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CHAPTER 6

IS ADAM SMITH ROLLING OVER IN HIS GRAVE?

Perfect Competition, Efficiency, and the Father of Modern Economics

The celebrated eighteenth-century political scientist Adam Smith worshipped the workings of free markets, and his words are still quoted in support of unbridled capitalism. However, Smith’s role as the patron saint of unconstrained markets may be unwarranted: Smith abhorred market power, and the market efficiency he glorified was achieved only by perfectly competitive markets that were unlike most that have ever existed in the real world. Do a few detours from Smith’s market model matter? In a word, yes. And if you’ve seen prices that differ between gas stations or between burger joints, you’ve seen evidence that competition is seldom perfect. This chapter explains the splendor of markets at their best and presents some neglected truths about Adam Smith and his notion of the invisible hand.

Adam Smith is often proclaimed the patriarch of modern economics. His most famous saying appeared in his 1776 book, The Wealth of Nations, in which he wrote that the individual decision maker

intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. . . . By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.¹

¹ All quotes from Adam Smith’s Wealth of Nations are from http://www.online-literature.com/adam_smith/wealth_nations/ unless otherwise noted.

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The notion of the market embodying an “invisible hand” by which self-interested behavior yields socially desirable outcomes has captured the fancy of generations of economists and policymakers. As discussed in Section 1 Economics by Example, efficiency is a matter of attaining the largest possible gains with the least possible waste. The efficiency of markets stems largely from desirable conditions that occur at market equilibrium, where the supply-and-demand curves intersect to establish quantity and price (see Section 2 Economics by Example). Smith explained how a competitive market tends toward a price that is fair to both buyers and sellers, and that this price allocates resources as well as possible from the broad standpoint of society. At their best, markets can achieve conditions bordering on the ideal. Suppose you were a benevolent, all-knowing dictator. After eliminating war and hunger, and banishing the word widget from economics textbooks, you could advance the well-being of society by allocating resources to achieve three types of efficiency:

Remarkably, perfectly competitive markets achieve all three of these outcomes without your help as dictator. The following sections explain how that happens.

Under conditions that resemble pure or perfect competition as Smith imagined it, a large number of sellers sell the same good to a large number of buyers. Competitors can enter and leave the market easily, and everyone involved in the market has full information about what is available from whom at what price. Under these conditions, no consumer would pay more than the lowest available price; a firm that charges more than its competitors would get no business. Firms need not charge less than the equilibrium price because they can sell all they want at the equilibrium price (by virtue of demand equaling supply at equilibrium). Thus, each firm in a perfectly competitive industry ends up as a price taker, taking on the equilibrium price determined by the balance of supply and demand in the market.

Consider (as a real market that provides a break from routine) the on-line market for rubber clown noses—those bright-red semispheres that fit over a real nose and make onlookers smile. There are many buyers and sellers, the noses are all pretty much the same,² ample information on prices and suppliers is available through a quick Internet search, and it’s possible for almost anyone with access to a computer to enter or exit the Internet market.³ Perfect competition isn’t all funny business; markets for agricultural products, such as corn and sugar, also approximate the perfectly competitive model.

² Assume they are the same for the purposes of this example. As with most things, you can find variations such as custom-made clown noses or foam noses, but they can be considered different products.

³ For example, there are 10 individual sellers and 68 “eBay stores” at www.ebay.com selling clown noses as of this writing. If you saw those stores earning worthwhile profits, you could start up a competing Internet “store” at almost no expense.

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Firms seek economic profits, calculated by subtracting all costs, including the value of entrepreneurs’ time and the opportunity costs of using capital,⁴ from revenues. Entrepreneurs would accept 0 economic profits if necessary because they could not earn anything more in their next-best work opportunity. For example, if your highest-paying alternative job were as a marketing manager earning $80,000 per year, you would subtract $80,000 as the value of your time when calculating economic profits in the clown nose industry. So earning 0 economic profits implies that you are covering all of your costs, including the $80,000 opportunity cost of your time, and you couldn’t earn another cent doing anything else.

⁴ For example, even if the owners of a pizza shop have purchased their pizza oven, by using it, they forgo the opportunity to rent it out to someone else. Thus, the rental rate of an oven is a cost of using it for owners and renters alike.

Productive efficiency is achieved in perfectly competitive markets thanks to the ease of entry and exit by similar firms seeking economic profits. If ClownAntics.com isn’t using the lowest-cost methods of clown nose production, competitors, such as TheClownShop.net, will.⁵ Rival firms can undercut the price charged by an inefficient firm and steal its business. If the market price for clown noses exceeds the average cost of producing them, other fully informed entrepreneurs, such as Betty at ClownCostumes.com, will be attracted to the market by the smell of profits, and the entrance of new firms will increase the supply and lower the equilibrium price. This pattern will continue until the lowest-cost process of nosemaking no longer provides economic profits. Similarly, if the market price for clown noses falls below the minimum average cost of producing them, nose sellers, such as TwinklesTheClown.com, will start going out of business. As these firms exit, supply will decrease and the equilibrium price will rise until the remaining firms are earning just enough to cover all their costs. In the long run, firms in a perfectly competitive industry will receive a price equal to their minimum average cost and will earn 0 economic profits. This situation leaves no room for the use of inefficient production methods in a perfectly competitive industry.

⁵ In this reality-based book, all Web addresses are real.

Remember that the supply curve represents the increasing marginal cost of producing each unit and that the demand curve represents the decreasing marginal value of each unit to consumers. At quantities of production below the equilibrium quantity, the demand curve is above the supply curve, indicating that the value of 1 more unit will exceed the cost. If the marginal value of another clown nose is $7 and the marginal cost is $3, more noses should be produced. However, it would be inefficient to produce beyond the equilibrium quantity because marginal value falls below marginal cost at the point of equilibrium. If another clown nose would cost $4 to make and it would be worth only $2, it would be unwise for society to allocate resources for another nose. It follows that to produce the equilibrium quantity is to produce all those units that are worth more than they cost to provide.

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Like the equilibrium quantity, the equilibrium price is established at the intersection of supply and demand, meaning that the price equals both the marginal cost and the marginal value of the last nose sold. The condition for allocative efficiency is often stated as the equality of marginal cost and price because if the price that buyers are willing to pay is above the marginal cost, consumers must value another nose at more than the cost of making one, and too few clown noses are being made. Conversely, if buyers are not willing to pay a price as high as marginal cost, marginal value is below marginal cost and too many noses have been made.

The well-being of society is maximized if clown noses go to those who value them the most—presumably clowns. A perfectly competitive market is up to the task of maximizing well-being. Consider a simplified market with 5 potential buyers: Abe, Ben, Clem, Dot, and Ernest, each of whom is interested in, at most, 1 clown nose. The values these clowns receive from a rubber nose are, respectively, $12, $8, $6, $3, and $1. Suppose the marginal cost of producing the first 5 clown noses is $2, $4, $6, $8, and $10, as shown in the accompanying table.⁶ Three noses should be produced, because any additional noses would be valued at less than the cost of producing them.⁷

⁶ These numbers are simply made up to comply with the law of supply (see Section 2 Economics by Example), which indicates that supply curves are upward sloping as a result of increasing marginal costs. The rate at which marginal costs increase is exaggerated here for the purpose of illustration.

⁷ It might be tempting to say that 4 noses should be produced because Dot would be willing to pay the $2 cost of the first nose, Clem would pay the $4 cost of the second nose, Ben would pay the $6 cost of the third nose, and Abe would pay the $8 cost of the fourth nose. Here’s the catch: No matter which clowns got which noses, the cost of making the fourth nose would be $8, and the combined benefit that the clowns receive would increase by only the $3 value that Dot receives when 4 rather than 3 are made. So making a fourth nose leads to a net loss of $8 − $3 = $5. Aside from this loss of efficiency, there’s also the problem that each good in a perfectly competitive market sells for the same price.

In our example, the equilibrium price will be $6 because that is the only price that equates supply and demand. As explained in the first section of this chapter, expect perfectly competitive firms to conform to the equilibrium price. Three of the clowns—Abe, Ben, and Clem—will be willing to pay the $6 equilibrium price. Because those who place the highest value on noses are willing to pay the highest price, clown noses will be rightly allocated to true nose lovers.

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In contrast, imagine that a lottery rather than a market is used to allocate 3 noses. If names are drawn out of a hat, the recipients are equally likely to be any of the 5 clowns. Suppose Ben, Dot, and Ernest win the lottery. The total value created by the noses is the sum of the recipients’ marginal values: $8 + $3 + $1 = $12; this amount falls below the $12 + $8 + $6 = $26 worth of value obtained through the market allocation. In both cases the cost of producing 3 noses would be $2 + $4 + $6 = $12, but the net gain is the highest with the help of the market. Nonetheless, lotteries are common for allocating dorm rooms and student tickets for popular football games, among other valuable goods and services.

The previous examples demonstrate how buyers and sellers can enhance the well-being of society merely by acting out of self-interest. Adam Smith marveled at the potential for markets to allocate resources efficiently without government assistance, as if they were guided by the invisible hand of a benevolent dictator. To Smith, competition was the great enforcer that held greed at bay. Should 1 merchant decide to charge an excessive price, another merchant would swiftly provide the same product for less money. This is the case under perfect competition. Those who cite Smith’s work to support a more general disdain for government must be aware of two issues about which Smith is often misinterpreted: market failure and morality. This section introduces the sources of market failure, each of which is covered in a full chapter later on, and discusses the overlap between markets and morality.

The cruelest of our revenue laws, I will venture to affirm, are mild and gentle, in comparison to some of those which the clamor of our merchants and manufacturers has extorted from the legislature, for the support of their own absurd and oppressive monopolies.

—Adam Smith, The Wealth of Nations

Although Smith venerated competitive markets, he abhorred monopoly power and trade secrets. In The Wealth of Nations, Smith wrote of “the mean rapacity, the monopolizing spirit, of merchants and manufacturers, who neither are, nor ought to be, the rulers of mankind.” The celebrated efficiency of competitive markets is jeopardized when individual sellers or buyers have market power, meaning that they can restrict supply and increase prices, or when any of the other conditions for perfect competition are violated.

Legal, technical, and economic barriers are among the deterrents to potential competitors in many markets, as a few examples will demonstrate. Pfizer, Inc., holds a patent on Viagra and ships the medication in bottles with radio frequency identification tags so that bottles coming from Pfizer can be distinguished from bottles coming from counterfeiters. In 2004, the De Beers Corporation, which controls much of the world’s diamond industry, paid a $10 million fine and pleaded guilty to criminal price fixing. Members of cartels, such as the Organization of Petroleum Exporting Countries (OPEC), collude to reduce production and raise prices. The Recording Industry Association of America (RIAA) has sued individuals for illegally using peer-to-peer file-sharing systems to swap recordings of copyrighted songs and to distribute public-domain music that competes with music industry offerings. Advertisements showing car engines flying in pursuit of name-brand gasoline trucks and resorts that take Visa but not American Express credit cards exemplify attempts to reduce the influence of competitors via product differentiation. And in the third-largest retail merger in history, Kmart and Sears joined forces, eliminating price competition between them.

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In order for the equilibrium quantity of a good or service to be efficient, buyers and sellers must also bear, or internalize, the full cost and benefit of that product. Otherwise, the market equilibrium formed by the marginal costs and marginal benefits that market participants perceive differs from the true equilibrium of marginal costs and marginal benefits felt by society. Consider the following examples:

Such benefits and costs that aren’t borne by those making decisions about the products are called externalities. What is to be done when the assumptions of perfect competition are violated, as in these examples? Economists Richard Lipsey and Kelvin Lancaster advanced the general theory of second-best, which demonstrates that, when 1 of the conditions for perfect competition is not met, intervention to remedy the situation can lead to a better outcome than a hands-off approach, even if every other condition is met. Thus, if free markets cultivate market power, pollution, and study benefits that aren’t internalized, then antitrust legislation, environmental regulations, and funding for education may be warranted to achieve the best possible situation. Do you have full information on the prices of competing doctors, restaurants, or hotels where you live and travel? If not, policies requiring the posting of prices could improve efficiency and social well-being, and such policies do exist for restaurants and hotels in some countries. Potential sources of market failure, including externalities, imperfect information, imperfect competition, and public goods, are the topics of Section 14 Economics by Example. The remainder of this chapter focuses on another widely misunderstood area of Adam Smith’s work.

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Smith believed that markets would overcome immoral behavior. He believed that benevolence would spring from market forces because, through trade, people gain in proportion to what they give and thus are prompted to develop ways to give more. But as with market failure, problems with morals have persisted in a way that Smith hoped they would not. Recent examples include the corporate ethics scandals at Arthur Andersen, Enron, Adelphia, ImClone, Citigroup, Qwest, WorldCom, and Tyco.

Tension exists between the desire for complete freedom and the desire to avoid the moral bankruptcy that threatens the efficiency of markets. The contemporary Adam Smith Institute is a self-proclaimed “free-market think tank,”⁸ but Smith himself was a moral philosopher, and his theories assumed a foundation of righteousness and human decency. He wrote of every person being “left perfectly free to pursue his own interest in his own way” on the premise that markets compel ethical behavior.

⁸ See www.adamsmith.org/.

Smith wrote at length about the morality that underpinned his laissez-faire disposition. In the context of children whose parents are poor role models, Smith wrote that “the example of that bad conduct commonly corrupts their morals; so that, instead of being useful to society by their industry, they become public nuisances by their vices and disorders.” In his book The Theory of Moral Sentiments (1759), Smith argued that an individual should examine his or her behaviors as would an impartial spectator. By Smith’s standard, an action is wrong if an individual feels a sentiment of disapproval when she or he considers that action. Several other schools of thought provide questions that assist decision making when markets and morals intersect:

Utilitarianism: Does this action bring the greatest good to the greatest number of people?

Ethical egoism: Is this action good for me?

The common good: Is this action good for society as a whole?

Virtue: Does this action reflect balance between vices?

Rights: Does this action respect the moral rights of everyone?

Kantianism: Would I want everyone to perform this action?

Justice: Is this action fair and just? Does it treat equals equally?

Role models: What would my hero do?

The newspaper test: Would I be embarrassed if this action appeared in a newspaper headline?

Smith would have us ruled neither by big government nor by big business. And he would have us behave in such ways as to win the approval of impartial observers. Would these observers approve of the exploitation of labor, the neglect of health and environmental concerns, exorbitant prices, or pressure on buyers to purchase items they don’t really need? Probably not—meaning that the progenitor of modern economics would disapprove of the license for unbridled greed that some see as his legacy.

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Saying “Smith says” lends credibility to actions in much the same way that saying “Simon says” does in the popular children’s game of that name. Smith may not be rolling over in his grave in response to becoming a laissez-faire icon, but he would certainly be glad that you have read this chapter so as to better understand the caveats that underpin his oft-quoted views. If we are to take our cues from the father of economics, it is important that we know what Adam Smith really said.

Smith said that markets can achieve miraculous efficiency and that constraints on otherwise efficient markets can distort the incentives for socially optimal behavior. Smith would not have liked artificial controls on prices, quantities, or wages; nor would he have advocated government subsidies or tax breaks. However, the markets that should not be distorted are those that involve many informed sellers of an identical product and no barriers to entry or exit by competitors. Smith probably would have appreciated such measures as nutrition information labels on food packages, restrictions on monopoly power, and harsh punishments for deceptive advertising. Likewise, the enforcement of health and environmental standards that prevent firms from imposing pollution costs on society are in the spirit of Smith’s sensibilities.

Many people study supply and demand without understanding that only firms in perfectly competitive markets have supply curves. Monopolies will charge different prices for the same quantity, depending on what the demand curve looks like. Like the lessons of Adam Smith, much of what is learned in economics classes is contingent on perfectly competitive markets. Given market imperfections, individuals should relish free markets within reason while maintaining high moral standards and accepting measures that deal with market failure in order to attain the highest possible level of social well-being.