to force up its price to this point. On the other hand, the price
the entrepreneur obtains for his product, together with the technological
productivity of the resource, will determine the value that he should place
upon the productive contribution of the resource. If an opportunity for
profit exists, due to a discrepancy in price between the product and the
required resources, it follows that unless someone perceives and seizes this
opportunity, a misallocation of resources will inevitably occur. A block
of resources capable of rendering, in one use, a productive contribution
with a high market value (evident in the price that could be obtained in
the market for their product in this use) will be employed in other uses
only if the market value placed on their productive contribution at the
margin is lower (as evidenced by the price that the block of resources can
be secured at). The discovery of a profit opportunity amounts thus to
the discovery of a situation where, from the normative viewpoint, resources
are being misallocated. The grasping of a profit opportunity amounts, by
the same token, to a step in the direction of correcting such misallocation.
Prices and the opportunities for profits that they may present play
a dual role in the market process whereby resource misallocation is cor-
rected. First, a price discrepancy exposes an existing misallocation of re-
sources. The perception of an opportunity for profit is thus the discovery
of such misallocation. (This, of course, is not surprising, considering the
fact that we are defining the correctness or incorrectness of allocation in
terms of existing prices.) Second, a price discrepancy promotes corrective
action. A price discrepancy means a chance to make profits. By definition
entrepreneurs seek profits; thus, the very situation that symptomizes the
need for a correction creates the forces capable of inducing such action.
Moreover, and this is of fundamental importance, the entrepreneurial
search for profits implies a search for situations where resources are mis-
allocated. The price system not only announces the existence of incorrect
employments of resources and makes it worthwhile to correct them; it makes
304 MARKET THEORY AND THE PRICE SYSTEM


it worthwhile to ferret out such cases that may exist. (It is, of course, an
aspect of this function of the price system that induces entrepreneurs to
constantly seek out new products, new patterns of consumer tastes, new
resources, or new techniques of production.)

THE ENTREPRENEUR AND RESOURCE ALLOCATION
Thus, any appraisal concerning the efficiency of the market process in
detecting and ironing out existing "waste" in resource employment is re-
duced to an appraisal of the ability of entrepreneurs to detect and seize
profit opportunities. If those who are financially able and willing to
accept the risks of entrepreneurship are competent to their task, they will
attain a high degree of success in pouncing upon even the smallest profit
opportunities. They will familiarize themselves with current prices in
all parts of the market, for all kinds of resources and products. Specialists
among them will concentrate, perhaps, on maintaining complete aware-
ness of all price movements relating to certain limited kinds of productive
activity. The ceaseless activity of such entrepreneurs will tend to keep the
opportunities for profit relatively small and very short lived. This, as we
know, is merely a different way of saying that their activity will prevent
resources from being grossly misallocated, and that whatever cases of mis-
allocation do emerge will be of only temporary duration.
On the other hand, if entrepreneurs are not adept in discovering price
discrepancies, these discrepancies may conceivably persist for some time, and
may even reach considerable proportions. Entrepreneurial errors may be
fully as "wasteful," from the normative point of view of allocative economics,
as corrective entrepreneurial activity is "beneficial." When an entrepreneur
makes losses, at the same time he has also wasted resources in employments
less valuable than others open to them.
The price-profit system rewards the successful entrepreneur”the one
who corrects existing cases of resource misallocation”and penalizes the
unsuccessful ones. In the long run, the market process itself thus attracts
only those most able and competent to direct the future course of the process.
After all, the efficiency of the market process in detecting waste can only be
judged against the background of alternative possibilities. Since some
entrepreneurs may be incompetent, and since profit incentives are as attrac-
tive to the competent entrepreneur as to the others, it will be the competent
and successful entrepreneurs who will tend to stay in business. If the best
entrepreneurial talent is insufficient to remove all misallocation, even with
the inducement of the profit motive, then the remaining misallocation must
simply be undetectable.
The entrepreneur, as noted before, does not have to know all the
information concerning a misallocated resource. It is sufficient for him
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 305


to detect a price discrepancy. Changes in consumer demand, the avail-
ability of resources, and the technologies of different branches of production
will probably create numerous cases where the allocation of resources is
inadequate. The entrepreneur need not discover the exact nature of these
changes in order to perform corrective action. All that he needs to know
are the relevant price changes that have occurred. If he becomes aware
of price changes in the product markets before these are reflected, corre-
spondingly, in the resource markets, he will be able to make profits and
contribute toward the correction of an otherwise inadequate pattern of
resource employment. In fact, this is one of the chief advantages of a price
system as a means of communicating knowledge (for the purpose of a more
correct allocation of resources), namely, that it conveys only that part of
relevant information essential for corrective action.

RESOURCE MOBILITY AND THE ALLOCATION PATTERN
Until now our discussion has implicitly assumed perfect mobility of
all resources. In other words we have argued as if every resource owner will
respond immediately to the offer of a higher price, and that all that is
needed for a profit-seeking entrepreneur to succeed in luring away resources
from a "wrong" employment to the correct one is to offer slightly higher
prices than are being offered by the other (less well-informed) entrepreneurs.
In a purely formal sense this assumption is irreproachable, but needs some
interpretation and caution when the analysis is applied to real world situ-
ations.
It may happen that a resource owner cannot transfer the sale of his
resource endowment from one branch of production to another without
incurring costs. Such costs may be either psychological or pecuniary in
nature (or both). A laborer may feel an attachment to his job, friends,
and surroundings that is sufficiently strong to prevent his changing jobs
for a small increase in pay. Some resource owners may prefer that the
services of their resources go into one branch of production rather than into
another. Again, the different location of two entrepreneurs competing for
the services of a given block of resources may involve out-of-pocket expendi-
tures on the part of the resource owner desiring to take advantage of a more
attractive price offer. All these may be grouped together as costs of trans-
ferring resources. These costs have the effect of reducing the mobility of
resources, and of delaying the adjustments that would otherwise be secured
by the market process.
Insofar as these costs express the personal tastes of resource owners, or
reflect, say, the direct employment of other resources physically neces-
sary to effect resource transfers, it is misleading to say that these costs inter-
fere with the correct allocation of resources. These costs may be no less
306 MARKET THEORY AND THE PRICE SYSTEM


real, and no less "deserving" of being considered in the pattern of resource
allocation, than any other kinds of cost. A system which directs labor to
a more productive employment for one less productive, but that altogether
ignores the costs of transporting the laborers from the one location to
another would clearly be inefficient. Similarly, any other costs of moving,
insofar as they can influence prices, must be considered in the appraisal of
the allocational efficiency of a price system.
Any inquiry into a real world concerning the efficiency of its allocation
pattern must bear these considerations in mind. Especially if the norma-
tive standards of the inquiring economist lead him to measure efficiency
against a yardstick that does not consider certain of these costs of transferring
resources, he must be prepared to find the market process delayed in the
execution of its allocative functions. It may happen, in addition, that
from the long-run point of view, such costs of transfer may be less formi-
dable than in the short run. (In the long view, it might not be more diffi-
cult to make friends in a new location than in an old location; in the long
view, it might not cost more to furnish a home in a new location than to
refurnish a home in the old location; and so on.) 3 In this case the market
process will secure results (in respect to advancing toward a more correct
allocation of resources) slowly but surely, if the conditions that call for a cor-
rection in resource allocation are sufficiently permanent in character.

MONOPOLY AS AN OBSTACLE TO
CORRECT RESOURCE ALLOCATION
A genuine obstacle to the ability of the market process to secure the
correct allocation of resources is the monopolization of resources. We have
seen in the preceding chapter that where a resource has been endowed only
to one market participant, he may be able to exact monopoly prices from the
market for the sale of the resource itself, or he may be able, by monopolizing
the production of products that require the monopolized resource as a
factor of production, to exact monopoly prices for the products. In such
cases the monopolist's control over the resource enables him to defy the mar-
ket process. He serves his own interests best by refusing to allow his re-
source to be combined with other resources where, together, they can make
their most valuable productive contribution to the market (as measured by
the prices of the other resources and the price of the product from which the
monopolist is able to bar them).
Whereas in the absence of monopoly power, entrepreneurial activity
tends to manipulate the allocation of resources so as to lead toward the
3 From a wider point of view, the long run increases mobility in the sense that young
members of a labor force, for example, can begin their careers in places strange to their
parents, far more easily than their parents themselves could have changed location.
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 307


elimination of profit, the monopolist-producer may be able to secure a
permanent gain in the form of an excess of sales revenue over costs of pro-
duction, which is immune from erosion through the efforts of other entre-
preneurs.

ARTIFICIAL OBSTACLES TO
CORRECT RESOURCE ALLOCATION
Besides monopoly power (which may be endowed by nature), there
may be numerous artificial obstacles to the process working toward correct
resource allocation. Although such obstacles are ruled out of a pure market
system by definition, 4 arbitrary controls may easily be grafted on to a
market system. (Most present-day "capitalist" economies, in fact, consist
of market systems where a greater or smaller volume of obstacles have been
imposed for various reasons.) From the point of view of the market system
itself, all such arbitrary controls are "obstacles" that "interfere" with the
normal operation of the market process. Such controls hamper the alloca-
tive functions of the market system. (From the point of view of policy,
therefore, the advantages expected to follow from the imposition of any
controls upon the market system must be compared with the consequent
loss in allocative efficiency.)5
Market participants may band together (for example, through appro-
priate extensions of governmental power) to circumscribe the range within
which each participant can exercise free choice in the market. A very gen-
eral form that such circumscriptions may assume is that of imposed restric-
tions upon price movements. Minimum (or maximum) prices may be
declared for particular products (or for products sold to particular con-
sumers), or for particular resources (or for the resources when sold to
producers of specified products). If the free market prices do not conflict
with the imposed price floors (ceilings), then, of course, the restrictions are
innocuous and, indeed, superfluous. But where the price that would have
emerged on the free market is prohibited, the restrictions tend to interdict
the market from allocating resources in the optimum manner with respect
to the given availability of resources, the given tastes of consumers, and the
given distribution of knowledge concerning these data. Exchanges that
might have taken place at lower (higher) prices are prohibited. Quantities
of output that might have been produced and sold at lower (higher) prices
remain unproduced; the resources that might have been employed in more

4 See pp. 13-14.
5 Of course, a society might attempt to alter the consequences of a free market sys-
tem, not by hampering the free market, but by redistributing at the start of each day
the initial natural endowments of the market participants. This would change the
data, but might permit the market process to continue without obstacle. Not all nat-
ural endowments, of course, can be transferred.
308 MARKET THEORY AND THE PRICE SYSTEM

important uses must seek employment in the production of other, less
important products. Resources that might have been employed at lower
prices (or at higher prices) remain idle, with either a consequent direct loss
of potential output (output for which consumers are prepared to pay), or
a consequent loss of efficiency because of the use of inferior substitutes or
substitutes needed urgently for other purposes.
In addition, hindrance of the market process may consist of artificial
obstacles to resource mobility (for example, immigration laws). Or there
may be institutional grants of monopoly power (for example, patent laws).
Or there may be an infinity of different patterns of taxes and subsidies that
might bring about an allocation of resources different from what would
result from the unhampered market process. Clearly, each such possibility
must be analyzed on its own merits. The general tools of analysis developed
in earlier chapters must be applied to the special restrictions imposed in
each case. In each case the restrictions will then affect in some way the re-
sulting complex of productive organization, incomes, and resource employ-
ment.
These interferences with the market mechanism may prevent it from
revealing existing misallocations of resources (as when the market is pre-
vented from allowing the "true" prices of resources or of products to
emerge), or they may prevent the exploitation and correction of such mis-
allocations as are discovered (as when the mobility of resources is restricted,
or when competition is artificially curbed, or when special taxes or other
sanctions are imposed on profits, or when inefficient producers are sub-
sidized).
A market economy, even the purest of pure, can never be a Utopia.
So long as scarcity is the fundamental fact of economic life, the participants
in the market must resign themselves to limited consumption. Participants
are endowed with only limited, periodic initial resource endowments. They
may be able to convert these endowments in the market, through exchange
and/or production, into more highly desired income streams. However
successful they may be in their attempts to do this, they can still imagine
income streams that they would prize even more highly but that are beyond
their reach. All that a market can do is to provide the framework within
which participants may squeeze the utmost out of their initial endowments
through a system of social competitive cooperation and division of labor.
Even if such a process were carried through to its ultimate possibilities,
nobody would necessarily be guaranteed against unhappiness or even
hunger. All that participants would be guaranteed against would be waste.
But, as we have seen, the market process cannot be carried to its utmost
possibilities. All that the market can offer to its participants, therefore, is
a process that is ceaselessly at work tending to prevent waste from being
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 309


perpetuated and from being carried too far. This is certainly no guarantee
against dissatisfaction, but it is at the same time of tremendous value when
the extent and complexity of the required processes are considered. Inter-
ference with the webs of forces that are woven through the market process
limits the attempts of participants to coordinate their activities through
an engine of remarkable efficiency”the market. The analysis of the mar-
ket process can clarify the costs involved through such interference, making
it possible for market participants to decide, through the political process,
upon the extent to which they are willing to lay aside their engine of effi-
ciency for the sake of special purposes of possibly overriding importance.

SUMMARY
This chapter appraises the degree of coordination among the decisions
made individually by market participants that can be achieved by a price
system. The appraisal undertaken here deals with the degree of success
achieved by the market in detecting and correcting existing "errors."
A unit of resource is said to be misallocated if the market value of the
actual productive contribution falls short of the market value of some alter-
native productive contribution that it could be making elsewhere in the
economy. A unit of resource can be misallocated only as a result of the
imperfect knowledge of some market participants. An appraisal of the
efficiency of the market process therefore involves the appraisal of the way
it detects gaps in available knowledge, and the way it proceeds to fill these
gaps. The key point with respect to the market process is that the mis-
allocation of a unit of a resource (together with the antecedent imperfec-
tion of knowledge) implies the existence of an unexploited opportunity for
profit. Price discrepancies expose misallocation in the form of profit oppor-
tunities. Further prices promote corrective activity by attracting entre-
preneurs to seize these opportunities. The entrepreneurial search for
profit implies a search for the consequences of previously imperfect knowl-
edge and an attempt to correct them.
Rapidity in this process of correcting existing misallocations requires
resource mobility. An obstacle to the process may be monopoly control of
certain resources. Numerous artificial obstacles may conceivably be intro-
duced into an economy that may hamper this market process. Control of
prices is the most direct kind of obstacle of this group. The analysis of
the market process throws light on the costs involved in attempts to interfere
in such ways with the market process.
310 MARKET THEORY AND THE PRICE SYSTEM


Suggested Readings
Hayek, F. A., "The Use of Knowledge in Society," American Economic Review,
September, 1945, reprinted in Individualism and Economic Order, Routledge
and Kegan Paul Ltd., London, 1949.
Baumol, W. J., Economic Theory and Operations Analysis, Prentice-Hall Inc.,
Englewood Cliffs, New Jersey, Ch. 13.
Appendix

The Application oj Market Theory
to Multi-Period Planning



has outlined the process by
XHIS BOOK
which decisions of individual market participants interact and are brought
into mutual coordination. Through the price system, the owners of re-
sources are attracted to sell their respective resources to entrepreneurs whose
production plans are designed to dovetail with the consumption plans being
made by consumers. The presentation of the analysis, thus far, implied
that the masses of decisions involved in the process of plan-interaction were
made solely with reference to a single short period of time. Resource own-
ers were viewed as deciding each day on the quantity of the day's resource
endowments to offer for sale and the prices to ask. Consumers were viewed
as deciding each day on the best pattern of income allocation to seek to
achieve. Entrepreneurs were seen as deciding each day on what to produce,
and what particular combination of resources to employ for the production
of a given product. The market process was seen as bringing about re-
visions, each day, in the plans being made for that day as compared with
those made for the preceding day.
Once the nature of the market process is understood, it becomes possible
to extend the analysis explicitly to cover the interaction of plans made (at
any one time) for any number of future time periods. A consumer may
make plans for the allocation of his income, not merely the income for the
current week, but also the incomes of any number of future weeks. In the
summer he may make plans to buy sports clothes now, and at the same time
he may plan to set aside enough of his annual income to buy winter clothes
several months later. Resource owners may plan to sell some of their
currently endowed resources now and next year to sell a different quantity
out of the resources they expect to be endowed with next year. In each of
311
312 MARKET THEORY AND THE PRICE SYSTEM


these examples a single unified plan is made to cover a number of periods
of time. A decision within each of these plans, with respect to any one of
the periods, is a part of the whole multi-period plan”the decision made for
one period fits in with the decisions made for the other periods. (This is
of course completely analogous to the situation with respect to a plan made
for only a single period, say a particular month. Plans for the quantity
of food to be bought this month are coordinated with, and fit into, plans
made to buy clothing during the same month.)
In reality, of course, all planning is multi-period planning in the sense
that the component parts of any plan are related to one another in some
sort of time sequence. One does not plan, in any one month, to buy or
consume both food and clothing perfectly simultaneously. Even plans
made for only the next half-hour specify the sequence of activities. How-
ever, it has been convenient to ignore this aspect of plans thus far in this
book. The discussion assumed that within each period activities were
being planned for, the sequence of activities was of no importance”pre-
cisely as if the length of the time period were compressed into a single
moment in time. In this appendix we consider in barest outline the conse-
quences, for the analysis of the market process, of the relaxation of this
assumption. We wish to take notice of the kinds of alternatives facing the
individual resource owner-consumer who plans for several successive periods
of time. We wish to explore the consequences of the interaction, in the
market, of the plans of numerous such individuals. In addition, we will
consider the consequences of the fact that production planning too, involves
planning for a number of successive periods in the future. In particular,
we will notice the market consequences of multi-period production planning.

MULTI-PERIOD DECISIONS IN THE
PURE EXCHANGE ECONOMY
The analysis of individual multi-period plans and of the interaction
in the market of numerous individual plans of this kind can be demonstrated
most simply by the case of the pure exchange economy discussed in Chapter
7. It will be recalled that in such an economy each of the participants finds
himself endowed each day with some bundle of endowed commodities which
he is free to consume himself or to exchange in the market for other com-
modities. No production is possible in such an economy: consumption is
restricted to the commodities in one's own endowment, or to the commodi-
ties obtained by exchange from the endowments of others.
In Chapter 7, each of the participants was viewed as coming to market
each day with a plan of action”for buying and for selling”based on his own
scale of values on the one hand, and on the market prices that he expects
to prevail for each of the commodities on the other hand. Such a plan of
THE APPLICATION OF MARKET THEORY TO MULTI-PERIOD PLANNING 31 3


action was viewed as incorporating no provision of any kind, however, for
future "days." No commodities were saved for future consumption nor

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