In a recent New York Times article, Robert Shiller takes aim at the idea that “an unregulated competitive economy is optimal for everyone.” While a defender of certain aspects of the free market, he has misgivings about the amount of manipulation and deceit that permeates it. A competitive economy, in his eyes, features numerous entrepreneurs preying on consumers making decisions that run counter to their best interests.
Too Many Assumptions
This view of the free market is the result of a particular theoretical perspective that unfortunately pervades mainstream economics. In this view, which draws its inspiration primarily from Vilfredo Pareto and John Hicks, markets are optimal because they bring about a state of near-perfect rationality. Each consumer’s preferences are assumed to be error-free, reflecting the latest scientific knowledge. Thus, a consumer, when making decisions about what to eat, follows the advice of dietary experts. He never makes a “mistake” by consuming products that are deemed to be unhealthy. He never indulges himself in a candy bar or a box of chocolates.
Similarly, when making decisions which affect his health the consumer never runs afoul of his doctor’s instructions. Smoking cigarettes, excessive alcohol consumption or inadequate exercise are options that are off the table. Each consumer, moreover, has perfect knowledge regarding the state of the market and the prevailing prices. Therefore he never purchases a good and then finds out that it was available cheaper elsewhere. Such errors are ruled out by assumption.
The process of competition ensures that resources are allocated to best satisfy these rational consumer preferences, thereby bringing about a state of equilibrium that is optimal for everyone. In such a state each market participant is maximizing his or her welfare, allocating the scarce money income at his disposal to satisfy the most highly ranked wants that will truly contribute to it.
It should come as no surprise that the neoclassical economist, when turning his attention from such a defense of the free market, should gasp with horror at the irrationality pervading the real world. The consumers he meets in the supermarket are very different from those that pervade his theoretical model. They purchase candy, often in abundance, eat junk food, consume excessive alcohol, and make a host of other choices which experts in various fields would disapprove of. Why, they even happen to have a proclivity for gossip magazines, something that any rational being would surely see as nothing but a complete waste of time!
It is then a short jump to the conclusion that the entrepreneurs providing the consumers with the means to satisfy these irrational wants are mere manipulators and deceivers. Their desire to make profits in the face of competition forces them to exploit the human frailties of their customers, often finding ways to make them choose in a manner that is contrary to their true welfare. They take advantage of a consumer’s weak moments, when he fails to reason like a scientist or an expert and is inclined to give in to mere whims and fancies. In the process the entrepreneurs, far from ensuring the maximization of welfare, push consumers to make choices that leave them worse off.
Observing the Economy as it Is, Not as it Should Be
Economists working in the Austrian tradition provide a completely different defense of the benefits of the market that are immune to the criticisms advanced by Shiller. The heart of this defense lies in the concept of consumer sovereignty. The characteristic feature of a free, competitive economy is that the decisions of the entrepreneurs and the allocation of resources are always aligned to anticipated consumer preferences, however irrational they may be.
These preferences don’t have to stand up to rational scrutiny. They don’t have to be guided by the most up to date scientific knowledge. Instead, they reflect the momentary valuations of men as they are: erroneous, imperfect, and whimsical. As Mises notes, “Not what a man should do, but what he does, counts for praxeology and economics. Hygiene may be right or wrong in calling alcohol and nicotine poisons. But economics must explain the prices of tobacco and liquor as they are, not as they would be under different conditions.”
Consumers, Not Producers, Direct the Market
The prices that entrepreneurs bid for the factors of production merely reflect their expectations of these preferences. And those who are correct in their anticipations are rewarded with profits whereas those who are not are punished with losses. Thus, the real boss in the realm of the market, the true captain of the ship, is the consumer, irrational and ignorant as he is, and it is he who decides what should and should not be produced.
Any notion of welfare is inseparable from the satisfaction of these imperfect and irrational preferences. The market maximizes consumer welfare because it caters to the whims and fancies of consumers, not because it satisfies the wants of men guided by knowledge deemed to be perfectly rational by the economist.
Thus, when an Austrian economist walks into a supermarket he does not see irrationality, manipulation, and deceit. Instead he sees the miracle of the market at work; he sees the manifestation of the price system and its ability to ensure the satisfaction of the whims and fancies of consumers. When he notices candy bars and gossip magazines being sold in the checkout aisles he does not conclude that entrepreneurs are trying to manipulate consumers. Instead, he realizes that this allocation of resources merely mirrors the preferences of the vast majority of his fellow men. The ability of entrepreneurs to correctly anticipate these preferences and to cater to them enhances rather than diminishes consumer welfare.
Defending the free market is important but how one goes about doing it is equally important. Austrian economists defend the market not because it is perfect but because it allows us to prosper and thrive while letting us embrace our innate human frailties and limitations.