The most important single central fact about a free market is that no exchange takes place unless both parties benefit.

—Milton Friedman¹

What do we mean by exchange? An exchange takes place when I agree to help you move apartments and you agree to help me do the same. An exchange takes place if the teenager who lives down the street agrees to mow my lawn and I agree to give him $30. When you go to a coffee shop and trade $3 for a cappuccino, you are engaged in a voluntary exchange. Same goes when you go to Amazon.com and purchase my latest book or when the United States imports manufactured goods from China and exports financial services to Europe.

Because they are voluntary, these exchanges must make both parties better off. Why else would they make the trade? You would prefer to be $11.06 poorer if it means that you can own a copy of my book.² Amazon would prefer to have an extra $11.06 of revenue if it means they can sell you a copy of my book. Since the trade makes you both better off, you do it. The teenager down the street would rather spend an hour mowing my lawn if it means he can get $30 for doing so. I would rather give him $30 than spend an hour mowing my lawn. We are both better off if we make the exchange.

This is one of the most important features of a free market. Its economic implications are enormous. But it also has crucial implications for public policy and for our understanding of a free society.

Take the minimum wage. There are many arguments against the “Fight for $15”—the campaign that would more than double the federal minimum wage to $15 per hour. Opponents frequently cite that a minimum wage this high would cost well over one million jobs. More sophisticated observers note that even workers who kept their jobs would incur harm because they would face higher prices at stores that employ low-wage workers.

But there is a more fundamental argument that can be made, as well. If a mom-and-pop cafe would like to pay me $9 per hour for my services, and if I would like to work there for $9 per hour, then both the cafe and I would be better off if we entered into an employment relationship under those terms. Presumably, I know my employment options, and I only want to take the job at the cafe if I think it is the best job available to me. Presumably, the cafe thinks I will add at least $9 per hour of value if it hires me.

So we’d both be better off if this $9-per-hour employment relationship existed than if it did not. Why does the United States Congress think it knows better?³

The Importance of Exchange

People trade because it makes them better off. But why does it make them better off? Economics has well-developed answers to this question.

Like much in economic theory, it begins with simple intuition. Imagine there are only two people in the country: Michael Strain and Bruce Springsteen. Strain can write essays, and Springsteen can write songs. If they trade with one another, Strain can enjoy the music of Springsteen, who in turn can gain wisdom and insight from Strain’s writings. If they don’t trade, then they are writing only for themselves.

But man can’t live on essays and songs alone. In addition to their writing, Strain and Springsteen need to build houses, make clothes, build furniture, grow and cook food, produce espresso and Scotch, and do chores and make repairs. Now let’s imagine that Springsteen is better at everything than Strain. Does it still make sense for them to trade?

Yes.

To see why, let’s consider a simple situation in which Strain and Springsteen need to do only two things: grow apples and grow bananas. Since Strain is worse than Springsteen at everything, he is worse at growing both apples and bananas. If he works all day and focuses only on growing apples, he can harvest 15. If he focuses exclusively on bananas, he can harvest 10.

If he chooses to grow both apples and bananas, he trades off at a rate of 1.5 apples for every banana. So he can produce three apples and eight bananas, or six apples and six bananas, or nine apples and four bananas, and so on.

Springsteen can grow 20 apples in a day, if apples are his exclusive focus, or 40 bananas in a day, if he chooses not to grow any apples. He trades off apples and bananas at a rate of one to two. So he can produce one apple and 38 bananas, or two apples and 36 bananas, or three apples and 34 bananas, and so on.

If they don’t trade with each other, then they can only eat what they each individually produce. They each like variety, so Strain chooses six apples and six bananas, and Springsteen chooses 13 apples and 14 bananas.

Springsteen is clearly better off than Strain in a world with no trade. But—perhaps counterintuitively—he would also be better off if he could trade.

To see why, consider that the cost of an additional banana to Strain is 1.5 apples, while the cost of an additional banana to Springsteen is one-half of an apple. Likewise, the cost of an additional apple to Strain is two-thirds of a banana, while the cost of an additional apple to Springsteen is two bananas.

So to make bananas, Strain has to give up more apples than does Springsteen. To make apples, Springsteen has to give up more bananas than Strain. Even though Springsteen is objectively better than Strain at producing apples—remember, Springsteen can grow 20 apples in a day, while Strain can only grow 15—Springsteen has to give up more bananas to grow an apple than does Strain. Strain faces a lower cost of producing apples than does Springsteen.

Strain approaches Springsteen and explains to him the basic economics of this situation.⁴ He tells Springsteen that if Strain specializes more in producing apples and if Springsteen specializes more in producing bananas, then they can trade and both be better off.

Springsteen aims to produce 20 bananas and 10 apples each day. Strain ups his apple production to 12 and produces only two bananas. Springsteen trades five of his bananas for four of Strain’s apples. Thanks to their exchange, Springsteen can consume 14 apples and 15 bananas, and Strain gets to eat eight apples and seven bananas. Importantly, they are both eating more apples and bananas than they were in a world with less specialization and no trade.

Specialization expands the total amount that Springsteen and Strain—or you and your grocery store, or Kansas and Virginia, or the United States and the United Kingdom—can produce, and trade expands the total amount that can be consumed. In this way, trade can make everyone in a society better off because it enables people to specialize in doing what they do best.

Economists have known this since the birth of their discipline. Consider this famous passage from Adam Smith, taken from The Wealth of Nations:

It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of part of it, whatever else they have occasion for.⁵

Coordination: “No Exchange Takes Place Unless Both Parties Benefit”

In the example we have been using, it is easy to see how Strain and Springsteen coordinated: They just talked to each other and agreed to barter apples for bananas. But for mutually beneficial, voluntary exchanges—of the type Milton Friedman referred to in the opening quote of this chapter—to take place across a society with millions of households and businesses, these types of individual negotiations are infeasible.

Yes, if every individual and business specializes, then society as a whole can produce more goods and services than if every person grows their own food, cooks their own meals, builds their own house, sews their own clothes, and the like. But for everyone’s consumption to increase—for everyone to benefit from all that extra production—the goods and services that are produced have to be allocated to households across all of society.

Moreover, for them to be allocated in the best way possible, individual goods and services need to be allocated to the households and individuals that will value them most. (You likely would place no value on being allocated a jar of Marmite, but my British wife loves the stuff. So society is better off if it goes to her rather than to you, even after accounting for my displeasure at having it within eyeshot.)

In a command economy, the task of allocating goods and services falls to the central government. But, to put it mildly, history has shown that this task is too large for any government to handle. And in this system, exchange is not voluntary.

Instead of a central authority handing out bread and meat and telling people where to go to work, markets are the best system to allocate goods and services, coordinating activity across all of society and ensuring that exchanges take place only if both parties benefit.

To accomplish this, markets use prices.

Prices are commonly understood as the dollar cost of a particular good or service that a consumer would face if he or she were to purchase the item. But the role they play in a market economy runs much deeper. Prices are fundamentally a mechanism to communicate information to all members of society and to coordinate behavior based on the information they contain. The economist F. A. Hayek described them in this way: Prices attach

to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure.⁶

To unpack that, let’s consider the market for cookies. Imagine you to go the store intent on buying a box of chocolate chip cookies. But you arrive at the store and discover that the cookies have doubled in price. So instead, you purchase sugar cookies, which are much cheaper. Your neighbor, however, really wants the chocolate chip cookies and is willing to pay the higher price.

Neither of you knows the full chain of calamities that has hit the chocolate chip cookie industry. You don’t know that a massive fire had burnt hundreds of acres of cacao trees to the ground, severely restricting the amount of chocolate that can be made. Furthermore, the workers at the port that receives chocolate supplies had gone on strike, and ships were lined up unable to deliver their cargo, further restricting the chocolate that can get to your bakery. At the end of the day, the baker had so little chocolate he could only make a few dozen cookies. He had to pay a significant premium to get the chocolate, too, and he passed that along to his customers. Hence the higher price.

Neither of you knows any of that—and neither of you needs to know. All you need to know is that the price of chocolate chip cookies—the “numerical index” attached to chocolate chip cookies—increased, making them more expensive relative to sugar cookies.

Because there is less chocolate and fewer chocolate chip cookies available for consumption, for society to be best off, those cookies need to be allocated to people who value them most highly. Society needs fewer people to receive chocolate chip cookies and for those who do receive them to be the people who really, really love to eat them.

The price system achieves this coordination. Hayek referred to it, correctly, as a marvel:

The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction.⁷ (Emphasis in original.)

Moreover, it achieves this without anyone being coerced and while preserving the mutually beneficial nature of the transactions. When you walked through the front door of the store, you were willing and expecting to pay $2 for your cookie, because that is the usual price. You would have been better off being $2 poorer if it meant you got to eat the cookie, and the baker would have been better off selling you the cookie for $2 than not. But because of the chocolate shortage, selling cookies at $2 a pop would make the baker worse off, so he raised their price to $5. At the new price, you would not be better off. You’d rather have $5 in your pocket and no cookie.

Because the exchange at a price of $2 makes the baker worse off, it doesn’t happen. Because the exchange at a price of $5 makes you worse off, it doesn’t happen. You are each better off without the exchange than with it at those prices.

But your neighbor would be better off paying $5 for the cookie than keeping his $5 and not having the cookie. And the baker is better off selling at $5 than not. So the exchange happens, because it makes both parties—your neighbor and the baker—better off.

Whether you buy a cookie won’t change your life. But prices coordinate major decisions as well. Consider the decision to attend college.

As computers, software, and machines became more and more sophisticated four decades ago, workers who could productively use advancing technology became more valuable to businesses. As a consequence, businesses tried harder to attract and retain those highly skilled workers. In the language of market analysis, their “price” went up. The price of labor is simply the wage.

Markets are the best system to allocate goods and services, coordinating activity across all of society and ensuring that exchanges take place only if both parties benefit.

Society needed more people to attend college to acquire the skills required in the modern workforce due to technological advances. Because employers demanded those skills, the wages of college graduates increased relative to high school graduates. This made going to college more attractive, encouraging people to attend college to receive the skills employers demanded in the modern economy.

All the exchanges in this chain of events satisfy the mutually beneficial criteria as well. You only go to college if you think going and paying tuition will make you better off than not, and colleges accept you only if your tuition is worth the costs associated with teaching you. Once you’ve graduated, employers only hire you at a given wage if doing so will make them better off, and you only agree to work for an employer at the wage they are offering if doing so is best for you.

But Government Sometimes Can Improve Outcomes

Generally speaking, free exchange is the best way to allocate goods and services, in part because exchanges don’t happen unless both parties to the exchange are made better off. But there are situations in which government intervention in free markets can make society better off.

Imagine you live in an apartment and decide to buy an electric guitar. You pay $100 for the guitar. You do so because you are better off without the $100 but with the guitar, and the person from whom you buy the guitar is better off without the guitar but with the $100.

You and the guitar seller are the two parties to the exchange. But when you fire it up and blast your attempt at “Stairway to Heaven” throughout your apartment building, your neighbors pay a price: They can’t read or sleep. By reducing your neighbors’ welfare, you have created a negative externality. The free market failed to account for this in the transaction. The cost to society of you owning the guitar is different than the market price.

On the flip side, consider education. Education confers many private benefits: It boosts wages and forms character, and learning is often simply enjoyable. But not all the benefits of education are captured by the people who receive education. A more educated society is more creative and innovative; the benefits of innovation are not restricted to the innovator. A more educated society is one with lower crime rates. Educated people are better off in a society with less crime, but so is everyone else in society.

The free market also fails to account for these benefits. The benefit to society of your education is different—and larger—than the benefit to you.

Because the social costs of guitars sold to college students living in apartments are higher than the private costs, from the perspective of what is best for society as a whole, the free market leads to “too many” guitars being sold. Their price is too low. Because the social benefits of education are greater than the benefits received by the people receiving the education, the free market leads to “too little” education relative to what is best for society as a whole.

In both these instances, government can step in to improve on the outcomes generated by the free market. How? By imposing a tax on guitars sold to college students living in apartments, the government can raise the total costs of purchase a guitar, lowering the number of guitars sold, and moving that quantity into line with what is best for society as a whole. By subsidizing education, the government can reduce its private costs, leading to more people receiving an education, and moving the quantity of education more into line with what is best for society as a whole.

These sorts of “corrective” taxes and subsidies are often called Pigouvian taxes and Pigouvian subsidies, named after the economist Arthur Pigou. They are designed to lead private decision makers to take into account not just private costs and benefits but social costs and benefits.

Markets also fail to provide what economists call public goods, such as national defense. Public goods are unusual because they are not rivals or excludable in consumption. To understand this, consider an apple. If I eat an apple, that means you can’t: It is rival in consumption. And it is easy to exclude anyone from consuming an apple.

Now consider national defense. My consumption of national defense does not decrease yours, so we aren’t rivals in consumption of that good. And there is really no way of excluding you from enjoying the benefits of national defense once it has been provided.

Public goods give rise to the free-rider problem. If I can’t be excluded from enjoying the benefits of a national defense, why would I voluntarily pay for it in a free market? Some might out of a sense of obligation or altruism, but many wouldn’t. As a consequence, the free market would provide a weaker national defense than is best for society as a whole.

More generally, there can be a role for government intervention in free markets when those markets have more subtle flaws than generating clear externalities or in producing public goods. Sometimes the solution is for government to assign property rights, as is in the case with common resources. Other times, many economists believe that direct intervention through regulation is appropriate.

Let’s return to the minimum wage. In the textbook model, workers’ wages are determined by their productivity. In the real world, productivity is the main driver of wages, but bargaining power and labor-market institutions can push actual wages above or below productivity.⁸ Many economists believe that these real-world factors justify occasional, modest minimum wage increases.⁹

Moreover, while markets generally maximize economic efficiency, there may be other concerns, rooted in notions of justice, that compel society to accept inefficiencies.¹⁰ For example, I believe that no one who heads a household and works full-time should live in poverty. That is a moral proposition, not an economic one. It leads me to support federal earnings subsidies to low-income, working households, financed by income taxes.¹¹ The United States pays for these subsidies through slower economic growth. But that is a price I am willing to pay.

Liberty

The previous section detailed important caveats and considerations. But those do not alter the fundamental desirability or superiority of markets as a means of organizing economic activity and allocating scarce resources.

“The most important single central fact about a free market is that no exchange takes place unless both parties benefit,” wrote Friedman. That market exchanges are mutually beneficial and voluntary has enormous economic implications, which I have discussed in this chapter. The political implications are significant as well. Economic liberty is a component of overall liberty, of course. In addition, the diminishment of economic liberty necessarily requires an increase in the scope of government, reducing political liberty. Liberty, to borrow from the philosopher Thomas Hobbes, depends on “the silence of the law.”

There is a role for energetic, limited government in advancing economic opportunity and promoting human flourishing. But the burden of proof rests with government intervention, not free exchange. This holds for many reasons, not the least of which is that in free markets, you and I only trade if it makes us both better off.

Notes