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.