We often describe ourselves as a free market economy, but is the free market really what is driving our wealth? Or are markets just a small part of the picture, obscuring the much bigger driver of our prosperity.

Adam Smith argued that at the heart of economic development was gains from specialisation. The idea was that when we were self sufficient, growing our own food, building our own homes and sewing our own clothes, we were ‘jack of all trades’ but master of none. We performed all of these tasks at a very low level.

The process of economic development he argued was driven by a process of specialisation and trade.  Specialising in a single task enabled us to become much more efficient at it. We developed high level skills and better tools. This boosted productivity enabled us to produce more. People could then take their surplus and trade it for other goods they needed.

This process of specialisation began with the shift from self-sufficiency into small villages. It continued as the early factories organised people to complete even more specialised tasks in long production chains.  These days our production chains stretch around the globe. There are literally thousands of people who have had a role in producing the pen you write with.

So where do markets fit into this picture? They occur between some of the links of the chain. There are sections of chain where all the links occur within a business. Then markets occur linking one business to another. In our longest production chains there are many businesses combining together to produce the ultimate product.

In this approach markets are not the sources of wealth and efficiency. That has come from specialisation. But they do perform a very important role in connecting up the chains and co-ordinating the links. The way they do this is ingenious.

Benefits of the Pursuit of Profit

The question of how co-ordinate the links in the chain to produce the goods society wants   is one of the most complex we could possibly imagine. Fortunately, the pursuit of profit provides a stunning solution.

You make a profit by selling something for a higher price than it cost to make it.  If you are an entrepreneur in search of a profit you will seek out the opportunities where a product is highly valued and people are prepared to pay a high price for it, but where costs are low and the product doesn’t cost much to make.

If entrepreneurs were able to operate in a fully rational and full informed way, their profit seeking would systematically link up the chains in the most efficient way possible. They would start where the gap between price and cost was greatest. As the most profitable options were taken up it would target the next most profitable connection, then the next and the next. They would always pull up before price paid was less than the cost.

The market of course does not always live up to that ideal. Arguably, instead of perfect information and rationality, what we have is thousands of people trying things out through trial and error. Those that find the most profitable connections make a motza, and the majority fail.  As a society, however, we collectively benefit from this process of trial and error, as once successful connections are made they tend to endure and provide considerable efficiency gains and wealth to the society.

In all, as a de-centralized social co-ordination mechanism, it’s genius. But it is not without its faults.

Downsides of the Pursuit of Profit

The pursuit of profit does have some serious downsides.

The first issue is that there are two ways you can make a profit. One approach to profit seeking is to find a brilliant way to connect  up links in the chain so that you can find a low cost way to deliver something that is highly valued and people will pay a high price for. When entrepreneurs do this their profits reflect that they have added wealth to the community.

However, the other approach to making a profit it to redistribute wealth along the chain. In this case business people try to concentrate the wealth of the chain into their link. The wealth of long chains is created by the co-ordination of a large number of specialized links. It is the combination of the small parts into the whole that creates new wealth. What is each links’ share of the wealth is indeterminant and up for negotiation. By trying to push down the prices you pay to your suppliers, or by cranking up the price you charge to your customers business people can boost their own bottomline.

The first approach to pursuing a profit co-ordinates our chains and brings wealth to our societies. The second approach is exploitative and drives inequality.

This means that one of the great challenges of the long chain society is about how to create just chains, where the wealth is spread fairly along the chain.  

I have a few thoughts about how this can practically be done in terms of current policy debates. More on that next time.