Critically discuss by means of diagrams the proposition that a free market is the most

efficient framework for the allocation of resources to produce goods and for the distribution

of these goods.

Introduction

Adam Smith argues that the free market is the most efficient system if resource allocation, as

the market, without state intervention is guided by the ‘invisible hand’ to the equilibrium

point where aggregate demand meets aggregate supply. Although later Smith refuted his

own claim, recognizing the limitations of the free market, he claimed that it was an

inequitable system.

In late Victorian society, when Smith propounded his theory, individualism and utilitarian was

the leading ideology. In the wake of the industrial revolution, and the inflow of huge amounts

of capital in England, two new classes emerged. In a class society, objects of convenience

became the trappings of social status and acquired centrality in human thought. Smith, like

others was concerned with material betterment of his society, precisely how to increase the

wealth of nations, for greater satisfaction. He argued for the division of labor to

exponentially increase productivity. Social division of labor lead to the proliferation of money

as a unit of exchange. Hence, in a free market economy, individuals could consume whatever

they wanted to maximize their pleasure with the money they earned through exchange.
Arguement

Thus, in theory, an individual as a consumer will consume as much as he can (from a basket

of goods) with his available resources to maximize his pleasure and the producer in order to

maximize his pleasure through profits, since he too is a consumer, will seek to produce the

most he can by allocating his resources in the most efficient manner possible, out of his self

interest he would produce as cheaply and abundantly as possible, to be competitive since

there are a large number of producers. He will innovate to stay ahead of the competition,

thus “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect

our dinner, but from their regard to their own interest” in theory leading to aggregate

betterment of society. (Smith, Wealth of Nations, I:II, p.26-27 )

Thus, the consumer will not consume if the price set by the producer is too high, or is the

product is relatively inferior, so the producer in order to survive will produce better. Capital

will flow, out of the interest of the capitalist who seeks maximum return, from where return

is low to where return is high. Hence, when the rate of return is high for a product, more and

people will invest in delivering it to the market in order to make a profit, a high number of

producers will push up the supply in terms of the demand to a point of over production, the

fall in demand will reduce the prices, because of the law of diminishing returns of capital,

capital will be withdrawn, and price will rise. Guided by the invisible hand of the market, until

demand meets supply and the equilibrium is reached. When the price is set by the invisible

hand, no individual producer or consumer will be large enough to influence the price, as

there will be a large number of producers and a larger number of consumers, these price
points will be akin to ‘stars on a desert landscape’ which will guide the individual producer

and consumer. In a free market, where every producer and consumer would be free to

peruse their own self-interests, they would seek to produce more efficiently, leading to the

aggregate benefit of the society.

There are however flaws with this model. All models are based on a few assumptions, and a

good model takes into account accurate details of reality. This model might have functioned

well in late Victorian society, during the heyday of capitalism but is no longer applicable or

equitable. The underlying assumptions are as follows:

 Society is an aggregate of atomized individuals, who are independent of others

 There is perfect information, thus the sales effort doesn’t work

 Goods are perfectly divisible

 There is perfect competition

Firstly, society is not an aggregate of atomized individuals, rather it can be argued that

people are intimately tied to one another. Secondly, sales effort is proven to create demand,

as Marx later argued that capitalism or market economy not only creates products but also

creates the demand for the products in creates. As a result of advertisements, individuals

who can not afford to consume the products might feel alienated when others are consuming

the products. Thirdly, goods aren’t perfectly divisible, and there can thus be a number of

indifferent curves, as there would be an infinite number of budget lines. Fourthly, as a result

of capitalist competition, smaller firms have been wiped out by larger firms and perfect

competition exists only in theory. In reality however, monopolization and market failure

prevail. There is another flaw with this theory, since it limits pleasure to hedonistic

consumption. There are other, higher forms of pleasures, such as the pleasures of the soul,

which are antagonistic to the market forces. Smith himself propounded “How selfish soever

man may be supposed, there are evidently some principles in his nature, which interest him

in the fortune of others, and render their happiness necessary to him, though he derives

nothing from it, except the pleasure of seeing it.” (Smith, The Theory of Moral Sentiments, I:I:I,

p.9.)
Further, the market system doesn’t register needs or wants, rather it only registers

purchasing power. This might lead to resources being allocated to luxury production and

consumption over the basic needs of those who do not generate sufficient income, leaving

those who do not have the means to consume vulnerable to exploitation by the market

forces. A laborer will only have his labor to sell in the market in exchange for sustenance, his

wages will be determined by the market forces of demand and supply, and will be low, as

labor is abundant in relation to capital. Labor power is also a unique commodity since it is

the source of all value, thus the appropriation of the surplus value by the capitalist will result

in alienation. In a market system which awards advantage, inequality is inevitable, as it leads

to accumulation of capital on one end and deprivation on the other.

Conclusion

Thus, we have arrived at the conclusion that the free-market system is an inefficient system

of resource allocation since it only registers purchasing power, leads to market failure since it

rewards advantage, and causes exploitation. Smith wrote ‘No society can surely be

flourishing and happy, of which the far greater part of the members are poor and miserable.’

(Smith, Wealth of Nations, I:VIII, p.96.)