Supply and Demand: A Process of Coordination PDF

# Supply and Demand: A Process of Coordination ## Learning Objectives * Describe the market as a process that coordinates the plans of millions of people involved in the production of a single good. * Analyze markets using the supply and demand model. * Distinguish between shortages and surpluses...

# Supply and Demand: A Process of Coordination ## Learning Objectives * Describe the market as a process that coordinates the plans of millions of people involved in the production of a single good. * Analyze markets using the supply and demand model. * Distinguish between shortages and surpluses, and explain the way free-market prices adjust to generate market-clearing outcomes. * Describe how free-market prices transmit scarce information. * Explain how money reduces transaction costs. * Analyze the role that interest rates play in coordinating economic activity. ## Specialization Specialization is what distinguishes every wealthy society the world has ever known. As Adam Smith observed when reflecting on the economic growth that had occurred in Britain during the eighteenth century: > It is the great multiplication of the productions of all the different arts, in consequence of the division of labor, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people. A society becomes wealthy when its members acquire the ability to specialize effectively, to "divide" their labor, as Smith put it. ## How Does the Division of Labor—Specialization—Arise? Chapter 1 posed that as a central question of economics. In Chapter 2 we began answering that question when we explored the incentives to specialize and exchange and the increase in opportunities or wealth that specialization generates. We called that the "law of comparative advantage." But how exactly do the people in a wealthy, highly specialized commercial society encourage one another to take those interconnected actions that wind up producing the incredible array of goods and services that they enjoy? The basic problem is massive ignorance. Specialists, by their very nature, don't know how to do everything. (Can you name one person, specialist or otherwise, who does know how to do everything, or at least can productively order everybody to produce goods and services efficiently?) The fact is, people do have some skills and abilities and they remain genuinely ignorant of countless other skills and abilities. Consider this incredible example, one thoroughly rooted in the real world: Probably no single person anywhere in the world knows how to produce something as simple as an ordinary no. 2 pencil. That sounds crazy at first, but go outside the box and think about it. Lots of specialists know how to assemble a pencil once the wood, graphite, rubber, paint, glue, tin ferrule, appropriate tools, and machinery are all in the pencil factory. But specialists in pencil assembly don't know how to produce those essential inputs. That's not their own comparative advantage. Consider the wood itself. It took loggers to fell the trees. And the loggers depend on specialized, high-tech equipment, as well as coffee, meals, clothing, health care, and countless other goods and services to do their job adequately. The logging equipment is made, in part, from steel. So steelworkers had a hand in the making of pencils, too, whether they know it or not. The steel is made from iron ore—which was probably mined in Michigan's Upper Peninsula, and sent first by rail on the Lake Superior & Ishpeming Railroad and the CN Railroad, and then by hundreds of ships down Lakes Superior and Michigan to ports all around the Great Lakes. Who made the trains, the tracks, the ships, the varieties of food that fed the crews (let alone the clothing, toiletries, and so on)? Who contributed to producing the fuel, the ports, or the sophisticated communications systems that guided the ships? The answer is countless other specialists, people pursuing their comparative advantage, acting on their limited knowledge and skills, and cooperating with still other specialized input providers. Imagine the number of different people, from different races, colors, and creeds, with different opinions, skills, and goals, within the country and abroad, whose goods and services contributed to the production of a simple no. 2 pencil. All those people cannot possibly know one another, they may not even speak the same language, yet no. 2 pencils get produced. And we consumers generally know where to find them, cheap. ## The Miracle of the Market The miracle of the market, as some have quite properly described it, is that millions of people who don't even know of one another's existence, manage to cooperate and produce not only no. 2 pencils, but also innumerable other goods of much greater complexity, and to do so in ways that make them readily and abundantly available. And people are encouraged to cooperate not by obeying the orders of some comprehensive, national economic plan issued in part, say, from a government Writing Implement Bureau. The government's role is much more limited. Recall what Adam Smith said, “in a well-governed society." The government plays an important role in all of this, especially in monitoring and enforcing private property rights and contracts—the overall rules of the game—that allow for these countless exchanges to take place. People often tend to take this orderly, nonchaotic network of exchanges for granted (“What do you mean you're out of pencils?"). Surely a market system is much more complex than the smooth flow of traffic (also taken for granted) that we discussed in Chapter 1. While the orderly nature of markets might appear miraculous, it is not, however, mysterious. What are the key signals, the traffic lights, if you will, that help people in a commercial society coordinate their varied production and consumption plans? The answer is prices. Millions of people receive important information and signals, as well as incentives to act on those signals, from prices formed in the market. Market prices emerge through the interplay of supply and demand, which we introduced separately in Chapters 3 and 4. In this chapter we put supply and demand together and describe the principles of the market process itself. ## The Market Is a Process of Plan Coordination Many people often think of “the market” as a place or forum, such as a baseball card and collectible show at Gateway Center in St. Louis, or a cattle auction at the fairgrounds in Kansas City, or the New York Stock Exchange in the Wall Street district. But all of these are really elements of markets that stretch across regions, around the globe, and even into cyberspace. Formal markets might have emerged with town fairs during the Middle Ages, but it makes little economic sense to view markets as mere places or forums today. Journalists and those in the financial community use many mixed metaphors to describe markets, often making it sound as if a market is a person. How many times have we heard some expert on the evening news or the financial channels say that Wall Street was "excited” or “nervous” about the latest economic data, or that the stock market “hopes” or “expects” that Ben Bernanke at the Federal Reserve will engage in yet another round of quantitative easing? Perhaps someday when the conditions are right, one of those experts will report that “the stock market has awakened bloated, with terrible cramps and a bad headache, and has called in sick today.” Although that kind of statement might make the news more interesting, the economic way of thinking recognizes that individuals have hopes, expectations, cramps, and headaches; markets don't. ## Misleading Metaphors Even economists themselves use misleading metaphors. They often refer to market systems as “automatic” or “self-adjusting,” giving the impression that markets function without the intervention of human beings! Many economists make it sound as if the market is some kind of mechanical thing, like a thermostat. That's wrong. Market systems are entirely composed of demanders and suppliers, who are real human beings pursuing the projects that interest them, economizing on the basis of the relative scarcities that they confront, and negotiating arrangements to secure what they want from others by offering others what they in turn want to obtain. It is best to avoid these common but misleading interpretations of markets. The market is not a person, place, or thing. The market is a process of plan coordination among sellers and buyers. When economists use the terms supply and demand, they are really talking about these kinds of continual, ongoing negotiations among individuals. ## The Basic Process We're now ready to consider, with the help of a graph, the supply and demand process. Let's consider the market for relatively inexpensive acoustic guitars, the kinds bought by beginning and intermediate pickers throughout the country. Figure 5–1 depicts the market. Notice the downward-sloping market demand curve. That reflects an essential point from Chapter 3—the law of demand. People would plan to purchase more guitars as the relative price falls, and plan to purchase fewer guitars as the relative price increases. The quantity demanded increases or decreases, not the overall demand curve, when only the price of guitars changes. Next, notice the upward-sloping supply curve. Recall from Chapter 4 that supply curves generally slope upward, which reflects the increasing marginal opportunity costs of producing more guitars. Making more acoustic guitars requires many specialized resources, from specific grades of spruce and mahogany to the highly skilled labor of the workers. For guitar producers to obtain spruce and mahogany, they must bid those resources away from other productive uses, such as Christmas trees, fine cabinets, incense holders, and the many other goods that people desire that can also be made from those materials. Higher prices for the guitars will induce producers to make more guitars. Notice where the supply and demand curves intersect. There, the market price is $500 per guitar and the market output is 1,000 guitars. At the $500 price, note that the quantity demanded is 1,000 guitars, which is exactly equal to the quantity supplied. In this event, the plans of guitar buyers are fully coordinated with the plans of guitar producers. In a free market, of course, producers can charge any price they wish, and consumers can offer any price they wish. So let's suppose that the market price were substantially higher than $500. Say it's $700. If guitar producers plan to receive $700 per guitar, how would they respond? The upward-sloping supply curve helps illustrate the answer. At $700, the quantity supplied would increase well beyond 1,000 guitars, to 1,200. (Supply doesn't increase—only the quantity supplied!) But never forget that the market is made up of two sides, sellers and buyers. While sellers would increase output at the higher price, how would potential buyers respond? The demand curve helps illustrate that answer: At the $700 price, people would reduce their planned purchases of guitars. Quantity demanded (not overall demand!) would decrease to only 800 guitars. Who would be able to fulfill their plans, and whose plans would become frustrated? Consumers, as a whole, would be able to purchase all the guitars they wish at $700 apiece (the quantity demanded is 800), but producers would find that they have over-produced. They made and planned to sell 1,200 guitars (the quantity supplied). That's a difference of 400 guitars, guitars that are undesirably piling up in the manufacturers' inventories. Here, the market is not fully coordinated. A surplus of guitars has emerged. A surplus occurs when the quantity supplied is greater than the quantity demanded. In our example, there is a surplus of 400 guitars. Sellers often become aware of a surplus—aware of their own errors by the unplanned piling up of their inventories. They simply aren't selling as much as they had counted on. How can producers unload their unplanned inventories of guitars? Perhaps they can point guns to the heads of terrified people and force them to purchase the remaining guitars for $700 apiece. But that goes against the rules of the free market. Perhaps one manufacturer can sell more guitars by burning down another competitor's guitar-making facilities. But that, too, breaks the rules of the game. Perhaps they can seek legislation requiring children to learn how to play guitars, which might improve demand and sales. That is an effort of manipulating and changing the rules of the game in their favor, but that takes quite a lot of time and political maneuvering and is a costly activity. What they can do, and what generally happens in free markets, is that producers will cut their own prices. Indeed, we would predict that the market price of guitars would fall from $700 to $500. As the price falls, potential buyers would be more receptive: The quantity demanded (not the overall demand!) would increase from 800 to 1,000 guitars. At the same time, quantity supplied (not the overall supply!) would decrease from 1,200 to 1,000. Then the surplus would disappear: The plans of both buyers and sellers would fully mesh; the market would become fully coordinated at the $500 price. Sellers would have no further incentive to compete against other sellers by lowering their prices. Finally, consider the opposite case. Suppose the current market price were well below $500. At a price of $300 per guitar, people would eagerly plan to purchase a total of 1,200 guitars (the quantity demanded), but producers would produce and plan to sell only 800 guitars (the quantity supplied). While the plans of the producers would be achieved, many customers would be frustrated as they try to purchase a guitar, but find them sold out. Here we have a shortage, which is the opposite of a surplus. A shortage occurs when the quantity demanded is greater than the quantity supplied. Customers might sense a shortage by facing unusually long lines or finding items out of stock. Sellers might have to unexpectedly dip into their planned inventories, discovering that they are selling more than they originally expected. ## The Role of Competition What can a frustrated buyer do? Breaking into the shop and stealing is a violation of the law. So is putting sand in the gas tank of another customer who might race out before you to purchase the last remaining guitar in stock. People are, however, free to offer a higher price for a guitar. If consumers begin bidding up the price of guitars, how will sellers respond? By producing more guitars. As the market price rises from $300 to $500, notice that the quantity supplied will increase, from 800 to 1,000 guitars. At the same time, the increased price will reduce quantity demanded from 1,200 to 1,000 guitars. Whether people actually begin to bid the price up, or sellers find that they can substitute for the consumer bidding process by raising their own prices and selling more guitars, there are tendencies for the market price to rise and the overall shortage to disappear. ## Competition, Cooperation, and Market Clearing People often argue that buyers compete with sellers in the market economy. Is this true? Back in Chapter 2 Brown and Jones cooperated with each other by exchanging stouts and lagers. Does the exchange for money alter that cooperative relationship between two trading parties? No. If you voluntarily purchase a guitar for $20, $200, $500, or whatever, you and the seller have found a way to cooperate with each other—that's the essence of mutually beneficial exchange, whether the exchange takes place through money or barter. Money facilitates the ability to induce these acts of cooperation. Competition does, of course, occur, and like cooperation, competition is rampant throughout the market process. Rather than competition between buyer and seller, however, buyers tend to compete with other buyers, and sellers tend to compete with other sellers. Consider the case of a shortage. Frustrated guitar shoppers compete with one another by offering higher money prices or by demonstrating their own willingness to pay the higher posted price. The bidding process eliminates the shortage. The sellers of guitars would like, of course, the highest prices they can receive, and will eagerly try to accommodate buyers who are offering more money. In the opposite case of a surplus, sellers compete among themselves by trying to attract customers and move excess inventories. It is not a rivalry between buyer and seller; it's a rivalry between guitar sellers. The rivalry works itself out not through violence and mayhem—as long as the rules of the game are respected and enforced!—but by price reductions. “Every other shop is charging $700 for this guitar. Because I see you love this guitar, I'll give you a break. $595. And I'll even throw in free strings." The seller is finding a way to compete against other sellers and cooperate with you. The competitor who was only offering free strings with her $700 guitar will soon find that's not enough. She will soon lower her price as well. (When you shop for a car, is the seller intent on competing with you or the dealer down the street? You want a low price, but do you fear the seller, or do you fear that your offer may be too low, and the car may be sold to a buyer who offered $750 more than you did?) Therefore, the price tends to rise during times of shortages and fall during times of surpluses. The competitive bidding process runs its course once the shortage or surplus is alleviated. In our example, that ends at the $500 price. Individual buyers will have no incentive to increase their bids without the shortage. Individual sellers will have no incentive to lower their price without the surplus. Economists typically refer to that price as an equilibrium price, as the "forces" of supply and demand have worked themselves out, and there is no further tendency for the price to change. But again, that sounds a bit too mechanical, as if the market were a thing. The authors instead prefer the term market-clearing price. To say that the market is clear is to say there is neither a shortage nor a surplus, The plans of buyers have become fully coordinated with the plans of sellers. ## Market Clearing The economic way of thinking emerged in part to explain the phenomenon of market clearing. It's not only the market for guitars that tends to clear. Free markets for any good or service show a tendency to clear. The "laws" or principles of supply and demand help us explain why and how markets generally tend to clear, how people with limited information nevertheless find ways to accomplish many of their plans. One final but crucial point. A commercial society doesn't require expert economists to clear markets. It instead requires that there are effective rules of the game that allow people to buy, sell, and trade their property—to coordinate their own plans-as they best see fit. Economists are useful in explaining how market processes coordinate people's plans and generate wealth and economic growth, something that a lot of people still don't understand. People often fail to see that market clearing is an unintended consequence of the specific choices that individuals make. Guitar buyers couldn't care less about the overall state of the market. They want guitars at an acceptable price. They can't possibly know everything there is to know about the state of the guitar industry. Same for guitar sellers. They pursue their own goals, too, geared toward making a living and a profit. The tendency for market clearing is not planned and engineered by economists, government agencies, nor even producers or consumers. Markets tend to clear as an unintended consequence of people competitively bidding and cooperatively exchanging, following their own projects, plans, and goals, with inescapably limited information and knowledge. ## Changing Market Conditions And now for a little further practice. Our discussion centered around the tendency for the market to clear with given supply and demand curves. But, as you learned in Chapters 3 and 4, demand and supply curves themselves can shift. Let's practice a couple of those shifts. Suppose, for example, the price of spruce fell, with other prices (for skilled labor, mahogany, and other materials) unchanged. Your first challenge is to decide whether this would affect the supply or the demand curve. Lower spruce prices would tend to reduce the marginal opportunity costs of making guitars. More guitars would be produced as a result. And, recall that the supply curve is derived from the "height" of those marginal costs. Lower marginal costs mean a rightward shift of the supply curve. As more guitars come on the market, and the overall supply increases, the price would fall from \$500 to \$400. (What would happen if supply increased, but the price stayed at \$500? A surplus would emerge. Sellers would compete by lowering their prices until the surplus is eliminated.) A new market-clearing price would emerge, at \$400 per guitar. (Notice that the demand curve for guitars has not changed. The quantity demanded increased as the price fell from \$500 to \$400.) Consider a different example. What if the price of electric guitars were to increase? How would this initially affect the market for acoustics? Electric and acoustic guitars are generally considered good substitutes. People who planned to buy electric guitars would revise their plans in light of the higher price. Some would switch to acoustic guitars instead, while a couple of others would consider trombones, accordions, or other things to purchase with their money. Nevertheless, this raises the overall demand for acoustic guitars. We could depict that with a rightward shift of the demand curve in the market for acoustic guitars. A new market-clearing price would emerge, at \$600 per acoustic guitar ## Learning from Free-Market Prices No one blames the thermometer for low temperatures, or seriously proposes to warm up the house on a cold day by holding a candle under the furnace thermostat. That's because they have a more-or-less correct understanding of how those things work. People do, however, often blame high prices for the scarcity of certain goods, and act as if scarcity could be eliminated by enforcing price controls. We will discuss price controls in the next chapter. For now, let it be understood that scarcity is a relationship between desirability and availability, or between demand and supply. A good is scarce whenever people cannot obtain as much of it as they would like without being required to sacrifice something else of value. Market prices inform us of relative scarcities. But don't confuse scarcity with rarity. Something is rare if it is available in a relatively small quantity. Eight-track cassette tapes, therefore, are rarer than compact discs. Desirability is not a component of rarity. Who really wants eight tracks anymore? The demand just isn't there. Old eight tracks sell for a buck or two at urban flea markets. The same music on compact discs fetches much higher prices. People are willing to sacrifice more cash for the disc. It is therefore more scarce than an eight track. (If you still can't see it, consider this. Suppose one of the authors—Prychitko—autographs a baseball. It will be much rarer than an Alex Rodriguez ball, because there would be only one in existence, whereas A-Rod has signed hundreds, if not more. But nobody wants to pay as much for a Prychitko as for Rodriguez. In fact, Prychitko's signature probably reduces the value of the ball close to zero. It is therefore nowhere near as scarce as a Rodriquez.) Now it follows immediately, as Chapter 3 insisted, that if a good is scarce, some selection process, criteria of some kind, must be established for discriminating among claimants to determine who will get how much. The criterion could be age, eloquence, swiftness, public esteem, willingness to pay money, or almost anything else. In commercial society it's most commonly on the basis of willingness to pay money. But sometimes we use other criteria. For example, Harvard University each year has many more applicants than it can place in the freshman class, so Harvard discriminates on the basis of high school grades, test scores, recommendations, relationship to important alumni, and other criteria. Joe College is the most popular man on campus, and has young women clamoring for his favor. He must therefore direct his attentions. Whether he employs the criterion of beauty, intelligence, geniality, or something else, he must and will discriminate in some fashion. Once Harvard announces its criteria for discrimination, freshman applicants will compete to meet them. If the women eager to date Joe College believe that beauty is his main criterion, they will compete with one another to seem more beautiful. Competition is obviously not confined to capitalist societies, or to societies that use money. Competition results from scarcity, and can be eliminated only with the elimination of scarcity—it occurs when people strive to meet the criteria that are being used to determine who gets what. The criteria that are used make a difference, sometimes a huge and important difference. If a society coordinates economic plans on the basis of willingness to pay money, members of that society will strive to make money. If it uses physical strength as a primary criterion, members of the society will do bodybuilding exercises. If it coordinates on the basis of people's ability to play brass instruments, members will try to learn how to play bugles. If the better colleges and universities use high school grades as an important criterion for selection, high school students will compete for grades. They might be competing for grades to acquire other goods as well (status among classmates, compliments from teachers, use of the family car, or the old man's credit card), but the discriminatory criteria used by these schools will certainly encourage students to compete for higher grades. ## Central Planning and the Knowledge Problem The economic task for a society is to secure coordination among people in using what is available to obtain what is wanted. Effective plan coordination among large numbers of people who barely know each other requires that the terms of exchange be clear, simple, and standardized, so that transaction costs can be kept down. We live in a world of people with highly diverse skills, interests, values, and preferences; where resources have many different potential uses, and opportunity costs vary infinitely; where continual change and constant discovery are the features of everyday life. Imagine an alternative economic system of socialist central planning, in which all the means of production—resources, machinery, factories, and so on—are not owned privately, but by society as a whole, with decisions about the best uses of these scarce goods deposited in the hands of a group of expert economists, sociologists, chemists, and so on, who would form a central planning board and decide what to produce, how to produce, and for whom to produce. The entire socialist economy would be run like a huge state post office. Markets would be abolished. So, too, would the use of money. What information and signals would central planners use to effectively and efficiently produce and distribute the massive array of goods and services desired by millions of citizens? After all, the engineers on the planning committee could announce that it is physically possible to make buses out of gold, to make train tracks out of platinum, and to make wedding rings out of tin. In a free-market system, bus producers, railroad builders, and jewelers are both politically and economically free to make these goods in this way. So why don't they commonly do that in a market economy? Because it would be ridiculously unprofitable to do so. The market prices of those resources, compared to the prices people are willing to pay for the final goods, help inform producers that these will likely generate losses in advance of actually undertaking the activity. That's what monetary calculation is all about. Those same prices emerge by millions of people's daily acts of voluntary exchange and negotiation in the market process. But socialist central planning abolishes that process. What signals and information will be readily available to the planners? They might enjoy reams of engineering principles and equations, huge warehouses stockpiled with material resources, an eager and fit-for-work population, and sophisticated computer systems tracking all the data, but will the data be economically useful? The data show that tin wedding rings are remarkably rare. Should more be produced? Or less? At what cost? Just how scarce are tin wedding rings? Platinum provides less friction than steel, but does that inform planners that platinum is best used to make railroad tracks? What are all the alternative uses of platinum and the associated costs of using platinum for medical equipment, railroad tracks, or whatever? Indeed, what are the associated costs of producing a railroad track when those materials and workers could be devoted to producing hospitals, toasters, pencils, and countless other scarce goods and services? Without money and market pricing, planners cannot effectively engage in economic calculation. The demise of central planning in China, and in the former USSR and its client states illustrated what economic theory has long suggested: Central economic planners, even if they are brilliant and loving people, don't even begin to know enough to manage effectively the day-to-day business of a commercial society. The issue is not getting better people to plan our way to economic growth; it's getting more effective institutions and rules of the game that encourage people to discover their own comparative advantage, and make the most effective use of their limited knowledge, information, and resources. Lack of market pricing also creates significant transaction costs and failures of cooperation among suppliers and demanders. As the system of central economic planning in the USSR disintegrated, news reports regularly told about unharvested food rotting in rural areas, while grocery store shelves stood empty in the cities. How could a thing like this occur? Why didn't someone transport that food to the cities where it was so much in demand? Collapse of the system of bureaucratic control does not provide an adequate explanation. People should be able to move food out of the fields and into the hands of hungry people without explicit orders from above. Or so one would suppose. But think more carefully and concretely. Who owned the food that was going to waste? Who had authority to harvest it? Who owned harvesting equipment? Who could authorize the use of the equipment? Who owned trucks to transport the food to the cities? Who had fuel for the trucks? How was the food to be distributed once it arrived in the cities? The mere fact that food is going to waste in the fields while people are hungry in the cities is not enough to get food actually moving from farms to urban pantries. The right people must first acquire the appropriate information and incentives. Transaction costs explain that “wasteful” situation. The word wasteful is set within quotation marks because it's not at all clear that what happened really was wasteful. It's not wasteful to let food rot rather than consume it if the costs of getting the food to consumers exceed the value of the food. And that was apparently the case. Transaction costs are just as real, and no less important than the costs of harvesting and transporting. ## Property Rights and Institutions Such a situation would be much less likely to develop in the United States, where fields, food, farm machinery, trucks, warehouses, and retail stores are privately owned. The rules of the game are different. Under a system of clearly defined property rights, people with information about the situation would have strong incentives to acquire control of whatever resources were needed to move the food from where it had no use to where it did. And within a system that allows for free exchange among property owners, the necessary resources will quickly and at low cost come together under the control of those who can put them to valuable uses. Contrast the frustrating situation in the former USSR with the way that people, tractors, construction equipment, and everything else needed for emergency relief and reconstruction moves into hurricane-torn regions in the U.S. The crucial difference is the well-established system of clearly defined property rights in the United States, along with the extensive freedom that people have to trade those rights as they choose. This has produced over the years a vast network of institutions—profit and not-for-profit—in the United States that keeps transaction costs low for almost all the exchanges in which people engage with any frequency or regularity. (The thoughtful reader will shrewdly note that people frequently and regularly engage in particular transactions only because the transaction costs are low.) Think again about how easy it usually is to obtain the precise pizza on which your hungry heart is set. The many transactions that make your pizza possible—that constructed the pizzeria, grew the peppers, shipped the olives, milked the cows, and arranged the requisite lines of credit for all these activities-all had to be negotiated. These negotiations succeeded because the transaction costs were sufficiently low. And the transaction costs were low because the transactions occurred within an extensive set of institutions that evolved over time as market participants worked to lower the costs of the transactions in which they wanted to engage. Think of specialized manufacturers, specialized Internet retailers, specialized providers of every kind of service; the principles of financial accounting, the rules of the road, the customs of the trade in varied lines of business; banks, credit reporting agencies, highly organized stock exchanges; the classified sections of daily newspapers, the telephone companies' Yellow Pages, lists of brokers and suppliers that can be obtained on a moment's notice; the rules of the common law, police to enforce these rules, and courts to resolve disputed issues, plus private systems of arbitration to supplement the system of public law. In those nations where central planning has failed, market systems have been evolving. Achievement of those market systems faces the enormous obstacle of high transaction costs at almost every turn, precisely because many of the institutions that are crucial are still lacking. Can individual transactors (ordinary people) in these nations now create by design what evolved without design in long-established market economies? Can they create quickly the complex institutions that have elsewhere come into existence through a slow, evolutionary process? Can they overcome the problem of high transaction costs rapidly enough to satisfy the aspirations of their citizens, who are impatient to enjoy the promised rewards of a market system? The success of the reform programs in many of the nations of the former Soviet bloc depends largely on the answers to these questions. ## An Appendix: The Coordinating Roles of Money and Interest ### Money: The General Medium of Exchange Why do almost all the exchanges in a market system take place for money? Why don't more people engage in barter, trading what they produce directly for what they want? Why do business owners sell goods and services for money, and workers accept payment in money, even though money is of little use in itself. The answer is that money lowers transaction costs. Money is a general medium of exchange. It pervades all markets, licit and illicit. The advantages of using money rather than relying solely on a barter system are enormous. The cost of arranging exchanges would be far greater, and our wealth as a consequence far less, if there were no money in our society to facilitate the process. (Don't forget, wealth is not defined as money or material things; wealth is whatever people value.) In an economic system limited to barter, people would have to spend a tremendous amount of time searching for others with whom they could make a trade. A guitar maker would have to find a farmer, toilet paper manufacturer, logging mill owner, toolmaker, glue supplier, building contractor, among many others, each willing to accept guitars in return for the goods that he or she produces. All that time spent on searching would be time not available for guitar making, and the production of guitars would decline steeply. So, too, would the production of all those other goods whose owners must also search for the right people to barter with. Aware of the high transaction costs attached to almost every exchange, people would increasingly try to produce for themselves most of whatever they wanted. Specialization would decline dramatically in a society confined to barter, an exchange system without the facility of money, and everyone would be much poorer. The evolution of some kind of money system in almost every known society, even when conditions were extremely unfavorable to it, is eloquent testimony to the advantages of using money. Money has another important advantage. The amount of money offered in exchange can be adjusted up or down by very small or very large amounts. Imagine the guitar maker wanting one concert ticket in a pure barter economy. Can he offer only 1/10 of a guitar for the ticket and trade the remaining portions of his guitar for a six-pack, Big Mac and fries, gasoline, and the many other things he values? Or must he trade a whole guitar for, say, 10 concert tickets, and then find ways to exchange the extra tickets for the six-pack, burger, and so on? Think of the ridiculously large transaction costs! No wonder Buddha gave it all up. But if the guitar maker sells guitars for money, he can buy a little bit more, or a little bit less of what he wants with no trouble at all. And he can raise the exchange value—the money price of his guitars by a small amount if he senses that his customers are willing to pay more for them than before, or lower their exchange value by just a little if he thinks this would secure some sales that he wouldn't otherwise get. The ability to make small adjustments is essential to the coordination of a commercial society. Consider a gallon of gasoline. If we are to be able to fill our tanks at the station on Tuesday evening at 5:30, just the right number of people with just the right abilities and command over just the right physical resources must cooperate at just the right times, and in just the right ways to explore, drill, pump, pipe, refine, truck, and store. That intricate system is coordinated basically by means of the responses people make to adjustments in money prices. The people who regularly accomplish this spectacular feat of coordination don't do it because they love us and know how much we want gasoline, but to further the innumerable and diverse projects in which they themselves happen to be interested. Their efforts mesh because those efforts are coordinated by the continually changing signals that money prices emit. We must insist once again that the crucial importance of money prices to the working of our society implies nothing about the character or morality of our citizens. People pay attention to money prices insofar as they want to economize, that is, to get as much as possible of what they value from the resources they command. Money prices help consumers establish budgets and clarify their options. Money prices help producers calculate expected costs and expected revenues. People don't pay attention exclusively to money prices, of course; that wouldn't make sense. They do, however, change their behavior when prices change, in order to "take advantage” of the new situation signaled by the new prices. This is what causes coordination to occur and self-interested (again, not necessarily selfish) behavior to become cooperative action. ### Money and Interest Recently a financial journalist wrote, “If Ben Bernanke at the Federal Reserve raises interest rates the price of money will go up." Unfortunately, statements like this are entirely wrong from the perspective of the economic way of thinking. Interest is not the price of money. Nor is it a payment made to use money. Interest is paid not for using money, but for borrowing money. Borrowing is a matter of obtaining purchasing power that we have not yet earned. Borrowers, through the channels of banks, persuade lenders to provide them with credit now, by promising to pay back the principle plus interest later. They enter a mutually agreed-upon contract. The interest rate reflects the price of credit, the terms of the deal. Think of a student loan. Why are you willing to pay interest? Current resources are generally more valuable than future resources because having them usually expands one's opportunities-enabling us to do things that cause our earning capacity to increase over time, so that we might have more resources at some future date. When we see such