Educating in Economics, History, and Philosophy and Organizing for Liberty
Why doesn't milk cost $20?
Got Milk? Did it cost $20? Why not?
derivative from Fields of View / CC BY
Oftentimes, the market and its capabilities for growth and development are taken for granted by many of us without even blinking. As we saw in "I, Pencil," markets are able to coordinate a seemingly-impossible task without any central institution forcing everyone toward the final goal. Unfortunately, even some pro-market people don't understand the workings of the market process and sometimes blindly proclaim the efficiency of a system they have never studied. A basic understanding of free markets and economics is fundamental to any discussion of libertarianism. We will here define "free markets" and examine the role of competition in a free market to answer the question "If businesses are greedy, why doesn't milk cost $20?"
Defining the market
To understand the free market, we need to begin our journey with the building block that underlies the entire economy: the individual. Individuals in a free society are self-owners – that is, an individual owns his or her body and has ultimate choice over his actions as long as he is acting peacefully and respecting the rights of other. He cannot be coerced to act against his will.
Individuals are also able to own various types of physical property – such as chairs, houses, food, and money. As with self-ownership, on a free market an individual has security in his property, meaning that it cannot be violated by others.
Individuals are purposeful economic actors who have a right to their body and property
jetheriot / CC BY
Individuals are always going about doing various things – whether it is working on a farm, shopping for clothes, attending a ball game, or reading about economics. In each of these actions is inherent one thing – people act in order to achieve certain goals, or ends. For example, if Jane is reading economics, she could be doing it because she has an economics test coming up and she wants to do well. Alternatively, she could simply find it enjoyable to read economics. In either case, she is trying to attain a certain end – whether it is doing well on a test or relaxing with a good book.
In order to achieve their ends, people use certain means. One of the means Jane uses to achieve her end is the economics book she is reading. Reading itself is also a means to her end. To take another example, if I work at a job manufacturing cars, then the job itself is not my end – I do not work for the sake of working. I work so that I can earn money which I will spend in the future to buy food, clothes, and entertainment. My job, then, is a means to an end.
It often happens that individuals do not at the present possess the specific combination of means that they need to achieve their ends . For example, I might have a sack of apples while I actually want a bottle of soda. If it so happens that you have a bottle of soda and you want a sack of apples instead, then we can benefit from trade. It is said that we have a mutual coincidence of wants – I would like your soda, and you would like my apples. Since we would both prefer the other's goods, exchanging them would benefit us both – I get what I want and you get what you want. In fact, every voluntary trade makes both parties better off. If it did not, then the trade would not have occurred.
Since in society different individuals have different preferences and different skills, individuals find it beneficial to specialize in the production of a certain good or the provision of a certain service. This is called the division of labor. The division of labor allows society to best make use of people's comparative advantage – an economic concept we will discuss in coming articles.
Oftentimes under the division of labor, individuals come together as a business to perform a certain job. As the system of specialization and trade grows more complex, finding someone who wants the specific commodity (or good) you have in exchange for the specific commodity they have becomes more difficult. That is, if I have chickens which lay eggs, it is difficult to go around exchanging eggs for other things like furniture, cell phones, or electricity. Who would possibly want to trade me a table for 300 eggs? That is why as economies grow to any size beyond that of a very primitive economy, direct exchange of goods falls out of favor, and indirect exchange takes over. Under indirect exchange, people do not trade their goods for things that they can use directly to satisfy their desires. Instead, they acquire goods which will indirectly help them achieve their ends. To the reader, it will be obvious that money is such a good. I do not earn money so that I can eat it and burn it in the winter. I earn money so that I can later trade it for goods that I want. Money is of great importance in markets, and we will discuss its properties in later articles.
The economy is made up of all the voluntary individual interactions
marcp_dmoz / People Photos / CC BY-NC-SA
We have so far gone over all the elements that make up markets. We can now put them together to understand the economy. The economy refers to the aggregation of all individual actors who produce and trade with each other. In other words, it is the entire system of people voluntarily exchanging goods and services.
It must be stressed once again that although we often talk of "the economy" and "the market," there is no one thing that is this economy. The economy is merely the collection of all individuals and their respective property. The very fact that we have named this intricate web of interactions is a testament to the power of spontaneous order. No one mastermind discovered the wants and skills of all the workers and drew up plans for the creation of this machine called the economy. Instead, economic actors – whether they are individual people or groups of people as businesses – undertook the lines of production that were most productive and marketable to create this important structure we call the market.
We have finally and carefully completed the description of the free market. Now, we can begin studying how it works by examining the interactions of its composing groups. Specifically, we will focus on competition within the market.
Competition is one of the most essential aspects of the market. It is what keeps prices down and businesses innovating. Let's examine the role of competition by taking a hypothetical market for milk.
The market for milk is composed of all of the buyers and sellers of milk. One common assumption that is made both by economists and the public at large is that businesses are profit-maximizing. That is, they will try to produce goods and price them at the level which maximizes their profits . This assumption is imperfect, as it does not hold all the time. Still, it is a good enough assumption for our purposes – and it certainly provides a "worst case scenario" (so to speak). Since we know that businesses are, if we may, "greedy," then why doesn't milk cost $20? Why don't companies jack up prices so that they could make more money? The answer: competition on the market.
cszar / Foter.com / CC BY-NC-ND
Imagine a milk producer called Milk-Corp. It's a company led by a very greedy CEO. He would like to make as much money as possible. If he could make all the money ever, he would. Say that it costs Milk-Corp $3 to produce their milk. However, the CEO would like to charge customers $20 for the milk. The more the better, right? In accordance with his greed, the CEO makes the price of his milk a ridiculous $20.
What happens on the market? Customers are outraged. A lot of people can't afford the high price of Milk-Corp's milk. The few people who love milk very much or absolutely need it for some purpose still shell out the $20, but they are very displeased with the price. Milk-Corp makes a profit of $17 per gallon of milk they sell, and the CEO twirls his moustache. Money everywhere!
But is this the end of the story? Far from it. Sometimes people incorrectly end the analysis here without taking into account the exciting sequel to this first novel in the history of Milk-Corp. The explanation that follows is the reason why the introduction to this article was so long – economists take into account the decision making of separate economic actors under the incentive structures they face. This is fancy talk for the simpler statement that it is not correct to talk of "business" doing X or Y. We must talk about specific businesses doing X and Y. Why would that be? Let's find out.
While Milk-Corp is rolling around in money and milk, other companies take notice of the profits Milk-Corp is making. These companies are also profit-maximizing. That is, they would like to make as much profit as possible. They see Milk-Corp raking in $17 per gallon and they decide that they want a piece of it. One of Milk-Corp's competitors gets smart and tricky – she decides to make the price of her milk $18. This is below Milk-Corp's price of $20, but still above the $3 cost of producing the milk . This means she is making $15 on each gallon of milk – less than Milk-Corp was making before, but still more than she was when she was not getting any of Milk-Corp's customers!
Now, $15 of profit on a gallon of milk is still an extremely high amount of money! A lot more profit can be captured by the competition! In fact, a smart competitor, since he is profit maximizing, decides to enter the market and offers $15 milk. Why did he do this? Again, because he is profit maximizing. He can draw away from the profit of his competitors by lowering the price of the milk while still covering his costs. This gives him a profit of $12 that he did not have before.
Let's return to Milk-Corp for a second. They're having an extremely tough time selling their milk at $20. The competing profit-maximizing businesses drew their customers away. The Milk-Corp CEO is still the greediest old man anyone has ever seen, but being greedy was not enough to guarantee him the riches he wanted. To stay in the market and make as much profit as he can, he now brings the price of milk down to $12.
The process continues and new firms enter the market to capture profits and get some of the precious moolah. You can see the pattern – the price keeps getting cut more and more and it approaches the cost of production: $3. Why does this happen? Because businesses cut prices to draw customers away from their competitors while still making a profit. This process of competition is present not only in the market for milk, but in the entire free market as a whole for various goods and services.
As competition works its magic, the power of firms to extract high profits fades away
Other drivers of competition
We have seen that competition is fueled when competitors drive prices down. There are also other sources of competition between businesses.
For one, the very knowledge that potential competitors can enter the market is able to keep prices down. The competitors do not, in fact, have to be present. Furthermore, businesses know that there are often substitutes for their products which they do not produce and hence which they cannot control. For example, instead of drinking milk, people may choose to drink orange juice or coffee. If they are feeling especially adventurous, they might even opt for a bagel or toast for breakfast. Milk producers also have to keep in mind the competition from businesses outside their specific market.
Another factor which fuels competition and keeps prices down for the consumer is the possibility of innovation. Not only can firms lower prices to draw customers away, but they can also improve their products or even invent new ones. This can readily be seen in the present day with electronic devices and websites, for example. Going back to milk, a competitor might decide to add Vitamin D to her milk to entice customers. Others might improve package design for better storage or appearance. Milk-Corp needs to remember that not only can firms decrease the price they ask for milk, but they can offer a better product at the same price. If Milk-Corp is to keep its customers, it needs to either improve its milk or lower its price. This is the result of competition.
When do these results hold?
The process of competition that was described (and it really is a process – a web of interactions) happens spontaneously on a free market thanks to the incentives of the various parties involved. Once again, a free market is one where individuals are able to own and exchange property unhindered.
Problems begin to occur when there is a force outside the free market which starts erecting barriers to entry around it. That is, the forces of free competition are blocked and firms are denied the capability to enter the market.
Government often places such barriers to entry, which hit the brakes on competition and lead to a centralization of power in the market in the hands of fewer and fewer businesses – like Milk-Corp. These barriers to entry can (and often are) varied and difficult to spot.
One example could be the subsidization by government of a favored, connected business. Government favoritism distorts markets and gives artificial advantages to certain firms, which allows them to increase their market share through non-market means. When profit is gained through non-market means, a miscoordination of resources begins to occur in the market. Businesses no longer earn a profit because they are serving customers who willingly give up money. A few select businesses start growing larger thanks to milking the political process. Such businesses should rightly be condemned for their actions.
"Competitors stay out"
HurwiczRocks / Foter.com / CC BY-SA
Another example of barriers to entry be high tax rates. In our analysis we made the simplifying assumption that firms have more or less the same costs of production. In the real world, costs vary, and smaller businesses (and especially completely new businesses) sometimes face higher costs and uncertainty than established businesses. So while a milk farm may be able to stay in business on the market when it earns some small amount of profit on its product, a high tax rate could make it impossible for the farm to stay in business. In economics, we say that this forces the marginal business to drop out of the market. Tax rates can also discourage entrepreneurs from starting a business at all. Remember – entrepreneurship includes various sources of uncertainty. A hindrance on the ability to react to changing market conditions severely hampers the ability of smaller businesses to compete. When firms are not free to enter the market, competition grinds to a halt. The incentives for current businesses to bring prices down slowly start disappearing, and the moustache twirling can resume again.
Another source of barriers to entry can be any of a wide range of regulations imposed on businesses. Regulation places a large fixed cost on businesses. For example, if the government were to mandate that businesses start using some specific process of production, this would make entering the market more difficult. Some firms which are able to enter the market when it is free could find themselves blocked off after the addition of the regulations due to higher costs. The pressure on existing firms to lower prices, then, is decreased, and they are able to charge higher prices and slack off on innovating. Remember that the costs of regulation are not simply the costs of purchasing the additional equipment required. They also involve navigating the complex web of regulations imposed by the federal, state, and local governments on businesses . Remember, too, as was mentioned in our article "Pro-business or Pro-market?" , that it can sometimes be in the interest of specific businesses to have the government impose regulations on the market. Large businesses, especially, know that they can take a hit from compliance with regulations, but stand to gain a lot by having their competition decimated by government. All of this, of course, is nicely wrapped in the political language of "public safety."
Explaining all the ways in which government distorts markets to centralize power (whether accidentally or not) would likely require several books. Therefore, we will cover only one more such method in this article. Government sometimes grants exclusive powers to certain companies to provide a specific product or service. This cartelization freezes competition in its tracks, because very few competitors are left in the market – and sometimes none at all. The remaining firms can then jack up prices and stop innovating.
Keep these possible ways of erecting barriers to entry in mind as you read about various occurrences in the world. When analyzing a situation, ask yourself whether a firm got to where it is through market-means or through government-granted privilege (whether direct or indirect). The barriers described above are restrictive enough on their own; yet when combined, not only do they team up to bring down competition, but they also become relatively difficult to spot and disentangle.
A free market exists when individuals are secure in their right to produce, own, and exchange property voluntarily. On the market, prices are kept down and innovation is incentivized through the process of competition – both with companies making the same good as your own company and with companies making substitute goods. This process makes the price of various goods tend to move toward the cost of production. This process can be hindered when outside forces violate property rights in order to impose various requirements on businesses. This leads to a decrease in competitive pressure and to stagnation in the market. In future articles we will explore the vital coordinating role prices play in the economy, as well as the importance of trade to individual well-being.
In this article we discussed a free market in the production and sale of milk. It is a fun fact that in the United States, the government actually imposes on milk what is known as a price floor – the government mandates that businesses sell milk above a certain price. That is, government keeps the price of milk artificially high, above the market rate.