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Modern Market Economies and the Allocation of Factors of Production Essay

Market economies, actually mixed economies, pride themselves on efficiency. The market so writers like Hayek have long held, is the only means of synthesizing the desires and demands of billions of individual consuming units. But the actual mechanics of this transformation still remain controversial.

In terms of “mechanics,” the economy must have the means at its disposal of translating the desires of billions of consumers into the allocation of resources of producers. It is not enough to hold that consumer demand is signaled by prices. This approach is accurate, but highly simplistic, more needs to be added to prices as such in terms of translating demand. Hence, this brief description will deal with a few variables in the mechanics of resource allocation.

Typical textbooks on introductory economics hold that qualitative demand is transformed into quantitative measures in terms of prices, barring any external distortion. The unintended consequence of this is that demand, ultimately a qualitative factor, is in fact standardized into prices and hence, signals producers. Hayek is only correct to the extent that qualitative factors such as demand (i.e. the demand of individuals) is altered radically through prices and hence quality is transformed into quantity (Hayek, 1954, 40-42). But even here the equation is too simple.

It may be the case that the quality of demand survives to some extent through the concept of derived demand. The textbook approach deals normally with demand for a product being regulated and standardized into prices. But derived demand may in fact retain the qualitative element of demand by spreading “ripples” through the economy.

The demand for oil, for example, automatically gives rise to a demand for technical skill and certain specific forms of labor, refining capability, computer programs and programmers that specialize in related formats and software. In other words, this kind of transformation of demand is far more than for a product, but for an industry and support staff, hence possibly maintaining demand as a qualitative rather than a merely quantitative variable (Bull, 1988, 169-170).

The distinction between quantitative and qualitative variables might be as simple as differential compensation. In such an approach to salary, those who are most productive as workers receive more money than other, otherwise identical workers. Recently however, in terms of such sectors as the CEOs of major banks, differential compensation has basically had no relation to actual performance (Joyce, 2001, 93-95). Nevertheless, the purpose here is the slow but sure rejection of standardization in respect to demand. The performance of labor is taken more seriously as a qualitative measure, and one consequence of this has been the concept of differential compensation.

But differential compensation is not significantly different from return and reward. If anything the latter concept is a more qualitatively based approach to the former. A slow move away from standardization–that is, the purely Hayekian transformation of demand through prices–and to a highly nuanced differentiation in pay and compensation is part of the increasingly efficient approach to resource allocation.

The nuances in pay can bring the qualitative shift in compensation right to the factor floor, so to speak. But of course, writers like Joyce hold that it is precisely this promising element of the post-modern world that is being violated at the upper reaches of the economic ladder, where power, rather than the market, controls compensation.

But dealing with power brings us to the concept of regulation. Regulation is the interference of the state (though other actors are relevant) in the functioning of the market with the aim of bringing about intended, positive consequences that the market cannot itself provide. Needless to say the potential here for unintended consequences is endless.

State regulation seeks to provide goods for the community (e.g. demanding that wheelchair access ramps be installed in restaurants), but instead allocates resources in the direction of which interest groups are able to pay their way into the halls of Congress or the bureaucracy. While the normal sense of regulation is to assist the community in some desirable way, the reality behind the rhetoric is that regulation is a matter of power and interest group politics (Posner, 1971, 24-ff).

The way writers like Posner see it, state regulation of the economy has the unintended consequence of subsiding certain industries.  Hence, the construction companies that put in the wheelchair ramps are given a “government grant,” so to speak, as a result of regulation. Hence, the concept of derived demand also makes sense relative to regulation and politics.

Another example might be the raising of the minimum wage. In a recent WSJ article, David Neumark holds that raising the minimum wage in depression conditions is disastrous because demanding more money from employers forces a mis-allocation of resources that ultimately forces the cutting of jobs, precisely the low paying jobs that are hardest hit during times of recession and depression (Neumark, 2009, A15, also see Fang, 2005). The unintended consequence here is elementary: the desire to assist the least well off forces employers to eliminate jobs that they would have provided at a lower rate of pay.

The problem with this common neo-conservative argument is that it assumes that jobs are given as gifts to the community. In this case, it assumes that increasing the wage by a dollar would force an employer to eliminate a job. But the job, presumably, was necessary for the functioning of the enterprise, and hence, the rate of pay seems to be basically irrelevant within limits. Here, the problem created by return and reward manifests itself–is it possible for the owner of the enterprise to take a tiny cut in profits for the sake of a functionally necessary job? If not, then is the job functionally necessary? Or is the market only marginally interested in function, or the structures necessary to organize a working enterprise?

In Rose’s (2002) work on CEO pay and state caps upon it, the basic thesis is that such regulation does not work and has the unintended consequence of justifying the current radical differentiation of CEO pay relative to lower level workers. In fact, the state regulated cap on “non-performance”-based CEO compensation is “insulated” from the tax code due to the power structure of the firm itself. But here is an example of the failure of differential compensation and risk and reward relative to performance, that is, the response to demand and represents a position of power rather than a market-based response (Rose, 2002, 139).

In fact, Rose claims that the market has nothing to do with the pay of CEOs, and that public opinion has no channels by which this pay is regulated, suggesting that the firm in the private sector is as insulated from the market as from the state (Rose, 2002, 140-142).  Hence, one might be seeing an intended consequence of the rise of the mega-conglomerate, that is, the completed insulation of the corporate power structure from society and the market and further, a complete breakdown of the return-reward nexus.

Nevertheless, the idea of incentives is built into these ideas, as well as differential compensation. Incentives are a powerful means by which an economy can place its resources into the most profitable avenues dictated by demand. An incentive is a more general concept of differential compensation or risk and reward, in that replying to the means by which demand makes itself heard to the producer is the key to market share and profits. In terms of differential compensation, the structure is obvious: the reward of more money brings about labor that works harder, takes more difficult shifts or even more dangerous jobs.

In conclusion, the basic mechanics of resource allocation in modern economies are a mixed bag. Differential compensation might follow the laws of the market or may exist as a function of political power. The same exists for all the other concepts dealt with in this description, complex as these relations can be.

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