5. Getting the greatest value for everyone - do money and markets allocate scarce resources efficiently.

And this week, some history.

Adam Smith’s The Wealth of nations is the starting point of modern economics. Smith was part of the Scottish Enlightenment. An important part of their philosophy was based on the sentimentalism of Frances Hutcheson and David Hume. Smith was also writing at roughly the same time as the ideas of more overtly political philosophers, Edmund Burke and Jeremy Bentham, were gaining traction. Smith was living in interesting times. The Industrial Revolution was in its infancy, America declared independence in the year The Wealth of nations was published, and the revolution in France was little more than 10 years away. Concerned with the opportunities offered by the new industry, Smith was keen to promote policies that he thought would lead to prosperity for all of those who worked for it. The Wealth of nations is not a narrow work: it covers subjects that we might now describe as politics, sociology, psychology and moral philosophy as well as economics.

Smith attacked the problem of value directly. He concluded that it was a measure of the labour that went into bringing a product to the market and, in the famous example of the pin-making enterprise, showed how specialisation and the division of labour could reduce the amount of labour and increase productivity, offering greater rewards those involved in the enterprise. He also argued that trade was of benefit to nations, while it was left to David Ricardo early in the nineteenth century to persuade the world that differential advantages in costs and productivity between two countries could benefit both, even if one had the absolute advantage in the goods being traded.

Smith also argued that it was by acting on our own individual interests, interests that included our reputation and, hence, the interests and opinions of others, that collectively we could improve our (material) lot. Smith uses the metaphor of the invisible hand to show the self-organising benefits of markets.

Smith is lionised by the right as a champion of free markets, of the reduction or removal of tariffs and of free international trade and that much is, in general, true. The Wealth of nations contains a polemic against mercantilism, the hoarding of gold and silver for national pride and betterment, and in favour of trade that would make all nations better off. But Smith was also a Scottish moralist, and his morality was based in religion. He opposed all forms of excess economic rent (very broadly, income generated from sitting on your backside, such as rent from land and property, intellectual property rights, monopoly profits and so on) and would have disapproved of many of the policy proposals of some of the modern free market think tanks such as, say, The Adam Smith Institute.

The psychological philosophy of David Hume and Adam Smith shared the opinion that utility or usefulness was at the heart of value. They had slightly different definitions of utility but both were interpersonal. For Smith, in markets we need to anticipate what others want. We have a mutually interacting set of wants and needs and so they have a mutual dependency. For the later Hume (1), the connection is stronger; our relationships are intersubjective. My wants and needs themselves are related to yours. To give a simple example of this, in team sports, our interests in a game are the same as our teammates and contrary to the opposing team and the individuals that comprise it. For Smith, it is the extent to which our teammates enable and the opposition prevents victory that determines utility (although both teams must play to a set of rules to make the whole exercise meaningful). To Hume, the relationships are important in themselves, less transactional, less instrumental. To both of them, we are rarely independent actors.

Jeremy Bentham is known as the father of Utilitarianism. He concluded that actions should be judged by their impact on human well-being or utility. In 1776, the same year as The Wealth of nations was published, (and Hume died) Bentham stated his “fundamental axiom”:

“it is the greatest happiness of the greatest number that is the measure of right and wrong”.

This version of utility weakens the interpersonal link - it remains in the background but it was not (and could not be) part of the “felicific calculus” used in calculations of happiness. Had Hume been alive, he would have argued that you cannot simply add happinesses and deduct unhappinesses to understand what utility was, let alone maximise it but the die was cast for this particular utilitarian approach to economics.

Bentham’s oversimplification was repeated in the next century. John Stuart Mill devised the concept of the Rational economic man, a person who behaves in the market to maximise their utility. Mill made assumptions that were explicit and was well aware that the concept itself was a simplification. However, the theoretical basis of economic value, indeed of the whole of microeconomics, was soon to undergo a dramatic change. The Marginal Revolution in economic theory (roughly 1870 - 1896) assumed that Rational economic man was a psychological theory, the way people did or should act in a market, not a simplification to make the models more manageable. An assumption became a fact.

Smith argued for open markets. The Marginalists argued for perfect markets, a more theoretical formulation but with a similar foundation. What do such markets look like? Perfect competition assumes that everyone in the marketplace has equal power (no monopolies, quasi-monopolies or cartels, either for buyers or sellers), perfect information for both buyers and sellers, that buyers and sellers can leave the market, that products are undifferentiated, and that nothing slows down or gets in the way of transactions, in the jargon, that transactions are frictionless and costless. So far, so unrealistic.

Over the century covering 1776-1876, value in economics had changed from Smith’s labour theory to the marginalists’ marginal unit of utility. This much you will find in any textbook on the subject. Less well remarked is that what utility meant in economics had changed from something complex and, well, valuable, into something that felt much more operationally useful in economic models. However, it also lost much of its richness, its intersubjectivity in the process.

In 1932, Lionel Robbins thought that a narrow definition of economics based solely on wealth (broadly, the Rational economic man part of the argument) was insufficient and proposed one based on scarcity, and, with it, a different way of looking at value.

“The economist studies the disposal of scarce means. He is interested in the way different degrees of scarcity of different goods give rise to different ratios of valuation between them, and he is interested in the way in which changes in the conditions of scarcity, whether coming from changes in ends or changes in means - from the demand side or from the supply side - affect these ratios.”

Robbins’ view is often expressed as: Economics is the allocation of scarce resources. Market advocates argue that using the market is the (only) way to allocate goods and services efficiently. But that truth only holds when many simplifying assumptions are made. When are markets inadequate? Here is a list with some brief comments about their shortcomings in each case:

1. In the provision of Public goods, such as fresh air and national defence. We either have them or we don’t, and, with current technologies, the benefits accrue to everyone - no-one is excluded. In the case of fresh air, markets aren’t necessary; in the case of the provision (but not supply) of national defence, markets don’t work.
2. Monopolies or quasi-monopolies In last week’s post, I used the example of Apple differentiating its brand and defending its intellectual property to retain its monopoly position and super profits in the market. Apple is the same as google, Microsoft and Meta in this regard. There are some good reasons to have a monopoly in supply of platform technologies. The more members, the more efficient they are on some measures. Another example the benefits of scale comes from some production technologies. If we want to make steel, it’s generally better, even environmentally, to do it in a large plant. Some businesses operate most efficiently as monopolies but that is a supply-side assessment. We have two questions to answer: do we want to break up the monopoly to promote competition?; and, how are the spoils of monopoly to be distributed? A government must decide how to constrain the excesses of monopoly power.
3. Principle-agent problems When some people are perceived as experts or to have authority delegated to them for practical reasons, or have privileged information, their services may be sought after. But his gives rise to conflicts: in the first two cases, as principle-agent problems; and, in the latter, as insider dealing. When one party, the agent, has personal interests that are different from, and may even conflict with, those of someone using their services, the principal, the agent is not acting independently. The investment adviser’s (the agent’s) income is usually not dependent on the fortunes of the investor (the principal) whose money they are investing. The agent has two motivations, the principal only one.
4. The commercialisation problem This counterfactual argument, by Fred Hirsch, asks the question, what would have happened if the market had not existed? We know that, in some circumstances, markets promote behaviours that are sub-optimal and even anti-social. They can change perceptions. A fine may express a social disincentive, a fee at a higher level is merely a market indicator.
5. The problem of the firm Ronald Coase argued that inside a firm was one place that market rules were more or less suspended and that for the firm, at least, that was a good thing. Within a firm, market forces are more expensive than the benefits they bring to the firm. As Taleb says, when a business offers salaries, pensions and healthcare they are asking employees for their loyalty, or, from the employees perspective, a loss of freedom. That’s a deal, but it’s not a free market.
6. Time One of the ways firms reduce uncertainty (and reduce transaction costs) is to change and constrain the market by, for example, offering contracts of employment rather than hiring everyone as independent contractors. There are several problems concerning time and markets, the most intransigent being that people are inconsistent; their preferences change, and most of the models assume they are consistent.
7. Coercion It may not need a monopoly for coercive power to be exercised in markets.

And, finally, the classes that I have discussed in several posts:

1. Externalities, where the value is not reflected in the price The examples I have given here are the classic negative externality of pollution and the positive externalities of relationships such as family, friendship and, with things, sacredness.

All of the items on the list may be seen as examples of market failure. The next post will look at what we should do when markets don’t allocate efficiently or usefully.

(1) David Hume wrote two major works of philosophy. Most of the professional philosophers prefer the first, A treatise on human nature, published in 1739. It is more comprehensive and more detailed than the later work but Hume himself said that anyone wanting to understand his philosophical works should refer to the later work, An enquiry into human understanding, published in 1748. His working out of a sentimentalist philosophy changed, I think for the better.