market prices, and thus give directions to the producers as to what should be produced. Changes in consumer preferences, which are responsible for the price changes, compel producers to alter their production processes. Any non-market obstacles placed in the way of the pricing process thus necessarily interfere with the priority system that consumers have set up. It must always be borne in mind that such a priority system cannot necessarily lay claim to any kind of ethical excellence. All that can be claimed for the priority system is that it offers potential market participants more attractive alternatives than are available to them otherwise.
2. That production in a market economy is undertaken for profit also has definite consequences with respect to the second task of coordination. When a given product can be produced by different methods of production, it is most profitable to use the cheapest method of production. The entrepreneur will therefore tend to use this method of production. The cheapest method of production is that which requires the smallest expenditure for the resources used. Whether or not one production process is cheaper (and therefore more likely to be employed) than another depends not only on the quantities of resources required for the processes, but also on their prices. The market value of different resource combinations influences the decisions of producers to use more machinery or less, more skilled labor or less, a larger plant or a smaller, and so on.
Now, as with the prices of products, the analysis of the determination of the prices of resources must wait until later chapters in this book. But generally it is not difficult to see what factors are at work in the determination of resource prices, and to appreciate how these factors relate to the coordination problem of securing the use of “socially efficient” methods of production. Market prices are the basis of cost calculation by producers. The price of each resource tends toward the point where all supplies of the resource available at this price are bought by producers.5 Producers tend to bid up resource prices in order to secure resources for the production of given products for as long as it is profitable to do so; thus, at the market price, the resource will be used by producers of those products in whose production the resource yields greatest profits. Producers bidding for the resource to produce a product in which the resource will be relatively less profitable will soon find it impossible to compete with the producers of more valuable products. In buying the cheapest resources (among all those resources that are for him technically equivalent), the producer will therefore tend to be buying those resources least valuable elsewhere in the economy—“valuable,” that is, in the sense of being able to cater to consumer wants having higher (pecuniary sacrifice) priority.
It cannot be expected, to be sure, that at any one time the market process should have succeeded in securing complete coordination of decisions concerning methods of production. Inevitably, at any one time, certain processes of production will be carried on using resources some units of which could be used more valuably in other production processes. So long as the market is competitive, however, the existence of such opportunities for increased efficiency will tend to be discovered and exploited by profit-seeking entrepreneurs. The market process will constantly tend to rearrange and reshuffle the allocation of productive resources so as to conform more closely with the most recent changes in the patterns of available resources and consumer preferences.6
3. The price system a market economy has its setting in is responsible also for the solution of the third problem of coordination, that of determining the individual rewards to be received by each of the resource owners cooperating in the productive process. This function is fulfilled as a different aspect of the same pricing process that determines resource allocation and the organization of production. Resource owners selling the services of their resources in the market secure prices that are determined by the interaction of resource supply and entrepreneurial demand. Acting in their capacity of consumers, the resource owners will in turn use the money prices, which they receive in the resource markets (their “incomes”), to buy goods in the product markets. Thus, the market value of the goods and services a consumer can buy with his income is determined by the value that the market places upon the services that, in his capacity of resource owner, he has furnished to the production process.
The real incomes received by consumers are therefore determined by the prices that emerge in the market for the services of the various resources. In general, the price of a resource depends on its productivity in the different branches of production. When a resource owner is otherwise indifferent to the use his resource will be applied to, he will sell its services to the highest bidder. The highest bidder will tend to be that entrepreneur to whose profit calculations the services of additional quantities of the resource add most. The market process therefore tends to ensure the apportioning of rewards among cooperating resource owners in a way that attracts resources to their most productive uses. At the same time each individual resource owner participating in the market process is able to enjoy the fruits of the production of the market to an extent depending on the usefulness to the market of the productive services that he is willing to supply on these terms. That portion of production that is not earned by resource owners is received by entrepreneurs as pure profit. We now consider briefly the factors that determine the size of profits, and especially the coordinating functions that profits fulfill.
THE COORDINATING FUNCTION OF PROFITS IN A MARKET ECONOMY
In the previous sections it was seen that the market process simultaneously solves the three fundamental problems of economic coordination through the price system. The emergence of a price structure reflects a priority system that guides resources to (what this priority system pronounces to be) their most productive uses. But the price system is not “automatic”; it functions only as the expression of human actions. In particular the price system is the expression of entrepreneurial decisions consciously planned and executed. Entrepreneurial decisions are made with the purpose of winning profits.
Profits are to be won whenever something can be sold for a price higher than the price it can be bought at (or higher than the sum of the prices of everything needed for its production). For an entrepreneur to win profits it is necessary, first, that such a price discrepancy exist; and second, that the entrepreneur know that it exists. Now, for a price discrepancy to exist, it is necessary that those willing to sell the commodity (or the factors necessary for its production) for the lower price and those willing to buy the commodity at the higher price be unaware of each other’s attitudes. If these sellers and buyers knew each other’s attitudes, these would soon be altered to eliminate the price discrepancy. The entrepreneur wins profits by becoming aware, earlier than others, of the hitherto unknown discrepancy (reflected in the price differential) between the attitudes of those willing to sell for less and of those willing to buy for more.
It is the characteristic of the real world to which the analysis of market theory may be applied that, at any one time, numerous instances occur of the kind of ignorance that makes it possible for price discrepancies and profits to emerge. Each market participant knows some of the market facts relevant to his own situation, but is ignorant of a great many more. Among the alternatives from which Market Participant A believes he has to choose, some particularly attractive alternative is usually missing (obtainable by dealing with Market Participant B) which might have been included if only A and B would have known of each other’s situation and attitude. From the point of view of an imaginary, disinterested outsider knowing all these facts, both A and B are the losers due to their ignorance of some market facts. From the point of view of the omniscient outsider, the market always has room for a reshuffling of resources or goods according to the pattern that would take place if the market participants themselves were not in ignorance of the opportunities available to them.
It is here that we can see the essential character of the coordinating functions performed by the market process. The market process tends to present market participants with alternatives that approximate those opportunities they would choose if they possessed all the relevant information. The market
