

“Prices are the central force directing resources and shaping consumption in a market economy. But most economic activity seems to take place without any influence from prices at all. Most employment, and in dollar terms most production, choices are not directly guided by any observable price.”

W hen I teach political economy, I start with the neoclassical theory of consumption, and then cover production. And I show students how miraculous is it that the actions of millions of people who have never met can be directed by prices. Resources move toward their highest valued use, and consumption goods are delivered to the consumers who want them.

For example, the United States promoted ethanol as an auto fuel. This sharply increased the price of corn worldwide. As Brazilian reporter Kieran Gartlan put it: “Higher prices are leading Brazilian farmers to plant more second crop corn this year, and the country’s modest corn exports are expected to expand [from 42 million tonnes to 48 million tonnes, an increase of 230 million bushels.]” (DTN, March 2, 2007, emphasis mine).

No one directed the Brazilian farmers to shift to corn production. The article puts it perfectly: “Higher prices are leading farmers….” The leadership comes from the prices themselves! The farmers may have had no idea why the price of corn had increased, to $4.00 per bushel. (After all, Brazil uses sugar, not corn, to produce its ethanol.) But Brazilian corn production increased within a year, by nearly 15%. No one made the farmers switch; they made choices. Other corn producers, in Argentina, Mexico, and several African countries, followed suit. No one talked about it, no one gave any orders; prices led them.

There is nothing wrong with this lesson, nothing I would change in my presentation to students. But there is a problem of emphasis, for someone who wants to understand, fundamentally understand, markets. And the problem is this: Prices are the central force directing resources and shaping consumption in a market economy. But most economic activity seems (at first glance) to take place without any influence from prices at all. Most employment choices, and in dollar terms most production decisions, are not directly guided by any observable price.

Most people work for a firm, a company, a large organization, and they have a boss. There are people who provide computer services, janitorial services, legal advice, and myriad other day to day activities who are paid a salary. They are directed by their boss, not by prices. The boss has to gauge (guess?) whether that worker is carrying her weight and adding to the profitability of the firm.

In such a setting, the boss also must try to figure out if there are enough servers or computers (my hunch? Your IT guy says, “no.” Never enough). Now, the manager does buy this equipment on the market, and pays real prices. But he doesn’t sell the computer time to the staff. He gives it away. Is it worth it, in terms of somehow increasing profits or raising the company’s share values? The boss has to guess. Many different bosses, in many different firms, make different guesses. Some of the firms are profitable, some are not. No one knows what specific choices led to increased profits, or to bankruptcy.

Then one day, in one firm, one manager, perhaps on a whim, outsources the computer services or janitorial services or the legal advice. Not to India or Ireland but simply to another company across town or across country. The boss signs a contract, after taking bids from several companies that provide similar services. These companies are forced by the scolding winds of market competition to provide excellent service at low cost. By looking at the different prices in the bids offered in this competition, the boss learns something. He learns how much the service costs to provide. And he learns how much money he saves by laying off the employees who used to provide the service in-house.

It’s hard to fire employees, particularly since most employees are smart enough to work hard enough to get acceptable performance reviews. The boss also has a hard time motivating the in-house staff, because watching each employee is expensive and tiresome. But it’s easy to fire contracted employees, because you just sign a new contract with a competitor. Why not let the market system do your motivation work? Let’s suppose that our outsourcing boss sees the company’s profits rise dramatically, and the stock price goes up 18% in six months. Life is good, for the boss.

So, one day the boss has this crazy thought. He asks himself a question that has never occurred to him before: Why have any employees at all? Why have a building? Why not just sit home, wearing his jammies and bunny slippers, sipping a nice cup of tea, and outsource everything? He can write contracts to buy parts, he can pay workers to assemble the parts, and he can use shipping companies to box and transport the product.

The boss is elated. He never really liked these people anyway. Always asking questions, constantly looking for direction and expecting him to know the answers. He fires all his employees, effective one month from now, and takes bids on all the design, parts manufacture, assembly, and shipping that those people used to do.

On day 31, after all those wasteful employees are gone and the new contracting efficiency regime is in place, the boss has a nice breakfast, pours his tea, and puts his bunny-slippered feet up on his desk at home. Checking his email, he notices he has 1,239 new messages. He turns on his cell phone, and sees he has missed 485 calls. What the heck?

It turns out that coordinating all those contract employees, and making all those different transactions work together in time and space, is a really hard job. The manager shucks the bunnies, puts on his suit, and hurries over to his primary contract supplier of inputs. “What are you doing? We have a contract!”

The supplier says, “Who are you again?”

The boss gives his name, frantically. Not one of the other contracts can be fulfilled if he can’t get these parts.

The supplier checks, “Oh, yeah, I see the order. Sorry, we’re running behind. We’ll have the stuff to you by the end of the week, maybe the following Monday.”

Within three days, the boss is fired, because the company is plunging into bankruptcy. Stock prices fall by 75%, and a desperate effort is made to rehire most of the old employees back to their old jobs.