Producing Prosperity

An Inquiry into the Operation of the Market Process

Randall Holcombe

• Publisher: Taylor & Francis
• Year: 2013
• eBook ISBN: 9781136162305
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The substantial prosperity that characterizes market economies at the beginning of the twenty-first century is relatively recent in human history. Prior to the Industrial Revolution, economic progress was so slow that people would not have been able to recognize it in their lifetimes, whereas today, economic progress is so much a part of people's lives that they take it for granted.

In this new volume, Randall G. Holcombe argues that economic analysis, as it developed through the twentieth century, relies heavily on concepts of economic equilibrium, and is not descriptive of the dynamic real-world economy that is characterized by economic progress. Even in dynamic settings, economic models focus on income growth, leaving out the entrepreneurial forces that generate economic progress, resulting in the introduction of new goods and services and new production processes. Economic analysis focuses on the forces that lead to an economic equilibrium, not the forces that produce prosperity.

This characterization of economic analysis describes a substantial component of economics as it has developed over the past century. However, there are also economists who have analyzed the factors that lead to an entrepreneurial and innovative economy, generating progress rather than equilibrium. This volume does not question the value of past research, but argues that, looking ahead, economics should build on its past to focus on factors that create an entrepreneurial and innovative economy that is characterized by progress and prosperity. This would make economic analysis more consistent with the remarkable progress and prosperity that characterizes the modern economy. This volume lays out a framework for economic analysis that consistently incorporates the real-world factors that produce prosperity.

1 Producing prosperity

The subject matter of economics

Since its beginning, the primary subject matter of economics has been what enables economies to produce prosperity. Adam Smith, often cited as the father of economics, titled his great 1776 treatise An Inquiry Into the Nature and Causes of the Wealth of Nations. The title reveals that Smith’s primary interest was to explain how economies produce prosperity. That topic remains at the forefront of economic analysis up into the twenty-first century, but economists’ views on how prosperity can be produced have changed substantially from the late twentieth century to the early twenty-first. Until the fall of the Berlin Wall in 1989, followed by the dissolution of the Soviet Union in 1991, conventional wisdom among economists leaned toward the idea that economic planning by government was the surest road to prosperity. Despite the fact that market economies were more prosperous during the twentieth century than centrally-planned economies, much of the economics profession perceived central planning as a more rational way to organize an economy. A belief common among professional economists was that centrally-planned economies would grow faster and eventually overtake market economies. By the beginning of the twentieth century, the overwhelming evidence on the failure of central planning reversed that conventional wisdom. Market economies, not central economic planning, are now seen as the way to produce prosperity.

This change in the conventional wisdom of economists came about because of the real-world evidence that markets work better than central planning, not because of any advances in economic theory. In fact, economic theory had much to do with the tendency of economists to see the merits of central planning. Economic theory had developed in the twentieth century in a way that supported the organization of an economy through central planning, and that ignored those aspects of market economies that actually were responsible for the increasing prosperity they enjoyed. Economists developed complex mathematical models of the economy, and thinking that the models captured the essential elements of the real-world economy, looked for policy changes that could improve the performance of their model economies in theory. Then they recommended to real-world policy-makers that they implement those same policies. In the real world, however, those policies did not give the same results as in the theoretical model economies. While that would seem to indicate that, at best, those models did an incomplete job of understanding the causes of prosperity, at the beginning of the twenty-first century the theory remained the same, and had not yet caught up to correspond with the evidence on the way that market economies work to produce prosperity.

The purpose of this volume is not to add any evidence to the argument that market economies pave the road to producing prosperity. In addition to the real-world evidence, there is also a substantial amount of literature – much of it written since 1990 – that makes a solid case. So, this volume takes that conclusion as given. This book examines the development of economics in the twentieth century and suggests that it developed in a way that supports the idea that central planning can work better than markets, and left out of its analysis the key factors that actually contribute toward producing prosperity. The market economy is an engine of economic progress, and this volume examines economic theory to see how it can be developed to more closely correspond with the real-world advances in prosperity that have been occurring for more than two centuries.

The payoffof this exploration, at its most ambitious, would be to point the way toward the development of economic theory that more closely corresponds to the real-world economy, and that can lead to better policy recommendations. Even with more modest ambition, if such an exploration shows the shortcomings of applying twentieth-century economic theory to the issue of economic progress, it might prevent some poor policy decisions from being made.

The remarkable rise of prosperity

The substantial increase in world prosperity since the beginning of the Industrial Revolution is nothing short of remarkable; yet it is easy to take for granted because it is so much a part of everyday modern life. Prior to about 1750, when the Industrial Revolution was beginning, prosperity was a privilege of the very few, and people became prosperous not because of their own productivity, but rather because a lot of workers had no choice but to turn over a share of their productivity to the prosperous classes. Prior to the Industrial Revolution, prosperity was a function of class. People were born into a certain station in life, and the institutions of the day did not allow the mobility that would permit those of modest birth status to rise to the level of the prosperous classes. Wealth and status were inherited, and the transfer of resources toward the prosperous classes did not occur as a by-product of voluntary exchange, but rather as a forced transfer, enforced through political and military power. That changed with the Industrial Revolution, which allowed people born into modest circumstances to build businesses, and through those businesses to build wealth rivaling and even surpassing those with inherited wealth.

Opportunities for the masses to become prosperous did not come instantaneously with the Industrial Revolution. Indeed, John Stuart Mill, writing in 1848, a century after the Industrial Revolution began, noted the very uneven – and in his view unfair – distribution of income produced by the Industrial Revolution. Discussing the prospects for communism, Mill observed:

If ... the choice were to be made between Communism with all its chances, and the present state of society with all its sufferings and injustices; if the institution of private property necessarily carried with it as a consequence, that the produce of labour should be apportioned as we now see it, almost in an inverse proportion to the labour – the largest portions to those who have never worked at all, the next largest to those whose work is almost nominal, and so in a descending scale, the remuneration dwindling as the work grows harder and more disagreeable, until the most fatiguing and exhausting bodily labour cannot count with certainty on being able to earn even the necessaries of life; if this or Communism were the alternatives, all the difficulties, great or small, of Communism would be as dust in the balance.¹

Ultimately, Mill decided that the present state of society could be modified, so the choice was broader than just the present state of society of communism, but Mill’s discussion of income inequality is a telling observation of the consequences of capitalism in his time.

There was one substantial difference in the inequality Mill observed and the inequality that had characterized the world just a century before. The prosperity of the most prosperous in Mill’s day came from their direction of productive activity, and that production laid the foundation for an increasing standard of living for everyone. Within a century and a half, the wealthy nobility of 1750 was being displaced by the new industrialists, and the wealth of John D. Rockefeller, Andrew Carnegie, and Cornelius Vanderbilt far eclipsed the wealth of nobility.

By the middle of the twentieth century, just two centuries into the Industrial Revolution, prosperity had trickled down to the common worker. In 1798 Thomas Robert Malthus had famously predicted that most people would be consigned to life at a subsistence level of income, because population growth would always outstrip the increase in available resources to support that population. By 1950, ordinary citizens in the most prosperous nations were not only well-fed, but enjoyed indoor plumbing, a wide variety of electrical appliances to make their lives easier, and could often afford their own automobiles. By the beginning of the twenty-first century, even most people who were classified below the poverty line in developed economies owned automobiles, mobile telephones, refrigerators, televisions with VCRs, microwave ovens, and lived in housing with indoor plumbing and central heating. By many measures, the standard of living of most people classified as living in poverty at the beginning of the twenty-first century was above the average standard of living just half a century before.

This prosperity has not been shared throughout the world. While growing prosperity continues in many of the world’swealthier countries, people in the world’s poorest countries remain at a subsistence level of income, or worse, as they starve because of an inadequate food supply. As much of the world enjoys an increasing standard of living, the standard of living has fallen in some of the world’s poorest countries. Obviously, prosperity is not inevitable. Some have argued that the prosperity of people in some nations is a result of their exploiting those in poor nations. This possibility alone provides a good reason for investigating the origins of prosperity. The analysis below shows that for the most part, this is not true. Progress in the most prosperous nations benefits those who live in the poorest, but exceptions to this conclusion are noted later in this chapter. Overall, prosperity in one part of the world provides advantages to people in less-prosperous places. The existence of more and less prosperous places points toward two important issues, however.

One issue is what makes the difference between prosperous and poor societies. If one can understand how prosperity is produced, the lesson can be applied to make everyone more prosperous. A second issue is that prosperity is not inevitable, meaning that there is the risk that societies characterized by prosperity and progress could find themselves stagnating or even declining if they do not maintain those conditions that produced prosperity to begin with. There are good reasons for understanding the underlying factors that produce prosperity.

Two functions of the economy: market clearing and progress

To lay a foundation for understanding where this analysis is heading, consider two functions that a market economy undertakes: market clearing and producing progress. Every day the economy produces a vast array of goods and services, and the economic activities of people are coordinated so that, in general, those goods and services are consumed by the people who value them the most. While this idea can be debated and discussed in detail, it can be safely glossed over at this point, because most of twentieth century economics was devoted to analyzing just this idea. As the forces of supply and demand work, prices adjust in an economy so that the quantity supplied in each market just about equals the quantity demanded, and markets clear with goods and services going to those who are willing to pay the most for them. This describes the market-clearing function of the economy.

This market clearing has been analyzed from two related perspectives: equilibrium and efficiency. In twentieth-century terms, when the quantity supplied equals the quantity demanded in all markets, the economy arrives at a general equilibrium, and the equilibrium notion is that as long as the underlying conditions do not change, market forces always tend to pull the economy toward this equilibrium state. Under certain conditions this equilibrium state also allocates resources as efficiently as possible, and a substantial amount of twentieth-century economics was devoted to understanding what the conditions of efficiency are, and how the economy can be nudged toward a more efficient allocation of resources when they are violated.

As depicted by twentieth-century economics, both of these perspectives – equilibrium and efficiency – are static in nature. Equilibrium is static almost by definition, because the economy tends toward a particular outcome, and if that equilibrium is disturbed, economic forces tend to pull the economy back to the equilibrium. The fundamental nature of models of dynamic equilibrium is not much different; the economy just tends toward a determinate equilibrium path. Efficiency also is defined in static terms, as a Pareto optimum. Once an economy arrived at an efficient allocation of resources, there was no way, in theory, to improve on that allocation. In a competitive equilibrium, resources would be allocated as efficiently as possible, and markets would continually clear by allocating resources to their most highly valued uses.

This market-clearing function of the economy is awe inspiring: something to marvel at, to be sure. It is well worth studying and understanding, and it was the focus of attention of the economics profession throughout the twentieth century. Models were developed in an equilibrium framework, and within the twentieth-century equilibrium framework progress was left out of the analysis. Even when models turned to topics of economic growth, they did not capture the process of economic progress as it actually occurred in market economies. Economics as a discipline should certainly retain the lessons it learned about the way that markets clear, but in the twenty-first century there is a strong argument to be made that the focus of economic analysis should turn to economic progress – the topic that most interested Adam Smith – rather than the properties of economic equilibrium that dominated twentieth-century economic analysis.

Looking at the real world, market economies are characterized by markets that clear, and by continual economic progress. Economists understand the market-clearing aspects of the economy well, and this volume looks toward developing economic analysis so that it reflects those characteristics of the economy that generate progress and prosperity.

This section deliberately refers to market clearing rather than equilibrium, because they are different things. However, within an equilibrium framework, they can easily appear to be the same. As such, this distinction deserves some analysis at the outset. In an equilibrium model, the quantity supplied equals the quantity demanded, so the market clears. It appears, therefore, that market clearing is evidence of equilibrium. Within the equilibrium framework, it is the case that in an equilibrium the market clears. However, markets might clear without there being any underlying equilibrium. What is required for market clearing is that the price adjusts to equate the quantities supplied and demanded. If the market is disrupted, in an equilibrium framework market forces bring it back to equilibrium. However, if disruptions occur that change the underlying conditions markets can still clear (prices move to equate the quantities supplied and demanded) without there being any underlying equilibrium toward which the economy is moving.

For those who have been schooled in the equilibrium framework (the present writer included) there is a temptation to preserve that framework by depicting such disruptions as changing the underlying equilibrium, so that the economy moves from one equilibrium to another, or in a dynamic framework, to depict the economy as maintaining some equilibrium trajectory. However, if the disruptions are due to the nondeterministic choices of market participants – and many of them are – then there is no equilibrium that underlies the trajectory of the economy. Where it goes tomorrow depends on the choices individuals make today, and there is no way to depict this path dependence as determinate, or as an equilibrium. That idea will be developed further in Chapter 3, but to start on this line of analysis it is valuable to point out that market clearing and equilibrium are two distinctly different economic phenomena. Equilibrium implies market clearing, making them appear equivalent when viewed through the lens of equilibrium economics. However, the economy can be changing daily, in a non-deterministic fashion, never returning to conditions that existed before, and still prices can adjust so that markets continually clear. Thus, the distinction is important within the context of twentieth-century equilibrium economics, and the marvel of market clearing does not imply the economy is characterized by any sort of equilibrium.

It is important to understand how and why markets clear, and those insights of twentieth-century equilibrium economics remain an important part of economic wisdom. However, the process that generates economic progress is not the same as the process that clears markets. Starting from a hypothetical condition of equilibrium, the analysis that follows shows: why the economy can never remain in equilibrium; that when one is analyzing the causes of prosperity it is misleading to view the economy in equilibrium; and that many of the implications for economic growth that emanate from equilibrium models misrepresent the actual process that produces prosperity.

Equilibrium versus progress: a brief history of economic ideas

To place the ideas in this volume within the context of contemporary economic theory, it is worth considering the background within which economic analysis became so firmly grounded in an equilibrium framework. Economics as an area of inquiry was not always so focused on the properties of economic equilibrium. That fixation on equilibrium only began in the twentieth century, and prior to the this economists would not have thought of an economic system tending toward some equilibrium outcome. Rather, until the twentieth century economists had the idea that the economic activities of today were leading toward economic conditions that would be different in the future.

Economics as a discipline is only about three centuries old. Ludwig von Mises begins ...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• Preface
• 1 Producing prosperity: The subject matter of economics
• 2 Economic models: A framework for analysis
• 3 The market process
• 4 Market clearing forces in the economy
• 5 The innovative nature of firms
• 6 The role of firms in the market
• 7 The trajectory of the economy: Growth and progress
• 8 Economic welfare: Theory and policy
• 9 Rent seeking in a creative economy
• 10 The coordination of economic activity
• 11 Agglomeration economies and economic progress
• 12 The evolution of the economy: Differentiation, selection, replication
• 13 Producing prosperity
• Notes
• References
• Index