The Costs, Preferences And Social Wealth Of A Free Market Economy
If you want to understand the free market economy you need to be clear about what it is and how it works. Failing that, the tendency is to too easily lapse into well worn cliches and platitudes.
Elsewhere, I've defined the free market economy in a way that put the emphasis upon principles of voluntary exchange. The function of this quality is another matter. It has to do with the overall increase of social wealth. Understanding how a free market economy increases social wealth requires understanding the dynamics of voluntary exchange.
To be clear, I do not mean by social wealth some kind of collective good. Rather it refers to the total wealth in a society as measured by the wealth of all its individuals. Voluntary exchange is the way to make the most people wealthier and thus increase the level of total wealth in a society.
So, we begin by asking how voluntary exchange achieves this increase of social wealth. It is often erroneously assumed that an exchange of goods cannot change the aggregate of social wealth. The items exchanged, to be exchanged, must be of equal value. Otherwise the market actors would not have made the trade. The only other option is presumed to be that one must have gotten the better of the other in the trade. In that case, though, the total social wealth would be unchanged.
Such assumptions are fundamentally wrong. They fail to understand two important economic facts: 1) transaction costs and 2) subjective preferences. All exchanges have costs arising from the transaction. In any trade each participant is simultaneously a buyer and a seller. Money, after all, is just another commodity being exchanged .
1) Though it's a bit perplexing why someone would take the bother of trading an item for another that he valued equally, but even if for whatever whimsical reason he did, the final result would be a loss on the part of the trader. This is due to the transaction costs that are entailed in all trades.
Consider an example: imagine you're walking by the store front of your local grocer. If you valued the dollar in your pocket and the apple for sale in the store equally, you wouldn't care which you had. If you actually were so indifferent, would you detour from your journey to enter the store, find your way to the apple bin, peruse them in search of a ripe one, free of bruises, then walk over to the cashier and wait for the line to inch along until you reached the cashier and could pay?
Those are all transaction costs to your time and energy. Why would you incur them if you really didn't care whether you had an apple or the dollar in your pocket? (If you did incur those costs that would be empirical evidence that contrary to what you said, or thought, you obviously did prefer the apple to the dollar.)
This leads us to the other important point of subjective preferences. The reason that two people, engaging in a trade, each buying something they value more than what they're selling, despite transaction costs, can both simultaneously profit (increase their wealth), is that people have different values at any given moment in time.
Feeling hungry as you near the local grocery store could well have you value an apple more than a dollar in your pocket. Your greater valuation of the apple may be so much greater than the dollar that you'd happily incur the transaction costs (detour, perusal, waiting in line) to exchange dollar for apple.
The apple though is not objectively more valuable than your dollar. That's just your subjective valuing of each at that moment. Walking by the grocer's, after a big lunch, yesterday, you might have thought quite differently about their relative value.
Subjective differences in value not only apply to one person at different times, but to different people. Your grocer's evaluation of the two goods is subjectively different from yours. With a bin full of apples, already paid for, he needs the income to run his store and support his family. Doing so depends on his success at selling the apples which he bought for just that purpose. To the grocer your dollar is more valuable than the apple you receive in return for giving him the dollar. The transaction costs incurred by the grocer, such as keeping the store clean, heated and well lit, are spent in anticipation of making it more attractive to you to incur the transaction costs on your end.
Think about how often upon arriving at the cash, as you pay, both you and the grocer thank each other simultaneously. Is this some strange confusion or paradox? Of course not! You are both thankful, because you are both getting what you prefer: something you value more in exchange for something you value less. You are in fact both wealthier thanks to the exchange.
Thereby, the total social wealth has been increased. This is the magic of a free market economy. And the freer it is, the more total social wealth can be created.
Elsewhere, I've defined the free market economy in a way that put the emphasis upon principles of voluntary exchange. The function of this quality is another matter. It has to do with the overall increase of social wealth. Understanding how a free market economy increases social wealth requires understanding the dynamics of voluntary exchange.
To be clear, I do not mean by social wealth some kind of collective good. Rather it refers to the total wealth in a society as measured by the wealth of all its individuals. Voluntary exchange is the way to make the most people wealthier and thus increase the level of total wealth in a society.
So, we begin by asking how voluntary exchange achieves this increase of social wealth. It is often erroneously assumed that an exchange of goods cannot change the aggregate of social wealth. The items exchanged, to be exchanged, must be of equal value. Otherwise the market actors would not have made the trade. The only other option is presumed to be that one must have gotten the better of the other in the trade. In that case, though, the total social wealth would be unchanged.
Such assumptions are fundamentally wrong. They fail to understand two important economic facts: 1) transaction costs and 2) subjective preferences. All exchanges have costs arising from the transaction. In any trade each participant is simultaneously a buyer and a seller. Money, after all, is just another commodity being exchanged .
1) Though it's a bit perplexing why someone would take the bother of trading an item for another that he valued equally, but even if for whatever whimsical reason he did, the final result would be a loss on the part of the trader. This is due to the transaction costs that are entailed in all trades.
Consider an example: imagine you're walking by the store front of your local grocer. If you valued the dollar in your pocket and the apple for sale in the store equally, you wouldn't care which you had. If you actually were so indifferent, would you detour from your journey to enter the store, find your way to the apple bin, peruse them in search of a ripe one, free of bruises, then walk over to the cashier and wait for the line to inch along until you reached the cashier and could pay?
Those are all transaction costs to your time and energy. Why would you incur them if you really didn't care whether you had an apple or the dollar in your pocket? (If you did incur those costs that would be empirical evidence that contrary to what you said, or thought, you obviously did prefer the apple to the dollar.)
This leads us to the other important point of subjective preferences. The reason that two people, engaging in a trade, each buying something they value more than what they're selling, despite transaction costs, can both simultaneously profit (increase their wealth), is that people have different values at any given moment in time.
Feeling hungry as you near the local grocery store could well have you value an apple more than a dollar in your pocket. Your greater valuation of the apple may be so much greater than the dollar that you'd happily incur the transaction costs (detour, perusal, waiting in line) to exchange dollar for apple.
The apple though is not objectively more valuable than your dollar. That's just your subjective valuing of each at that moment. Walking by the grocer's, after a big lunch, yesterday, you might have thought quite differently about their relative value.
Subjective differences in value not only apply to one person at different times, but to different people. Your grocer's evaluation of the two goods is subjectively different from yours. With a bin full of apples, already paid for, he needs the income to run his store and support his family. Doing so depends on his success at selling the apples which he bought for just that purpose. To the grocer your dollar is more valuable than the apple you receive in return for giving him the dollar. The transaction costs incurred by the grocer, such as keeping the store clean, heated and well lit, are spent in anticipation of making it more attractive to you to incur the transaction costs on your end.
Think about how often upon arriving at the cash, as you pay, both you and the grocer thank each other simultaneously. Is this some strange confusion or paradox? Of course not! You are both thankful, because you are both getting what you prefer: something you value more in exchange for something you value less. You are in fact both wealthier thanks to the exchange.
Thereby, the total social wealth has been increased. This is the magic of a free market economy. And the freer it is, the more total social wealth can be created.
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