The virtues of free markets.

• Author: Zupan, Mark A.

Free markets have many virtues. Arguably, the most recognized is the expansion of individual choice--and thus freedom--through mutually beneficial exchange (see Bauer's definition of economic development in Dorn 2002: 356). This proposition is at the heart of the enduring impact of Adam Smith's Wealth of Nations ([1776] 1937) which aptly spells out the benefits of the Invisible Hand for citizens and societies.

In Capitalism and Freedom (1962), Milton Friedman articulates why the economic freedom at the heart of free markets is also a precondition for political freedom. Freedom of expression is not possible when the means of production are under government control and individuals lack the economic means to sustain themselves and their points of view.

This article argues that free markets promote other important virtues that have heretofore received scant attention. Specifically, through fostering an indefinitely-lived series of exchanges, free markets create a future promoting integrity and trust. This is because the more the future matters, the better behaved are individuals in the present. Therefore, rather than being castigated, as they so often are in the popular media and political arena, for encouraging immorality, free markets should be praised for fostering integrity and cooperative behavior through their promotion of ongoing mutually beneficial exchange.

The two sections that follow provide a positive definition of integrity" and show how it differs from the normative concepts of morality, ethics, and legality. They also explain the fundamental reason free markets foster integrity. The rationale is demonstrated through a simple but powerful game-theoretic construct: the prisoner's dilemma. Through the prisoner's dilemma, we can see why repeated interaction between individuals promotes integrity as well as other forms of cooperative behavior.

While all economic systems feature some repeat interaction, well-defined and enforced rights to private property increase opportunities for repeat interaction. Relative to other forms of organizing economic activity, therefore, free markets are superior at promoting integrity, and other cooperative virtues as well as prosperity.

Empirical observations from a variety of settings supporting this article's proposition concerning the positive relationship between free markets and integrity are provided. The evidence demonstrates the link between the importance of the future and the practice of integrity in the present. Such a link also promotes cooperative behavior in general and thereby certain normative virtues from the spheres of morality, ethics, and legality. The evidence indicates why so much of how free markets are commonly conceived, in the popular media and elsewhere, needs to be recast. The reasons why free markets are so often misunderstood when it comes to the promotion of positive and normative virtues are explored.

There is, of course, a potential Achilles" heel in the argument about the beneficial effects of repeated interaction. This prospective flaw revolves around the fact that the repeat interaction typically involves a different and ever-broadening set of players. The means by which markets address this matter are discussed.

A Positive Definition of Integrity

Social scientists typically relegate integrity to the domain of normative analysis. Akin to concepts such as morality, ethics, and legality, integrity has been assumed to involve a nonscientific value judgment that cannot be proved right or wrong by facts, evidence, or logic. Rather, such assessments are taken to stem from the value system of the person making the judgment. Normative analysis contrasts with positive analysis, which is capable of providing a scientific, objective assessment (quantitative and/or qualitative) of the outcomes associated with any given action.

Yet, as Erhard, Jensen, and Zaffron (2010) show, it is possible to bring the concept of integrity into the sphere of positive analysis. They do so by arguing that integrity is "not about good or bad, or right or wrong, or what should or should not be." Rather, integrity boils down to honoring one's word, which implies that "you either keep your word, or as soon as you know that you will not, you say that you will not be keeping your word to those who were counting on your word and clean up any mess you caused by not keeping your word" (Erhard, Jensen, and Zaffron 2010: 2-3).

Erhard, Jensen, and Zaffron (2010: 2) go on to assert that integrity, as a state of being whole and complete, is a necessary condition for workability and that "the resultant level of workability determines for an individual, group, or organization the available opportunity set for performance." By improving workability, integrity enhances individual, group, or organizational performance, however performance is defined. (1)

Erhard, Jensen, and Zaffron (2010) contrast integrity with the concepts of morality, ethics, and legality that exist in the normative realm of virtues. Those related concepts reflect evolved norms of behavior in a particular group, society, and state.

Given our positive definition of integrity, the following section shows why free markets, relative to other means of organizing economic activity, more fully promote the practice of integrity as well as other cooperative virtues. Fundamentally, the reasons stern from the repeated nature of voluntary exchange and private property rights at the core of free markets.

Why Repeat Interaction and Private Property Rights Promote Integrity and Other Forms of Cooperative Behavior

Wily do individuals honor their word? In certain cases, there are adverse legal consequences associated with breaking one's promises, penalties that serve to mitigate any temptation to go back on one's word. Macauley (1963), however, reports that businesspeople often fail to plan exchange relationships completely and rarely rely on legal sanctions to adjust these relationships or to adjudicate disputes. One large manufacturer, for example, audited its records and found that 60-75 percent of the time in any given year it had failed to create legally binding contracts that set forth relevant terms and conditions with customers. Macauley finds a similar pattern across a wide variety of business dealings. His findings beg the question of how businesses can operate effectively with so little reliance on contractual details and legal sanctions.

In answering the core question, Macauley points to established norms honoring informal contracts. In addition, Macauley notes the overarching presence of a non-legal sanction. In particular, most exchanges are not one-shot affairs and instead hold the promise of repetition. The prospect of repeat business incentivizes parties to behave cooperatively consistent with the informal terms of the agreement (Telser 1980).

Niskanen (1991: 236-37) provides a telling observation from his days as the chief economist of the Ford Motor Company:

I was surprised to learn that Ford made billions of dollars of purchases a year through regular suppliers over the telephone with only the skeleton of a contract and with few contract disputes. The mutual desire for continued relations was what enforced the performance of both parties in each transaction. At any time that either party expected to end the relation or expected the other party to end the relation, moreover, the primary remaining discipline on the immediate transaction was the value of the firm's reputation with other parties, not the protection of a formal contract. Only when Ford made a major purchase without the expectation of a future relation was the contract extensive and often disputed. To more formally see the difference that the possibility of future dealings makes in determining present behavior, consider the gametheoretic construct of the prisoner's dilemma. In its one-shot or single-play form, the prisoner's dilemma explains why individuals are incentivized to renege on their formal agreements and/or tacit understandings with other participants--thereby lowering the collective well-being of all involved.

If the prisoner's dilemma game is played only once, each player's dominant strategy is to cheat or defect: the equivalent of going back on one's word in Erhard, Jensen, and Zaffron's (2010) parlance. That is, no matter the strategy other participants select, it is always better for any player to forsake actions promoting the greater workability and well-being of a group and its members.

Among other things, the prisoner's dilemma has been used to explain why cartels break down, public goods are undersupplied, medical costs burgeon under a system of third-party payment, litigiousness rises when judicial systems tap "deep pockets," and representative democracies run fiscal deficits (Browning and Zupan 2008). The one-shot version of the prisoner's dilemma thus illustrates that there are settings in which the pursuit of self-interest leads to suboptimal outcomes, in contrast to Adam Smith's insight regarding the socially beneficial workings of the Invisible Hand.

With repeated play of the prisoner's dilemma, however, there is a future. A future gives participating players a dimension with which to enforce agreements by punishing one another in out periods for any cheating in the present period. This critical dimension has been shown to elicit more cooperative outcomes. (2) Indeed, Axelrod (1984) shows that in an indefinitely-repeated prisoner's dilemma setting, the equilibrium that emerges is directly opposite to the one predicted by a one-shot framework. Behaving collaboratively until one's partner transgresses from such a strategy and then retaliating in kind (the "Tit-for-Tat" or Old Testament "Eye-for-Eye" approach) consistently outperforms any other strategy put forth in round-robin simulations. Repeated play in essence fosters integrity by creating a benefit that flows, through the dimension of the future, to the...