Balancing Production and Consumption
Before I continue discussing the allocation of resources in a free market, I would like to recap some of the points that I have made in the last few blog posts.
I started by explaining the concept of consumer sovereignty, which means that the whole purpose of production and markets consists of satisfying the needs of consumers. Second, because of the importance of consumers, producers have the motivation, and an obligation, to keep their costs as low. Next, I made the point that consumers are the major influence in determining prices because of the importance of their purchasing decisions in the market. At that point, I raised the question of the source of consumers. Because production must always precede consumption, consumers must first produce something or have a producer support them (e.g., family members supported by the primary breadwinner.) My last post introduced the concept of complexity. Before one can understand how all of this gets tied together, one must comprehend the tremendous complexity of markets.
This post will pull it all together and show how consumers, producers, and market complexity combine in free markets to make the most efficient and effective allocation of resources.
To open this discussion, I will describe an individual exchange.
It takes many, many individual exchanges to create what we refer to as a market. Thus, understanding market activity requires a clear understanding of an individual exchange. Whenever two people interact, an exchange occurs when each offers something that they prefer less than what they receive in exchange. This applies whether the two parties engage in a direct exchange, involving one good exchanged for another, or if the parties engage in an indirect exchange, involving the exchange of money for a good.
In every voluntary exchange, the parties involved both gain. Each person values what they receive more than what they gave up. Because of this fact, we can consider individual exchanges as an effective allocation of resources.
For indirect exchanges involving money, we tend to refer to the person offering the money as the buyer and the person offering the good as the seller.
Voluntary individual exchanges provide the foundation for free markets and the market allocation of resources.
Billions of exchanges, all connected, create large markets. All buyers and sellers free to exercise their discretion to achieve mutual gain. Because the objective of large markets consists of satisfying the needs of consumers, the mutual benefit from this multitude of transactions leads to effective and efficient allocation of resources throughout the economy.
Numerous people seem to have become enchanted with the idea of central planning. They think that government can do a better job in allocating resources than the market. A centrally planned economy has never worked and, in fact, cannot work.
The complexity of markets, even small markets, makes it impossible for one mind, or a group of minds, to know the needs and desires of all consumers. Central planning cannot match the effectiveness and efficiency of voluntary exchanges in a free market.
Because of the complexity of markets and the subjective nature of value, only free markets can achieve a proper balance between production and consumption — i.e., effective and efficient resource allocation.