Efficiency is Human

This following statement frequently heard.

The market is efficient.

This statement is not true. Markets cannot think, assess, decide or act, so they cannot decide what is efficient. Markets cannot be wise.

Efficiency is a human concept. Only people can be efficient. Some are clever, others are highly skilled, but everyone is better off, if producers make wise decisions. An economy becomes more productive as wise producers find more efficient ways to do complex tasks.

Japanese auto-makers found ways to make their production processes more efficient, which enabled them to offers better cars at lower prices. This wisdom and efficiency resides in the Japanese managers and engineers, not in the market. Free markets provided a way for consumers to access their efficiency and buy high-quality cars at a low price.

Specialisation and Efficiency

Specialisation generally increases efficiency. When a person can concentrate on one set of tasks, they the can learn to do them more effectively. Specialisation benefits everyone, but people can only specialise, if there is a way for other others to obtain what they have produced (without using force or theft, and not relying on compassion). Markets where goods and services can be offered for sale allow people to specialise in the activities which they do best.

The people who designed my computer produced an efficient product. If there were no markets and no specialisation, they would spend their days cultivating crops and hunting game. They would be worse off and I would be worse off too, because I could not make a computer in a thousand years.

Freedom to offer goods for sale on a market allows people to specialise, but the person who chooses to specialise immediately comes under pressure to operate efficiently. A person or business that decides to produce goods to offer in any market immediately faces a compelling dilemma. They must offer the goods for sale at price sufficient to cover their production costs, but pushing their offer price too high will dramatically reduce their sales.

The market producer must choose between higher prices and more sales. This dilemma forces an ambitious business to reduce the costs of production by finding ways to be more efficient. This allows them to increase their income, without increasing prices and losing sales. Markets facilitate efficiency.

Information and Efficiency

Producers and consumers need good information to make wise decisions. Markets do not make decisions, but they are excellent conveyors of information. To make sales, producers must share information to the market about the products and prices they are offering. Consumers and producers can use this information to enlighten their decisions.

Prices draw consumers towards the most efficient producer. If two sellers are offering exactly the same a product, but one offering a much lower price than the other, a wise consumer will accept the best offer. The efficient producer will be encouraged to produce more. The offers of inefficient or greedy producers will be rejected. They are not forced to change, but they will feel the pressure, if they want to sell their products.

Prices provide producers with information about the value of the resources they have used. This information flows right through the economy from extraction of raw materials to the retailing of final goods. Wise businesses respond to market information by adapting their production processes to eliminate waste and increase efficiency.

Markets do not "work all things together for good", but they do convey some of the information that people need to make good decisions. Market information will never be perfect and it will never be complete, but the wisdom of consumers and producers would be severely constrained without it.

Making Mistakes

Free markets are morally superior to theft and force. The reason is that an exchange in a free market can only occur, if both parties think that they will be better off after the transaction is completed. This is good, but transactions must be agreed on the basis of what buyers and sellers think and know at that time when time then the deal is finalised.

Mistakes are made because people have imperfect knowledge about the future. When buying and selling, we have to act on what we know at that time. We do not know what the future holds. If the future is different from what we expected then a transaction may turn out to be a mistake. If his brother arrives unexpectedly to stay for a couple of months, John might wish he had kept the car. He might begin to think that he had made a mistake in selling the car. Unexpected circumstances can turn good decisions into mistakes.

People make more mistakes when they are under pressure. Esau sold his birthright for a meal when he was famished (Gen 25:29-31). This was a free market. Jacob did not have to sell his stew (although he probably should have had compassion for his brother). Esau freely sold his birthright, because it would bring no benefit until way in the future, whereas his hunger was there now. Short-term thinking places a higher value a meal in the present than on a future blessing. Esau made a mistake, because hunger clouded his judgment.

Mistakes also occur because people change their minds about what they want. Bob bought John's car because it was blue. After driving the car for a month, he might get tired of blue and start thinking he would prefer a red car. As his thoughts about colour change, he might look back on the transaction later and think that he had made a mistake.

People make mistakes all the time when buying and selling, but if markets are functioning freely, they can be corrected easily, albeit at a cost. John can buy another car, if he chooses. If Bob decides that he really must have a red car, he can sell his blue car and buy a red one. He may lose some money in the process, but he is the only one who suffers for his mistake.

People learn from their mistakes Bob will not want to make the same mistake twice, so he will think more about colour, before buying another car.

Preventing Mistakes

Advocates for market regulation are really wanting to prevent people from making mistakes. This is a noble ideal, but it is impossible to apply in practice. Regulators would need two forms of knowledge to prevent mistakes when buying and selling.

  1. They would need to know what everyone should want and need. Parents may know what is good for their children, but a market regulator can never know everything that other people need.

  2. They would need perfect knowledge of the future.

Market regulation assumes the regulators have exceptional knowledge of both human needs and perfect knowledge of the future. These godlike regulators simply do not exist.

Political power amplifies the impact of mistakes. Ordinary people make mistakes that affect themselves. They sometimes make mistakes that harm their families. Politicians and regulators can make mistakes that damage the entire economy and harm the whole of society.

Business Cycles

The business cycle is caused by pervasive mistakes Ups and downs in economic activity are the result of changes in human mood. There will always be times of widespread exuberance and times of mass fear. Markets reflect these moods, but do cause them.

Joseph explained to Pharaoh that the seven good years would be followed by seven bad years. This is normal. During good years, people naively assume they will continue forever. They live it up, when they should be putting the surplus aside for the bad years that will inevitability follow.

People decide how they will respond to changes in moods and season. We should not blame markets for the mistakes of fickle and foolish of people.

The business cycle gets serious when governments amplify the mistakes of ordinary people. The laws that govern the modern banking system are flawed. This allows banks to exaggerate the business cycle by inflating the currency during times of exuberance and contracting leverage in response to fear.