And we are still not done with the wonders of the market. Suppose that an enterprising pizza maker invents a more efficient pizza oven and installs it in his store. This owner can now produce pizzas cheaper than his rivals. He can make higher profits because his costs per pizza are now lower. However, over time, his rivals will be forced to implement the new technology, and this will increase the supply of pizza, lowering its price (to the delight of pizza lovers) and returning everyone’s profits to rough equality. The implication of this example is that a competitive market will be very inducive to rapid technological development, but this is ultimately to the benefit of consumers.
Our pizza example can be extended almost infinitely. Suppose that workers demand more pleasant jobs. Just as in the pizza case, the increased demand for more pleasant jobs will raise the “price” of such jobs. That is, employers supplying less pleasant jobs will not be able to attract an adequate supply of workers. Wages for the less pleasant jobs will rise. The higher cost to employers supplying less pleasant jobs will encourage them or new employers to start supplying more pleasant (and temporarily less costly) jobs. Just as in the case of our pizza consumers, the workers get what they want. They are sovereign in the market.
any type of business regulation.
3. Income subsidies: Many countries have provided income to people who find themselves in unfortunate circumstances such as extreme poverty, unemployment, illness, and disability. Libertarians take a dim view of such income subsidies.5 Outright grants to the poor are especially criticized. In the United States, for example, certain poor persons, mainly single women with children, were once eligible for public assistance in the form of monthly cash grants. Some poor single men were also eligible. Libertarian neoclassicals are opposed to these grants. They argue that they encourage idleness by providing income without work effort. Just as we expect a person who hits a large lottery to quit working (because the demand for leisure will rise as income rises), so too we can expect the poor to work less or not at all when they get cash grants not tied to work effort. With respect to unemployment compensation, the libertarians reason that such compensation will create a certain amount of voluntary unemployment by encouraging the unemployed to take longer to find new jobs than would otherwise be the case. Payments for disability, especially if they are generous, will simply encourage workers to fake injury and illness to collect the subsidy. Again, the society loses valuable labor. We have already had occasion to examine the hostility of libertarians to social security (in Chapter One, although there we did not identify Professor Feldstein as a libertarian, just as a neoclassical).
Placing restrictions on the movements of foreign capital also denies people the benefits of higher production and lower prices. The more money available in domestic markets, the easier it will be to find financing for any number of production projects. Poor countries, for example, are often starved for capital (At least this is what the economists tell us). So, foreign capital fills a void and allows these nations to begin to develop their economies.
The libertarian neoclassical economists advise governments, then, to eliminate whatever restrictions they have placed on the free operation of markets. But how should a government handle the market failures? We have hinted at the answers above. If the market will not allow the production of certain useful goods and services, the government should provide for their production. The government should strictly limit public production; whenever possible, it should use tax revenues to contract out with private companies. It is alright for soldiers to be public employees, but the weapons they use should be produced by private corporations.
Libertarian neoclassical economists do not take the market failure of inequality very seriously. In fact, they usually argue the contrary: that inequality is a socially desirable thing. Inequality gives those with lower incomes an incentive to work hard and achieve, while it gives everyone the hope that they might accumulate very large sums of money and enjoy the life that money makes possible. Without the possibility of great riches, people would not be willing to take risks and innovate production. The only role the government might play here is to provide for those few people who, because of physical or mental disabilities, cannot possibly work. Private charities should be encouraged to help the less fortunate, and the government must strictly monitor the recipients of any aid to prevent cheating. Libertarian neoclassical economists wold not be opposed to public incentive schemes to encourage those who are poor to obtain education and training, the results of which will make them productive enough to earn more
money. Some programs which might help are school vouchers to help families to pay for school, perhaps low interest loans for school or training, and tax credits or wage subsidies to private employers to encourage them to hire poorer persons.
Social costs such as environmental destruction are best handled by extending the market mechanism rather than by legislation. The libertarian neoclassical economist points out that the reason a private business pollutes the air and water is because the water and the air are not private property. Thus, there are no costs the company must pay when it pollutes. The water and the air belong to no one; they can be used “free of charge.” What needs to be done is to place a price on the use of the water and air. This could be done through the creation, by the government, of what we might call “rights to pollute.” Such rights would have to be purchased by a company that wanted to dump a certain amount of a particular pollutant into the water or air. Once a business had to buy a pollution right, it would try to economize on its expenses, either by producing (and polluting) less or by finding a way to control pollution cheaper than the cost of
the pollution rights. The production of pollution control devices would be encouraged, since now there would be a demand for them. Companies which purchased rights that they did not use could sell them to any company that needed to pollute more than its own pollution rights allowed. All in all, this pollution rights scheme is another example of the “magic of the marketplace.”
Libertarian neoclassical economists suggest that, while barriers to entry in markets might be a short-term problem, they should not be a long-term issue. Barriers to entry result in abnormally high profits for those businesses creating the barriers. High profits, however, serve as an exceptionally strong incentive for capital to find a way into a market. In the 1950s, for example, the U.S. automobile and steel industries dominated world automobile and steel markets. Moreover, only a few giant firms dominated each industry in the United States. Very few cars were not produced by General Motors, Ford, and Chrysler. U.S. Steel and a handful of smaller but still large-scale producers made most of the world’s steel. Automobile and steel corporations were extremely profitable. General Motors achieved a rate of profit on invested capital of 20 percent, a phenomenally high rate of return at that time. Yet despite the massive
amount of money necessary to enter these markets and compete effectively, these corporations could not prevent rivals from entering their markets. Today, there are numerous Japanese, Korean, French, German, Swedish, and Italian automobile companies, and there are scores of competitors in the steel industry. Consumers have benefitted for this competition, and, at the same time, the efficiencies (called “economies of scale”) of large-scale production made possible by companies like Ford have been maintained.
With respect to involuntary unemployment, libertarian neoclassical economists were shocked by the Great Depression. They had been of the view that market forces would quickly bring a return of prosperity to a depressed economy. When a crisis strikes an economy, unemployment will increase as businesses cut back production or close. At the same time, the demand for bank loans will fall for the same reason. The growing unemployment, however, will
put downward pressure on wage rates, and this will encourage firms to begin hiring again. The fact that bank loan demand diminishes means that banks now have excess money to lend out. Banks will be forced by market competition to lower their loan interest rates, and this will encourage borrowing. As newly-hired workers spend their paychecks and borrowers spend the proceeds of their loans, business will begin to pick up, and the crisis will soon come to end.
During the Great Depression, wages and bank loan rates fell dramatically, but businesses did not hire more workers and no borrowers showed up at the banks. The Great Depression just dragged on. At first, the libertarians were dumbfounded, but in the years since the 1930s, they have put forth the position that the great crisis was the result of bad policies followed by governments in most of the world’s market economies. One public (or quasi-public as is
sometimes the case) institution that all neoclassical economists believe is necessary in modern economies is a central bank and a central banking authority. In the United States the bank is the Federal Reserve System, and the authority is the Board of Governors. One function of a central bank is to regulate the availability of credit. Central banks do this by engaging in activities that put upward or downward pressure on interest rates. They can also serve as “lenders of last
resort,” making money available to troubled sectors in the market. Had the Federal Reserve put more downward pressure on interest rates as soon as the downturn began in late 1929, and if it had made funds available to cash-strapped businesses, banks, and brokers, the downturn would not have been nearly so severe and the upturn would have taken hold in a relatively short amount of time. In addition, most nations responded to the depression by placing high tariffs on imports. The resulting slowdown in international trade only made the depression worse. One country’s
exports are another country’s imports. If the United States levies a high tariff on foreign goods, as it did in 1932 with the notorious Hawley-Smoot law (which imposed tariffs as high as 100 percent, doubling the price of some imports), other countries will not be able get the revenue necessary to buy U.S. exports. The inability of U.S. exporters to sell their wares means that U.S. residents won’t be able to buy another country’s exports. A vicious spiral will drive output down in all countries. So, the libertarians say that had countries not reacted to the 1930s crisis with such high trade barriers, the crisis would not have been as severe as it was.
In general, libertarian neoclassical economists believe that prompt actions by central banks can either prevent recessions or depressions altogether or end them soon after they begin. No other government action is needed. If a government reacts to unemployment by increasing its own spending or cutting taxes, it will only waste money or cause total spending in the country to increase by too much, causing inflation. Sometimes, libertarian neoclassicals favor tax cuts when a recession begins, but this is usually done for the strategic purpose of forcing the government to spend less money in the future. By reducing public revenues, a tax cut puts pressure on the government to curtail its spending or risk running a budget deficit.