Fair Exchanges and the Value of One’s Contribution

To begin with the first question, the reason it is appropriate to say that these fair exchanges are reflective of the value of what parties have to contribute in an exchange is to be found in Hayek’s insight into the informational sig­nificance of market prices remarked on in the first section of chapter 2.

By contrast, if an exchange is not fair, then the terms of the exchange do not accurately reflect the relative scarcity of one or the other party’s contri­bution to the well-being of others. Two examples illustrate. Suppose that Mary pays $15,000 for an automobile that (unbeknownst to her) is sold in many places around town for considerably less. Suppose that this market is not competitively efficient—perhaps because of some market failure, such as imperfect information due to insufficient advertising on local television.

To take another example, suppose that the purveyor of a good has a state- guaranteed monopoly, which he uses to make monopoly profits on the sale of this good. In this case, the price on the factor markets of the bundle of goods and services that make up the product is significantly less than the price of that bundle on the product market. In buying that bundle on the product market from the monopolist, purchasers of the product have been systematically misled about the true relative scarcity of that bundle of inputs.

This account of what constitutes a fair exchange and the value of someone’s contribution works reasonably well when the markets in question are stable, whether or not they are competitively efficient. If the cost and the price of an item are fairly close, sellers are getting the value of what they are selling and buyers are getting their money’s worth. On the other hand, if the price markedly exceeds the cost, then the seller is able to appropriate some value that he would not be able to get if markets were competitively efficient. An analogous situation arises if the cost exceeds the price.

However, there is a difficulty with this account of fair exchange and the value of one’s contribution, which becomes apparent when one tries to understand the value of the entrepreneur’s contribution. When the market for a firm’s product is competitively efficient, the residuals are zero, and the entrepreneur receives nothing—which seems appropriate, since no entre­preneurship is exercised.

Clearly, however, entrepreneurs make a contribution—indeed, a very valuable one when markets are not in equilibrium (i.e., not competitively effi­cient). Consider a case in which an entrepreneur institutes a technological innovation that lowers a firm’s costs and allows it to pass some of the savings on to its customers. If the market had been competitively efficient, it no longer is so, because of this change in the cost of producing the product. By his action, the entrepreneur is moving the market toward competitive effi­ciency, both directly by changing the price he charges and indirectly by informing the rest of the market that prices are not properly coordinated rel­ative to underlying economic conditions. Other purveyors of the product will have to find a way to lower their prices if they are to remain competitive. Call this a market in transition. The terms of exchange offered by this entrepreneur are on the leading edge of this market; that is, these terms are closer than any existing alternative to the new competitive equilibrium price that will emerge, a price that may be unknown to anyone at that time.¹³ The primary contri­bution of the entrepreneur is the signal he sends to the market by changing his price. That is the difference he makes, and that signal provides more accu­rate information (by hypothesis, the best currently available information) about the true relative scarcity of the product.

In a market in transition, that is the entrepreneur’s contribution. What is its value? An obvious suggestion is to identify the value of that contribution with the pure profits that the firm earns as a result of the entrepreneur’s action.

This problem can be easily fixed by altering the definition of a fair exchange and the associated account of the value of one’s contribution to take these considerations into account. The definition of ‘fair exchange’ can be restated as follows:

DEFINITION. An exchange e is fair if and only if either (i) the market in which e takes place is a competitively efficient market or (ii) e is on the leading edge of a market in transition.

As indicated, a market in transition is defined as one in which the terms of exchange are moving toward what will emerge when the market is competi­tively efficient; an exchange on the leading edge of such a market is defined as one for which there is none closer to the new equilibrium exchange rate. Suppose, for example, that the competitively efficient price of a copy machine had been $5,000. Because of a new technological development that drives down production costs, the new competitively efficient price that will even­tually emerge is $4,000, whether anyone knows that at the time or not.

The $500 in pure profit that firm A makes represents the value of the entre­preneur’s contribution. He is signaling to both customers and competitors that there have been changes in the underlying determinants of the competitively efficient price. As Adam Smith might say, this signaling is done out of self-inter­est and not the goodness of his heart, but it is a vital service that must be per­formed in any market economy. Indeed, it is no exaggeration to say that the efficiency of a market economy depends on this signaling. Nothing in this story assumes that this entrepreneur knows where the new equilibrium price will be; indeed, that is what the market process discovers. But under the assumption that this exchange is in fact on the leading edge of a market in transition, this entrepreneur is pointing the market in the right direction.

Notice that exchanges that take place with the other sellers are not fair exchanges according to the definition—which is as it should be. In the case of those continuing to sell at $5,000, their price tells the market nothing about the changes that have taken place. In the case of sales at $4,750, the fact that the seller earns $250 more than firm A makes no additional contri­bution to informing the market about changes in underlying conditions, so the seller is receiving more than the value of his product, which is now $4,500.¹⁴ This is true even if his cost structure is higher, and he has not been able to figure out how his rival sells the product for less.

The same considerations apply if a market is moving in the other direc­tion. Consider, for example, changes in the price of heating oil. Suppose an especially harsh winter is setting in, and the firms that own the heating oil refineries raise the price of their product to distributors.

On the other hand, it is important to call attention to the fact that not all pure profits pocketed by firms and individuals are captured on the leading edge of these transitional markets. Not only are there exchanges in transi­tional markets that are not on the leading edge, but there are also markets that are neither competitively efficient nor in transition. Some of these might be called ‘stagnant markets.’ In a stagnant market, prices are stable but some participants are making persistent pure profits or suffering persistent pure losses. Of course, firms suffering persistent losses will soon disappear from the scene, unless they are subsidized by someone (usually the state). The explanations for persistent profits are various. Firms might have a govern­ment-guaranteed monopoly or a state subsidy, or they might be facing dif­ferent cost structures even though those with the lowest costs have not low­ered their price. The pure profits that this company appropriates serve no signaling function at all and thus are not a return to any positive contribu­tion. They are like monopoly profits, which are imputable to the monopo­list’s status as sole supplier and serve no efficiency function. In a competitive environment, however, companies will usually not sit on cost savings for long, since they can often increase net revenues and market share by lowering their price, and they may face losing both if a competitor makes the same discov­ery and lowers her price.

Thus far, competitively efficient markets, markets in transition, and stag­nant markets have been discussed. There is one final possibility to consider. Sometimes market conditions are so chaotic that prices are very widely dis­persed or are highly volatile and not trending in any direction. Any of these circumstances may hold for an extended period of time, even if the compet­itive process usually eliminates either condition in relatively short order. Causes of these phenomena include exogenous shocks such as war, political upheaval, or unforeseen changes in the regulatory or legal environment. There may be endogenous causes, too, though an examination of this possi­bility would lead us further into macroeconomics than this book can go. Whatever the cause, it is relevant to ask what the value of something is in a chaotic market. Although various hypothetical equilibria can be defined, per­haps the most natural answer to this question is that the value of something under these circumstances is simply undefined; that is, there is no such thing as the value of a good or service in a chaotic market; there are only different prices at which people are making exchanges, and those prices do not bear any very close relationship to any of the usual underlying determinants of price.

Consider, for example, a highly volatile stock whose price fluctuates dra­matically on the most insubstantial rumors. If someone buys this stock, is it really worth what she is paying for it? The question seems to evaporate. If this is correct, no meaning can be assigned to the question, Are people get­ting the value of their contributions in chaotic markets? Although chaotic markets do exist, the belief that price theory (perhaps the best-established part of economics) tells us a fair amount about the real world presupposes that these chaotic markets are the exception and not the rule.

To summarize, the notion of a fair exchange can be defined in terms of what one receives in a competitively efficient market or on the leading edge of a market in transition. If the market is stagnant or if the exchange is not on the leading edge of a market in transition, then one of the parties is not getting the value of his or her contribution. This is the account of a fair price and the value of someone’s contribution that will be used in the rest of this book.¹⁶ It is a necessary but not sufficient condition for exploitation that someone is not getting the value of his contribution. Before passing on to consider the criteria for identifying competitively efficient markets and mar­kets in transition, there is an objection to this account of value that merits some discussion.

It starts from the observation that in any market system it is inevitable that some consumers have more “dollar votes” than others. In existing free enter­prise systems, this means that considerable resources are devoted to the pro­duction of luxury goods that would otherwise find other employment. This fact influences the entire structure of production and, indirectly, the terms of exchange for all goods and services. Can it really be that people are getting the “true value” of their contributions in a society that, for example, pays ath­letes millions of dollars a year; manufactures and sells perfumes, Rolls Royces, and fur coats; allows huge disparities of income and wealth; supports even half the number lawyers that American society supports; and so on? The var­ious social irrationalities, as they were called in chapter 2, distort the struc­ture of production in ways that defeat any attempt to identify some rate of exchange for any good or service in this type of economy as “fair.”

The problem with this objection is that it takes the terms ‘true value’ and ‘fair exchange’ too literally and in too moralistic a fashion. It is possible to distinguish two senses of these terms. One sense describes the terms of exchange that would exist in the good society, or at least in someone’s vision of the good society. For example, on some socialist’s conception of the good society, the exchange value of the writings of Milton Friedman would be about the same as the exchange value of the writings of Marx and Lenin in the former Soviet Union, namely, slightly above the value of scrap paper. That would be a fair exchange in the market for Milton Friedman’s writings in the good society, according to this socialist’s vision. Although it might be easy, one can suppose, to assess the ‘true value,’ in this sense, of Friedman’s writings, it would much more difficult to assess the ‘true value’ of many other goods in the good society (according to this vision of it), assuming that no existing soci­ety is too close to the theorist’s vision. This is especially true of producer goods, such as oil drilling equipment and road grading machines, since exist­ing exchange rates reflect factors and forces that would not exist in that soci­ety. So, it might be argued, there is a sense in which one cannot know the true value of many things—or possibly even anything.

However, according to the other sense of the terms ‘fair exchange’ and ‘true value’—the sense being employed here—what one is talking about is the rate of exchange that would be found in existing society if the relevant markets were functioning properly. Prices in competitively efficient markets reflect how people do value things, not how they ought to value things.

Indeed, one has to make a distinction like this to criticize the values that a society happens to hold—values made manifest by where and how pro­ductive resources are deployed. In speaking of the value of someone’s con­tribution (or the terms of a fair exchange), one is speaking of the value of that contribution in the society as it actually exists. This means that the point of reference is the set of actual values people have and express through their purchases, whatever those values are and whatever the distribution of that purchasing power is. One can acknowledge that people are getting (or not getting) the value of what they have to offer and yet still criticize the values that ultimately determine those exchange rates, or the distribution of wealth or income in that society that determines people’s “dollar votes,” or both. There is a sense in which exploitation is a surface phenomenon, however deep its explanation goes.¹⁷ Moreover, though exploitation is arguably a form of distributive injustice, there may be more to distributive justice than the absence of exploitation. This and related issues come up again in the last sec­tion of this chapter.

Consider now the question of the criteria for fair exchanges. Since fair exchanges are those that take place in competitively efficient markets or on the leading edge of markets in transition, the question resolves itself into determining the criteria by which these markets can be identified. To begin with competitively efficient markets, recall that the price at which a good exchanges in a competitively efficient market approximates the price that would be found in an ideal market for that good. Ideal markets are defined in terms of some very strong structural assumptions (many firms, homoge­neous product, perfect information, etc.). Though no real-world market may fit all of these defining features, some are reasonably close approximations to the ideal. Approximations to the defining features of an ideal market, then, are marks or criteria by which a competitively efficient market can be iden­tified. One can identify such markets by looking for most of the following: many competitors, knowledgeable customers, low transactions costs, easy entry, cheap information about price and quality, and few or no externalities. The basic idea is that if a market has many or most of the real-world analogs of the defining features of an ideal market, that is a good indication that this market is competitively efficient and that exchanges in it are fair. Consider, for example, the market in wholesale produce in most major cities. There are many suppliers and purchasers, price and quality information is easily available to both buyers and sellers (nearly all of whom are quite knowl­edgeable), barriers to entry are relatively low, the volume of transactions is high, price changes primarily reflect changing supply or demand conditions, and externalities and transaction costs are negligible. These are competitively efficient markets. What entrepreneurial profits there are (both positive and negative) tend to be relatively small and to be canceled out over relatively short periods of time, so that the owner-operators in the wholesale produce market earn about the equivalent of a wage plus a normal return on their capital investment. Exchanges in these markets are fair exchanges.

Approximation to an ideal market is a good criterion for competitively efficient markets, but there are two problems in applying it. First, it is unclear how many attributes of an ideal market must be approximated for a real- world market to count as competitively efficient. Having all those features would be highly restrictive. On the other hand, approximating only one defining feature of an ideal market is surely insufficient for saying that the market is competitively efficient. Second, it is unclear how closely a feature of a real-world market must resemble the template of the model for the approximation to hold. In short, the truth conditions for these approxima­tion claims are indeterminate along two dimensions. This does not mean that there are no clear cases of markets that closely approximate the model (wholesale produce markets in most major cities do), but it does mean there are cases where there may be no way to say whether the market approximates an ideal market.

In addition, as was noted, markets need bear no structural similarity to ideal markets in order to be competitively efficient. So approximation to an ideal market cannot be the sole criterion. What else could serve? What all competitively efficient markets (including those that approximate ideal mar­kets) have in common is that they are effectively invulnerable to successful entrepreneurship. No individual or firm is in a position to profit by reaping economies of scale; discovering a new, lower cost source of supply of inputs; instituting technological innovations that reduce production costs; making organizational changes that reduce transaction costs; expanding the market without incurring losses; appreciably increasing market share; repositioning their products in the market; or the like. These are the kind of things suc­cessful entrepreneurs do, but none of them can be done in a competitively efficient market.

There are other, less obvious ways in which a market may be invulnera­ble to successful entrepreneurship. The next chapter will explain how some exchanges are supported by highly specific assets, that is, assets that are costly to redeploy once they have been committed. For example, a supplier might purchase a specialized piece of equipment to manufacture a product for another firm. This piece of equipment might be so specialized that it can be used for no other purpose than making that product. Furthermore, that product might itself be so specialized that the only firm that has any use for it is the firm that buys it. Initially, there might be a number of potential part­ners available for each side of this exchange relation. However, once the relationship between these two firms is engaged and begins to develop, the purchaser effectively has no other source of supply and the supplier effec­tively has nowhere else to sell his product. The situation is one of bilateral monopoly.

The “micro market” in which this exchange takes place may still be com­petitively efficient, however. Suppose that the original terms of the contract (i.e., the exchange) were crafted in such a way that neither side could have got a better deal from some third party over the life of the contract. For example, suppose that each side builds an expensive specialized piece of equipment that can only be used in conjunction with this contract. Following Williamson, this can be called an “exchange of hostages” (1985, 190-95). As a result, successive adaptations of the terms of the contract (which can be thought of as a sequence of exchanges) result in what one would have expected if there were many other sellers and buyers around whenever the contract was renewed. Under a contract like this, it could said that both par­ties are operating as if they were in an environment that approximates an ideal market. If that is what happens, then this “micro market” is effectively invulnerable to successful entrepreneurship and thus can be pronounced competitively efficient. (Exchanges supported by highly specific assets are quite common and will be discussed in detail in the next chapter.)

A clearer idea about what invulnerability to successful entrepreneurship involves can be got from considering how what were called stagnant markets are vulnerable to successful entrepreneurship. One kind of vulnerability is more hypothetical than real. The American sugar market is, in one sense, highly vulnerable to successful entrepreneurship. American sugar produc­ers could be wiped out very easily by traders buying on the world market at the world market price and selling in the American market. However, tariffs and quotas make this illegal, thereby protecting domestic sugar producers from the rigors of the market. Producers of substitutes are also protected. For example, the Archer Daniels Midland Corporation is a powerful supporter of the domestic sugar industry because it can profitably sell a substitute for sugar (corn syrup) to soft drink companies, but only if the price of sugar is maintained at artificially high levels. Because of their political connections, these markets are, in one important sense, relatively invulnerable to success­ful entrepreneurship, but by ordinary economic criteria they are highly vul­nerable.

On the other hand, some stagnant markets consist of firms or individuals who really could be undercut by more efficient competitors. These markets, however, can only be reliably identified in hindsight. American steel, cloth­ing, and automobile manufacturers over the past twenty years have proved vulnerable in this sense. However, segments of these markets have become competitively efficient over the past ten years or so as some of these firms have shaped up, and others have gone out of business.

In the case where there are legal prohibitions or restriction on competi­tion, the relevant markets are almost always hypothetically vulnerable to suc­cessful entrepreneurship. In the other type of case, it is harder to determine, at least ex ante. The reason for this is the simple fact that identifying this sort of vulnerability is what successful entrepreneurs do. Judgments that a mar­ket is vulnerable to successful entrepreneurship can be decisively confirmed only after the fact, that is, when that market has been successfully invaded, and entrepreneurs have initiated what Schumpeter calls their waves of “cre­ative destruction” (1942, 81-86; 1961, chaps. 2, 4). If economists could read­ily identify these markets beforehand, they would not be hostage to the tra­ditional American slogan, “If you’re so smart, how come you’re not rich?”

What follows from these observations is that invulnerability to successful entrepreneurship, which is the mark of competitively efficient markets, is dif­ficult to identity. Structural similarity to an ideal market is not a necessary condition for competitive efficiency; it is simply a good indicator that the mar­ket is competitively efficient. There is, however, one additional uncertain indicator that should be mentioned: rates of return to equity owners. If gov­ernment securities are conceived of as essentially riskless investments, then the rate on these securities is the social discount rate (the pure time prefer­ence rate). If all the equity owners of firms that compete in a given market are getting about this rate of return on their investment, then there is some reason to believe that there are no pure profits to be made. However, the failure to receive pure profits may also indicate that the managements of all these firms have simply not done a good job in acting on opportunities that are “there” for anyone in the industry to see. Also, most firms sell a mix of products (or, at least, they segment markets in different ways), so the fact that some equity owners receive only the social discount rate of return on their investment may represent offsetting positive and negative pure profits in dif­ferent markets.

Unlike competitively efficient markets, markets in transition are easier to identify. If there is a more than one price for a product and if prices are trending in a certain direction, that indicates that the market in question is in transition to a new competitive equilibrium. It is not a guarantee, however, since the entrepreneurs initiating this change may be acting on mistaken beliefs about underlying conditions, and the market may end up heading in the other direction or returning to the old equilibrium. Finally, in chaotic markets, entrepreneurs’ guesses are not reflective of the underlying eco­nomic realities; any pure profits that they make do not signal real changes in the economy: they are purely speculative in the pejorative sense of the term. But when transactions take place on the leading edge of a market that is in transition to a new equilibrium, the exchanges are fair and both parties are getting the value of their contributions.

Recall that the point of identifying competitively efficient markets and mar­kets in transition was to determine in which markets buyers and sellers are getting the value of their respective contributions. Both sides are getting the value of what they are giving up when an exchange takes place in a compet­itively efficient market or on the leading edge of a market in transition. By implication, in these markets, reciprocity holds, and neither party is exploit­ing the other party. By contrast, in exchanges that are not fair—those in stag­nant markets or those not on the leading edge of markets in transition— someone is getting more or less than the value of his or her contribution; in either case, reciprocity fails. Such exchanges may or may not be exploitative, depending on whether or not other conditions for exploitation hold.

It is worth pointing out that a fair exchange in the product markets does not presuppose fair exchanges in the factor markets and vice versa. Suppose that a given product market is competitively efficient, so that exchanges in this market are fair. Those who provide factors of production to participants in this market may or may not be getting the value of what they contribute. That would depend on whether or not the exchanges in these factor markets are themselves fair. For example, they may be colluding in charging their cus­tomers a higher price. The converse is also true. Fair exchanges in the factor markets may or may not be accompanied by fair exchanges in the product markets. For example, the U.S. government has imposed a system of tobacco allotments which restricts production of salable tobacco to specified lots. This allows farmers to charge more than a competitive rate, and yet their supply markets (for, e.g., farm equipment) may be Rercely competitive. However politically invulnerable they are, from an economic point of view, they are highly vulnerable to successful entrepreneurship.

Exchanges in stagnant markets, as well as those not on the leading edge of markets in transition, are not fair exchanges. Since the lack of fairness is a necessary (though not sufficient) condition for economic exploitation, the extent of economic exploitation in any market economy will be, in part, determined by the extent to which the product and factor markets are vul­nerable to successful entrepreneur ship. On a purely intuitive level, this seems perfectly reasonable.

Another implication of this account is that where and whether fair exchanges take place is a question that can only be settled by empirical inves­tigation into how markets actually function, which means that the existence and extent of economic exploitation in market economies must be settled in the same way. This stands in sharp contrast to nearly all contemporary theo­ries of exploitation in capitalist (free enterprise) economic systems, which require no real empirical investigation into how markets actually function. Instead, all one has to know is the basic relations of production (capitalists own the means of production and the workers have to sell their labor) to pro­nounce the system exploitative. That way of discovering the existence and extent of exploitation should have seemed too easy, too good to be true; but for those antipathetic to capitalism, the temptation to buy into that kind of analysis has probably been irresistible.