Cryptoeconomic Theory: Markets vs. Planning

Understanding Economic Motivations and How They Affect Markets

This is Part 2 of the weekly Cryptoeconomics series

Three very important and distinct questions guide the organization of Production & Consumption:

• What to produce (& how)?
• By whom should it be produced?
• And who will consume it?

The answers to these questions have been provided by different systems and sciences throughout history, for various different purposes; each with varying levels of complexity.

From Self-sufficient Family to Markets

Consider a self-sufficient family farm on the American frontier in the early 19th century. All the decisions regarding clothing, food, firewood, tools, animals, a new fence, children born and raised were made under one roof.

What to produce and how to use them was coordinated by custom, necessity and patriarchal authority. Tasks were assigned by age and gender.

But not everything was provided in the family, which led to exchange among extended families. There was more specialization, which led to more complex exchanges between strangers; with complexity compounding continuously as technologies pace progressed.

This inevitable positive feedback loop led to different social arrangements throughout history about how the labor would be specialized and products distributed.

• By birth: In Indian caste system, people are born into occupational groups.
• By gender: Even in many advanced economies still, sex determines the type of the job the person can choose (societal norms) and the compensation for the job (gender-related hierarchical discrepancies).
• Theft & Tribute: Situations where some gangs and mafia-like organizations run the economy.
• Gift giving: A gift economy, gift culture, or gift exchange is a mode of exchange where valuables are not traded or sold, but rather given without an explicit agreement for immediate or future rewards. This contrasts with a barter economy or a market economy, where goods and services are primarily exchanged for value received.
• By custom

These are mostly viewed as archaic stepping stones to present-day theories of labor specialization.

The two most important methods of economic coordination in modern times have been both Markets & Planning.

• Market Economies: Coordination by rules → No one dictating anyone else’s precise behavior but everyone observing a set of rules
• Planned Economies: Coordination by command → Someone (or more than one) directing the behavior of others.

Coordination by Rules vs Command

In a market you obey sets of rules. They specify a range of behaviors appropriate in a given situation without specifying a particular behavior (some are collectively agreed upon social norms, some are written into law).

When driving a car, traffic is mainly coordinated by rules like “drive on the right-hand side”, without specifying anything about where to drive, or how to get there (that would be absurd).

On the other hand there are commands. Consider an airport with 100+ landings and takeoffs per hour. There is no chance traffic can be coordinated by a rule like “keep right and yield to traffic on your left of below”. Here, there would have to be a precise set of directed behavior (commands), ordered from an air-traffic control center.

What about an economy which is many more times complex (complexity compounds with greater exchange, remember)? There are about 25 million businesses, 100 million households and 200 million adults in the US. Similarly to cars, there is no feasible way to direct every one of them in their economic actions.

As we saw, the big insight of Adam Smith was: the economy will run itself if it is subjected to the right rules.

Prices

Prices come along to solve very important problems that exist in planned economies (coordination by command). This directly relates to the inherent economic difficulties of communism and market socialism.

We might think that if a central planner knows the market, they can adjust supply and demand, and a central planner can do the job of the market, right?? Unfortunately, no. The type of information in markets is very different than the type of information that’s scientific. In markets, each individual makes decisions based on his family upbringing, beliefs, judgment, experience, and local information. This information cannot be known to the central planner. This information is dispersed among many many people and many, many producers.

In addressing these two problems:

• Information : When ordering coordination, planners can’t have all the information about the tastes of consumers, capability of producers and the technologies.
• Motivation : The planners might not have incentive to come up with good plans or to implement them effectively. They are not saints, especially when they are not working within a defined democratic framework. Also, the people may not have the incentive to provide correct information and might have little incentive to carry out the plan itself.

— Prices are incredibly valuable. They solve both the problems faced by a central planner by providing a decentralized system of information and motivation.

Local information & knowledge is transmitted through price, andeconomic agents have incentive to act on these prices.

Air traffic control realizes the problems of information and motivation, and builds a system accondingly:

• Air controllers have information about the airplanes on their screens and radars.
• The pilots have incentive to provide correct information and obey orders because the life of their passengers and themselves are at stake.
• The air controllers have incentive to do a good job, because a mistake causes they lose their job and could result in a large loss of life.

However, at a large scale, not accounting for the two central planning problems has historically led to the collapse of economies.

Where markets work

The general function of the markets is to:

• The markets transmit economically important information.
• The markets provide the motivation to act on the information.

In market economies, prices transmit information. The price of a good or service shows its degree of scarcity.

• Self-interest causes the consumers look for lower prices. Producer’s want to maximize profit, therefore, they produce high price output with low price input.
• Competitive markets work through incentives in the form both of carrots (reward for success) and sticks (punishment for failure).

Greater profit is the carrot for the owner of a firm. Getting a good job or a promotion is the carrot for the worker. People with wealth (or the ability to borrow) take the risk of introducing new technologies and entering new markets, and win profit if the risk pays off.

For the carrot mechanism of the capitalist system to function, the business owner has to know that the rewards for risk-taking will come to him or her, and not be confiscated by the government or by criminals stealing his or her property.

The threat of going out of business if the firm fails is the stick for the business owner. Losing one’s job is the stick for the worker. For the stick mechanism to operate there has to be opportunities for competitors, such as new start-up firms, to produce and sell products.

Uncompetitive businesses have to be allowed to fail rather than being bailed out, or to be bought by people with better ways of using the firm’s assets.

Free markets and rapid technological development go together. The reason:

• It was the first economic system in human history in which membership of the elite depended on a high level of economic performance. The elite of a capitalist economy — the owners of these firms and their managers — might inherit the wealth that gives them a start, but remaining in the club of its elite requires that they produce goods that people want to buy at a lower price than the competition. As a firm owner, if you fail, you are no longer part of the club. Nobody kicks you out, because that is not necessary: you simply go bankrupt.
• The owner of a slave plantation who was not very good at growing cotton retained his status. He was a less-than-averagely-wealthy slave owner; but still an undisputed member of the elite (according to his collective societal norms). A feudal lord who managed his estate poorly was just a shabby lord. But the owner of a firm that cannot produce goods that people will buy, at prices that more than cover their cost, is bankrupted — and a bankrupt owner is an ex-owner.
• The motivation is when entrepreneurs realize they can build a new technology, will continuing to generate more profits.

Advantage of markets is that it provides the right information to the right people — Hayek

Next up: More theoretical aspects such as Game Theory, Pareto Efficiency and how those concepts relate to coordination.

Edited by: Steven McKie

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