The Utility of Free Markets: Adam Smith

by Manuel G. Velasquez

From Business Ethics: Concepts and Cases, 2002

Last date modified: March 18, 2011

This reproduces most of a section from Chapter 3 of Manuel G. Velasquez, Business Ethics: Concepts and Cases, Fifth Edition (Upper Saddle River, NJ: Prentice-Hall, 2002). I have inserted a number of explanatory notes not found in the original in the following form [xxx.—J.G.]

I have created some basic study questions for this material.

By way of prefacing this introduction, I want to discuss two what it means to say that Smith is a utilitarian and to call your attention to one issue of interpretation on which I am critical of Velasquez's essay.

[1. Velasquez attributes a utilitarian argument to Adam Smith, whose 1776 Wealth of Nations is the main text under discussion here. (For the full text, see Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations.) It is true that the first major thinker who explicitly advocated Utilitarianism as a general ethical strategy, Jeremy Bentham (1748-1832), did not publish his Introduction to the Principles of Morals, which is regarded as the founding document of British Utilitarianism, until 1789. But it is probable that utilitarian ideas were widespread in the United Kingdom before 1789, so Velasquez's attribution is reasonable. In any case, utilitarianism holds that an action or a social institution is the right, or morally defensible, one if, out of the options that might have been chosen, it is the one that will produce the best over-all consequences for society.—J.G.]

[2. Although Velasquez's treatment of Smith seems fair and balanced, there is one interpretation that he makes about which one might reasonably disagree. It has to do with his explanation of the "invisible hand" as competition. My alternative explanation is given below.]

[3. (Note New 10/31/11) I have learned from student writing assignments that Velasquez's use of the term "unregulated" to describe the kind of market system Adam Smith favors is misleading. Smith does not believe that government has no role in the maintenance of the most desirable economic system. Not only does it have a job to do in protecting the lives and property of individuals against crimes like murder and theft, but it may have a significant role beyond these concerns in the administration of justice, for instance, against commercial fraud and breach of contract. See Is There No Regulation at All in a Free Market?]

Velasquez's Discussion of Adam Smith

The second major defense of unregulated markets rests on the utilitarian argument that unregulated markets and private property will produce greater benefits than any amount of regulation could. In a system with free markets and private property, buyers will seek to purchase what they want for themselves at the lowest prices they can find. Therefore, it will pay private businesses to produce and sell what consumers want and it will do this at the lowest possible prices. To keep their prices down, private businesses will try to cut back on the costly resources they consume. Thus, the free market, coupled with private property, insures that the economy is producing what consumers want, that prices are at the lowest levels possible, and that resources are efficiently used. The economic utility of [benefit to—J.G.] society's members is thereby maximized.

[The Invisible Hand—J.G.]

Adam Smith (1723-1790), the "father of modem economics," is the originator of this utilitarian argument for the free market.30 According to Smith when private individuals are left free to seek their own interests in free markets they will inevitably be led to further the public welfare by an "invisible hand":

By directing [his] industry in such a manner as its produce may be of the greatest value, [the individual] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end that was no part of his intention.... By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it. 31
The "invisible hand," of course, is market competition.* Every producer seeks to make a living by using his or her private resources to produce and sell those goods that he or she perceives people want to buy. In a competitive market, a multiplicity of such private businesses must all compete with each other for the same buyers. To attract customers, therefore, each seller is forced not only to supply what consumers want, but to drop the price of goods as close as possible to "what it really costs the person who brings it to market."32 To increase one's profits, each producer must pare his or her costs, thereby reducing the resources he or she consumes.

[Self-Interested Motivation—J.G.]

The competition produced by a multiplicity of self-interested private sellers serves to lower prices, conserve resources, and make producers respond to consumer desires. Motivated only by self-interest, private businesses are led to serve society. As Smith put the matter in a famous passage:

It is not from the benevolence of the butcher, the baker, and the brewer that we expect our dinner, but from their regard for their own self-interest. We address ourselves not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.33

[Efficient Resource Allocation—J.G.]

Smith also argued that a system of competitive markets allocates resources efficiently among the various industries of a society.34 When the supply of a certain commodity is not enough to meet the demand, buyers bid the price of the commodity upward until it rises above what Smith called the natural price (i.e., the price that just covers the costs of producing the commodity, including the going rate of profit obtainable in other markets). Producers of that commodity then reap profits higher than those available to producers of other commodities. The higher profits induce producers of those other products to switch their resources into the production of the more profitable commodity. As a result, the shortage of that commodity disappears and its price sinks back to its natural level. Conversely, when the supply of a commodity is greater than the quantity demanded, its price falls, inducing its producers to switch their resources into the production of other, more profitable commodities. The fluctuating prices of commodities in a system of competitive markets then forces producers to allocate their resources to those industries where they are most in demand and to withdraw resources from industries where there is a relative oversupply of commodities. The market, in short, allocates resources so as to most efficiently meet consumer demand, thereby promoting social utility.

[Laissez-Faire Policy—J.G.]

The best policy of a government that hopes to advance the public welfare, therefore, is to do nothing: to let each individual pursue his or her self-interest in "natural liberty"35 Any interventions into the market by government can only serve to interrupt the self-regulating effect of competition and reduce its many beneficial consequences.

[Twentieth-Century Supplements—J.G.]

In the early 20th century, economists Ludwig von Mises and Friedrich A. Hayek supplemented Smith's market theories by an ingenious argument.36 They argued that not only does a system of free markets and private ownership serve to allocate resources efficiently, but it is in principle impossible for the government or any human being to allocate resources with the same efficiency. Human beings cannot allocate resources efficiently because they can never have enough information nor calculate fast enough to coordinate in an efficient way the hundreds of thousands of daily exchanges required by a complex industrial economy. In a free market, high prices indicate that additional resources are needed to meet consumer demand, and they motivate producers to allocate their resources to those consumers. The market thereby allocates resources efficiently from day to day through the pricing mechanism. If a human agency were to try to do the same thing, von Mises and Hayek argued, the agency would have to know from day to day what things each consumer desired, what materials each producer would need to produce the countless things consumers desired, and would then have to calculate how best to allocate resources among interrelated so as to enable them to meet consumer desires. The infinite quantity of detailed bits of information and the astronomical number of calculations that such an agency would need, von Mises and Hayek claimed, were beyond the capacity of any human beings. Thus, not only do free markets allocate goods efficiently, but it is quite impossible for government planners to duplicate their performance.

[Private Property Assumed—J.G.]

Finally, it is important to note that, although Adam Smith did not discuss the notion of private property at great length, it is a key assumption of his views. Before individuals can come together in markets to sell things to each other, they must have some agreement about what each individual "owns" and what each individual has the right to "sell" to others. Unless a society has a system of private property that allocates its resources to individuals, that society cannot have a free market system. For this reason, Adam Smith assumed that a society with free markets would have a private property system, although he gave no explicit utilitarian arguments showing that a system of private property was better than, say, a system where all productive resources were "owned" in common by everyone.

[Aquinas' Argument for Private Property—J.G.]

Earlier philosophers, however, had provided utilitarian arguments in support of a private property system [though they did not explicitly call them "utilitarian"—J.G.]. In the 13th century, for example, philosopher [and theologian—J.G.] Thomas Aquinas argued that society should not use a system in which all things were owned by everyone "in common." Instead, society would prosper only if its resources were owned by individuals who would then take an interest in improving and caring for those resources. A private property system, he argued,

—is necessary to human life for three reasons. First because every man is more careful to procure what is for himself alone than that which is common to many or to all: since each one would shirk the labor and leave to another that which concerns the community.... Secondly, because human affairs are conducted in more orderly fashion if each man is charged with taking care of some particular thing himself, whereas there would be confusion if everyone had to look after any one thing indeterminately. Thirdly, because a more peaceful state is ensured to man if each one is contented with his own. Hence it is to be observed that quarrels arise more frequently where there is no division of the things possessed.37
In the view Aquinas proposed, private property is not something that is "naturally" produced when labor is "mixed" into things. Instead, private property is a social construct, an artificial, but useful social arrangement, that can be shaped in numerous ways. These utilitarian arguments in favor of a private property system over a system of common ownership have often been repeated. In particular, many philosophers have repeated the argument that, without a private property system in which the individual gets the benefits that come from caring for the resources she owns, individuals would stop working because they would have no incentive to work.38 A private property system is best because it provides incentives for individuals to invest their time, work, and effort in improving and exploiting the resources they own and whose benefits they know they will personally receive.

Criticisms of Adam Smith

[Existence of Monopolies—J.G.]

Critics of Smith's classic utilitarian argument in defense of free markets and private property have attacked it on a variety of fronts. The most common criticism is that the argument rests on unrealistic assumptions.39 Smith's arguments assume, first, that the impersonal forces of supply and demand will force prices down to their lowest levels because the sellers of products are so numerous and each enterprise is so small that no one seller can control the price of a product. This assumption was perhaps true enough in Smith's day, when the largest firms employed only a few dozen men and a multitude of small shops and petty merchants competed for the consumer's attention. However, today many industries and markets are completely or partially monopolized, and the small firm is no longer the rule. In these monopolized industries, where one or a few large enterprises are able to set their own prices, it is no longer true that prices necessarily move to their lowest levels. The monopoly power of the industrial giants enables them to keep prices at artificially high levels and production at artificially low levels.

[External Effects, e.g., of Pollution—J.G.]

Second, critics claim, Smith's arguments assume that all the resources used to produce a product will be paid for by the manufacturer and that the manufacturer will try to reduce these costs to maximize his profits. As a result, there is a tendency toward a more efficient utilization of society's resources. This assumption is also proved false when the manufacturer of a product consumes resources for which he or she does not have to pay and on which he or she, therefore, does not try to economize. For example, when manufacturers use up clean air by polluting it, or when they impose health costs by dumping harmful chemicals into rivers, lakes, and seas, they are using resources of society for which they do not pay. Consequently, there is no reason for them to attempt to minimize these costs, and social waste is the result. Such waste is a particular instance of a more general problem that Smith's analysis ignored. Smith failed to take into account the external effects that business activities often have on their surrounding environment. Pollution is one example of such effects, but there are others, such as the effects on society of introducing advanced technology, the psychological effects increased mechanization has had on laborers, the harmful effects that handling dangerous products has on the health of workers, and the economic shocks that result when natural resources are depleted for short-term gains. Smith ignored these external effects of the firm and assumed that the firm is a self-contained agent whose activities affect only itself and its buyers.

[Motivation Not Exclusively Self-Interested—J.G.]

Third, critics claim, Smith's analysis wrongly assumes that every human being is motivated only by a "natural" and self-interested desire for profit. Smith, at least in The Wealth of Nations, assumes that in all his dealings a person "intends only his own gain."40 Human nature follows the rule of "economic rationality": Give away as little as you can in return for as much as you can get. Because a human being "intends only his own gain" anyway, the best economic arrangement is one that recognizes this "natural" motivation and allows it free play in competitive markets that force self-interest to serve the public interest. However, this theory of human nature, critics have claimed, is clearly false. First, human beings regularly show a concern for the good of others and constrain their self-interest for the sake of the rights of others. Even when buying and selling in markets, the constraints of honesty and fairness affect our conduct. Second, the critics claim, it is not necessarily "rational" to follow the rule "give away as little as you can for as much as you can get" In numerous situations, everyone is better off when everyone shows concern for others, and it is then rational to show such concern. Third, critics have argued, if human beings often behave like "rational economic men," this is not because such behavior is natural, but because the widespread adoption of competitive market relations forces humans to relate to each other as "rational economic men." The market system of a society makes humans selfish, and this widespread selfishness then makes us think the profit motive is "natural."41 It is the institutions of capitalism that engender selfishness, materialism, and competitiveness. In actual fact, human beings are born with a natural tendency to show concern for other members of their species (e.g., in their families). A major moral defect of a society built around competitive markets, in fact, is that within such societies this natural benevolent tendency toward virtue is gradually replaced by self-interested tendencies toward vice. In short, such societies are morally defective because they encourage morally bad character.

[Responses to von Mises and Hayek—J.G.]

As for the argument of von Mises and Hayek—that human planners can- not allocate resources efficiently—the examples of French, Dutch, and Swedish planning have demonstrated that planning within some sectors of the economy is not quite as impossible as von Mises and Hayek imagined. 42 Moreover, the argument of von Mises and Hayek was answered on theoretical grounds by the socialist economist Oskar Lange, who demonstrated that a "central planning board" could efficiently allocate goods in an economy without having to know everything about consumers and producers and without engaging in impossibly elaborate calculations. 43 All that is necessary is for the central planners to receive reports on the sizes of the inventories of producers and price their commodities accordingly. Surplus inventories would indicate that lowering of prices was necessary, whereas inventory shortages would indicate that prices should be raised. By setting the prices of all commodities in this way, the central planning board could create an efficient flow of resources throughout the economy. It must be acknowledged, however, that the kind of large-scale planning that has been attempted in some communist nations—particularly the former Soviet Union—has resulted in large-scale failure. Planning is possible so long as it remains but one component within an economy in which exchanges are for the most part based on market forces.

Notes

[Velasquez's Notes.] I have not reproduced all the notes for this section. They can be found in Velasquez's textbook itself. If any student of mine wishes more complete information than is found here, she may contact me and request it.—J.G.]

30. See Patricia Werhane, Adam Smith and His Legacy for Modern Capitalism (New York: Oxford University Press, 1991); S. Hollander, The Economics of Adam Smith (Toronto; University of Toronto Press, 1973).

31. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations [1776]. (New York: The Modern Library, n.d.), p. 423.

32. Ibid., p. 55.

33. Ibid., p. 14.

34. Ibid., pp. 55-58.

35. Ibid., p. 651.

36. Friedrich A. Hayek, "The Price System as a Mechanism for Using Knowledge," and Ludwig A. Mises, "Economic Calculation in Socialism," Both in Morris Bornstein, ed., Comparative Economic Systems: Models and Cases (Homewood, IL: Richard D. Irwin, Inc., 1965) pp. 39-50 and 79-85.

37. Thomas Aquinas, Summa Theologica, II-II, q. 66, a. 2.

…

43. Oskar Lange, "On the Economic Theory of Socialism," in Bornstein, ed., Comparative Economic Systems, pp. 86-94.

[Garrett's note on Smith's phrase "the invisible hand."

Velasquez's explanation of "the invisible hand" as another name for competition seems superficial and misleading. If that is the end of the story, why didn't Smith himself substitute "competition" or some familiar synonym of "competition" for "invisible hand"? See my essay on "The Metaphorical Origins of Adam Smith's Invisible Hand."]