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an appraisal can be undertaken.

THE ECONOMIC PROBLEM
Social phenomena can be examined from two distinct points of view.
First of all, they can be examined merely positively. Chains of cause and
effect can be proved to exist; the likely effects of particular changes can be
foretold; the probable responsibility of particular prior events for definite
current phenomena can be explained. Social phenomena, however, can
be examined in addition from a normative point of view. The way prior
causes bring about subsequent events can be judged by the success with
which the process fulfills definite goals (believed by the investigator to be
cherished by someone concerned with the usefulness of the process). A
breakdown in a commuter bus service may be seen positively as responsible
for highways swarming with an unusual number of private cars. It may
33
34 MARKET THEORY AND THE PRICE SYSTEM

be "blamed"”normatively”for the inconvenience experienced by those who
use the bus service for a convenient means of transportation.
The economic theorist, too, is able to view his subject matter from
both these perspectives. He may simply trace through the operation of
market forces. Or he may, in addition, appraise the market from the
perspective of one or other aspects of the "economic problem." Although
the concept of an economic problem is most frequently discussed with
respect to an entire society, the idea is fundamentally one relating to the
individual. For an individual, the economic problem consists in ensuring
that the resources at his disposal be utilized in the most effective manner
possible”from the point of view of the goals which he has set up. Success-
ful solution of this economic problem requires that the individual appor-
tion resources to promote his various adopted goals in a pattern that will
faithfully reflect the hierarchy of importance to him of the various goals.
If he desires goal A more urgently than goal B, and the available resources
are insufficient for both goals, a "correct" solution of the economic problem
requires that he allocate his resources to A rather, than to B; and so on.
From the perspective defined by the goal of correctly solving his eco-
nomic problem, an individual may judge his actions as being either efficient
or otherwise. From the point of view of his own chosen goals, considering
the varying degrees of urgency that he has assigned to these goals, the indi-
vidual may frown at a particular course of action as being at variance with
his goal program. Such a course of action is "inefficient," "wasteful," and
"irrational"; it fails to aim at the most important of the chosen goals.
The goal of "efficiency" is not really a separate goal in its own right.
Efficiency is nothing else, in the present context, that the consistent pursuit
of other goals. Consistency in the pursuit of goals calls for a refusal to
apply resources to achieve one goal when this implies forsaking a still more
highly cherished goal. Inefficiency is thus synonymous with inconsistency.
An inefficient course of action is one that is inconsistent with a given pro-
gram of goals. A course of action that is inefficient with respect to one set
of goals may be highly efficient with respect to a different set. But the
point is that, in making plans, individuals have in mind given sets of goals.
With respect to this set of goals, they seek a consistent, efficient course of
action.
SOCIETY AND THE ECONOMIC PROBLEM
Economists frequently speak of the economic problem facing society.
What they usually have in mind is something closely similar to the eco-
nomic problem faced by individuals. But the legitimacy of this interpreta-
tion of the term "economic problem" is by no means clear, and the
limitations on its use in this sense must be understood. Discussions that
deal with the economic problem facing society assume a group of human
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 35


beings, on the one hand, having numerous different desires for consumer
goods and services and, on the other hand, having command of a body of
productive resources. The economic problem facing the society is, once
again, that of securing efficiency. The problem consists in constructing an
organized social system that will most efficiently utilize the limited resources
of "society" for the satisfaction of the desires of "society" for consumer goods
and services. Once again a successful solution of this problem calls for
"consistency"”a pattern of activity and production that should faithfully
reflect the respective weights assigned to each of the goals that it is desired
to satisfy.1
The limitations surrounding this use of the term "economic problem"
arise from the fact that society is made up of numerous individuals. Each
individual can be viewed as independently selecting his goal program. And
in a market economy especially, each individual adopts his own courses of
action to achieve his goals. It is therefore unrealistic to speak of society
as a single unit seeking to allocate resources in order to faithfully reflect
"its" given hierarchy of goals. Society has no single mind where the goals
of different individuals can be ranked on a single scale.
Nevertheless, there is a sense where one form of societal organization
can be termed "more efficient" than another. For example, a market
economy, as we shall see, is unquestionably more "efficient" than a system
of self-sufficient individual "economies," because each individual shows
by his voluntary participation in the market that he is better off under the
former than the latter. Thus, each individual finds he can most efficiently
solve his own economic problem by cooperating with other individuals
through division of labor and the market. Any form of voluntary social
cooperation emerges only because each participant seeks in this way to
further his own goals. If he participates in a social system of any kind, he
does so in the interests of his own efficiency; his participation is a method
of solving his own economic problem.
We will be speaking of the efficiency or inefficiency of a social system
in this sense. We are not invoking the notion of a society having its goals
in any sense apart from the goals of the individuals making up the society.
Efficiency for a social system means the efficiency with which it permits its
individual members to achieve their several goals.

l This statement of the nature of the economic problem facing a society is worthy of
notice. Most nineteenth century economists (and many laymen today) use the adjective
"economic" to denote a relationship to tuealth (more or less carefully defined). Most
economists today, however, recognize that the term "economic problem" is fundamentally
suited to denote the problem discussed in the text.
36 MARKET THEORY AND THE PRICE SYSTEM


THE PROBLEM OF COORDINATION
However, when individuals seek to fulfill their purposes through some
form of social cooperation, the efficiency of the social system in the above
sense depends on the degree of coordination with which the separate activ-
ities of the participants are carried on. The cooperation of individuals
requires that their actions fit into an over-all pattern of organization. The
fundamental point is that the source of the advantages of social coopera-
tion over individual autarky exists in the possibilities that social co-
operation opens up for specialization and division of labor. It is efficient,
for example, to participate in a market economy (instead of being a self-
sufficient Robinson Crusoe) because the value of one's specialized services
to the market is higher than the value of all that one could produce by
spreading one's efforts over numerous branches of production for one's own
consumption.2
Now, the very factor specialization, which can make social cooperation
"efficient" for each of the cooperating individuals, itself introduces problems
upon whose successful solution the worthwhileness of specialization depends.
Clearly, if everyone specialized in the same kind of production, specializa-
tion would be worse than useless. A social system will emerge only if the
system promises individuals a way of cooperating with others in an efficient
way; that is, only if the system coordinates the specialized activities of the
participants.
In this chapter we discuss the market economy with respect to the way
it coordinates the activities of its participants. We do not "judge" the
degree of success that the market economy attains in this regard either as
compared with other economic systems or as to its own "efficiency." We
are concerned with finding out how the patterns of relationships existing in
the market process succeed at all in organizing numberless, independently
planned actions into a social system that efficiently serves the purposes of
its participants.
The general problem of coordination can be reduced, for a market
economy, into a number of fairly distinct special problems. First, we will
outline these problems, and then proceed in subsequent sections to discuss
how these problems are solved by the market.
1. The economy must somehow or other develop a system of "priorities"
governing what goods and services should be produced. Resources are
clearly insufficient to produce everything that the participants would like to
enjoy. There must be someway to decide on the kinds and quantities of
products to which resources should be allocated; this involves the notion of
2 The classic statement of the advantages to be derived from the division of labor is
in the opening chapter of Adam Smith's Wealth of Nations. See also Mises, L. v., Hu-
man Action, Yale University Press, New Haven, Connecticut, 1949. pp. 157-164.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 37


"priorities." If Mr. Smith wants a new coat, and Mrs. Jones wants a new
dress, then there must be some method of ranking these two wants so as to
guide producers in making their decisions as to what to produce. If one
viewed society as having wants that, in principle, can be ranked on a single
scale of absolute "importance," then this problem would be simply that of
discovering this ranking. Such a view of things recognizes the possibility
of declaring Mr. Smith's need for a coat to be somehow or other more or
less "urgent" from the standpoint of society than Mrs. Jones' need for a
dress. Efficiency in the operation of the economy requires that, in this view
of things, the system find out which want is the more urgent and then direct
producers to give it corresponding priority.
But even when it has become clear that no objective way exists of de-
termining the relative importance of the wants of different individuals
"from the point of view of society" in any such absolute sense (if any mean-
ing at all can be attached to this term), the problem of ranking must and
can be solved. For participation in a market economy to be attractive,
individuals must be assured that some reasonably satisfactory”and definite
”method will be used to assign priorities to the wants of all the different
participants. From the point of view of coordination, participants must be
assured that the decision of any individual entrepreneur to produce a given
commodity is consistent with this priority system. The priority system used
need not be able to lay claim to the achievement of ultimate justice or fair-
ness. Participants must merely be convinced that the degrees of importance
that the market attaches to different wants are such as to make the market
system profitable from their own individual point of view.3
2. A second problem of coordination relates to the way resources are
combined to produce those goods or services to which priority in production
has somehow been assigned. Once it has been decided that a certain good
is to be produced, the next step is to decide on the method of production to
be used. Very often there are a number of different methods of production
that are technically capable of yielding a desired commodity. Drinking
water can be brought from the mountains or extracted from the sea. The
economic system requires a device that will guide the producer of the com-
modity to use the most efficient method of production”efficiency in produc-
tion being measured with respect to the economy as a whole. The "correct"

3 The notion of priority in satisfying the wishes of market participants should be
interpreted very broadly. Under this heading should be included, for example, at least
part of the function frequently assigned to an economic system of providing for growth.
Insofar as growth involves a problem of resource allocation (for example insofar as it
involves denying Mr. Smith's wants today in order that Mrs. Jones' grandchildren should
enjoy a better life in the future), the market must determine the rate of growth of the
economy on some basis of priorities. It is also true that the priority attached by con-
sumers to present consumption over future consumption may be such that no growth
at all (or even economic decline) may be the most "efficient" outcome.
38 MARKET THEORY AND THE PRICE SYSTEM


method of production means the correct combination of resources. The
correct combination of resources used to produce a given commodity will
leave as a remainder, out of the entire available stock of resources, that body
of resources able to produce the greatest quantity of goods in their order
of priority. In other words, production is carried on efficiently, from the
viewpoint of society, when it interferes least with the rest of production.
Clearly, with innumerable producers making independent decisions as
to production techniques, the economy must coordinate these decisions so
as to ensure that each producer uses those resources least needed elsewhere
in the economy. Just as products can be produced in different ways, so
resources can be used to produce different products. It is in the interest of
each market participant that each unit of each resource be directed toward
the production of that product where it will be used most efficiently”in the
sense stated above.
3. The essence of the market economy is specialization and division of
labor in production; production, moreover, invariably involves the co-
operation of the productive services of several different resources. For both
these reasons it follows that, in a market economy, resources are generally
used in processes of production which go to satisfy the wants of others than
the owners of the resources themselves, and/or do not permit the productive
contribution of any particular unit of a resource to be distinguished or
identified. A truck driver transports food from one city to another. He
himself may need very little of this food; and it is quite impossible to
identify what portion of the utility of transportation is attributable to his
services, what portion is attributable to the truck, to the highways, and so on.
All this creates a problem of compensating each participant in the system
for his productive contribution as a resource owner (or entrepreneur). If an
individual is to participate in the economy, some definite system must exist,
which will insure that he will receive a share of what is being produced.4
An efficient system will provide sufficient reward to each participant to en-
able all participants to enjoy the benefits of the widest possible range of
resource services.

HOW THE MARKET SOLVES THE PROBLEMS
OF COORDINATION
In a market economy these problems of coordination find their solution
in the market process. The key role is played by market prices. The
reasonable success that a market economy is able to attain in the solution
of the three coordination problems outlined in the previous section is the
4 From a short-run viewpoint this coordinating problem is frequently seen as the
problem of distributing the national product. Some of the early economists saw the
principal task of economics as being the elucidation of the laws governing distribution.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 39


consequence of a market process that determines prices. Market prices
guide individual decision makers toward decisions that tend to consider
implicitly all the relevant conditions prevailing in the market.
Thus, the single process that determines the course of the various prices
in a market continuously works toward the simultaneous solution of the
three problems of coordination. These three, analytically distinct tasks
are fulfilled as aspects of the same market process market prices emerge from.
This will become apparent in the following paragraphs as we discuss the
different aspects of the market solution.
1. In a market economy the task of production is carried out by entre-
preneurs in search of profits. Where an entrepreneur has the choice of
producing two products at equal cost, he will produce that which promises
to sell for the highest price. Thus, priorities in a market economy are
assigned to different goods by the process that determines their prices.
Where equivalent combinations of resources can produce different products,
it is the product that can command the highest market price that top
priority is automatically assigned to.
Much of our study is concerned with the process by which the market
price of products is determined. Generally, it is obvious even at this point,
however, that those products for which consumers are prepared to undergo
the greatest pecuniary sacrifice will tend (other things being equal) to com-
mand the highest prices; so thus, the market tends to consider these
products as socially more "important." Resources will tend to be pur-
chased by entrepreneurs for use in the production of the relatively higher-
priced goods. Changes in the urgency with which consumers are anxious
to obtain specific goods will tend to be reflected in changes in their prices
and hence in the priority that the market attaches to their production. The
more responsive the price system is to changes in consumer preferences,
the more accurately will the decisions of producers be in conformity with the
priority system based on pecuniary sacrifice.
This kind of priority system is frequently described as consumer
sovereignty. It is the consumers' acts of purchase, translated into market
forces, which determine market prices, and thus give directions to the pro-
ducers as to what should be produced. Changes in consumer preferences,
which are responsible for the price changes, compel producers to alter their
production processes. Any non-market obstacles placed in the way of the
pricing process thus necessarily interfere with the priority system that con-
sumers have set up. It must always be borne in mind that such a priority
system cannot necessarily lay claim to any kind of ethical excellence. All
that can be claimed for the priority system is that it offers potential market
participants more attractive alternatives than are available to them other-
wise.
2. That production in a market economy is undertaken for profit also
40 MARKET THEORY AND THE PRICE SYSTEM

has definite consequences with respect to the second task of coordination.
When a given product can be produced by different methods of production, it
is most profitable to use the cheapest method of production. The entrepre-
neur will therefore tend to use this method of production. The cheapest
method of production is that which requires the smallest expenditure for
the resources used. Whether or not one production process is cheaper (and
therefore more likely to be employed) than another depends not only on the
quantities of resources required for the processes, but also on their prices.
The market value of different resource combinations influences the decisions
of producers to use more machinery or less, more skilled labor or less, a
larger plant or a smaller; and so on.
Now, as with the prices of products, the analysis of the determination
of the prices of resources must wait until later chapters in this book. But
generally it is not difficult to see what factors are at work in the determina-
tion of resource prices, and to appreciate how these factors relate to the
coordination problem of securing the use of "socially efficient" methods of
production. Market prices are the basis of cost calculation by producers.
The price of each resource tends toward the point where all supplies of
the resource available at this price are bought by producers.5 Producers
tend to bid up resource prices in order to secure resources for the production
of given products for as long as it is profitable to do so; thus, at the market
price, the resource will be used by producers of those products in whose
production the resource yields greatest profits. Producers bidding for the
resource to produce a product in which the resource will be relatively less
profitable will soon find it impossible to compete with the producers of
more valuable products. In buying the cheapest resources (among all those
resources that are for him technically equivalent), the producer will there-
fore tend to be buying those resources least valuable elsewhere in the econ-
omy”"valuable," that is, in the sense of being able to cater to consumer
wants having higher (pecuniary sacrifice) priority.
It cannot be expected, to be sure, that at any one time the market
process should have succeeded in securing complete coordination of deci-
sions concerning methods of production. Inevitably, at any one time,
certain processes of production will be carried on using resources some units
of which could be used more valuably in other production processes. So
long as the market is competitive, however, the existence of such oppor-
tunities for increased efficiency will tend to be discovered and exploited by
profit-seeking entrepreneurs. The market process will constantly tend to
rearrange and reshuffle the allocation of productive resources so as to con-
5 The sentence in the text needs to be qualified to some extent. It is possible that a
resource is so plentiful or so low in productivity that even if the price falls to practically
zero, it does not pay to employ the entire supply for production.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 41


form more closely with the most recent changes in the patterns of available
resources and consumer preferences.6
3. The price system a market economy has its setting in is responsible
also for the solution of the third problem of coordination, that of determin-
ing the individual rewards to be received by each of the resource owners
cooperating in the productive process. This function is fulfilled as a
different aspect of the same pricing process that determines resource alloca-
tion and the organization of production. Resource owners selling the
services of their resources in the market secure prices that are determined
by the interaction of resource supply and entrepreneurial demand. Acting
in their capacity of consumers, the resource owners will in turn use the
money prices, which they receive in the resource markets (their "incomes"),
to buy goods in the product markets. Thus, the market value of the goods
and services a consumer can buy with his income is determined by the
value that the market places upon the services that, in his capacity of re-
source owner, he has furnished to the production process.
The real incomes received by consumers are therefore determined by
the prices that emerge in the market for the services of the various resources.
In general, the price of a resource depends on its productivity in the differ-
ent branches of production. When a resource owner is otherwise indif-
ferent to the use his resource will be applied to, he will sell its services to the
highest bidder. The highest bidder will tend to be that entrepreneur to
whose profit calculations the services of additional quantities of the re-
source add most. The market process therefore tends to ensure the appor-
tioning of rewards among cooperating resource owners in a way that attracts
resources to their most productive uses. At the same time each individual
resource owner participating in the market process is able to enjoy the
fruits of the production of the market to an extent depending on the useful-
ness to the market of the productive services that he is willing to supply on
these terms. That portion of production that is not earned by resource
owners is received by entrepreneurs as pure profit. We now consider briefly
the factors that determine the size of profits, and especially the coordinating
functions that profits fulfill.

THE COORDINATING FUNCTION OF PROFITS
IN A MARKET ECONOMY
In the previous sections it was seen that the market process simulta-
neously solves the three fundamental problems of economic coordination
through the price system. The emergence of a price structure reflects a
priority system that guides resources to (what this priority system pronounces

6 See more on this point in Ch. 13.
42 MARKET THEORY AND THE PRICE SYSTEM

to be) their most productive uses. But the price system is not "automatic,"
it functions only as the expression of human actions. In particular the
price system is the expression of entrepreneurial decisions consciously
planned and executed. Entrepreneurial decisions are made with the pur-
pose of winning profits.
Profits are to be won whenever something can be sold for a price higher
than the price it can be bought at (or higher than the sum of the prices of
everything needed for its production). For an entrepreneur to win profits it
is necessary, first, that such a price discrepancy exist; and second, that the
entrepreneur know that it exists. Now, for a price discrepancy to exist, it
is necessary that those willing to sell the commodity (or the factors neces-
sary for its production) for the lower price and those willing to buy the
commodity at the higher price be unaware of each other's attitudes. If
these sellers and buyers knew each other's attitudes, these would soon be
altered to eliminate the price discrepancy. The entrepreneur wins profits
by becoming aware, earlier than others, of the hitherto unknown discrepancy
(reflected in the price differential) between the attitudes of those willing
to sell for less and of those willing to buy for more.
It is the characteristic of the real world to which the analysis of market
theory may be applied that, at any one time, numerous instances occur of
the kind of ignorance that makes it possible for price discrepancies and
profits to emerge. Each market participant knows some of the market
facts relevant to his own situation, but is ignorant of a great many more.
Among the alternatives from which Market Participant A believes he has
to choose, some particularly attractive alternative is usually missing (obtain-
able by dealing with Market Participant B) which might have been included
if only A and B would have known of each other's situation and attitude.
From the point of view of an imaginary, disinterested outsider knowing all
these facts, both A and B are the losers due to their ignorance of some
market facts. From the point of view of the omniscient outsider, the
market always has room for a reshuffling of resources or goods according to
the pattern that would take place if the market participants themselves

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