Is There No Regulation at All in a "Free Market"?

Or What Government Must Do to Guarantee a Free Market in Adam Smith's Sense

by Dr. Jan Garrett

Last revised October 31, 2011

This web page consists of two parts, a relatively brief part that summarizes the main points, and a longer part presenting the passages from works of Adam Smith that support the interpretation given in the briefer first part.

It is a misleading to say that Adam Smith's economic system has no role for government regulation, as Velasquez's wording suggests to some readers when he describes Smith's argument in The Wealth of Nations as a defense of the "unregulated market." It is clear that Smith supported government administration of justice and that this included punishing murder and theft. Crimes against property included theft. Given that possessions play an important role in a Smithian economy, it is wrong to infer that he wants government to simply do nothing with respect to murder or theft. From other things writen by Velasquez, it is clear that he himself does not misunderstand this aspect of Smith's view.

Chiefly, what Smith opposes are government interventions of the following types: setting prices, legislating minimum or maximum quality of goods, requiring the production of minimum or maximum quantities of goods, providing special support for some companies as opposed to others.

But would Adam Smith have supported government actions to prevent false advertising, coercive sales tactics, and breach of contract (failure to fulfill contractual promises)?

I believe he would have, although he regarded at least breach of contract as a less serious crime than direct violations of the right to life (murder) and violations of property rights (theft, etc.). The evidence is scattered in various places: in the Wealth of Nations in the discussion of "perfect liberty" (pp. 55-56, 62, 99, 118); and in the discussion of natural liberty (651), which seems to be close, if not identical, to perfect liberty discussed earlier; and in his other major work, The Theory of Moral Sentiments.

On p. 651 of Wealth of Nations he writes that "according to the system of natural liberty… the sovereign" (i.e., the government) has "the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice."

To appreciate Smith's view of justice, it is not so helpful to study the Wealth of Nations as it is his other major work, The Theory of Moral Sentiments, where he devotes a number of pages to the sentiment of justice and, in passing, to the violations of justice. In one place he rank orders violations of justice: attacks on individual life, attacks on private property or possessions, and violations of commercial justice such as breach of contract. He regards the first and second as more serious than the third, but the third still falls in the general category of injustice.

In a slightly later passage in Theory of Moral Sentiments, Smith indicates that "fraud and perfidy" deserve punishment not unlike other, more obvious, forms of injustice.

Since administration of justice is a duty he attributes to government, it is likely that he would endorse the more recent view that good government discourages false advertising (a type of fraud) and failure to fulfill contracts, through imposing costs (perhaps in the form of compensatory judgments or fines) upon individuals or businesses who fail in these ways.

In his textbook, Business Ethics: Concepts and Cases, chapter 6, Manuel Velasquez devotes a section to the ethics of commercial exchange related to the forming and carrying out of a sales contract. He notes four basic duties, which reflect current business law (not always well enforced):

1. the duty not to misrepresent (the product or service being considered for purchase);

2. the duty to disclose (the relevant features of the product or service being considered for purchase);

3. the duty to avoid coercion (in the interaction leading up to the contract); and

4. the duty to fulfill contractual promises.

A free choice, one respecting "perfect liberty," seems to presuppose respect for the first three duties. It is also important for the operation of Smith's ideal economic model, which supposes that the market operates most effectively when economic agents are able to rationally pursue their self-interest. Surely individuals' pursuit of their interests in economic interaction depends on having very good information about what they are purchasing. This condition will be missing if the buyer lacks adequate information before meeting the seller, which is typically the case, and when he does meet the seller or his agent, the latter fails to disclose relevant features of the thing being marketed or deliberately misrepresents them.

Smith seems to address #1, #3, and #4, at least indirectly: 1 with his reference to "fraud" in the context of a general discussion of justice and injustice, 3 in his stipulation of the desirability of perfect (or "natural") liberty, and 4 in his listing of breach of contract as a form of injustice (albeit less serious than murder or theft).

I am unaware of any passage in which Smith explicitly addresses #2, what Velasquez calls the duty to disclose. But I think it would hard to argue persuasively that any approximation to the Smith's ideal marketplace (in which "free" individuals rationally pursue their self-interests in a context of respect for the similar "freedom" of others) could operate without such a duty.

It is possible that Smith assumed that in an economy without monopolies, every producer or seller is just one of many producers or sellers in a given market, and that buyers can learn through trial and error, always at little cost to themselves, which sellers are honest and forthcoming about the nature of their products. With today's complex technology, that is often not the case.

A Discussion of Relevant Passages in Smith's Works

The Wealth of Nations (Modern Library, 1937)

In three passages, Adam Smith uses the term "perfect liberty." I have italicized the sentences or phrases that use this term in the following quotations.

There is in every society or neighbourhood an ordinary or average rate both of wages and profit in every different employment of labor and stock…

There is likewise in every society or neighbourhood an ordinary or average rate of rent,…

These ordinary or average rates may be called the nature rates of wages, profit, and rent, at the time and place in which they commonly prevail.

When the price of any commodity is neither more nor less that what is sufficient to pay the rent of the land, the wage of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price.

The commodity is then sold precisely for what it is worth, or for what it really costs the person who brings it to market. … [Smith includes the going rate of profit for the material embodiment of capital, what he here calls "stock," in the "worth" of the commodity.] (p.55)

Though the price … which leaves him this profit is not always the lowest at which a dealer may sometimes sell his goods, it is the lowest at which he is likely to sell them for any considerable time; at least where there is perfect liberty, or where he may change his trade as often as he pleases. (p. 56)

The market price of any particular commodity, though it may continue long above, can seldom continue long below, its natural price. Whatever part of it was paid below the natural rate, the persons whose interest it affected would immediately withdraw either so much land, or so much labour or so much stock, from being employed about it, that the quantity brought to market would soon be no more than sufficient to supply the effectual demand. Its market price, therefore, would soon rise to the natural price. This at least would be the case where there was perfect liberty. (p. 62)


The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, either be perfectly equal or continually tending to equality. If in the same neighbourhood, there was any employment evidently either or less advantageous than the rest, so many people would crowd into it in the one case, and so many would desert it in the other, that its advantages would soon return to the level of other employments. This at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was free to chuse what occupation he thought proper, and to change it as often as he thought proper. Every man's interest would prompt him to seek the advantageous, and to shun the disadvantageous employment. (p.99)

On p. 118 Smith says that the "policy of Europe" [i.e., non-British European states] violates perfect liberty in three ways:
first, by restricting the competition in some employments to a smaller number than would otherwise be disposed to enter into them; secondly, by increasing it in others beyond what would naturally be; and third, by obstructing the free circulation of labour and stock, both from employment to employment and from place to place.
Later, Smith speaks of the duties of the sovereign, by which he seems to mean the government, with respect to "natural liberty." "Natural liberty" seems to be the same as perfect liberty mentioned earlier.
All systems of preference or restraint [on the part of government], therefore, being completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man as long as he does not violate the laws of justice, is left perfectly free to pursue his interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty … the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interest of the society. According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to the common understanding: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number individuals, to erect and maintain; because the profit could never replay the expence to any individual or small number of individuals, though it may frequently do much more than replay it to a great society. (651)
The third duty, by the way, suggests the possible error of the rush to privatize historically public functions like the postal service, public education, and social security, and the possible defensibility of the Canadian system of universal (i.e., government administered) health insurance.

But what about the first and second duties, the protection of individuals from oppression and the exact administration of justice?

In the Wealth of Nations, Smith has no index entry on "oppression" and the index entries on justice mainly refer to the expenses of maintaining a system of justice.

This does not help us understand what rules of justice governing economic activity Smith has in mind.

The Theory of Moral Sentiments

Further insight into Smith's understanding of the rules of justice may be found in this work. Part II, Section II, is entitled "Of Justice and Benevolence."

In Chapter I of this section, S. distinguishes between "actions of a beneficent tendency, which proceed from proper motives," and "actions of a hurtful tendency, which proceed from improper motives." The former seem to require reward, the latter "seem alone to deserve punishment."

There is [a] virtue, … of which the violation exposes to resentment, and consequently to punishment. This virtue is justice: the violation of justice is injury: it does real and positive hurt to some particular persons, from motives which are naturally disapproved of." And, later, "we feel ourselves to be under a stricter obligation to act according to justice, than agreeably to friendship, charity, or generosity; that the practice of these last mentioned virtues seems to be left in some measure to our own choice, but that … we feel ourselves to be in a peculiar manner tied, bound, and obliged to the observation of justice.
The duties of justice are such that it is especially important that they have the backing of sovereign (i.e., governmental) command.
When he commands,… what, antecedent to any such order, could not have been omitted without the greatest blame, it surely becomes much more punishable to be wanting in obedience. Of all the duties of a lawgiver, however, this, perhaps, is that which it requires the greatest delicacy and reserve to execute with propriety and judgment. To neglect it altogether exposes the commonwealth to many gross disorders and shocking enormities, and to push it too far is destructive of all liberty, security, and justice.
Smith claims that
justice is, upon most occasions, but a negative virtue, and only hinders us from hurting our neighbour. The man who barely abstains from violating either the person, or the estate, or the reputation of his neighbours, has surely very little positive merit. He fulfills, however, all the rules of what is peculiarly called justice…We may often fulfil all the rules of justice by sitting still and doing nothing.

In Chapter II of this section, "Of the sense of Justice, etc." Smith gives, in passing, some further indication of what he thinks encompassed in justice:

Murder…is the most atrocious of all crimes which affect individuals only, in the sight both of mankind, and of the person who committed it. To be deprived of that which we are possessed of, is a greater evil than to be disappointed of what we have only the expectation. Breach of property, therefore, theft and robbery, which take from us what we are possessed of, are greater crimes than breach of contract, which only disappoints us of what we expected. The most sacred laws of justice, therefore, those whose violation seems to call loudest for vengeance and punishment, are the laws which guard the life and person of our neighbour; the next are those which guard his property and possessions; and last of all come those which guard what are called his personal rights, or what is due to him from the promises of others.
Smith seems to count all three types of violation count as injustice, but hold that murder and similar acts are the greatest violation; violations of property rights are in second place, and breach of contract in third.

Somewhat later in this chapter, we find the following sentence:

All men, even the most stupid and unthinking, abhor fraud, perfidy, and injustice, and delight to see them punished. But few men have reflected upon the necessity of justice to the existence of society, how obvious soever that necessity may appear to be.

The context suggests a direct negative relationship between justice, on the one hand, and what "all men … abhor." How to understand the phrase "fraud, perfidy, and injustice"? I think "injustice" refers only to the more serious and, to Smith's mind, obvious forms of injustice (attacks on persons and their property), but fraud and perfidy are added to the list in order to complete a slightly broader category of injustice. Fraud and perfidy are deliberate acts: fraud is "intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right" (Webster's Ninth New Collegiate Dictionary, p. 490); "perfidy" derives from Latin words meaning "to deceive by trust" (Webster's Ninth, p. 873) and seems to be very similar, insofar as belief in what another claims depends upon the believer's trust that what the speaker or writer says is true. Fraud and perfidy expand the class of injustices to include more than clear assaults on life and property.

A term often used today in connection with fraud is dishonesty. A seller who claims his product does what he has reason to believe it does not do is being dishonest and committing fraud.

Thus, it appears that Smith would count as injustice not only murder and harms to property but also fraud and breach of contract, even if he does not believe the latter two crimes to be of equal seriousness to the former. Since administration of justice is a duty he attributes to government, it is likely that he would endorse the more recent view that government should discourage false advertising and failure to fulfill contracts, through imposing costs (perhaps in the form of compensatory judgments or fines) upon individuals or businesses who fail in these ways.