Smith’s conclusions led to some basic principles that would enable nations to take full advantage of the wealth-creating potential of their people. These principles included an important role for government. However, instead of directing economic activity, government’s role was to ensure that individuals were provided the optimal environment in which to maximize their creative and productive energies.
With the right environment, individuals would combine resources in the most efficient way possible to provide things that other people wanted. The characteristics of a productive environment could be distilled to four essential principles:
Promote free markets.
Keep tax rates low and limit the role of government.
Protect individual property rights.
Provide a stable currency.
Each of these principles flow directly from a belief in each individual’s God-given right to liberty and freedom. As with liberty and freedom, the principles are so basic and fundamental that they apply to all people at all times.
Classical economists believed that these principles contained the keys to creating wealth. They had good reasons for these beliefs. We now turn to the reasoning behind each of these principles and examine why they are considered to be so important toward advancing the wealth of individuals and hence the wealth of nations.
Free Markets
Any attempt to control prices or quantities of particular commodities deprives competition of its power of bringing about an effective co-ordination of individual efforts, because price changes then cease to register the relevant changes in circumstance and no longer provide a reliable guide for the individual’s actions.—Friedrich A. Hayek
Free markets refer to a system where the prices and quantities of the things we buy and sell are unencumbered by artificial barriers or constraints.
The logic underlying free markets is straightforward. Whenever individuals agree to a transaction, they benefit from the exchange. Otherwise, they wouldn’t agree to it. Hence, the free exchange of goods and services benefits those individuals directly involved.
In addition to benefiting those directly involved, the free exchange of goods and services also benefits others. As a general rule, the more markets respond freely to the forces of supply and demand, the more individuals are able to use the nation’s resources efficiently to produce the things people want. Using resources efficiently contributes to the wealth of nations.
Making efficient use of resources is challenging. It requires a massive amount of information, cooperation and effort. Free markets provide the essential mechanism to accomplish this task.
Markets are extremely complex
We often take things for granted. When we buy something, we seldom give much thought to how it got there. When markets are free to operate just about anything we may want is almost always immediately available, as long as we are willing and able to pay the price.
Providing goods and services to the people who want them, when they want them, at a price that most are willing to pay is one of the most complicated tasks imaginable. It involves hundreds of millions of people making billions of decisions. Each individual contributes a small part to the process.
Grasping the complexity of the market system is the first step toward understanding why free markets are so crucial to creating wealth. An essay written over half a century ago provides some insight to this task.
Writing from the perspective of a pencil, Leonard Read makes the seemingly outlandish claim that there is not a single person on the face of the earth who knows how to make something as simple as a pencil. After explaining in great detail how the actions of millions of people all over the world contribute to the production of each component of a pencil, Read states:
…There isn’t a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field—paraffin being a by-product of petroleum.
Here is an astounding fact: Neither the worker in the oil field nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.
There is a fact still more astounding: the absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work.1
The invisible hand is the market system—a system that is so complex that no one individual knows how to make even the simplest product. It challenges the imagination to think what it takes to produce a TV, computer, or cell phone.
The complexity of creating anything of value is compounded by the fact that the entire system is dynamic. Our preferences are constantly changing. So is our knowhow and technology. Each change reverberates through the system affecting the supply and demand for all resources. These changes in turn affect each and every component of each and every product.
The challenge facing producers is daunting. If they fail to make all the proper decisions they will produce products that are too expensive to sell or are unsalable for any number of other reasons.
Producers must continually incorporate massive amounts of information and adjust production and delivery processes to assure that resources are continually used in the most efficient manner to produce the things that people want.
Only the invisible hand of a market system can coordinate the process to accomplish this task. It does so through the miracle of the price system. The price system provides all the information necessary so individuals can make the most efficient use of all available resources to provide us with the things we want.
Free markets make efficient use of resources
When prices are free of artificial barriers and constraints, they tend to reflect the relative scarcity of resources. A high price signals a product or resource that is relatively scarce compared to its demand. The high price not only informs everyone that this item is valuable, it also signals precisely how valuable it is to each person.
How much we have to spend often reflects what we have been paid in exchange for our knowhow. We use that knowhow to produce things that others want. What we choose to buy depends on our financial resources and our preferences. Each of us is unique. Each of us has a different amount of money to spend. And each of us attaches a different value to the things we want.
The market system is the only system that enables each of us to know precisely how much of our knowhow (in the form of money) we will have to give up in exchange for the things we want. The price of anything we want captures this vital information about our individual choices. Our response