Preconditions for Well-Functioning Markets

In order for markets to effectively coordinate economic activities, individuals must be embedded in a political environment that facilitates good economic decision making. Hayek identifies several factors as important for market functionality, all of which are relevant to environmental issues. Some of these factors follow from what we have just been saying: if markets are to operate effectively, then the authority to make most economic decisions must be decentralized to individuals and not centralized in a single political authority.2 Moreover, the prices of goods and services in the marketplace must be allowed to fluctuate in response to underlying economic circumstances.3

Another precondition for markets’ functionality is related to these. If individuals are to draw on each other’s knowledge as well as their own, then they need to be free to make their own decisions and not be subordinated to others’ plans. When societies compel their citizens to follow external commands, individuals are left with “no chance to use their own knowledge or follow their own predilections. The action performed according to such commands serves exclusively the purposes of him who has issued it” (1960, 132). By depriving individuals of the opportunity to make their own decisions, coercion “prevents a person from using his mental powers to the full and consequently from making the greatest contribution he is capable of to the community” (118).

Although Hayek advocates broad latitude for individual decision making, he does not take this stance to license every activity that people might want to undertake. On the contrary, he notes that even the protection of personal liberty requires some limitations on what people may do (1960, 19-20;

122). In order to minimize the negative effects of needed coercive measures, Hayek insists that when individuals’ choices must be constrained, this should be done exclusively in accordance with known general rules. Coercion so limited would be rendered innocuous because the rules themselves would provide each individual with “part of the data which, together with his knowledge of the particular circumstances of time and place, he can use as the basis for his decisions” (133).

Hayek believes that decentralized decision making, a working price system, and a robust scheme of individual autonomy are necessary to achieve prosperity. But these conditions alone do not suffice for a well-functioning market economy. For if individuals lack the resources or motivation to act on their knowledge in beneficial ways, then granting them liberty to respond to prices might prove unhelpful.

Part of the solution to this problem can be found in the rules defining institutions of property. Property rights play a crucial role in empowering individuals to act on their knowledge for, as Hayek writes, “We are rarely in a position to carry out a coherent plan of action unless we are certain of our exclusive control of some material objects; and where we do not control them, it is necessary that we know who does if we are to collaborate with others” (1960, 123). Hayek also sees property rights as providing citizens with an important source of discipline. Even though these rights give people authority to use resources as they please, they also ensure that individuals bear the costs of poor decisions. Hayek views this as especially important when discussing natural resources, since so many historical examples of ecological degradation align with the absence of property rights:

[T]he most important instance . . . —the depletion of forests—was largely due to the fact that they did not become private property but were retained as public land and given over to private exploitation on terms which gave the exploiters no incentive for conservation. (1960, 318-19)

This enthusiasm for the disciplining power of property rights is illustrative of a broader concern. Hayek believes that if individuals are to be empowered to make their own decisions in the marketplace, then they must also benefit and suffer depending on their success in responding to market demands:

In a free society we are remunerated not for our skill but for using it rightly; and this must be so as long as we are free to choose our particular occupation and are not to be directed to it. True, it is almost never possible to determine what part of a successful career has been due to superior knowledge, ability, or effort and what part to fortunate accidents; but this in no way detracts from the importance of making it worthwhile for everybody to make the right choice. (1960, 72)4

Hayek’s concern with incentives goes beyond ensuring that individuals’ well-being is tied to their economic contributions. Particularly important is the idea that individuals must not be able to achieve success at each other’s expense. Not only is such predation objectionable in itself, but it also severs the connection between individuals’ incentives and others’ interests that drives the efficacy of the market process. Hayek contends that societies must utilize their coercive powers to prevent citizens from coercing one another (1960, 122-23), as well as to combat other forms of predation, such as fraud (126). In the context of natural resource issues, Hayek also emphasizes “the neighborhood effects and . . . the more far-reaching consequences which the use of a particular piece of land may have for the rest of the community” (316). Here he argues that governments have an important function to perform in “the gradual improvement of the legal institutions which make the market function more effectively and induce the individual to take fuller account of the effects of his actions” (315).

In Hayek’s view, well-functioning markets will be built around decentralized decision making, unimpeded price systems, economic liberty, robust property institutions, and individual accountability. When these factors are absent or deficient, long-term prosperity might depend on remedying the relevant shortcomings. This could require action by government officials, who could help by defining and enforcing property rights (and sometimes by simply removing bad policies). But Hayek also emphasizes the power of evolutionary social processes to produce conditions in which markets can flourish, especially through the development of common law standards and cultural innovations (1973; 1976, 26).5

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