Markets are not much interested in fairness
(Introduction to Economics, Lesson 10)
A lot of economic decisions are made ‘by markets’ and are determined by ‘market forces.’
If you study Economics for any sort of formal qualification, you’ll probably spend a lot of time studying how markets work. You’ll hear about ‘the price mechanism’ and ‘the invisible hand’ of the market. You might spend a little bit of time learning definitions of what a market is — sometimes rather vague definitions, such as ‘the market is where demand meets supply.’ You’ll also be spending many hours looking at, drawing, manipulating and analysing countless demand and supply diagrams.
Even with all this studying, however, your actual understanding of markets may still be very limited. The trouble is that, useful as demand and supply diagrams often are, they can also lead students to skip over and fail to understand the much more fundamental basics of how a market actually works and the very important functions it performs on our behalf. Perhaps, however, you’ll find the following example rather revealing:
When Russia was part of the Soviet Union and had a communist government, they had a command economy where the state dictated to people where they would work, what they would produce, how much they had to produce and who would get to have the products they made.
By the late 1980s, this economic system was collapsing alongside the communist political system and the Soviet Union itself. New leaders were emerging and some of these believed that Russia should move to a more western-style, ‘market-led’ economy. One of these people was Boris Yeltsin, who, in 1991, became the first president of the new Russian Federation.
One of the problems, however, was that it was highly questionable whether Boris actually understood how market economies work. His questionable understanding of markets was laid bare when he arrived at a baker’s shop, journalists in tow, on one of his walkabouts around Moscow. At the time, there was a severe shortage of bread in Moscow and this baker was taking advantage of this shortage and was charging very high prices for his bread and making a lot of profit in the process. He was ‘profiteering.’
Boris Yeltsin went practically berserk, shouting at and severely castigating the baker for making extra money by taking advantage of the shortage. Yet, when you think about it, his anger made no sense at all — unless you believe it was merely a political stunt to make himself more popular. In many ways, the baker was actually doing the people of Moscow an enormous favour. He was doing exactly what needed to be done if a market economy is to work properly.
There was a shortage of bread because not enough of it was being produced. This problem will only be solved when people invest in new baking facilities — but people will only invest in these new facilities if they can see their way to making a decent profit from doing so.
In a free market, prices play an incredibly important signalling role that Boris did not appear to understand. When there’s a shortage of bread, consumers are desperate to get their hands on bread and are prepared to pay extra in order to do so. Suppliers realise they can increase the prices they charge to their customers and yet still manage to sell all the bread they have available.
By charging very high prices for his bread, the baker in our example was signalling to potential investors that there was money to be made from making bread. High prices encourage investment in new baking facilities by showing that such investments can be highly profitable. Investments are made, new supplies come on line and the shortage problems are solved.
Any interference that stopped the baker from charging high prices, could discourage other people and businesses from investing in new baking facilities. Rather than helping consumers, such interference might well lead to continued shortages for a long time to come. No-one’s likely to invest in a bakery if the price of bread is artificially low.
In a market system, in which prices are free to change, a remarkable thing happens! Buyers try to get themselves a good deal. They only pay what they have to pay — and this helps prevent wasteful surpluses of things people don’t want.
Similarly, sellers are free to charge buyers as much as they can get away with — in other words, as much as buyers are willing to pay. And it is sellers trying to charge as much as they can get away with that actually helps to prevent shortages. High prices are the signal to increase production in preparation for the future.
It may not seem fair that the Moscow baker in our example exploited the situation he found himself in to make extra profits. It may not seem fair that he charged high prices when he could have afforded to charge less. But I tell you what is even more unfair: people starving to death because there is not enough food to go around! The people of Moscow demanded bread. The baker had the forethought to produce bread. He was doing what the people wanted — meeting their essential needs — so the market and the price mechanism rewarded him for this.
Market forces help to prevent shortages. The price system helps allocate resources to where they are needed. Prices are not about fairness — they’re about avoiding people starving to death!