In A True Free Market, It’s Hard To Be Rich

by | Feb 7, 2020

In A True Free Market, It’s Hard To Be Rich

by | Feb 7, 2020

One interesting feature of libertarian theory is its ability to offer a critique of corporate capitalism from the perspective of laissez faire economics. The political economics of societies with large corporations are troublesome, and if you read left-wing literature you’re sure to encounter an endless stream of analysis discussing the problems with large and powerful corporations. What’s interesting, therefore, about the implications of Austrian – libertarian – economics is that under this interpretation one might conclude that free markets make the accumulation of wealth rather difficult to accomplish. A true free market may not favor large corporations – rent seeking from profitable cash cows – or permit much wealth inequality at all.

The argument that free market economics does not support the formation of large firms comes from the application of “Austrian” (so-called) economics to business strategy. This application finds that free market profits are very difficult to accumulate and can be consistently obtained only through entrepreneurial innovation. These conclusions fit well with the ideas of Stephan Kinsella, a famous free market opponent of intellectual property laws, in terms of how market structure generates both innovation and profits when firms cannot monopolize innovation through patents. Finally, the failure of the merger movement in the 19th century, as discussed by Gabriel Kolko, provides further evidence that large firms are inherently economically wasteful. 

Large firms substitute truly productive innovation with monopoly power and economies of scale (in addition to political influence). Society’s current financial system realizes and rationalizes profits mainly through funding and capitalizing this style of large, integrated firms. It may be the case that the promotion of this structure of the firm is the cause of the industrial boom and bust cycle. Naturally, central banking was meant to solve this problem, but many find that it has made the problem worse.

The alternative to large monopoly firms would be much smaller firms where manager-owners personally know their employees. Instead of rent seeking, large firms controlling society’s stable resource channels, most “cash-cow” economic activities would be distributed between a class of petite bourgeoisie who hardly make profits and are in fact more nimble than large firms. Top innovators would have the most wealth, but only in proportion to the value they create via entrepreneurship. In all likelihood, no single firm or person could monopolize innovation, so the gains of innovation would be highly distributed. This alternative world of free markets and distributed wealth may have been unobtainable in the past due to technological limitations, but these limitations no longer exist.

Austrian Economics And Profits

Business strategy is a conventional sub-field of business administration. The traditional master of this field is Michael Porter of Boston Consulting Group. His paradigm of strategy is called Industrial Organization and sees the marketplace as an environment where competing forces constantly try to chip away at a firm, which must gain as much of a competitive advantage as possible in order to survive. In particular, a firm must gain some sort of monopoly advantage over competitive players such as competitors or even suppliers and customers in order to realize profits. Profit is what a firm can gain through some unnatural advantage it forces upon its competition. Michael Porter has conceded to peers such as (socialist) marketing guru Philip Kotler that this feature of capitalism is one of its harsh and unfair realities; it is one which has to be mitigated. Porter’s book, “Rethinking Capitalism,” examines this. However, some people think Porter’s interpretation of business strategy is wrong.

Robert Jacobson wrote an article in “The Academy of Management Review” called, “The ‘Austrian’ School of Strategy”. He argues that Porter’s interpretation of business strategy relies on flawed economic assumptions from neoclassical economics which Austrian economics corrects. Using Austrian economics, Jacobson provides an alternative theory of strategy and profits.

Jacobson’s main complaint with Porter is that the old view of strategy doesn’t give enough attention to the dynamism of an economy being constantly disrupted by technology. In neoclassical economics, the economy reaches an equilibrium. In this equilibrium, firms reach a point where no one is making any profits. However, using the ideas of Menger, Hayek, Mises and Schumpeter, Jacobson argues that the market is in a state of disequilibrium. In Schumpeter’s language, the market is an environment of “creative destruction.”

In a dynamic economy, profits would not be a result of monopoly power, but a consequence of and incentive for engaging in discovery and innovation. New products, processes and organizational techniques are what are called entrepreneurial innovation. You can make profits when the value of base resources – their current price – plus the cost of adding value through production is less than what customers will pay for a final product. You are discovering a use of scarce resources that is more valuable than the current use. Until the supply chain converts over to apply the appropriate amount of those resources to the new use, the resources will be underpriced. Profit gained from the process of restructuring how resources are used is the reward for the restructuring effort.

In Jacobson’s language, “Entrepreneurship is an action that successfully directs the flow of resources towards the fulfillment of customer needs.” In contrast to neoclassical markets which assumes that entrepreneurs have perfect knowledge, Austrian economics assumes that there is ignorance aplenty in the market, and ample opportunity for entrepreneurial profits by correcting market ignorance. However, just like in neoclassical economics, Jacobson admits that any time profits are realized, they will be short lived. New opportunities signal other market participants to imitate. As they do, profits are distributed quickly until no one can profit anymore. Firms must constantly innovate to realize consistent profits.

There are certain features of a firm that would make it able to realize entrepreneurial profits. Some firms have more information than others. This might be idiosyncratic, related to the luck or experience of its employees. Firms that act more quickly can get a head start and leverage it to their advantage – only if they stay ahead in the race. Firms that are more competent in obtaining and using information would be most likely to make consistent profits.

In this “Austrian” view of business strategy, innovation means tiny improvements in a thousand places. Innovation is an ongoing, sleepless and comprehensive process. There are no profits otherwise.

Jacobson argues that flexibility is key to profit making. He notes that some firms have adopted a style which is inherently more flexible. This style, in fact, has additional costs compared to a more stable mode of business. However, depending on the environment, flexibility costs may be necessary to thrive.

Do Patents Help Or Hurt Innovation?

Stephan Kinsella, a lawyer who favors Hans-Herman Hoppe’s argumentation ethics defense of libertarian rights theory, is famous for arguing that libertarian property theory does not support the legitimacy of intellectual property laws. Although Kinsella’s argument is philosophical and logical, he has also discussed empirical arguments about the importance of IP.

He wrote, “…it is striking that there seems to be no empirical studies or analyses providing conclusive evidence that an IP system is indeed worth the cost. Every study I have ever seen is either neutral or ambivalent, or ends up condemning part or all of IP systems.” 

While I think that Kinsella’s point is probably true, I can neither defend nor argue against it empirically. However, in addition to the legal and empirical arguments against IP, what would the economic argument against it be? Kinsella links to an article that discusses a study which examined the question, and the author references a period of English history during the development of the steam engine.

“The authors argue that there have been some cases where a period of patent-free innovation took place in a way that ensured that the innovators were still rewarded. Their prime example is the case of the mining industry in Cornwall, England, where the expiration of several patents on steam engines spurred a period of openly shared innovations that led to rapid improvements in steam engine design. (You can read an academic examination of this period if you’re so inclined) The lack of intellectual property allowed multiple improvements to be incorporated in a single design, while the innovators benefited from having their mines operate more efficiently ahead of their competition.” 

In an environment without patents, open innovation occurs. If a user of a service, good or resources can improve the efficiency by which they are able to use it, they will gain. Referencing “Austrian” business strategy, we see that this sort of activity – in a free market – is where profits must be realized. Therefore, profit motive would be a driving force for experienced users to make small improvements to the technology they’re using.

Whenever entrepreneurial innovation occurs, it’s imitated. Profits can be realized, but very quickly others will copy the efficiency benefits of any given innovation. On the other hand, any innovations others develop will be available to the whole market very quickly. The power of this arrangement becomes apparent when one considers the structure of the economy.

In an economy, base resources are converted through a supply chain of added value until they become a variety of consumer products. This supply chain has multiple layers, and the entire structure is a complex, dynamic spider’s web. At every level, individual resources, parts or products are available for purchase by clients and customers who compete with each other to obtain these goods. Petroleum, for example, can be converted into gasoline or plastics. There is an annual total petroleum production, but the percentage of that total which converts to either gasoline or plastic can change depending on what balance of the two is most valuable to final consumption. The base resource level is called “upstream” of the middle parts level. The consumer level is “downstream”. Resources flow from the top through the added value chain to the bottom. This arrangement creates complex relationships that can be competitive and cooperative at the same time.

If I am a petroleum refinery, I may compete with other refineries for access to petroleum at a low price, and for customers and clients who will buy gasoline at a high price. In spite of this competition, my competitors and I will all be in agreement that high gasoline prices benefit our common bottom lines. We are competing, but we have a cooperative relationship relative to other places in the added value chain. When competition is seen to occur across the entire supply chain, and the entire economy, rather than within narrow industrial categories, the value of open innovation becomes clear.

The coal mines of Cornwall all profited, though they were competitors, from efficient delivery of coal to areas serviced by coal mines of other regions. The Cornwall mines competed against each other, but they competed more against mines of other regions. The railroad was the medium that defined which layer of competition mattered more. The markets to which the railroad connected Cornwall were more valuable than local competitive advantage. This force, plus open innovation, led to early important improvements in the locomotive which created competitive economic value and profits despite none of the creators of innovation deriving monopoly profits from it.

Gabriel Kolko And The Failure of the 19th Century Merger Movement in the USA

Left-wing scholar Gabriel Kolko famously argued, in Triumph of Conservatism, that the 19th century Progressive political movement in the USA was actually a front for big business to promote regulations that protected them from competition. He starts his book discussing the merger movement of the late 19th century. This movement, though full of its share of shysters hoping to make a buck off of hyping big profits for investors, was based on the idea that the structure of the newly realized American “firm” was failing to “rationalize the economy.”  What does this strange phrase mean?

Wikipedia provides one explanation: “In economics, rationalization is an attempt to change a pre-existing ad hoc workflow into one that is based on a set of published rules. There is a tendency in modern times to quantify experience, knowledge, and work. Means–end (goal-oriented) rationality is used to precisely calculate that which is necessary to attain a goal. Its effectiveness varies with the enthusiasm of the workers for the changes being made, the skill with which management applies the rules, and the degree to which the rules fit the job.”

In other words, rationalization means creating a consistent production process where revenue is stable. It means the ability to make a plan, and to be able to carry out that plan. It is the architect’s approach to business, and given the scale of American big business, it is the architect’s approach to social organization. There’s one problem: society doesn’t want to be planned. It can’t be planned. The economy, at a minimum, is dynamic and in disequilibrium. A review of Kolko’s book mentions exactly how this problem affected big businesses:

“Despite the merger movement between 1897 and 1901, ‘the first decades of the century were years of intense and growing competition.’ Giant corporations often didn’t even do very well, making mediocre profits. A financial journal observed in 1900 that ‘the most serious problem that confronts trust combinations today is competition from independent sources… In iron and steel, in paper and in constructive processes of large magnitude the sources of production are being multiplied, with a resultant decrease in profits…’ ”

Big profits don’t last long. Big businesses faced constant pressure from smaller competitors as profits flattened and increasing numbers of entrants captured them. Those capable of innovating would swamp big business, knocking out yesteryear’s titans. No wonder fat cat tycoons wanted government regulations.

Is Artificial Credit Fueled Booms and Busts A Game Theoretic Problem?

The big businesses, which could not rationalize the economy, can’t be blamed for seeking stability. Though they were surely motivated by greed, they also faced an insurmountable problem. When taking a base resource and choosing which uses of it are best, how can anyone possibly know?

In a market economy firms compete to use resources, and the alternative uses they have in mind, the competition itself, represent how the economy chooses how to use base resources. Competition, however, presents a paradox. The assumption is that one firm has the best knowledge of how to produce the most value with a base resource. This firm would be the winner of market competition (which isn’t to say there’s only one winner at a time). In order for the market to realize this firm is the winner – that its knowledge is best – other firms have to try and fail, through competition, to apply their knowledge. Does the effort of the losing firms represent a waste of real resources?

A free market economist would argue that competition is necessary for the discovery and information sharing it facilitates.  This may be true, and the free market may be better than centrally planned alternatives, but this does not mean that the competitive process isn’t wasteful. In order for competing firms to have the resources to embark on possibly futile quests to win the market, they need credit. If too much credit is applied to an industry, it will take too long to learn who the losers are. This means wasted real resources. However, if no credit is applied to an industry, the firms can’t play the game of guessing and proving who deserves to win. What’s the right balance?

Determining the right amount of credit necessary to capitalize an economy might be impossible. This could be the cause of the boom and bust cycle. Credit is applied, it creates capitalization which leads to innovation and scale. The cycle continues. Waste is distributed throughout the banking system until finally scale and innovation fail to create more value than the waste the banking system creates in order to provide credit.  This is an industrial bust. Central banking solves this problem, by making it worse.

In today’s economy we have stagnation. We have long-lived super cash cow firms, we have tech giant monopolies, and we have an industrial structure where very few industrial categories have been added relative to the past. It’s somewhat clear how this is a product of Progressive economic regulations, sustained government economic intervention, central banking and fiat money. We also have the greatest wealth inequality gap of all time.  Meanwhile, costs of living are pricing the middle class out of a middle class lifestyle.

The root of the problem seems to go back to the failure of firms to rationalize the economy. Profit seeking, credit fueled, scale requiring firms seem to be structured poorly. They require sustained profits to survive, just as the broader economy requires constant growth. This absolute need for profits, to keep financing channels open, leads to a need for either limited monopoly advantages (barriers to entry, patents, etc.), or expanded markets. In the case of the latter, the stated foreign policy of the United States from the 1890s to the 1930s was to use the military to open up foreign markets for American goods. It was argued that if these markets weren’t made available, the economy would collapse. I suppose the monopolized competitive firm and credit capitalism would have collapsed without such drastic colonialist measures.

The solution to this problem isn’t to rationalize the economy with integrated firms. The solution lies with an added value supply chain that features small flexible firms which have the ability to manage their competitive and cooperative relationships dynamically. In this author’s opinion, the lack of a technology which could facilitate the management of competition and cooperation is why this option wasn’t available in the 19th century. However, with technology such as blockchain, contemporary society now has a tool which can accomplish this managing of relationships.

How A Free Market Economy Would Look

A free market economy would look very different from today’s corporate, credit capitalist economy. With government enforced barriers removed, big firms would face constant competitive pressures. Well established economic activity would resolve to best practices. This would remove the ability to sustain profits. Such a market would follow rules similar to what neoclassical economics calls “perfect competition.” There would be many small firms, none of whom would make profits.

These small firms would be the industrial/information age equivalent of Yeoman farms. There might be owner/managers who make a slightly bigger salary than his employees, but he would be more invested in the firm and more connected to its history. The lack of profits means that the firm would operate near break-even. This puts even more pressure on the manager to not accept a salary much higher than employees, because all other such firms could out compete each other by lowering the managers’ salary. This is why these firms would be like Yeoman farmsteads. The owner would create the firm out of pride, a sense of family or personal history or petty social status, more so than some leap of wealth associated with ownership. The product or parts they produce will be commodities, and client/supplier relationships will become less important.

With technology, complex supply and logistics chains can create modern levels of production scale and quality even when incorporating a large variety of participants at every level. This is the “Uber-ization” of a manufacturing supply chain. If a small factory can achieve through scale more efficiency than smaller workshops, then the commodity part they produce will become a market dominated by firms all of around that same size.

The exception to Yeoman manufacturing and service fulfillment is the economy generated by entrepreneurial innovators. Successful innovators can both realize profits consistently and also develop natural monopolies that can achieve – at least temporarily – great scale. There would certainly be large, sexy, wealthy firms in this kind of economy. Nevertheless, they might take the form of partnerships, leveraging the combined skill and experience of a set of specific people.  The partnerships would last only as long as talent was kept fresh. These kinds partnerships were actually common in the economy of the 1950s and 60s in the US, but have since engaged in numerous mergers to become massive transnational firms.

Blockchain might be a key technology in this vision of a truly free market industrial economy. Instead of vertically integrating a supply chain inside of a corporate firm, a supply chain can be integrated through a series of relationships between erstwhile competitors, managed by smart contracts. There were reasons why corporate firms vertically integrated. Investment decisions required some guarantee of price stability of resources within the supply chain relevant to the investment. 

With blockchain, prices wouldn’t be guaranteed the way integrated corporate firms do using transfer prices. Instead, while the prices of stages in the supply chain would remain dynamic, the sharing of value between cooperating firms would be guaranteed. So, if I am promised 30% of profits of a supply chain’s final customer sales value, that could be 30% of $10 million, or 30% of $8 million – but my gains or losses would be in proportion to my competitors’ as well. Such a guarantee would be relevant because what is being managed is not the nominal value of resources, but the game theoretic consequences pertaining to competition. If gains and losses are realized fairly between competing firms, they might choose to cooperate in certain ways to help their joint competition with other areas of the economy. If all firms can agree that the final value of an added value supply chain would reach at least a certain threshold, and that the objective division of value between participants is guaranteed from the beginning, then they would be able to invest money into a large and complex cooperative infrastructure that can achieve scale.

Cooperating competitors would be more flexible and dynamic than a large corporate firm. Imagine an agricultural supply chain. To modernize it to new levels of efficiency, many improvements can be added. Self-driving delivery vehicles, an IT platform, warehouses, automated cargo ships, and a large variety of customers with their own varied demand curves. It would be exceedingly difficult to integrate a single firm across such a chain, let alone one with enough breadth to capture a large share of the market. If it was integrated as such, it would have a substantial calculation problem. 

However, if multiple firms at every level of such a supply chain engage in a smart contract enforced bidding and fulfillment process that is built around the vision of the planned infrastructure, then that infrastructure can be developed flexibly. One car company could produce the self-driving truck, only to later be outbid by another company that offers one for cheaper. A large integrated firm would be loath to take losses in one department when it has monopoly control over a supply chain. In a decentralized structure, competition would still occur where it can occur. However, the relationships between all farmers, as one group, all self-driving truck manufacturers, as one group, and shippers, as one group, would be fixed. The final value of the integrated supply chain can be partially rationalized, even if it can’t be perfectly forecast.

Today, if you want to buy a car you have to consider tradeoffs. Maybe Lincoln has the best interiors. Ford has the best engines. GM has the best service and support. Forgive me car enthusiasts, this is a hypothetical. In this scenario I have to decide which feature is most important to me. What if I could have a car with Lincoln interiors, Ford motors, and GM service? In corporate, credit capitalism, these companies can’t share their best features with each other to maximize the value each feature adds to the marketplace overall. They use their feature as a monopoly advantage. Those who love luxury interiors must buy Lincoln, so Lincoln can overcharge these customers and make profits. In my opinion, a better arrangement is one where almost every car on the market has captured the value of Lincoln’s interior design expertise. Lincoln’s profits would come from being the very most innovative design firm, when it comes to interiors, serving a very large market share of all automobile customers. Customers would own cars with Lincoln interiors, GM service, and Ford motors.

It’s Hard To Be Wealthy In A Free Market

In my opinion, Libertarianism should be seen as a disappointing ideology for the super-rich. Regional and local gentry, too, would probably stand to lose a fair amount of social status in a truly free market. They might have to downsize their McMansion and sell their boat. I genuinely believe that libertarian free markets would inherently be wealth equalizing. They would not create total social equity, however. People are different and have different skills and make different decisions. Some circumstances, due to birth, are genuinely unfair. That doesn’t mean that the disadvantaged have a right to infringe upon others’ rights to have every unfairness of birth corrected and resolved. All societies, even in communism, have unequal social status problems. Also, people just like to live different lifestyles and have different priorities. Libertarian free market economies would not be equity utopias dreamed of by the “eliminate negative outcomes” progressives of the modern era. Nevertheless, libertarian ideology does perceive a free market which is not very friendly to the rich, and only gives temporary rewards in proportion to merit.

Someone should call the GOP and inform them that the free market is not their friend. Someone should call the leaders of the populist right and teach them that the free market is their best friend. Someone should call the liberal socialist left and convince them that free markets come closest to their localist, equalist ideal. Hopefully, with new technologies like blockchain, we can solve the economic problems which have plagued free societies for 200 years, and have a freer world.

About Zack Sorenson

Zachary Sorenson worked for the United States Air Force for six years as a Navigation Officer. He recently quit because of a principled opposition to war. He considers himself to be a Libertarian, and studied Economics at the University of Maryland, College Park. He would like to see the resurgence of a non-political commitment to peace for its own sake, across the spectrum of ideologies.

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