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Adam Smith and Competitive Markets: A Laissez Faire Approach

Introduction

Adam Smith is a fountainhead of modern economic thought. Smith is often regarded as the father of economics, and his writings have been enormously influential. The theory that he is most known for is his work based on “the invisible hand.” (Brew, 2000) Rational well-being and free-market economy rest on this principle.

Adam Smith is the first major theorist of international trade. He believed that all countries benefit from unrestricted trade. Free trade is said to exist where citizens can sell abroad (export) and buy from abroad (import) without restrictions or barriers by governments of either the exporting or importing country. Smith reasoned that if trade were unrestricted, each country would specialize in those products that resulted in a competitive advantage for it. Each countries resource would shift to the efficient industries because the country could not complete in the inefficient ones.

In his book, The Wealth of Nations (1776), He articulated the advantages of importing goods where these could be obtained more cheaply than by domestic manufacture. This classical theory is now generally known as the theory of absolute advantage. Smith argued in favors of the ‘invisible hand’ of market forces, as opposed to government intervention. When countries produce the products in which they are the most efficient producers, they are said to have an ‘absolute advantage’ in these products. A country may then sell there goods overseas and purchase goods from overseas which are produced more efficiently elsewhere. Thus, both countries benefit from trade. As nations possess absolute advantages in the production of different goods, he suggested that each nation should specialize in the production of goods it was particularly well equipped to produce. Furthermore, he argued that part of the output should be exported, taking in exchange those goods that the country could not readily produce with equal levels of efficiency and effectiveness. If this principle were replicated in every country, discernible mutual benefits would arise.

Adam Smith and Absolute Advantage

The theory of absolute advantage has been found unsatisfactory by other economists. The main criticism focuses on the assumption that all nations have absolute advantage in the production of one product or the other. This has raises a number of questions. Suppose a country din not have absolute advantage in any product? Suppose a country had absolute advantage in producing all goods? Would these still be the need for international trade on both counts? These unanswered questions have undermined the relevance of the theory of absolute advantage as the basis for international trade policies.

Smith identified three main ingredients to his theory those being freedom, self-interest, and competition. Freedom is classified as the right to produce and exchange products, labor, and capital. Self-interest is the right to pursue one’s own business and to appeal to the self-interest of others. Competition is the right to compete in the production and exchange of goods and services. Adam Smith argues that it was market forces that ensured the production of the right goods and services. This would happen because producers would want to make profits by providing them.

Competitive Advantage and Laissez Faire Approach

Greed makes us dream, makes us ambitious, makes us become more productive and the sum of all these things increases the wealth of society. Individual greed of merchants in competition meets society’s need for goods and services. Individual animals in an ecosystem live and die in fierce competition yet their efforts create balance and growth. So too individual businesses live and die in fierce competition yet their efforts create balance and growth. This is the invisible hand. Greed is good for society. This ambitious quality of human nature allows for growth and evolution in civilization. The ability to work for in our own self-interest and without government intervention promotes progress in the marketplace.

The concept of laissez-faire is discussed in Book IV of V of the Wealth of Nations. As argued in the text, wealth depends on the division of labor, that depends on accumulation of stock, and that depends on profitability, thus government’s best contribution to the wealth of the nation is to leave individuals free to find the most profitable employment of their labor and capital. One of the most famous passages of this book discusses the social benefits that can be derived from the free movement of capital.

Smith’s terminology revenue means net income, and annual revenue is the sum of the incomes or net national income, and annual produce is net national product. Smith’s point is that competition is what drives core values that the country celebrates: efficiency, innovation, growth, and responsiveness to consumer preference. The self-interest that influences the market is closely connected to the harmony between individual growth and the social good.

In such an economy, the investor seeks and follows his own desires and interests, directing his investments to spheres where the profit will be most. The “invisible hand” is described as unintended and unanticipated influences or forces that move the net national income. The “invisible hand” leads the economy to a state in which the various economic operations of different participants become compatible, even though this state might not coincide with the desired objective of any one of them. In this competitive model, Smith takes into account that the better employment of resources will be followed by better outcomes. In the free and fair competitive economy, government intervention is incompetent because government decisions are often influenced by specific interest.

Economic libertarians recognize that markets spontaneously produce order rather than chaos. They recognize that self-interested actions in a free market produce overall benefits. These benefits are a natural result, which may or may not be intended by the individuals doing business in that market. Libertarians favor Adam Smith’s view on natural liberty in business. Libertarians hold that life, legitimate property ownership and liberty are foundation rights and that government’s purpose is solely to defend and promote these through systems of justice (libertarian.org). Most Libertarians know for a fact that that a strong socialist central government will always be much less efficient than the invisible hand of the market. The market provides the invisible hand that guides men and women toward right decisions. The invisible hand is as efficient in the marketplace of ideas as in any other marketplace.

The term “laissez-faire” also provides a means of understanding an important aspect of the complex and detailed account of the commercialization of Western society that we find in the Wealth of Nations. A careful reading of this book shows that Smith never portrayed free trade as an unmixed blessing. It shows, too, that Smith thought the ideal of a completely free commercial market was something of a utopian dream. More profoundly than the Physiocrats, also more deeply than his friend Hume, Smith was especially aware that calling for government to end regulation of economic activity was not the same thing as calling for government to abdicate all its power in the economic realm.

Commerce in the eighteenth century, as in the three preceding it, was a matter of producing goods to provision the wide-ranging military and naval efforts of rival European nations and of furnishing commodities to overseas suppliers in exchange for goods to be sold as commodities at home. These activities created the global commercial network, celebrated by Voltaire and many other eighteenth-century observers that supplied raw materials for Western factories in the nineteenth century. But few merchants in fact brought laborers directly into owner-supervised establishments, choosing instead to reap the profits of commodity circulation while leaving the risks of production to local domestic producers.

Yet many of the ideas used to explain and defend commercial society were carried over into the age of industrial capitalism. Two views of human nature that Adam Smith powerfully presented would become conventional wisdom in the thinking of that new class of men who purchased machines and bought human energy to power their new factories. First of all, there was the view of man as a laborer and improver. The primary means by which he betters his condition is the increase of his private wealth. Specialization is the rational form of labor; profit is the aim of those who direct labor and the unqualified expression of the successful improvement of our condition. Second, there was the argument that man by nature is an acquisitive creature. He is a trader and seeks before anything else his own personal gain; he also is most capable of rational action when in single-minded pursuit of that end. (Karl, 1944) But it would be misleading to suggest that these views help us to understand the historical origins of capitalism as a particular mode of production. The fact remains that the world of early modern commerce was not one in which a specific type of wage labor is the main clue to the nature of economic activity.

Competitive Markets and Globalization

To the end of the eighteenth century, the global network of European commerce remained largely within politically defined channels, limited by privileges and prerogatives guaranteed by the state. Before capitalist relations could come to dominate industrial production, the political supervision of economic activity had to be eliminated in some areas, curtailed in others. Monopolies of all kinds, created by rulers who sought to increase their own treasuries at the expense of their rivals, had to be abolished because they hampered the reproductive capacity of capital. Statesmen and legislators also needed to understand that the demands of capital accumulation required the state to surrender its control over the movement of raw materials and human labor. Not all of the new demands made upon the state by the champions of capitalist relations required a diminishment of its power. Defenders of free trade recognized that state assistance sometimes would be necessary to open up new foreign markets or to protect nascent industries against external competition. At the same time, they called for state investment to create an infrastructure of education, transportation, and communications that would benefit a capitalist economy without demanding major outlays from it. But even here, the various political messages of capitalism were of one piece. Law and government must be the servants of economic activity; they also must give the greatest possible freedom to men who engage in trade and manufacturing. (Jacob, 1968)

There are many ways of tracing the ascendancy of this view of politics, a view summarized–accurately, even if with sometimes misleading convenience–in the phrase “laissez-faire.” One is through the impact of events themselves, which is the traditional province of political and economic historians. Another way is to keep events on the margin and reconstruct particular conceptions of human purpose that inspired or interpreted those events. Here the distinction between eighteenth-century “commerce” and nineteenth-century “capitalism” begins to blur. Smith knew little or nothing of factories and wage-earning laborers; they did address the deep and persistent problem of the proper relation between economic and political affairs. And it is precisely because these three thinkers help us to grasp the intellectual origins of political ideas crucial to capitalism, even if we view it strictly as a particular mode of production, that we can connect his views to its intellectual history (Muller, 1993).

Smith was an analyst of social conflict and change as well as an economist. And it was precisely this awareness of the disruptions that free commerce might bring to eighteenth-century societies that colored his policy advice to those legislators and statesmen who alone had the power to create a truly free market place. Smith was far more circumspect in his account of how economic improvement would come to serve both “the greatness of the state” and “the happiness of its subjects.” (Dankert, 2004) He conceded that many of the most powerful subjects in existing societies already recognized that a government’s adoption of a laissez-faire policy in the economic realm promised their failure. The elimination of apprenticeship laws, for example, would be both an act of justice and a practical benefit to the public, since the work of artisans would thereby become cheaper. But the old masters would of course be losers here, and “in the end, perhaps, the apprentice himself would be a loser.” For under conditions of free market competition not only would the inefficient be driven out of business by the efficient? Those who remained in businesses where a trade was easily learned would have more competitors, and the outcome here would be that their wages “would be much less than at present.” There was, in brief, always something of a zero-sum analysis in Smith’s argument for free competition. (Smith, 1776) To be sure, in his mind the winnings in a laissez-faire policy outweighed the losses. But Smith was not blind to the fact that winners could only exist if losers existed, and in his vision of economic order, among the projected losers were those who then still had the power to foil his open and defiant plotting against them.

This last point was made in a slightly different way in Smith’s discussions of the division of labor. The Wealth of Nations was by no means the first work to argue that an ever-increasing rationalization of human labor, together with a steady expansion of the market place, were the keys to economic growth. Schumpeter observed that the book was remarkable because “nobody, either before or after A. Smith thought of putting such a burden upon division of labor”; indeed, it was “practically the only factor in economic progress.” But Smith’s account of the division of labor was also remarkable in its willingness to measure the dangers that he thought would appear in an economy dependent upon highly specialized techniques of labor. (Schumpeter, 1785) Where Hume linked a “quick march of the spirits” with commerce and manufacturing, Smith observed that labor in simple and unchanging tasks threatened to reduce a workman’s capacity for invention and render him “as stupid, and ignorant as it is possible for a human creature to become. The torpor of his mind renders him, not only incapable of relishing or bearing a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment, and consequently of forming any just judgment concerning many even of the ordinary duties of private life.” In sum, while improving dexterity in one’s particular line of business may be essential to productivity, it seems to be acquired at the expense of one’s “intellectual, social, and martial virtues.” This, Smith concluded, was a situation that government must “take some pains to prevent,” and we shall consider his remedy in a moment (Smith, 1776).

The main thrust of Smith’s reassessment of the conception of government that supported “free trade” can be found in the three concluding paragraphs of book IV, chapter II. He declared at the end of this famous chapter that to expect freedom of trade would ever be entirely restored in Great Britain was “as absurd as to expect that an Oceana or Utopia should ever be established in it.” This was by no means an off-hand remark; Smith went on in some detail to explain what he meant. He meant, above all else, that a policy of laissez-faire, whatever its considerable intellectual merits, ran far ahead of actual social developments in eighteenth-century Europe. Even in Britain, the most advanced of all European economies, “not only the prejudices of the public, but what is much more unconquerable, the private interests of many individuals, irresistibly oppose it.” The “master manufacturers,” Smith wrote, were not only opposed in principle to the doctrines of free trade and competition. In practice, their influence in most instances had been powerful enough to muffle those members of Parliament calling out for an end to legislated economic privileges. “The monopoly which our manufacturers have obtained against us,” Smith de clared, “has so much increased the number of them, that, like an overgrown standing army, they have become formidable to government and upon many occasions intimidate the legislature.” The inevitable outcome was that members of parliament who had supported existing monopolies acquired “not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance.” Those who opposed monopolies, in turn, had stood unprotected “from the most infamous abuse and detraction, from personal insults, [and] sometimes from real danger, arising from the insolent outrage of furious and disappointed monopolists” (Frank, 1979).

It should be said again that none of this is to suggest Smith himself doubted the intellectual soundness of the free trade and laissez faire positions. Indeed, it was in the opening pages of this chapter that he offered what has become the most famous statement of those positions ever written: the doctrine that a man given freedom to pursue his own gain is “led by an invisible hand” to promote the growth of commerce and industry (Smith, 1776).  But his view, as we saw in examining Hume Political Discourses, was in no way unique to Smith. In fact, it was more typical of Smith’s approach throughout the Wealth of Nations to find him at the end of the chapter emphasizing that those who would defend or implement a laissez-faire policy necessary to establish free trade in the first place must see that this policy represented a radical challenge to an established socio-political order–and a challenge whose prospects of full success were at best uncertain.

Conclusion

In conclusion, essentially Adam Smith says that individuals try to maximize their own good (and become wealthier), and by doing so, through trade and entrepreneurship, society as a whole will be better off. Furthermore, any government intervention in the economy isn’t needed, as the invisible hand would best guide the economy. For Smith’s system to work there must be free movement for all in the system so that each man might seek the best opportunity for his labor or resources. There must be free competition among all: for markets, labor and for jobs. There most be no monopolies or combinations in restraint for trade or limiting entry into new fields, and no government granted privileges for a favored few.

Whatever notion of the free market is used, the analysis of an actual market requires understanding the structure of rules that govern demand, supply, and transaction options for a particular set of transactions. Borrowing from the experimental economics literature, we argue that all exchange can be modeled as a combination of rules constituting an exchange structure or a microeconomic institution. The set of traders is composed of participants, their resource endowments, and their knowledge endowments. The set of rights and obligations specifies the rights of agents to communicate in order to affect exchange, property rights, allocation rules, and cost-imputation rules. Thus, we may view an exchange structure as a set of rules that indicate the agents and the options that they are allowed in any transaction.

In the free market case, if an organization provides valued services, it grows and prospers. If it fails to provide services, it suffers for its failures at the hand of the free and natural market. It loses members, specialists, activists, and donations. The invisible hand steers the economy toward more desired goods and services.

Adam Smith established trading based on the law of absolute advantage. Initially, it was deemed that for two nations to trade with each other voluntarily, both nations must gain. That is, when each nation specializes in producing the commodity of its absolute advantage and exchanges part of it for the commodity of its absolute disadvantage, then both nations would wind up consuming more of both commodities. However, absolute advantage describes only a small portion of the contemporary international trade, particularly that of the trade between developed and developing countries. Trade among developed countries could not be explained by absolute advantage, thus David Ricardo, with the law of comparative advantage, further explain the basis for and the gain from trade. The law of comparative advantage postulates that even if one nation is less efficient that the other nation in the production of both commodities, mutual benefit from trade is still possible. It will be attained if the first nation would specialize in the production and exports of the commodity in which it has smaller absolute disadvantage, while simultaneously imports the commodity in which its absolute disadvantage is greater. Nevertheless, there is again an exception to the law of comparative advantage, and that is the discussion regarding the effect that international trade has on the earnings of labor as well as on international differences in earnings.

Exchange may arise from other motives, however. Under conditions of resource abundance, elements of prestige exchange structures are likely to be present. The anthropological literature suggests that prestige exchange reduces the risk of trading where no formal regulation exists. In other words, moral regulation is substituted for formal regulation. Owing to the absence of money and the high search and transaction costs, trading for financial gain is undeveloped. Thus, in the Fat of the Land scenario people will use goods as a medium to create social bonding just as they do in poor urban areas at present. Indeed, relations of interpersonal trust regulated by customary ethics formed the basis of civil society from which the modern market system emerged. The world of Adam Smith was one of thousands of small family firms, of visible merchants and customers, so that Smith could look to civil society, not government, as the arena in which competition would be regulated by custom and ethics rather than by contract and law.

In the case of the Wealth of Nations, Smith’s strategy can be summarized as follows. In pursuit of an economic order whose principal objective was growth, to be realized partly through the free pursuit of self-interest and partly through vigilant political campaigns against privileged economic orders, Smith set out a policy that avoided utopian visions and mechanical formulas. Yet he projected at the same time a single goal–the “system of natural liberty”–that was difficult, audacious, but also imaginable as a guide for eighteenth-century policy. Free trade and laissez-faire in Smith’s mind presented a series of demanding lessons that statesmen and legislators would learn more painfully, gradually, and incompletely than its previous exponents had recognized. In pursuit of what he understood to be justice and economic freedom, Smith was an historical realist and a political pragmatist.

References

Brew, Anthony. 2000 “Adam Smith’s Two invisible hand’s” The University of Bristol Dankert, Clyde. 2004; Adam Smith: Man of Letters and Economist. New York: Exposition Press, Inc

Frank E. Manuel and Fritzie P. Manuel, 1979; Utopian Thought in the Western World (Cambridge, Mass)

Jacob Viner, 1968; “Adam Smith,” in The International Encyclopedia of the Social Sciences (Glencoe, Ill), 14: 325.

Karl Polanyi; 1944: The Great Transformation: The Political and Economic Origins of Our Times (Boston), pp. 3, 33,

Muller, Jerry. 1993; Adam Smith in His Time and Ours; New York: The Free Press

Schumpeter, J. 1785; History of Economic Analysis, p. 187. Paris.

Smith, Adam; 1904: An Inquiry into the Nature and Causes of the Wealth of Nations; London: Methuen and Co., Ltd., ed. Edwin Cannan, 1904. Fifth edition First published: 1776.