As we have seen, afirm's success in a market economy depends on satisfying customers by producing theproducts they want and selling those goods and services at prices that meet thecompetition they face from other businesses. Doing that requires firms to develop carefulanswers to one of the most important questions every economic system faces: how can asociety produce goods and services most efficiently? In a market economy, that meansgetting the greatest value of output from the inputs producers use.
To Build a Bicycle
Let's take the case of a firm that is considering the manufacture and sale of bicycles.Before launching such a venture, any entrepreneur or company has to consider a host offactors. First, what is the potential size and nature of consumer demand for a new brandof bicycle? Is there a single, large market for standard model bicycles? Or is the bicyclemarket divided into many smaller markets, or niches, for specialized bicycles forchildren, customized racing bikes, or bicycles built for two? A new trend, such as thesudden popularity of so-called mountain bikes that can handle wilderness trails, mightalso attract new manufacturers who see an opportunity to make a profit. On the other hand,prospective suppliers may simply feel that they have developed innovative manufacturingtechniques for a standard bicycle, or possess significantly lower labor costs, so that thecompany can undersell their rivals in the marketplace and still make a profit.
Not only are there many kinds of bikes to make, but there are many ways to make thesebicycles -- from using a highly automated assembly line to stamp out thousands ofidentical parts and put the bikes together, to using more labor and much less machinery todesign and make customized bikes. Once again, the firm making these decisions in a marketeconomy has to consider several different prices that may rise or fall in response to thebehavior of people who buy and sell those products.
For example, the prices the firm has to pay for its inputs will obviously play a majorrole in determining how much steel, aluminum, labor, machinery, and other materials thefirm will use in making its bicycles. If the price of steel rises and the price ofaluminum falls, many bicycle firms will look for ways to use more aluminum and less steel.Similarly, if wages for workers rise sharply, firms will have a strong incentive to lookfor ways to use more machinery, or capital, and less labor. A firm might decide to buymore forklifts, for example, using fewer workers to move its inventory around thecompany's warehouses. Or it might use more machines to make routine and repetitive weldson its bikes, and thus hire fewer workers to do welding jobs. (As a consequence, thenumber of workers in factories producing the welding machinery used by the bicyclemanufacturers would increase.)
Any such venture carries a large element of risk: a new bicycle design may fail toattract customers, or manufacturing costs may be unexpectedly high, pricing the company'sbikes out of the market. Companies alone bear this risk of failure -- and reap theeconomic rewards of success if they have planned correctly and their bicycle venturesucceeds.
This balancing of risk and rewards by individuals and private companies points to anessential role of government in any market economy: protecting private property rights andenforcing a law of contracts. Property rights must be well-defined legally, and businessowners and investors must be treated the same by the law and commercial regulationswhether they are citizens of the country or foreign nationals.
Only if property rights are free from the threat of expropriation by government, orexploitation by political interests, will individuals and companies be willing to risktheir money by investing in new or expanded businesses. Moreover, they must be assuredthat the state's legal system will settle disputes over contract terms in a fair andconsistent manner.
In short, entrepreneurs, whether domestic or foreign, must be willing to face economicuncertainty in their ventures -- but should not have to face political or legaluncertainty about the legitimacy of their enterprise.
Competition and Productivity
Making these adjustments as the prices for a firm's inputs change is an important part ofwhat it means to produce efficiently and to compete with other firms making similarproducts. Companies that don't hold their production costs down may try to charge a higherprice for their products; but that just won't work if other firms can make the samequality products at a lower cost and sell them at a lower price.
Consumers benefit from this competition among firms because they get better products atlower prices. And if most goods and services they buy are made in markets characterized bya high degree of competition, their budgets will go further and allow them to buy moreproducts with the income they receive.
Even in competitive markets, however, not all firms will choose to use exactly the samematerials or production methods. In many cases, that will reflect the different kinds ofbicycles or other products they choose to make. For example, firms making a very basicbike for young children to ride or for adults who use the bikes as daily transportation toand from work will very likely want to make a large number of identical bicycles and putthem together using standardized materials and assembly line methods that keep productioncosts and prices very low. On the other hand, companies specializing in customized racingbikes are likely to use more labor, special design tools, and more expensive metals, butuse fewer stamping machines and assembly lines making identical parts. Not surprisingly,prices for the customized bikes will usually be higher than prices for the bikes that aremass produced in large factories.
Ideally, of course, everyone would like to have all of the things they buy face sharpcompetition -- thereby holding those prices down -- but face little or no competition fromothers in what they do to earn their own income -- so that their wages will remain high.More generally, everyone seems to favor the idea of high wages and low production costs(including labor costs, which are most firms' largest expense), because that seems toimply that everyone will be able to afford to buy more goods and services. But no economicsystem can provide high wages and low prices at the same time, because workers' wagesrepresent a company's labor cost in making and selling the goods and services it produces.In other words, as long as other costs and demand remain unchanged, raising everyone'swages simply raises production costs and product prices.
Over time, however, there are ways for workers and firms to resolve this dilemma --that is, to earn higher wages and profits without driving up the prices consumers pay forproducts and thereby risk losing their jobs or sales to competitors. The answer is toincrease productivity, the level of output that an industry or company achieves from eachworker or each unit of input into its products and services. To increase productivity,workers and firms must develop new products for the marketplace or produce goods andservices more efficiently than the competition, at a lower cost, or with better quality.In short, their products must be newer, better, or cheaper.
Higher production levels justify higher wages and living standards. Higher productivitymeans higher output per worker, which translates into greater prosperity that can beshared through higher wages and a better standard of living. Cutting costs and workingmore efficiently are ways of increasing productivity, but in modern technology-basedeconomies, research and innovation are critical to the sustained productivity and growthof a nation's and the world's economy. Advances in computers, telecommunications, andbiogenetics are the result of scientific research, experimentation, and testing. Theseadvances occur continuously in market economies as companies seek to develop new productsand services, or to produce existing ones more efficiently. The result: new jobs,expanding opportunity, and greater prosperity for all. This, too, is the same way allworkers and businesses in a country can improve their competitive position in the worldeconomy, to raise the material living standards in their nation over time.
International trade can make an important contribution to productivity and prosperityas well. Think for a moment of Robert and Maria shopping for oranges. Robert is amachinist, skilled and experienced in what he does. Suppose that instead of workingfulltime as a machinist, Robert had to devote some of his time to growing oranges -- andthe orchard owner, who has grown oranges and other tree crops for years, had to spend timemaking machine tools. Neither would be as productive and efficient in his secondary job asin his primary work. The result would be predictable: fewer oranges and lower-qualitymachine tools for everyone. Just as two people are both made better off when they buy andsell from each other and specialize in the production of the things they do best and mostefficiently, so too are regions and nations better off when they can specialize and tradefreely with each other. When nations trade in the goods and services they make well and atlow cost, the benefits accrue to the people in all the countries involved.
The most popular arguments calling for policies that limit free trade -- usually taxeson imported goods or limits on their amounts -- claim that protecting jobs in someindustries is good for a country because the workers and owners in those industries willearn higher wages and profits and spend most of that money in their own country. Thisclaim has an element of truth, but it is only part of the story. Protecting some producersand workers also means that prices for the goods and services they make will be higher.This is bad news for consumers, for other producers who use those products as inputs, andfor firms that find their sales falling because some of their customers paid more for theprotected products.
