All Commentary
Thursday, October 1, 1992

Human Imperfection as a Market Strength

Do people interfere with market efficiency?

Professor Cunningham teaches economics at the University of Connecticut at Storrs.

At a roundtable discussion among economists and officials from the United States and republics of the former Soviet Union, I was surprised to hear that there is a single discipline that is central to the ability of a market economy to generate its obvious benefits. Moreover, this discipline, and with it the value of the market system, is diminished when human imperfections are taken into account. Market economics, you see, is one of those many things that “works pretty well in theory, but suffers when the realities of life are factored in.” Of course, nothing could be further from the truth.

Faced with the reluctance of some republics’ representatives to make the full leap to market-based systems, some members of the panel offered a perverted “insight.” They suggested that capitalism generates its enormous social benefits neither through its guarantees of private property, nor by its cultivation of personal initiative in response to personal incentives, nor by capital flowing freely to seek its highest return based upon market and social valuation. Capitalism’s strength, they argued, is that it places enterprises on a profit-and-loss basis. Inefficient enterprises are unprofitable, and therefore cannot sustain themselves over the long run, go bankrupt, and are replaced by firms that are efficient. This is the market discipline. Even some Western market economists who should know better were nodding yes to this concept. People, they argued, can interfere with the efficiency of the theoretical market system by being slow to respond to market changes because they may misinterpret, misunderstand, or develop habits or loyalties that may make them slow to respond to product changes and allow inefficient firms to survive longer than they should. People always do seem to be a problem for social theories.

By focusing on profit and loss, the republics could maintain some of the “comfortable” elements of the old system. State ownership of the major enterprises would allow “us” to “protect” society from unfair income distribution and unbridled profit-seeking behavior. Placing the state-run enterprises on a profit-and-loss basis would mean that the state would not subsidize enterprises that could not sustain themselves by generating sufficient revenues to prevent losses and replace spent capital.


The Market and Human Nature

Such socialist rhetoric is seductive, but unconvincing. There is so much wrong with these arguments that one hardly knows where to begin in refuting them. The central fallacy is likely the regard of human beings and human nature as negatives in society and economy. The power of the market system is that it makes human diversity, human “imperfection,” and human nature the central engines for personal freedom, individual progress, and the highest possible standard of living. Under capitalism the society is not corrupted or complicated by individuals, but rather is the individuals. It is not possible for individual differences to be an obstacle to the efficient operation of a market system; a market system demands and thrives on individuality. Human tendencies to form social bonds, to show reluctance to change, and to be vocal about changes in the economic world are not imperfections but rather strengths in a market system, it is not a weakness to show loyalty, to be considerate in making change, or to provide information to the social process.

In his 1970 book, Exit, Voice, and Loyalty (Harvard University Press), Albert O. Hirschman provides the basis for a powerful argument for the efficiency benefits that accrue to the society that encourages loyalties to producers and products, and voice in the face of change. Anyone who has ever worked with American customers in a retail setting, as a salesclerk at the local Sears or J. C. Penney Company, for example, can readily grasp Hirschman’s insight. If product quality slips, or the product is not what the customer expected it to be, American customers do not silently switch brands. American customers take the product back, pound their fists on the counter, and demand satisfaction. They say things like, “I have been a customer of this firm for over 20 years and I expect better from you. Get your act together!” The fact that the customer comes back and continues to buy (at least for a while) after his or her disappointment—Hirschman calls loyalty. The customer’s expressed outrage, he calls voice. To be sure, if the firm does not “get its act together” in short order, then the firm will experience the customer’s exit—the customer will take his or her business to another firm.


Market Efficiency

The loyalty-voice-exit process is much more efficient than the simple exit process. Firms in the real world do not go into and out of business costlessly, and the collapse of a firm almost always involves personal tragedies. People suffer the psychological trauma of unemployment and the search costs of looking for a new job, and the standard of living declines for all. Loyalty and voice, human “imperfections” as they are, provide time and information to the market process. Loyalty and voice are the whips that crack over firms in a market economy.

The human “imperfection” of self-interest makes people, private property, unrestricted capital flows, and free exchange into a formula for economic efficiency, the highest possible standard of living, consumer sovereignty, and freedom for the members of a society.

Self-interest can only be sustained when the gains from production and trade fall to those who produced and traded. People are either allowed to enjoy the rewards of their achievements or they are not. If they are, then self-interest is served, and incentives are created. If they are not, then nothing drives the engine of the economy but the rule of the state. Only socialists find fault with individuality and so-called “imperfections” because humanity eventually, inexorably, opposes the centrally planned state.

Without people exchanging property in markets, you cannot have a market economy. You cannot trade what you do not own; without private property, individual self-interest has no vehicle for its expression. If property is not privately owned, then no one has an incentive to try to achieve the highest return by putting it to use in the way that society values most. Society provides this valuation constantly and with great voice through markets. It is a sham to claim that a nation is pursuing market economics when it prohibits private property. Capital, the means of production, is a kind of property. If individuals cannot own property, then the state owns the means of production, and it is a socialist state.

Somehow, most of the members of our roundtable discussion had forgotten these early lessons. Markets are not constructed, they arise spontaneously because of human needs and wants, as well as differences in talents, abilities, and perceptions. Markets are blind to the “imperfections” in people because markets, like societies, are those individuals.