The Effects of Market Exchange on Human Welfare

Hello everyone! Welcome to another another installment of Soup of the Day (formerly ‘The Pebble’), PEA Soup’s forum for public philosophy. Today’s entry is brought to us by Gregory Robson, Assistant Professor of Philosophy at Iowa State University. Here is Professor Robson now:

Each day, firms supply us with everything from the computers on which we read and write to the medicines we depend on and the foods we eat. This entry discusses how exchanges between firms and consumers increase human welfare. The final part considers and contextualizes some important criticisms of market exchange.

First, a few facts and terms. Markets are arenas of economic exchange governed by informal and (usually also) formal rules and institutions. Individuals and groups engage in market exchange when one party trades a good or service to another for a different good or service. This is usually done with money and can involve trading one kind of currency for another. Human beings have been exchanging items for many thousands of years, at least since the earliest agricultural and nomadic communities took shape, and the character of our markets has varied considerably, from Trajan’s Market in ancient Rome to markets in rural France and Tokyo today. Capitalism is a system of political economy consisting of markets and profit-seeking firms that are hierarchically structured. There are tens of millions of firms in (e.g.) the United States today, ranging from small businesses, such as sole proprietorships, to Fortune 500 companies with large bureaucracies that operate across countries and continents. Finally, crony capitalism is a political-economic system in which firms leverage the powers and privileges of the state to gain unfair competitive advantages. Proponents and opponents of capitalism alike regard this system as morally objectionable.

This entry will focus on ordinary market exchange that is noncoercive and nondeceptive. To see why such exchange is valuable, suppose you go to an outdoor market where haggling is common. You see a blue scarf you’d like to buy. You estimate that it’s worth a bit over $25 to you (the most you are willing to pay, or your “reservation price,” as economists say). Then you make an initial offer: $15. The vendor estimates that they would benefit if (and only if) they sell it for at least $15 (their reservation price). While they’d happily accept $15 for it, they seek their self-interest broadly understood (e.g., to make money to feed their family), so they counteroffer $22. You reply, “How about 20?”, and the vendor says, “Deal!”

What just happened? Did you take the scarf, or any value, from the seller? Did the seller take the money, or any value, from you? Quite importantly, neither: You both transacted voluntarily. The transaction began with your offering to give your item (money) to the vendor for theirs (the scarf). And you both benefited. If you and your trading partner estimated well, then you each gained the equivalent of $5 in value: your consumer surplus (the roughly $25 value you assigned to the scarf minus the $20 you paid) and the seller’s producer surplus (their $20 in proceeds minus the $15 minimal price at which they were willing to sell the scarf). So, with no third party effects, $10 of total value was created: your $5 gain plus theirs. The upshot? You and your fellow exchanger have just made each other better off, increasing each other’s welfare [1]. Perhaps thousands of “win-win” exchanges of this ilk occur on our planet every second [2].

The Scottish philosopher and economist Adam Smith knew well the advantages of the market system. Nations become wealthy, he observed, when they trade extensively, encourage specialized production, and divide productive process into particular tasks for individuals and groups to perform [3]. Market-based increases in prosperity also have important epistemic aspects. F. A. Hayek observed that markets enable participants to make use of their local knowledge in ways that central (government) planners cannot [4]. Producers, distributors, buyers, and sellers act to satisfy their preferences in the light of their own knowledge of their personal, professional, and social contexts. Their actions drive the price “signal,” enabling prices to “internalize” or “embody” local information. When, say, there is a shortage of corn in Iowa, the price of corn might spike in North Carolina, signaling to local families, firms, and other prospective buyers to curtail corn consumption or switch to a substitute good. This price signal can embody a remarkably vast complex of information: a corn shortage in Iowa, a nation-wide hike in gasoline prices, a hit podcast in California claiming that corn is the new kale, an unexpected disruption in long haul trucking, and on and on.

The welfare-enhancing effects of trade and market innovation are often hidden in plain sight. Consider the ordinary situation of flying on a commercial airplane. We—you or I, and many others with whom we have no previous acquaintance—move about in metal boxes in the sky at 500 miles per hour. We trust each other. We trust those who designed and built the planes. And we trust that our pilot will take us to our destination. What makes such stunning cooperation possible? Answer: Firms that employ people we do not know and have never met. Such firms are surprisingly dependable, even when funded by many people whom they do not know and have never met (as with corporations issuing public stock). Due partly to the legal enforcement of contracts and to informal norms of fair dealing, we very often trust firms to provide us with high-quality medicines, vehicles, home construction, and other goods on which our welfare and lives depend. In fact, firms enable us to engage daily in activities that past generations would see as well-nigh miraculous—for instance, talking to people hundreds of miles away by phone instantly. Notice, there is no taking here. In standard cases, like that of commercial airline travel, firms and consumers cooperate voluntarily for mutual gain. They freely offer their cooperation to others, creating surplus value for all involved.

So, the basic case for the value of market exchange in promoting human welfare can be summarized as follows. If buyers and sellers are sufficiently rational and informed and exchange freely (on which more soon), then whether a consumer is exchanging with a grocery store, a local scarf vendor, or some other firm, the logic is the same: Parties to ordinary exchanges strongly tend to become better off. Exchanges harness human foresight, industry, and cooperation in ways that improve exchangers’ lives, creating large consumer and producer surpluses of the sort discussed in the scarf example above. Empirical evidence seems to bear this out [5].

Given such gains in human welfare, how morally valuable is it for noncoercive and nondeceptive firms to engage in market exchange? Arguments for the moral value of market exchange appeal not only to the welfare effects of markets (our focus herein) but also to whether and how markets respect rights and promote virtue [6]. Smith develops the classic account of how markets produce welfare-enhancing prosperity [7]. But some theorists today go farther in a sense by arguing that market exchange is so valuable, welfare-wise, that firms are morally required to maximize their profits. For instance, Michael Jensen espouses a form of welfare consequentialism according to which what matters ethically is the consequences of a given action or set of actions—e.g., a set or pattern of market exchanges [8]. On this view, an act’s (or rule’s) good or bad consequences make it right or wrong. Jensen holds that a firm’s profit (total revenue minus total costs) is ordinarily an apt proxy for how much the firm contributes to human welfare. He claims that firms have a welfare-consequentialist duty to increase human welfare as much as they can, and, to do so, they ought to maximize their profits.

Yet the idea of a duty to profit maximize is, of course, highly controversial. A key reason why is that profit maximization does not always seem to track welfare maximization. For instance, a family-run business might choose to maintain limited hours. This might increase the family’s welfare more than it reduces consumers’ welfare by limiting their opportunities to exchange with the firm [9]. Further, consumption decisions often fail to meet rationality and information conditions, reducing rather than increasing human welfare in certain cases [10]. Nevertheless, even if market exchanges sometimes reduce human welfare, it bears emphasis that markets have long generated major benefits. In recent decades, markets have even lifted hundreds of millions of people out of poverty [11].

To appreciate the welfare-enhancing effects of market exchange is not, however, to assume that markets have an entirely positive moral valence. Many moral and other concerns have been raised. For instance, while Smith developed sophisticated arguments detailing the power of markets to improve human lives, he also noted deep concerns about collusive and monopolistic firms [12]. And Marx argued that capitalistic employers extract “surplus” value that workers add to productive processes, paying workers just enough to subsist and remain willing to work. Capitalists can pay low wages and mistreat workers, Marx argued, because unemployed persons stand ready to take jobs for low wages should the workers be terminated or quit [13]. Markets (or particular market actors) have also been criticized for generating harmful third-party effects (“negative externalities”), damaging the environment, and being morally, economically, or otherwise problematic [14].

No doubt such criticisms deserve careful consideration. We want a system of market exchange with fair rules that market participants actually follow. We want a system that mitigates and disincentivizes negative externalities [15]. And we want a system that increases human welfare and virtue while respecting rights. Yet, markets and firms (like governments) are human institutions, so they are subject to our many cognitive, affective, and volitional limitations. Given this and the ubiquity of markets in societies worldwide, it should come as no surprise that market exchanges do not always enhance human welfare. The quality and values of markets, after all, reflect the quality and values of market participants, which can vary considerably. The key question regarding welfare enhancement and other moral desiderata is how resource allocation via markets compares, morally and in terms of efficiency, to other feasible options [16].

There are also complex debates over the proper relationships between markets and the state. For example, how and how far can (and should) governments regulate or block market exchange? How and how far can (and should) market mechanisms themselves be allowed to counteract problematic market processes? And, how and how far can (and should) governments create economic and social value (e.g., by publicly funding or developing technology, research, and infrastructure from which firms and consumers might benefit)? Answers to such questions will likely depend on the projected welfare effects of such activities and whether or not they adequately respect rights.

A realistic assessment of the moral promises and perils of markets would heed the foregoing criticisms and questions without losing sight of the many upsides of markets. These include the remarkable fact that markets have increased human wealth in market-oriented societies not by, say, 25% in recent decades, which would still be a major achievement, but multiple times—hundreds of percent (or more). Members of many societies today enjoy several times the GDP per capita of their counterparts just centuries or even decades ago. Average wealth levels were between “$1 to $3 per day per person” from 10,000 BC to the eighteenth century [17], and “the average person in the world of 1800 was no better off [economically] than the average person of 100,000 BC” [18]. The growth of market exchange from the industrial revolution until now has thus transformed the human condition in short order. Members of modern societies typically enjoy more reliable medicines, greater educational and health resources, larger homes, more air conditioning and better heating, more opportunities for travel and socioeconomic advancement, and more tools and appliances, such as washing machines—all of which can transform one’s daily routines through saved time, enhanced convenience, and increased opportunity. Today we can access, as well, a large fraction of the world’s information online in mere seconds. Market exchange, for all its imperfections as a human activity, has proven to be a remarkably able vehicle for improving human lives.

 

[1] I will discuss such benefits in terms of generic “welfare gains.” One can alternatively speak in terms of advancing interests, satisfying preferences or desires, meeting needs, and so on.

[2] Exchanges are “win-win” if the exchanged items enhance the exchangers’ welfare and no one is made worse off.

[3] Smith (1976 [1776]), An Inquiry into the Nature and Causes of the Wealth of Nations, R.H. Campbell, A.S. Skinner, and W. B. Todd (eds.), Oxford: Oxford University Press. For an excellent overview of Smith’s thought, see James R. Otteson (2018), The Essential Adam Smith, Fraser Institute.

[4] Hayek (2014), “The Use of Knowledge in Society,” in The Collected Works of F.A. Hayek: The Market and Other Orders (vol. 15) Chicago: University of Chicago Press.

[5] Consider, for example, the Chinese marketization beginning in the late 1970s that has lifted hundreds of millions out of poverty.

[6] See, e.g., Smith (1976 [1776]). Recent arguments for the moral and overall value of markets include, e.g., Robert Nozick, (1974), Anarchy, State, and Utopia, New York: Basic Books; Deirdre McCloskey (2006), The Bourgeois Virtues: Ethics for an Age of Commerce, Chicago: University of Chicago Press; and James R. Otteson (2019), Honorable Business: A Framework for Business in a Just and Humane Society, Oxford: Oxford University Press.

[7] Smith (1976 [1776]).

[8] Michael Jensen (2001), “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance 14: 8–21.

[9] See Gregory Robson (2019), “To Profit Maximize, or Not to Profit Maximize?: For Firms, This Is a Valid Question,” Economics & Philosophy 35: 307-320. The above example is discussed at p. 314.

[10] For related discussion challenging Jensen-style views, see Waheed Hussain (2012), “Corporations, Profit Maximization, and the Personal Sphere,” Economics & Philosophy 28: 311-331; and Robson (2019).

[11] See note 5 above on market reforms in China.

[12] For assessments of Smithian and related ideas in political economy, see Otteson (ed., 2014), What Adam Smith Knew: Moral Lessons on Capitalism from Its Greatest Champions and Fiercest Opponents, Encounter Books.

[13] Karl Marx (1867), Capital: A Critique of Political Economy, vols. 1–3, Chicago: C.H. Kerr and Company. See vol. 1, ch. 25, sect. 3, on the “Industrial Reserve Army.”

[14] For diverse critical discussions, see Elizabeth Anderson (2017), Private Government: How Employers Rule Our Lives (and Why We Don’t Talk about It), Princeton: Princeton University Press; G. A. Cohen (2009), Why Not Socialism?, Princeton: Princeton University Press; Michael Sandel (2012), What Money Can’t Buy: The Moral Limits of Markets, New York: Farrar Straus Giroux; and Debra Satz (2010), Why Some Things Should Not Be For Sale: The Moral Limits of Markets, Oxford: Oxford University Press. For important responses to such criticisms, see (e.g.) Jason Brennan and Peter M. Jaworski (2016), Markets without Limits: Moral Virtues and Commercial Interests, London: Routledge; and Otteson (2019).

[15] See R. H. Coase (1960), “The Problem of Social Cost”, Journal of Law and Economics, 3: 1-44; and Elinor Ostrom (1990), Governing the Commons: The Evolution of Institutions for Collective Action, Cambridge: Cambridge University Press.

[16] For a very good introduction, see Allen Buchanan (1985), Ethics, Efficiency, and the Market. New Jersey: Rowman & Allanheld.

[17] Otteson (2019), p. 45. See pp. 44-48 for a general account of increases in human prosperity.

[18] Gregory Clark (2007), A Farewell to Alms: A Brief Economic History of the World. Princeton, NJ: Princeton University Press, p. 1.