Economic Evolution

My colleague John Baden has long argued that economics is best understood as a branch of evolutionary biology. Like biological systems, economic life evolves as people and organizations learn, respond, and innovate. Markets, like DNA-driven organisms, are highly efficient information-processing systems. The realization that prices transmit and process information was a great insight of the 20th century.

Nobel Prize winner and founder of the Mont Pelerin Society F.A. Hayek observed that every society faces two central challenges: how best to allocate scarce resources and how to coordinate the actions of millions of self-interested individuals.

For most of the 20th century, many intellectuals believed that socialism was the most productive and humane method of coordinating human action. (Folks who worked with real stuff, rather than symbols, knew better.) National economies would be run like a factory, where every product was predetermined. Goods and services were organized to directly benefit society. Market exchanges where eliminated, and “just” prices set by the government. The British economy for 35 years after WWII exemplified this approach.

Experience tells us socialism works only on the smallest scale. It suffers from inherent flaws: planners need to know what goods people want, what they are willing to give up to get them, and how they can be most efficiently produced. But planners can know none of this.

The U.S.S.R. created the State Committee on Prices. Here, a few hundred bureaucrats set all prices in the Soviet economy. Imagine the odds against this working in the U.S., where a single Boeing airliner has millions of separate parts, each with its own price.

In modern societies, knowledge of time- and place-specific conditions is dispersed among millions of individuals. Consumers and producers communicate their desires through prices. Markets then allocate resources – labor, capital, and human ingenuity – in a manner that can’t be anticipated or mimicked by a central plan.

Societies are becoming ever more complex. As complexity increases, the advantages of decentralized decision making – the market economy – become ever greater. But how do the coordinators of economic life (i.e., markets and prices) come into existence? The experience of R. A. Radford, an inmate in a WWII German POW camp, offers a fascinating insight.

POWs received “commodities” in the form of Red Cross food parcels, (e.g., chocolate and cigarettes). Prisoners traded these goods and markets spontaneously arose. The laws of supply and demand set prices, with cigarettes as the standard currency. A cigarette would buy several chocolates. A tin of diced carrots was worth practically nothing.

Entrepreneurs emerged. One prisoner sold tea, coffee, and cocoa at two cigarettes a cup. As demand grew, he hired employees, including a CPA. A commodity exchange developed, with prices advertised on boards throughout the camp. These transparent, public transactions promoted honesty in business dealings. By engaging in voluntary exchanges, individual preferences were satisfied.

There was a strong feeling among some in Radford’s camp that everything had its “just price.” The medical officer feared that some were selling too much food and thus, endangering their health. Some senior officers tried to promote “fairness” by fixing the prices of goods. They developed schemes to control prices. Prisoners were forbidden from selling goods that deviated 5 percent from the set price. A black market emerged. Soon public opinion turned against price controls and the officers gave up.

This experience applies across time. The Wall Street Journal recently reported on the spontaneous emergence of markets for goods in high demand (e.g., cigarettes) among Marines. The Journal reported: “As the war entered its second week, American supply lines are stretched thin. And the price of cigarettes is going through the roof.” Prices are set by open-air auctions and cash is not required. “I’ll give you 10 bags of Skittles for one cigaretteĀ….” exemplifies the process.

These experiences show how, in a society of self-interested individuals, markets and prices spontaneously emerge. This facilitates voluntary and peaceful interactions.

No system equals the market in maximizing the conjunction of liberty and prosperity. To understand the value of markets we must recognize them as a natural process, not a political construct. They are mechanisms by which people can, without coercion, communicate and coordinate their actions.