The Rationale of the Market Economy

The fall of the Berlin Wall in November 1989 was the defining economic event of our lifetime. It marked the end of the most extensive controlled experiment in the history of social sciences – the division of Germany into two economic zones, one centralised and planned, the other a market economy. After forty years, the gap in living standards between the two was so extreme that the experiment was terminated. This outcome is counterintuitive. A striking formulation by Ken Arrow and Frank Hahn spells out the issues. The immediate 'common sense' answer to the question 'what will an economy motivated by individual greed and controlled by a very large number of different agents look like?' is probably: 'There will be chaos'. Even in the 1960s, most countries – developed and developing – outside the United States believed that central planning should be at the centre of their economic management. The US itself was concerned that the Soviet Union might achieve technological superiority. So why did markets perform so well? A popular caricature of the market economy sees greed as the dominant human motivation, and economic progress best achieved by acknowledging that behaviour and imposing as few restrictions as possible on what these greedy people do. This is the economic environment of Nigeria and Haiti, and it does not work: it is the commercial environment of the Ik tribe described by the anthropologist Colin Turnbull and of Lehman described by the inmate Laurence McDonald, and it does not work there either. Greed must be constrained, but it is inadequate to describe that constraint simply as 'the rule of law'. The property rights that are critical to 'the rule of law' are not given by nature, but are socially constructed. Information asymmetry is endemic in modern economies with complex products, and that asymmetry is handled mainly through the mechanisms of trust relationships and reputation. Market economies operate with far more coordination and cooperation than the model of unrestricted greed allows. The simplistic account of human motivation based on self interest comprehensively fails to recognise the real complexities of human behaviour. So what are the real strengths of the market economy? There are three components. Prices act as signals; the operation of the price mechanism is a better guide to resource allocation than central planning. Markets function as a process of discovery – the chaotic process of experimentation through which a market economy adapts to change. And markets yield benefits from the diffusion of political and economic power. Prosperity and growth require that entrepreneurial energy should be focussed on the creation of wealth rather than the appropriation of other people's wealth. Decentralisation of authority and deconcentration of activity limit rent seeking

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