Morals and the Free Society: 3. Morals That Create the Free Market

Here is the third chunk of the argument. To return to the second chunk, click here. To advance to the fourth chunk, click here. The complete essay is posted here.


Of course, this moral vision of pure egoistic utility maximization applies only within a perfectly free market. This means the free society’s members must abide by the rules whose observance brings the free market into being in the first place. The free market depends on the observance of clearly defined property rights, for example, as well as on the observance of rules against direct coercion. But observing these rules is not always utility maximizing. Notwithstanding the many cogent reasons that have been advanced to show why coercive and rights-violating behavior is often not in the agent’s utility-maximizing self-interest, it seems clear that there are still many situations in which such behavior is utility maximizing. Thus, if the free market is to exist, agents must abide by its rules at the expense of their own utility maximization. And these rules—against fraud, theft, and murder, for example—are clearly moral rules. So the free market requires obedience to a certain set of moral rules—namely, the moral rules that establish the free market—that are distinct and apparently not derivable from the morality of egoistic utility maximization.

That’s not all. Recall that the neoclassical conditions for perfect competition included such items as that all agents in the market have perfect, costless information concerning the availability of goods, services, factors of production, and exchange opportunities, as well as the pertinent characteristics of these, that agents are capable of calculating with certainty the outcomes of their decisions, and that rights and contracts are perfectly and costlessly adjudicated and enforced. This is a tall order, and to fill it even approximately requires more limits on egoistic utility maximization than merely observing others’ rights. Consider honesty, for example. The seller of a used car who fails to reveal to the buyer a persistent series of engine problems does not lie, if the buyer hasn’t asked about such problems and the engine is working normally at the time of sale. But the seller’s reticence means the buyer has inadequate (not to mention imperfect) information about the car. So the conditions for perfect competition are not satisfied. And the inefficiency this introduces is clear: used car buyers bear costs of seeking information about potential purchases, and used car sellers bear costs in the form of lower sale prices that result from buyers’ justified wariness. These are costs that would not exist in conditions of more perfect competition where sellers were completely forthcoming about the cars they are selling. Unfortunately, in the sale just described, if the seller and buyer are strangers to one another and the sale is a one-time transaction (for example, the seller may be selling his own car), the seller can maximize his own utility by keeping quiet about the engine’s history. Therefore, to be transparent in accordance with the conditions for perfect competition would impose on the seller a limit on his utility maximization. Notice that keeping quiet does not violate the buyer’s rights, but it still violates the conditions of a perfectly free market. (Akerlof 1970 explores the deleterious effects on the market of this sort of example.)

There are many such examples. Thus, even better for market efficiency would be to reveal not only shortcomings of products without being asked, but alternative products offered by rival sellers that might better suit the buyer’s needs. Again, litigiousness raises the costs of contracts (in the form legal fees, highly detailed contracts, defensive provisions, insurance, and so forth), which could be avoided by forbearance and accommodation of perceived injuries, which of course means agents limiting their own utility maximization. And again, the phenomenon of bad debt imposes costs (credit checks, credit ratings, loan insurance, lengthy approval process, etc.) which would be greatly reduced if borrowers could be counted on as a matter of honor to always repay their debts.

In all these examples, the efficiency of the market (or in other words, the degree to which the conditions for perfect competition in neoclassical theory are realized) is harmed by people’s utility maximizing behavior, even though no one’s rights are necessarily violated. Therefore, the free market ideal requires that agents limit their pursuit of utility in ways that seem recognizably moral but that go beyond merely observing the rights of others.

In general, costs of exchange that result from difficulty (or absence) of enforcement of property rights or other rights, or from poor information, about goods or opportunities or about the qualities and intentions of other agents—in short enforcement and information costs—are dubbed by Douglas North (1990) transactions costs. Transactions costs tend to be neglected by economists because they represent violations of the assumptions of neoclassical theory. They stand outside that theory and can only be brought into it by kludgy devices. But North argues that they are important. Even in the advanced, relatively free capitalist economy of modern America, transactions costs (associated with banking, insurance, finance, lawyers, accountants, and so forth) amount to 45 percent of national income (North 1990, 28). In general, less free economies will be associated with higher transactions costs. In many cases—in all economies—transactions costs will be high enough that certain transactions are not worth pursuing. High transactions costs choke off economic activity and stifle an economy. North argues that what he calls institutions, both formal legal codes and political constitutions and informal customs, mores, traditions, and habits, have a major impact on the performance of an economy, for good or ill depending on whether they tend to enhance or destroy economic efficiency by lowering or raising transactions costs. Indeed, he argues that their influence is so important that the difference in performance between the advanced economies and the developing economies of the third world is due largely to differences in their institutions, especially their informal institutions.

I regard North’s “new institutionalism” in economics as an extremely important recent development. There is a great deal more to be said about it, but that is a topic for another occasion. For now, the point is that “the free society” is not an all-or-nothing affair, nor does the degree to which it exists depend only on the degree to which individual rights are respected. Rather, it exists to the degree to which the conditions for perfect competition obtain, and this is a matter not only of respect for individual rights but of low transactions costs of all kinds. And this depends in turn on established mores that require agents to forego the pursuit of individual utility for the sake of values such as honesty, candor, forbearance, and fidelity, in addition to respect for private property and the principle of noncoercion.

Gauthier is very alive to the discrepancy between the egoism of the theory of the free market and the moral constraints that are needed to create the free market. The central ambition of Morals by Agreement is to show that it is rational for agents to constrain their pursuit of utility in order to observe individual rights. Since he wishes to show this even for purely self-interested economic agents, this means he has set himself the task of showing why agents who are concerned only with their own utility maximization, without regard for the utilities of others, nevertheless have reason to restrain themselves to maintain the conditions of a free market. The problem is that although it is clearly rational for such agents to want to live in a free market society—that is, in a society where other agents obey the rules of the free market—it is not so clear why it would be rational to obey those rules oneself on occasions when one can break them with impunity and thereby gain an advantage. As noted previously, such occasions may be fewer than is sometimes supposed (especially in contexts of repeat interactions among the same agents), but it is unrealistic to think they never arise or even that they are not commonplace. Indeed, ironically, the more perfect the market becomes, the greater the opportunities for violating its rules. For, as the free market becomes more perfect, transactions costs decrease—meaning less is spent, because less is needed, on lawyers, police, written contracts, insurance, security, credentials, audits, warranties, certifications, background checks, and so on—making agents in general more vulnerable.

Thus, it is a serious question why agents in a free society will behave in accordance with mores that sustain and perfect it. Gauthier attempts to show that such behavior is rational even for purely self-interested utility maximizers. Compressed to two sentences, his argument ultimately boils down to the claim that what it is rational to intend in advance to do, it must be rational to follow through on at the moment of action (Gauthier 1986, 182–187). Therefore, since it is rational, when making the social contract, to intend to join a free society and follow its rules—because the alternative of living in an unfree society entails far lower personal utility (and one is not offered the choice of joining with others and then ripping them off, since others will not agree to this)—it must be rational to obey the rules at the moment of action that one intended to when forming the social contract.

Without denying the philosophical difficulties here or the argumentative resources on Gauthier’s side, I will just assert that, in my view, Gauthier commits a fallacy by attempting on the one hand to restrict the utility-maximizing choice to the level of the intention (for the record, he actually says “disposition”) to pursue a certain course of action going forward, and then insisting on the other hand that the future actions entailed by that intention so to speak inherit (“carry through,” 1986, 187) rationality from the rationality of the intention. According to the argument, it is rational to form the intention to pursue a certain future course of action—say, respecting the rights of others—if genuinely having this intention is necessary to gain admittance to a free society. This is a reason that appeals to the expected value of the intention itself, not to the expected value of the future course of action. Therefore, since the argument in favor of forming the intention does not appeal to the expected value of the intended actions, it simply does not follow that the rationality of forming the intention implies the rationality of performing the intended actions. In general, the notion that actions inherit their rationality from the rationality of the intention to perform them is just a mistake. What actions inherit from the intention to perform them is their causation, not their rationality. The true direction of rationality inheritance runs the other way: it is rational to intend to do what it is rational to do. The paradox of the present situation—intending to respect others’ rights in order to join a society it would be advantageous to be a member of, even though, once a member, it may often be advantageous to violate others’ rights—is that it presents a case in which one has reason to form an intention for future action that does not derive from the rationality of that future action; indeed, a case where the intention is rational despite the irrationality of the action intended. It may be questioned whether it is possible to form such a paradoxical intention: a genuine intention to perform an action that one knows will be irrational when it comes time to perform it. (This sort of question is explored by problems such as Kavka’s toxin puzzle and Newcomb’s two box problem.) However, the very paradoxical nature of such an intention implies that, if it is possible to form it, that does not cause the irrational action to be rational after all. Rather, it only means we have the power to genuinely intend to do something irrational.

In any event, my own view is that Gauthier is wrong to suppose that selfish, utility-maximizing agents are rational to obey the rules of a free society on all occasions, even if they genuinely intended to at the time when they opted into the society. (For a similar analysis of Gauthier’s stand on a closely related problem, see David Lewis 1984. See also Frank’s 1988, 243n. comment on Gauthier.) So, whatever such agents originally intended, when obeying the rules is irrational they ought not to obey them. And if agents are rational, they will not.

It therefore seems that the economic agent presupposed by neoclassical economic theory—an egoistic utility maximizer—has reason on many occasions to violate the behavioral rules that are necessary for an even approximately free market to exist. If there is no solution to this problem—and it appears that there isn’t—then neoclassical economic theory cannot explain how the free market can exist. The free market must be created and maintained by action on the part of the agents who compose the economy that is irrational from the egoistic, utility-maximizing point of view. As Chicago economist Frank Knight put it, writing in 1935 (“Intellectual Confusion in Morals and Economics,” quoted as the epigraph to Buchanan’s 1975):

And the main, most serious problem of social order and progress is… the problem of having the rules obeyed, or preventing cheating. As far as I can see there is no intellectual solution of that problem. No social machinery of “sanctions” will keep the game from breaking up in a quarrel, or a fight… unless the participants have an irrational preference to having it go on even when they seem individually to get the worst of it.

Works Cited

  • Akerlof, George. 1970. “The Market for ‘Lemons’: Quality, Uncertainty, and the Market Mechanism.” The Quarterly Journal of Economics, 84 (3): 488–500.
  • Buchanan, James M. 1975. The Limits of Liberty: Between Anarchy and Leviathan. University of Chicago Press.
  • Frank, Robert H. 1988. Passions within Reason: The Strategic Role of the Emotions. Norton.
  • Gauthier, David. 1986. Morals by Agreement. Oxford University Press.
  • Lewis, David. 1984. “Devil’s Bargains and the Real World.” In Douglas MacLean (ed.), The Security Gamble: Deterrence in the Nuclear Age. Rowman and Allenheld.
  • North, Douglas C. 1990. Institutions, Institutional Change, and Economic Performance. Cambridge University Press.

9 thoughts on “Morals and the Free Society: 3. Morals That Create the Free Market

  1. Pingback: Morals and the Free Society: 2. Is the Perfectly Free Market a “Morally Free Zone”? | Policy of Truth

  2. Well done, David. Maybe Douglas North raises some of these topics, but I proceed. My keywords will be time and trust. David appeals to trust and reliability, which is part of trust, but I will expand upon them. I believe my comments will bolster David’s case and weaken the appeal of portraying free market participants as merely short-term, egoistic utility maximizers. Ayn Rand’s brand of egoism stressed long-term survival, but she didn’t elaborate much in terms of day-to-day market activities.

    Much free market activity between trading partners occurs multiple times over several days up to even years. Retailers rely on wholesalers. Manufacturers and contractors rely on suppliers. The buyer in such trades relies on the seller for a steady supply of goods of a desired quality set by contract or expectations. One example is an auto manufacturer relying on a parts supplier. Arguably even more significant is a business owner relying on its employees to do their jobs well.

    Trust and reliability are important in such matters. A buyer often puts significant search time before deciding on a supplier-seller and doesn’t want to repeat-search every time more supply is needed. A buyer expects the supplier to meet expected quality standards and to deliver the goods on time, the right amount, and at an agreed price. If these criteria are not met, transactions cost rise and maybe even harm the business. Again, these ideas are extendable to the business owner-employee relationship.

    There is an example in the first chapter of Atlas Shrugged. James Taggart relies on Orren Boyle to supply steel rails for Taggart Transcontinental track. Boyle fails to deliver for months. Dagny Taggart reacts by contracting with Hank Rearden to deliver rails made of a new alloy, Rearden Metal. Henry always delivers, she explains. That is trust and reliability.

    I do disagree with David a little when he says, “There thus seems to be no escape from the conclusion that respect for the rights of others, along with other transactions cost–reducing principles—-candor, probity, and the others—-are fundamentally pro-group principles, not pro-individual” (p. 30). It seems to me that this relies too much on a dichotomy between the individual and the group. Much free market activity — inherent in the division of labor — requires extensive cooperation and trust between different individuals. Such individuals often simultaneously pursue their own interest and the common interest of the group, or more specifically, the firm.

    Reliability and trust are also significant to all kinds of consumers. If a couple purchases life insurance and pays the periodic premiums, they expect the insurer to pay the benefit if and when the unfortunate event occurs. The buyer of an annuity, who pays a premium of many times one monthly payment, expects to receive the monthly payments for as long as contracted for. Principals and beneficiaries of trusts rely on the trustees being loyal to the interests of the former. A trustee typically pursues his/her own interest, like being paid, but the interests of the trustee and principals and beneficiaries are hardly incompatible. A trustee might consider a breach of that trust in pursuit of a short-term gain to the detriment of the principals and beneficiaries, but a reasonable trustee will also consider the potential ramifications of doing so. Hopefully, he or she will decide that the long-term gains of no breach outweigh the short-term gain of a breach.

    I could provide many more examples and even other kinds of examples, but the above seems adequate to convey my essential point.

    Liked by 1 person

    • Thanks, Merlin. I naturally don’t disagree with any of your remarks here. On the matter of group functions, I have a short paper in which I attempt to justify this idea in terms of group selection theory in evolutionary biology. You can have a look at that, if you want, and see whether you find it convincing. I posted an early version of it on this blog back in July.

      By the way, I’ve started reading the book by David Rose, The Moral Foundation of Economic Behavior, which you recommended to me (offline). I’m only in the middle of the second chapter. It looks excellent (if a bit long for its real substance). He comes to many of the same conclusions as me, and supplies a ton of interesting-looking references. I expect to post a review of it here when I get it done.

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      • Thanks, David. I read your ergon post. I agree that (1) egoism meaning to benefit only the agent, even constrained to not violate the rights of others, falls short of an ideal ethic, and (2) some element of pro-group traits is desired.

        You wrote: “Egoism should be defined in terms of what is fundamental to it—the primacy of self-interest—not by whether one has trouble explaining why we shouldn’t lie, cheat, and steal when we can do so to our advantage.”

        That egoism has been defined that way, especially by critics, is undoubtedly true. But I question whether it should be. Lying, cheating, etc. is not conducive to the best life, at least long-run. Anyway, that kind of definition of “egoism” implicitly assumes a mutually-exclusive dichotomy between acting for the benefit of oneself and acting for the benefit of another person. You might be interested in my article Egoism And/or Altruism in The Journal of Ayn Rand Studies Volume 13, No. 2 that challenges said dichotomy.

        You wrote: “In particular, it is beginning to be recognized that natural selection also operates at the level of groups. For this to happen, it is necessary that groups compete as groups. But this does happen. In the human case, for example, two tribes may fight over the same foraging territory. Which tribe will be more likely to win this fight, the tribe whose members exhibit solidarity and discipline or the tribe whose members are looking out for number one? Clearly when tribes are at war, it is better to be a member of the tribe whose members exhibit solidarity and discipline. To be a member of the other tribe is to be doomed to destruction no matter how personally big and strong and brave one is.”

        That’s an interesting argument. I think it becomes even more interesting with groups other than a tribe. Consider a business partnership, in which each partner performs different kinds of work, e.g. one making the product and the other getting customers. Consider a basketball team.

        Liked by 1 person

    • Hi again, David. Your stack of books to read is probably already high. Regardless, here I am with another suggestion relevant to your topic. The book is The Foundations of Morality by Henry Hazlitt. The Mises Institute even offers a free download here. Of particular relevance are chapters 13 (Egoism, Altruism, Mutualism) and 30 (The Ethics of Capitalism).

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      • Thanks for the tip. I downloaded the book and looked through it. My own approach is anything but utilitarian, though there are still bound to be some commonalities between my view and Hazlitt’s. And I would say his book is also valuable in being an explicit working out the moral view implicit in Mises’s writings, but which Mises never stated in detail.

        Yes, I have an enormous and ever growing stack of books. I need to stop buying them! And papers. Greedily reading as much as I can is the main reason I’m such a poor correspondent around here. I’m just so slow at everything. And I find it very difficult to sacrifice reading time, even to keep up with “obligations” to reply to people’s comments.

        There turns out to be no shortage of books on “morals and economics,” by the way. One could make a big stack of just those which were written the past couple of decades. The volume of literature on simply everything is really amazing.

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  3. Pingback: Morals and the Free Society: 4. The Moral Contradiction of the Free Society | Policy of Truth

  4. When I tell the truth in a normal situation, it is mainly with furtherance of the self-interest of the truth-receiver in my mind. Will economic rationality boot any such thinking as irrational? Will economic rationality absorb any level of such motivation, however high the level, into their “rationality” by treating my concern for others in telling the truth as part of my maximization of utility? Would reduction of exchanges due to full honesty reduce overall utility in the classical economic view? Is such reduction a sign of irrationality to them?

    I doubt that one who in a normal situation tells the truth with only furtherance of his own “self-interest” in mind would be sane, let alone rational in the normal sense (not the apparently impoverished economic sense).

    Whether the preceding queries result from sleepy reading, big ignorance, profundity, or childishness, it certainly looks to me you have a grand and fertile project underway here. Assimilation, with criticism, of Gauthier and North seems right for expert readership and is informative window to me.

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    • Yes, whereas Gauthier attempts to derive morals from economic rationality alone, North thinks the assumption of economic rationality has “prevented economists from coming to grips with some very fundamental issues and that a modification of [this assumption] is essential to further progress in the social sciences” (1990, 17). But he is not thinking of “behavioral economics” of the sort represented by Daniel Kahneman and Richard Thaler. This is the sort that concentrates on cognitive psychology findings that people do not conform to the norms of economic rationality. For example, different descriptions of a decision situation can induce reversals of preference between possible actions; people do not treat utilities on a single scale as they rationally should but code gains and losses separately (and have different marginal utility functions for the two, which is also irrational); people irrationally assign higher value to goods they happen to own than to identical goods they don’t; and so on. North considers all this and dismisses it as beside the point (18–19). The point, for him, is that people are often simply not motivated by utility maximization, but by “altruism and self-imposed constraints, which radically alter the outcomes with respect to the choices that people actually make” (20).

      This seems very clearly to be making the point you are talking about, and that’s how I read the rest of the book. But I have more investigating to do. Not everybody reads New Institutionalism this way, I have learned. For instance, McCloskey, who I saw at the APA-Pacific last week, hates New Institutionalism. I knew this already, and at her talk I asked her why (because frankly her 50 page treatment of it in Bourgeois Dignity left the matter unclear to me). From her reply, I gathered that she simply doesn’t believe him. She doesn’t think he actually wants to incorporate motivations other than utility maximization into economics. Since he explicitly says he does, and since he seems to actually do so, at least in Institutions, Institutional Change, and Economic Performance (1990), I’m skeptical whether she’s really got it right. Or him right. On the other hand, I get the impression that other New Institutionalists may think of institutions as merely tricky ways of channeling self-interest. (As opposed to regarding institutions as often being informal mores of non-self-interest in the way (on my reading) North does.) Which is her complaint. Anyway, as I say, I have more investigating to do on this.

      I do hope the project is fertile! So far, it seems to me to be a productive way of (a) integrating social and personal morality and (b) establishing a new empirical basis for an important range of “human functions” on the social side that can be incorporated into an Aristotelian ethical framework. That’s my goal, anyway.

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