The Working of Competitive Markets

Smith's most significant contribution to economic theory was his analysis of the workings of competitive markets. He was able to specify with greater accuracy than previous writers the mechanism whereby the price resulting from compe­tition would, in the long run, equal the cost of production. In his analysis of price formation and resource allocation, he called short-run prices "market prices" and long-run prices "natural prices." His primary concern was with the forma­tion of long-run natural prices. He saw competition as fundamentally requiring a large number of sellers; a group of resource owners who were knowledgeable about profits, wages, and rents in the economy; and freedom of movement for

⁴Smith, Wealth of Nations, p. 423.

resources among industries. Given these conditions, the self-interest of resource owners would lead to long-run natural prices that would equalize the rates of profits, wages, and rents among the various sectors of the economy. If, for example, the price of a final good is higher than its long-run natural price, then either profits, wages, or rent in this sector of the economy must be higher than its natural level, and adjustments will take place via the movement of resources until the natural price prevails. With competitive markets and an absence of government regulation, the resulting natural prices bring about an optimum allocation of resources in that consumers receive the goods they want at the lowest possible cost and maximum rates of growth are ensured.

Having established the superiority of competitive markets, Smith easily constructed his case against monopoly and government intervention. He recog­nized the desire of businessmen to monopolize trade by joining forces, and although he was not able to specify what the monopoly price would be, he recognized that monopolists would extract a higher price by restricting output. Note that Smith's advocacy of laissez faire assumes the existence of competitive markets. Various groups in the economy have parroted Smith's denunciation of government intervention while ignoring his precept that a laissez-faire policy presupposes the existence of competitive markets.

Smith's argument against government intervention in the economy has politi­cal, philosophical, and economic bases. He argued that in general any govern­ment interference is undesirable, because it infringes upon the natural rights and liberties of individuals. However, he examined the economic arguments against government intervention much more extensively. He reviewed many of the mercantilist regulations of domestic and foreign trade and showed that they resulted in an allocation of resources that was less desirable than that produced by competitive market forces. Smith believed that many of the mercantilist arguments for government intervention, although purporting to promote the social good, were in fact self-serving. The regulation of domestic and foreign commerce benefited not the nation but the merchant. This was not a purely theoretical argument; it came from Smith's personal observation of how govern­ments actually operate. It was Smith practicing the art of economics, looking at the policy of regulation in the context of the institutions of his time. If governments were different, they could promote the social good; but given the way they are, they inevitably do more harm than good. In this sense, the roots of modern public-choice theory extend back to Adam Smith's perception of how merchants use government to enrich themselves.

Smith's great achievement was his brilliant overview of the workings of markets. Though he did not himself fashion his analytical tools, and despite the difficulties and inaccuracies in his analysis of the formation of relative prices, his accomplishment was immense. He supplemented his broad overview of market processes with descriptive and historical material and produced a work that could be read and understood by the educated people of his time. In this manner he was able to exert an influence on economic policy and lend support to the increasingly favored view that the wealth of England would best be promoted by a government policy of laissez faire.

ome historians of economic theory have attempted to rank economists according to their technical brilliance— their ability to develop new techniques of economic analysis and their virtuoso performance in applying technique. Judged by this criterion, Adam Smith ranks low. Other historians have at­tempted to rank past writers by origi­nality. Judged in this way, Smith ranks behind Cantillon, Quesnay, and Turgot. But viewed historically, Smith's abilities and his contribution to the flow of eco­nomic ideas represent a much scarcer resource than either originality or tech­nical competence: his role was to take up the best ideas of other men and meld them, not with technique but with judgment and wisdom, into a com­prehensive system that not only re­vealed the essential functioning of the economy but also provided rich insights into policy questions. Smith's system was not an abstract, bare-bones analyti­cal framework of pure economic theory;

it was political economy focused almost exclusively on the question of which policies best promote what today we call economic growth and what Smith called the wealth of nations. Smith was a master at contextual policymaking, first rate at the art of economics.

In advocating a laissez-faire policy, Smith was very cautious. His invisible hand works to tie public interests to private interests only when competi­tive forces exist to channel self-interest to the social good. His exceptions to laissez faire—situations in which he saw the public good as not flowing from competitive markets—are stand­ard fare in modern welfare economics and are sometimes cited in socialist calls for government intervention. No other economist has had the impact on economic policy of Adam Smith. Mod­ern economics has added extensive for-malization to Smith's vision but little to its inherent insights.

Smith's advocacy of laissez faire must be qualified, however, for he cited several areas in which he believed government intervention, in the context of the historical, political, and institutional structure of his time, was necessary. For example, although he was generally against the regulation of international trade, he made exceptions for tariffs that protected infant industries. Trade regulation was also necessary when national defense might be weakened by a policy of perfectly free international trade. The government was to provide for the national defense, build and maintain roads and schools, administer justice, and keep vital records. It is most significant that Smith qualified his argument for laissez faire by advocating government provision of goods that have great social benefits but that are not supplied by the private market because supplying them would not be sufficiently profitable. For example, the social benefits of education are very great, but the profits to be realized from the private provision of education are so small that, if the market is left alone, less education will be supplied than is socially desirable. (Much of modern welfare economics deals with externalities, third-party or spillover effects, and how these must be considered if maximum social welfare is to be achieved.) The qualifications of

the laissez-faire maxim are an index of Smith's scholarship and intellectual honesty. They did little, however, to diminish the vigor of his laissez-faire creed.

Date: 2015-02-03; view: 902