Why Are Markets So Scary? Some Things (Liberal) Academics Get Wrong

11 October 2007 at 4:19 pm 17 comments

| David Hoopes |

Many people make incorrect assumptions about capitalism. Some would have us believe that capitalism is based on greed, selfishness, and promotes behavior that is completely self-centered. This is a common interpretation of Smith’s advice to allow people to make decisions based on self-interest. Examples are easy to find in the many organization theory-based papers complaining about economics and economists.

Two very good papers can aid in a deeper understanding of the invisible hand. First is James Q. Wilson’s “Adam Smith on Business Ethics.” A central point Wilson makes is that Adam Smith assumed people will behave with a moral sense. Wilson, “A moral man is one whose sense of duty is shaped by conscience; that is, by that impartial spectator within our breast who evaluates our own actions as others would evaluate it.” By suggesting people be allowed to make decisions based on their own self interest Smith was not advocating selfishness and greed. What then was he advocating?

This leads to the second paper, Harold Demstez’s “The Theory of the Firm Revisited.” In the third paragraph Demsetz notes that the debate between mercantilists and free traders was over the role of the government in the economic affairs of the state. “Is central economic planning necessary to avoid chaotic economic conditions?” The great achievement of the perfect competition model, what Demsetz argues should be called perfect decentralization, is its abstraction from centralized control of the economy.

Thus, the central element to capitalism is that decision making is pushed down as far as possible.

To many O&M readers this is not news. However, many people think of capitalism and think of centralized power (big corporations). Yet, the whole point of capitalism is to allow each individual to choose what to buy, where to work, how much to pay, how to spend their time so and so forth.

The stark contrast is in planned economies. Few who have lived in these economies yearn for their return. Only those what have no idea of what it is like to have so many choices removed idealize such a life. How many academics would like living in a planned economy if planners decided the economy needed fewer academics and more farmers (cultural revolution anyone)? How many Hollywood actors would like living in an economic system where they were paid the same as everyone else, where central planners chose scripts, and where the government decides what kind of entertainment people “need?”

The choice is not between a system where you think of yourself versus a system where you think of others. The choice is between a system where you think for your self versus a system where you are told what to do.

Further, not only did Adam Smith not promote greed, but he believed in human sympathy and other virtues necessary for an economic system centered on liberty.

James Q., “The Adam Smith who…showed how the free pursuit of self-interest would lead to greater prosperity than any system of state-controlled exchanges was also the Adam Smith [in an earlier text on morality] explored the sources and power of human sympathy and the relationship between sympathy and justice.”

Wilson paraphrases from Smith’s introduction to Wealth of Nations, “Among savage nations made up of hunters and fishermen, every man is employed, and the differences in wealth are not great; but most people are very poor. In civilized nations, by contast, many people do not work at all, there are great inequalities in wealth and income, but very few people, provided they are industrious and frugal, live in poverty.

What is considered poor in present-day United States is incredible wealth to most other times and places (poor people in Africa and China are rarely obese). But, that is a discussion for another day.

Entry filed under: Business/Economic History, Classical Liberalism, Former Guest Bloggers, Management Theory, Myths and Realities, Papers, People, Recommended Reading, Theory of the Firm.

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17 Comments Add your own

  • 1. Eric H  |  11 October 2007 at 10:48 pm

    Thus, the central element to capitalism is that decision making is pushed down as far as possible.

    Which isn’t terribly far, given the structure of most capitalist industries. There’s a lot of planning going on in those “islands of conscious power”. And given Chandler’s narrative, we’re a long ways from Adam Smith’s world, aren’t we?

  • 2. Gavin Kennedy  |  12 October 2007 at 12:45 am

    An excellent short post on Adam Smith’s philosophy and his political economy.

    Smith’s Wealth Of Nations was not a textbook of the ‘perfect society’. It explicitly denies that perfection is a necessary condition for progres to opulance (Book IV on Quesnay’s assertion to the contrary). It was a critique of the distortions of mercantile policies on the 17th-18th century economy and cannot be read straight across to ‘capitalism’ today.

    David Hoopes is closer to the real Adam Smith from Kirkcaldy than the Chicago version from 57th Street.

  • 3. Matt  |  12 October 2007 at 12:56 am

    This was an interesting post for me, because I used to be just such a liberal. I’ve become a bit more classically liberal, and Hayek’s Road to Serfdom had a lot to do with that. In fact, I read it in a small seminar with three liberal professors and one other liberal grad student, and ended up playing the Devil’s – er, Hayek’s – advocate pretty successfully, although I’m sure some of my interpretations would horrify the guys at Mises. But I still see a lot of problems with c-liberalism, and this might be a good opportunity to bring some of those issues up. I get a chance to learn some of the more nuanced arguments for c-lib, you all get the chance to learn a bit about what goes on inside the mind of a Hayek-sympathetic liberal – we all win. This is going to be a huge comment; my apologies.

    1) Let’s start with decentralized decision-making, which I love. David wrote, “Thus, the central element to capitalism is that decision making is pushed down as far as possible. To many O&M readers this is not news. However, many people think of capitalism and think of centralized power (big corporations). Yet, the whole point of capitalism is to allow each individual to choose what to buy, where to work, how much to pay, how to spend their time so and so forth.”
    Right on. But people who equate capitalism with centralized power aren’t necessarily wrong to do so. The planned economy is only the worst instance of a whole series of economies that centralize decision-making. A corporate oligarchy might be another, but you don’t even have to go that far: corporations – as an institutional form – only need to dominate the market to remove people’s choices. I think Hayek (I’ve lent out my book, unfortunately) makes a similar statement about government – i.e., it only needs to control a majority of the economy to control the whole economy. Maybe capitalism is about allowing people to make choices, but I think corporations work against that in at least three ways:
    First, there’s the fact that public corporations are required by law to be run for shareholder return only. Insofar as I understand Dodge v. Ford Motor Company, even a minority of shareholders can demand that the corporation be run for their benefit. Where’s the choice in that? What about the property rights of the majority of shareholders? Okay, I don’t really believe that shareholders own corporations, but I’m leaving that out of this argument. Maybe the majority of shareholders would still act the same way as a corporation bound to run for shareholder return, but I’d just feel better with humans behind the wheel instead of a law. That court decision preempts Smith’s thoughts about morality, because it’s basically barred from the picture. I hate hostile takeovers, too, but that’s more because I think the economic rationale about why they’re good is garbage (no, I can’t back that up).
    There’s also the fact that big corporations face knowledge issues just like governments do. You’ve got a small group of people at the top with absolute authority commanding everyone else both how to work, and to what end (the public good analog: shareholder return). Regardless of which corporation I choose to work for, I’m working for the same end – and because of the concentration of share ownership, there’s a good chance I’m working for literally the same people. Is that better than a centrally planned economy? You bet. Is it good by classically liberal standards? Not in my interpretation.

    Finally, there’s the fact that many aspects of corporations are basically anti-market mechanisms. Hierarchies aren’t markets, and the more economic activity that’s subjected to them, the less free the economy is. Transfer pricing is a joke. Who controls the hierarchy is irrelevant. (Damn – Eric H beat me to this one)

    So what’s the liberal defense of the corporation? And why do I rarely hear anything about worker cooperatives from classical liberals (except the odd mutualist)? As far as I can tell from my brief investigation, they decentralize authority to those with the most intimate knowledge of the task at hand and reduce the problem of alienation, all while killing off a whole bunch of agency problems. The unique problem they seem to face is financing, which seems to be mostly because banks are used to dealing with proprietorships and corporations.

    2) Hayek rightly points out that central planning leads to totalitarianism, but I think that Polanyi’s Great Transformation makes a good point: severe fluctuations of markets are one of the things that lead to that central planning in the first place. If a lot of people are suffering, they just aren’t going to keep playing the market game. They’ll jump on the bandwagon of first demagogue who comes along, overturn the whole system, and generally cause bad things to happen. History is full of examples. Much as Communism failed because it ignored basic human nature, I’m guessing liberalism would fail without providing some kind of security to those on the bottom (for an interesting policy response, check out Denmark’s flexicurity). People don’t give a damn about the collective good if they’re starving – and that’s true whether the collective good is a socialist public good or a liberal maintenance of freedom. The most shocking thing I read in The Road to Serfdom was Hayek casually commenting about how we would naturally need some system to protect the poor during economic downturns for a paragraph or two, and then moving on. I had to reread that about ten times to make sure I wasn’t hallucinating.

    3) Since we’re on the topic of historical oversights, can anybody tell me of a country that industrialized without extensive government intervention? I know free trade is good for a competitive economy, but I can’t find any example of a pre-industrial country that’s gotten anywhere without either internal or external intervention.

    4) As far as poverty goes, well, relative deprivation is my cop-out answer. But I agree, that’s a hairy question.

    So, that’s what’s on my mind. Let me know what you think. In particular, I’m curious about how Hayek’s arguments might have changed in his later work.

  • 4. Matt  |  12 October 2007 at 1:05 am

    Oh, man. That’s really much longer than I realized. Sorry – should have emailed it instead.

  • 5. Meh  |  12 October 2007 at 12:17 pm

    I’ll believe markets are less scary the day economists like you get a job in a less protected market than academia. Until then, I’ll continue to believe the evidence that suggests the brightest economists avoid submitting themselves to market forces as far as possible.

  • 6. nordsieck  |  12 October 2007 at 1:02 pm

    I’ll probably get some of this wrong, but I want to see if I can answer some of your points:

    1a. Corporate and government control over the economy are very different things. specifically, governments propagate into the private sector by using contracts and regulation to expand the scope of their power. Corporations may engage in this behavior as well, but they are constrained by efficiency – if they become too inefficient, Schumpeter’s creative destruction will kick in and they will go out of business.

    1b. By definition shareholders own the corporation.

    1c. It follows, that corporate management is required to manage for the benefit of shareholders. A law is required here because of the nature of corporations – the indirect control shareholders have over corporate management, etc.

    1d. The point of the market is not the size of the participants, but that all associations are voluntary – you as an individual are always better off dealing with the market than isolating yourself. This is not possible with a planned economy.

    As to your objection to hierarchies – certain endeavours require a certain level of capital investment. With high capital investment requirements, come large organizations and hierarchies, and all the rest.

    2. I don’t think you really asked a question here, but I’d like to make a point anyhow. If firms made decisions like most people (allegedly) do, they would all be out of business. The simple fact is that economic shocks are not hard to weather – people just need the discipline to save (say… 6 month’s salary). The ones that do become rich and the ones that don’t stay poor. The fact that most people are in the latter category doesn’t do much to inspire my sympathy.

    3. Estonia might be a good example. I’m not sure what level of industrialization the Soviets left when the USSR went down, but since then there has been remarkably little government intervention. I must confess that off the top of my head, I couldn’t readily give a good example.

    4. I don’t know what you were trying to say here, but it is worth pointing out that markets on their own tend to maintain relative inequality and simultaneously, to boost absolute levels of wealth. I can buy 300 lbs of rice – a year’s worth of starch – for something like 12 hours of work at minimum wage. That is nothing short of a miracle.

  • 7. srp  |  12 October 2007 at 6:21 pm

    As a factual matter, there is nothing stopping coops or other alternative institutional forms from entering various markets and trying to compete with corporations. We already have a vast “non-profit” sector that often implicitly competes with corporations, is less regulated, and pays lower taxes. (The NFIB regularly bitches about competition from universtiy bookstores and the like. Think about for-profit hospitals and educators and what they’re up against.)

    As for for-profit corporations, they can always place in their charters various objectives other than profit. So long as investors are informed of these objectives, there is no legal reason it couldn’t work. No legal doctrine prevents me from starting the XYZ Moral Sentiment Co. that makes shoes and guarantees that it only uses union workers in domestic factories. Of course, it will receive no funding from rational investors and/or go out of business pretty quickly unless it can convince customers to pay a lot more for its “morally superior” product. (Lots of people might question whether not employing desperately poor people overseas at higher wages than they would otherwise receive is really “moral,” but that’s a discussion for another time.)

  • 8. David Hoopes  |  13 October 2007 at 10:02 am

    Meh: Academics do compete in an international market. Very bright hard working people from all over the world come to the U.S. to get Ph.D.s and to stay on at universities.

    I think most academics see this as a good thing because all of this brain-power increases the quality of our universities.

  • 9. David Hoopes  |  13 October 2007 at 10:07 am

    More on Smith (and James Q.): Smith thought there were five moral issues relating to open markets. He did not believe that there were no potential problems. He was concerned about the laziness and indulgence of the wealthy classes, he was concerned that merchants would collude. His critique of the system he advocated is substantially better than most modern critiques. Again, for a great summary see James Q. Wilson’s California Management Review paper.

  • 10. twofish  |  13 October 2007 at 12:09 pm

    Something that people also miss the that power *within* a large corporation is very decentralized. One reason that I’ve ended up in the corporate world is that I end up with far more real freedom and choices than I would have in academia. Academia is wonderful for people on top but it depends on the exploitation of a lot of serfs.

    By contrast, I’m at the bottom of the corporate hierarchy and things are a lot of fun here. I don’t feel like a serf or an adjunct faculty. Part of the reason for this is that if I am unhappy and someone offers me a better role, I leave.

  • 11. twofish  |  13 October 2007 at 12:18 pm

    Meh: I’ll believe markets are less scary the day economists like you get a job in a less protected market than academia. Until then, I’ll continue to believe the evidence that suggests the brightest economists avoid submitting themselves to market forces as far as possible.

    Ummmm… There are lot of bright economists in the corporate world. Fisher Black just to name one. The typical quantitative research department in a major Wall Street investment bank has got about 50 or so physics and math Ph.D.’s working for them.

  • 12. twofish  |  13 October 2007 at 12:27 pm

    There is absolutely no legal requirement that a corporation be run to maximize profit, and some states (like New York) explicitly put in their corporate law that the board of directors can make whatever charitable donations that the wish.

    Personally, I *don’t* think that profit maximization is a good description of corporate behavior. The main driver of corporate behavior is “bankruptcy avoidance” which is different. You can maximize profit by increasing risk, and so if you are focused on maximizing profits, the logical thing to do is to go out and buy lottery tickets. Also, if a board of directors doesn’t want to maximize profits, there is nothing that can practically be done in legal terms.

    Bankruptcy avoidance is different. If a company goes broke, then it dies.

    Also, the reason that corporations do end up trying to make money is that that’s often “making the most money” is the only thing that the people on the board can agree on. I have a list of social goals that I think people ought to spend things on. You have yours. Someone else has there. If we end up on the same board of directors, the only thing that we are likely to agree on is to make a profit.

  • 13. twofish  |  13 October 2007 at 12:39 pm

    Matt: Regardless of which corporation I choose to work for, I’m working for the same end – and because of the concentration of share ownership, there’s a good chance I’m working for literally the same people.

    However in a market economy, I’m also working for my own interests which are in some ways fundamentally opposite to that of the corporation. The more money goes into my bank account, the less money goes into the bank account of the shareholders.

    There is this tension between my personal self-interest and those of the corporation that exists in the context of a market economy that makes working within a corporation different from working within a planned economy.

    I think a lot of the problem with what is written in academia is that it doesn’t take into account the *intra-corporate* politics. I am not a mindless automaton working for the good of the shareholders, I have my own direct personal interests which fundamentally conflict with those of the shareholders. Also, in day to day work, the interests of the shareholders are so far removed from what I do.

  • 14. links for 2007-10-15 at Jacob Christensen  |  15 October 2007 at 7:27 am

    […] Why Are Markets So Scary? Some Things (Liberal) Academics Get Wrong « Organizations and Markets …many people think of capitalism and think of centralized power (big corporations). Yet, the whole point of capitalism is to allow each individual to choose what to buy, where to work, how much to pay, how to spend their time so and so forth. (tags: economics academic liberalism) […]

  • 15. Vladimir Dzhuvinov  |  20 November 2007 at 2:46 pm

    “Why are markets so sexy” — what an interesting post, I thought, but then I put my glasses on and “sexy” became “scary” :-(

    I’ve spent almost a third of my life in a “planned economy” and now I sing hymns of praise to the heavens that the bloody thing collapsed, at least in our part of the world.

    But to think the demon of the centralised economy is slain would be a gross fallacy. It is still very much alive, even in a “capitalist” country like the US. If you don’t believe me just enter the HQ of a big corporation and ask yourself the question: “what is the economy of this place?”

  • 16. dhoopes  |  20 November 2007 at 3:01 pm

    I would probably get more comments if I HAD said that markets are sexy. However, with a few notable exceptions I don’t think too many markets are sexy.

    Most people who like the idea of planned economies have not had to live in one (or so I would guess).

  • 17. David Hoopes  |  12 December 2009 at 4:09 am

    The economy of some big corporations are in fact economies of SCALE. No mystery. Obviously some corporations are not efficient in their size. However, they are more likely to finally die of their own foolishness than their public counterpart. All these temporary bureaucracies we’re getting will be here forever. Fearing larger corporations just because they are large is silly. And thinking that people in businesses are any more fallible than government workers is insane.

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