Chapter 1: The invisible hand

Humans have been trading goods and services since prehistoric times, either by direct exchange or using some form of money to represent value. We don’t know the details, but at some time many thousands of years ago the imagination and communication skills of our ancestors evolved sufficiently for a fisherman to suggest to a farmer that they might both be better off if they were to exchange a fish for a handful of eggs, so gaining them each a more varied diet for very little extra effort. Man’s economic adventure had begun.

Of course such a trade can only take place if they can agree on an exchange rate. The fisherman would be very happy if the farmer were prepared to part with ten eggs for a single fish: the farmer would be delighted if the fisherman would accept just one egg in exchange for a fish. Both realise that neither scenario is likely so they have to compromise if the exchange is to proceed. Whether a compromise can be reached depends on the relative values they put on the produce. While the fisherman would like to receive as many eggs as possible, we can assume that there is a minimum below which he would not be willing to go. He might, for example, be prepared to proceed provided he received at least three eggs in return. Anything less and he would prefer to keep the fish. The farmer, on the other hand, might be prepared to hand over up to seven eggs for a fish.

If this is the case then the deal can go ahead. Furthermore, we can actually put a figure on how much they each benefit from the transaction. If they finally agree on a rate of five eggs per fish then each is better off by two eggs: the fisherman because he valued his fish at three eggs and actually got five; the farmer because he valued the fish at seven eggs and only had to part with five. However, if the fisherman thought each fish worth at least seven eggs, but the farmer wasn’t prepared to part with more than five, then no deal would take place.

In this example we are effectively using an egg as a unit of value, and indeed we could imagine the farmer doing another deal at a later date with a furniture maker, perhaps swapping a table for 100 eggs. This would suggest that the fisherman ought to be able to get a table in exchange for 20 fish. However the furniture maker may not be as partial to fish as the farmer, which could cause problems. Furthermore, eggs are easy to break and have a limited shelf life, neither of which makes them a good candidate as a measure of value. Far better to choose something small, durable and hard to come by such as cowrie shells or, at least over the last few thousand years, metal coins.

Such transactions are at the heart of all economic activity. Whether buying groceries or partaking in a multi-million pound business deal, the idea is that all participants walk away better off than they were when they started. The buying and selling of goods is a win-win game and forms the basis of the marketplace, as anyone who has haggled over the price of anything in the bazaars of Marrakech, Cairo or Mumbai will know.

But this is only part of the story. To understand the full power of the market, let us assume that our fisherman decides to sell fish to the people of the local town. The town already has a butcher, a baker and a greengrocer but so far no-one has tried selling fish, so he sets up a stall in the main square that displays his goods in an appealing fashion, together with a sign stating his intention. Although he might occasionally be prepared to haggle over price if business is slow, he cannot afford to go through such a lengthy process with every single customer so he needs to settle on a price before he can start.

There are two aspects to this decision. On the one hand he needs to earn a certain amount each day if he is to cover the basic costs of running the business – in other words the cost of maintaining a fishing boat and renting and managing the stall. He also needs to have enough left over to feed and house his family. If he can’t make at least enough to cover these costs then he might as well give up and try some other way of earning a living.

On the other hand the people of the town are under no compulsion to part with their money. They are not going to buy unless they value ownership of a fish greater than ownership of whatever else they can get for the same price. Price is not so much an issue for the more wealthy who may quite happily part with £10 for the benefit of putting a fresh fish on the dinner table. On the other hand, many of the townspeople may not be able to afford more than £1 a fish. Unless he enters into separate negotiations with each potential buyer, he will never know. However he does know that the lower he sets the price, the more people will be prepared to make the exchange.

He also has the luxury of being the only fish seller in town which means he can experiment to find the price that gives him the greatest profit. If he prices the fish too high then he risks being left with fish still to sell at the end of the day. If he prices too low then demand could be so high that he sells out before the day is done. Let’s imagine that he finds the optimum price to be £5 per fish. Furthermore, let us imagine that his costs amount to £2 per fish, which leaves him a healthy profit of £3 per fish – enough to indulge in a few of the luxuries of life or to invest in his business so that he can make even more profit, perhaps by buying a second boat or running a second stall.

Unfortunately for him, his new-found success does not go unnoticed.  One morning he goes to open up his stall only to find that someone else has set up a stall opposite his and is selling fish at £4.50 a time. Faced with such a situation he could of course reduce his price to £4 and still make a handsome profit. However he can see where this is likely to lead so he pays a visit to his rival and points out that they could either enter into a price war, which could eventually drive them both out of business, or they could reach an agreement. After all, demand is high and they could both make a good living by holding their prices at £4.50.

Nevertheless the balance of power has shifted. As a monopoly he could set the price to suit himself: his customers had to either pay or go without. Moreover the success of both him and his rival inevitably attracts further fishermen into the market and soon there are too many for him to enter into cosy agreements. He will have to drop his price if he is to compete, as will every other fisherman in the market.

As prices drop, each fisherman finds himself making less and less profit. However no fisherman will be willing or even able to sell fish for less than it costs him to catch and sell, with enough left over to feed his family. Assuming every fisherman faces the same costs, prices will therefore naturally stabilise at a ‘market price’ of £2 a fish. Any fisherman reducing the price below £2 may well sell more fish in the short term but will quickly go out of business; any fisherman who raises his price above £2 a fish will quickly lose customers as they realise they can buy cheaper elsewhere.

This is a very efficient situation. The competition between the fishermen has forced the price to a point where demand from the townsfolk is exactly enough to empty the fishermen’s stalls by the end of each day. If the price was any higher, fishermen would be left with unsold fish at the end of the day which they would have to sell off cheap or let rot. Any lower and fishermen would stop selling fish because it is no longer a sustainable business. Demand would be greater but less fish would be available. The remaining fishermen would therefore raise their prices so their stock would last through the day, and the higher price would attract more fishermen back into the market. Eventually the market would stabilise back at the original market price.

Now imagine that fish become more plentiful, perhaps because of a change in environmental conditions. As a result the number of fish that the fishermen catch each day increases with very little extra cost or effort on their part. Pretty soon at least one of the fishermen realises that he can now undercut his competitors by selling fish at £1.50 a time without going out of business. Other fishermen will have no choice but to follow suit, and so the price of fish throughout the market will fall to £1.50.  For the consumer, this increases the attraction of fish when compared to other produce available, such as beef or lamb, and many who were not prepared to pay £2 for a fish decide they are happy to pay £1.50. The fall in price has effectively communicated the increase in supply to the consumer and brought about an increase in demand to match.

Conversely, imagine that a newspaper article appears extolling the health benefits to be had by eating fish. Demand increases as consumers who were only prepared to spend £1.50 on a fish are now prepared to spend £2. As a result the fishermen start running out of fish by early afternoon, rather than at the end of each day. As the fish run out it inevitably occurs to at least one of them that he can make his supply last longer by increasing the price of his fish. He increases it to £4, which gives him a tidy profit. However pretty soon other fishermen will follow suit, undercutting him in order to attract consumers. New fishermen start working the market, attracted by the greater profits to be made, while existing fishermen invest in bigger boats and larger stalls so they can catch and sell more fish each day. The resulting competition brings the market price down until it stabilises at a value that ensures the supply of each fisherman lasts throughout the day. This will be higher than the original price to reflect the increase in demand and the increased costs faced by the fishermen as a result of their expansion, perhaps settling at £2.50 a fish.

This is the ‘price mechanism’ in action, so called because of the central role that price plays in communicating the needs of consumers and the availability of the produce. Consumers use prices to make decisions about consumption. Suppliers use prices to make decisions about production. A price rise signals either that an item is becoming scarce or that it is becoming more desirable. Whatever the cause, higher prices mean greater profits which will attract new suppliers to the market and encourage existing suppliers to increase production. The resulting increase in supply either eliminates the short-fall or satisfies the increased demand.

Conversely, a fall in price indicates either that the item has become more commonly available or that it is going out of fashion. The reduction in price means a cut in profits which will drive some suppliers out of business and encourage others to direct their efforts elsewhere. The reduction in supply removes the surplus, so matching supply to consumer demand.

And of course the price mechanism is not just operating in the fish market: it is determining the price that the fishermen pay to rent their stalls, buy their boats, employ their staff and feed their families. An increase in demand for fish means that the fishermen will be demanding more boats. This will increase the price of boats, attracting more boat builders and so increasing the supply of boats to meet the extra demand. The boat builders in turn will be demanding more wood, nails and tools, and so on. Every supplier is also a consumer, and every consumer also a supplier. Even if the consumer has no business of his own, he will still be supplying his brawn and skills to his employer so that he can earn the money he needs to pay for his consumption.

The effects will be felt elsewhere, too. If more people choose to eat fish it is likely that they are reducing their consumption of alternatives, such as beef. The fall in demand for beef will force butchers to reduce prices rather than be left with a surplus. This in turn will encourage farmers to move out of beef cattle, so reducing demand for slaughter houses and for the grain used to feed the cattle. As the economist Henry Hazlitt put it:

“The private enterprise system, then, might be compared to thousands of machines, each regulated by its own quasi-automatic governor, yet with these machines and their governors all interconnected and influencing each other, so that they act in effect like one great machine.” (Hazlitt, 1946)

Price may be the medium of communication but it is the combined efforts of the participants that are driving the price mechanism. Furthermore, those efforts are not directed towards altruistic goals but rather towards maximising the benefit that each individual gets out of each transaction. The consumer is looking to maximise return by paying as little as possible for the items he requires. The supplier is looking to maximise return by making as much profit as possible from the goods he supplies. The result is a self-regulating system that matches supply to demand across the economy. It works because it is driven by the self-interest of each participant.

Indeed the price mechanism has been described as an ‘invisible hand’, a phrase most often attributed to the great 18th century philosopher Adam Smith and a favourite of proponents of the free market, although it is unlikely that Smith was the first to use it in this manner. As he put it in The Wealth of Nations, the book for which he is best known:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard for their own interest.” (Smith, 1776, pp. 26-27)

Many find the idea of a mechanism that is driven by self interest distasteful. Greed, after all, is one of the seven deadly sins. Early Christian and Islamic thinkers had problems with the concept of trade, recognising its role in distributing goods, and the right of individuals to be rewarded for their efforts, but warning against the pursuit of wealth for its own sake. However few would argue that we shouldn’t strive to better our condition, and the competition between suppliers does act as an effective curb against undue profiteering. Indeed in a truly competitive market the driving force is not greed but simply the will to survive.

The scenario that we have described is a theoretical model and makes many assumptions that are unlikely to hold true in the real world. In reality, for example, the first fisherman on the scene is likely to have chosen a prime position, right on the main thoroughfare. As a result he can get away with charging a higher price than those coming later who are forced to set up shop in quieter back-streets. However if the price differential is too large then he will find his customers drifting away in search of lower prices. Market forces still apply, and indeed the premium he eventually settles on is an effective measure of the value that shoppers put on the convenience of not having to go out of their way.

The operation of the price mechanism is often used as an argument to support the free market, but it is important to distinguish between the two. The phrase ‘free market’ describes a market that is not regulated by outside authorities: in other words, a market where prices are allowed to rise and fall freely, and where suppliers are free to determine their own levels of production and to enter or leave an industry as they see fit. The price mechanism, on the other hand, simply describes the way in which supply, demand and price are related.

Imagine that the government decides to impose a 50p tax on the sale of fish. This will have the effect of increasing the market price of fish from £2 to £2.50, which will cause a decrease in demand as some of the customers who would have bought fish decide that beef is now better value. The increase in demand for beef will cause its price to rise, prompting farmers to increase production. The price mechanism is still functioning but the tax has effectively ‘distorted’ the market so as to reduce the consumption of fish in favour of beef. This may of course have been the government’s intention, perhaps to preserve dwindling fish stocks.

Alternatively, the government may decide to limit the supply of fish by imposing a quota that only allows fishermen to catch a certain amount of fish each day. Assuming the quota is less than the quantity currently being caught, the price mechanism will operate to push up fish prices until demand falls to a level that matches the quota. Again this will prompt some customers to chose beef rather than fish. Neither of these scenarios can be described as free markets, but in both the price mechanism still functions.

All very well in theory, but what about in real life? Few would suggest that the global market for petroleum, for example, is a free market. It is dominated by the Organisation of the Petroleum Exporting Countries (OPEC) which was founded in 1960 by five of the largest oil suppliers, namely Iran, Iraq, Kuwait, Saudi Arabia and Venezuela (later joined by Qatar, Indonesia, Libya, United Arab Emirates, Algeria, Nigeria, Ecuador and Angola).

One of OPEC’s primary missions is to “achieve stable oil prices which are fair and reasonable for producers and consumers.” OPEC currently produces around 55 per cent of the crude oil traded internationally and, although it no longer directly sets the prices at which members sell their oil, member countries do agree to limit the quantities released so as to “avoid harmful and unnecessary price fluctuations.” The organisation controls some 78 per cent of our known reserves (OPEC). Outside of OPEC, the largest known reserves are in Canada, although most is held in oil sands in the form of bitumen which makes it much more expensive to extract and process. Next largest are in Russia, Kazakhstan, United States, China, Mexico and Brazil (Special Report: Oil Production, 2006).

The activities of OPEC, coupled with the political forces at work between these countries and the activities of speculators, mean that the price mechanism is seriously distorted: the price of crude oil does not directly reflect the available supply. Adjusting for inflation to 2006 prices, crude oil stayed below $20 a barrel from 1947 to 1973, at which point the price shot up as a result of the embargo imposed by Arab nations in response to western support of Israel during the Yom Kippur War, and then the war between Iran and Iraq in 1980, reaching a peak of nearly $70 a barrel. It then fell back to below $30 where it stayed until the early part of the 21st century. Since then the price has steadily risen and at the time of writing stands at nearly $90 (Williams, 2007).

We do not know for sure that the recent price rise is due to a diminishing supply as the OPEC countries are saying little about the state of their oil fields, but it is a plausible explanation. The response of the oil industry is what we would expect from our understanding of the price mechanism: work is increasing on the extraction of oil from sites that were previously not profitable, such as the oil sands in Alberta, Canada. To quote the Canadian Economic Observer:

“Alberta is in the midst of the strongest period of economic growth ever recorded by any province in Canada’s history… Most of this increase reflects the soaring price of oil and gas exports… Furthermore, the growth of oil sands output will trigger other investments, notably pipelines to carry the oil to market and upgraders and refineries to process the raw bitumen. And a host of other projects have been spun off, ranging from office buildings… to petrochemical plants using feedstock from refiners.” (Cross & Bowlby, 2006)

So as our oil supplies run out, the resulting increase in price is encouraging extraction and exploration in areas previously thought unprofitable. Not only that but it is increasing the attraction of alternative sources of energy that were previously thought too expensive, such as not only nuclear but also wind, tide and solar. Indeed a United Nations report suggests that global investment in sustainable energy through 2006 was up 43 per cent on the previous year (Global Trends in Sustainable Energy Investment 2007). There is also evidence of greater demand for fuel-efficient cars, particularly in the United States where lower fuel tax means that the increased price of crude oil has a greater effect on the price of petrol than in countries such as the United Kingdom where tax makes up a greater proportion of the overall cost (Austin, 2008). Campaigners have long fought to promote such changes and now it looks as though they have the price mechanism on their side.

The price mechanism can also be used as a tool to achieve a desired goal. For example, the Clean Air Act Amendments of 1990 was an attempt by the Environmental Protection Agency (EPA) to reduce the amount of sulphur dioxide, a major cause of acid rain, emitted by electric power stations in the United States. Each year the EPA sets a target level of sulphur dioxide emissions for the country as a whole. These determine the number of ‘emissions allowances’ issued each year, with each allowance representing the right to emit one ton of sulphur dioxide into the atmosphere. The EPA gives these allowances free of charge to the companies concerned according to a set of fairly complicated rules. In addition, all of the companies involved agree to install monitors so their emissions can be measured.  At the end of each year, each company must hold enough allowances to cover all its emissions, or face a heavy fine.

Companies can choose to use allowances in the year they were issued, or hold them for use in any future year. Alternatively, companies can buy and sell allowances on the open market – not only to other power companies but also to brokers and ordinary individuals. The EPA arranges an annual auction to encourage trading, the first one being held in 1993, but by 1995 the bulk of the trade in emissions allowances was happening privately. Initial allowance prices were projected to range between $250 and $700, but the market-clearing price at the first auction was $131. The lowest auction price achieved was $63 in 1996, by which time nearly five million allowances were changing hands privately. The market price stood at $172 in 2005 (Joskow, Schmalensee, & Bailey, 2006).

The scheme has proved successful with emissions falling from 17.3 million tons in 1980 to 11.2 million tons in 2000, a drop of 35 per cent. Emissions have continued to diminish and the programme is on target to achieve 8.95 million tons by 2010 (White & Rao, 2005). As a result such ‘cap and trade’ schemes are being adopted elsewhere. The most ambitious is the European Union Emission Trading Scheme, introduced in 2005. The Kyoto Protocol is an attempt at a world-wide scheme to reduce the emissions of six greenhouse gases.

Such markets are completely artificial. Reductions are achieved because the number of allowances issued is reduced each year, a result which could equally be achieved by simply imposing a steadily reducing cap on emission levels. What the market does is put a price on the cost of emission reduction, which is valuable information for both the legislators and the polluters. It also leaves the polluters to decide whether to purchase allowances or reduce emissions, giving them more control over their operations and so reducing their resistance to the scheme.

Liberty and anarchy →