Classical economic theory from the time of Adam Smith and Karl Marx considered the four factors of production as Land, Labour , Capital and Entrepreneurship.
This model was appropriate for Basic agricultural and emerging industrial societies but can be tweaked to encompass factors which are relevant for the modern post industrial era as well.
For the economic machinery to operate in balance, there are two critical but implicit assumptions :
1) Rule of law 2) Free Market
Think of the overall economy very simplistically as a very large box full of gears of different sizes — green gears for Land, red for labour and blue for capital and think of entrepreneurs as people who buy these different gears and connect them to a very large rotating shaft of there economy which has a very large number of black gears of different sizes attached to it.
The job of the entrepreneur is to create his little machine of green red and blue gears and ensure that it’s connected to the right sized black gear in the economic shaft (either directly or indirectly) and everything is moving smoothly.
A stable, fair and transparent rule of law allows for 2 very important things :
1) No coercion of any sort and 2) Contracts can be enforced.
Rule of law creates a high trust society, which increases efficiency all around. In the absence of rule of law, societies rely on family and clans, which by definition reduces the talent and partners pool and therefore the size of the enterprise.
Free markets allow for everyone to have access to all factors of production equally, for prices to be determined fairly and for anyone to have the ability to enter and exit any business.
Eternal vigilance is the price to be paid for a well functioning free market. The same Principle of “democracy is the least bad system of governance” is applicable to free markets as well. I am not in favour of untrammelled free markets which could lead to monopolies. In fact it means that equal access is not being provided fairly and is actually a breakdown of free market principles
(the principle of easy entry/exit as well as against the principle of lack of coercion).
Similarly, not pricing common resources (such as clean air, water etc ) means again a breakdown of the free market principle of fair pricing of inputs.
In our gear example , free markets means that anyone is free to buy any gear at the right price and connect it to any black gear in the economic machine.
Rule of law and free markets are complementary in many ways.
In the next parts, let’s analyse what can go wrong based on various policies / market structures.
To be Continued … next article: why is stable , fair and transparent Rule of Law critical for a well functioning economy link to next article