From my experience sending out political emails, I understand the value of a catchy subject line, or in this case a catchy post title. I could have used a title like "laissez-faire economics", which is sort of what this post is about, but then you would have ignored it and signed on to facebook, and now here you are!
Everyone's heard of Adam Smith's famous 'invisible hand', a metaphor for the theory that society's best allocation of resources will be achieved by everyone pursuing their own individual self-interest in a marketplace. Why then, are firms necessary? If individuals can go to the market to get everything they need, why do they become involved with firms? If you think about it, firms are organized in the exact way--centralized, planned, authoritarian--that is rejected by the invisible hand. It's a question that The Economist takes on. The answer, they argue, is due to the high transaction costs associated with going to market, as well as the collective expertise that can be achieved by a company of people.
It's the same reason you join any group--to be more successful than you could be on your own. If you are a great baker but aren't good at accounting, you might want to become part of a bakery so that you can focus on baking and they can keep track of how many people buy your snickerdoodles. If you are a commercial airline pilot, you need to become part of a firm so they can buy the plane you fly, attract the customers that need you to fly them somewhere, and negotiate with the government to make sure you don't fly in restricted airspace.
I'm reminded of a scene in The Beautiful Mind, the movie about the Nobel-Prize winning economist John Nash. In the movie, Nash comes to his breakthrough idea when a group of young women walk into the bar, with one of the women being the most attractive:
For the purposes of our little discussion here, let's call this super-hot woman "Hillary Clinton". The invisible hand would predict that all the guys would hit on Hillary. But Nash reasons that if everyone tries to impress Hillary, only 1 guy could potentially attract her, leaving the loser guys with no girlfriend. And the loser guys would not be able to hit on Hillary's friends, because Hillary's friends are offended that they weren't the original target of the guys' affection. So in Adam Smith's scenario one guy wins and the others lose. Nash reasons that the best outcome is for all the guys to go after Hillary's friends--and not Hillary at all! At least then, all the guys would have a girlfriend, even know nobody would be dating a supermodel. "Adam Smith was wrong", the Nash character announces to his confused friends as he passes by all the Hillarys in the bar to go back and develop his theory.
In both the example of the firm and the 'non-cooperative games' to which Nash's theory is referred, Adam Smith's theory shows some weakness. As an undergraduate economics student, I was forced to tattoo Adam Smith's name on my left bicep as a show of appreciation for the so-called father of economics. "How could he be wrong?", I wondered, a foray into philosophy that was surely a result of a hangover and daydreaming during a class I really didn't care about. I asked this guy, who was my faculty mentor, and remains the smartest person I think I've ever met. The brilliant power of Adam Smith, he advised, was that despite a couple scratches on the fender, the Smith-mobile is still driving in the fast lane. (We're using a car metaphor now--try and keep up!). Despite the odd theory or exception now and then, it still remains mostly true that the best outcome is achieved by everybody doing what's best for them in a market free of coercion.
Taking the position that we are free-market experts, economists from the Chicago School argue that humans are 'economic robots'--that every decision they make is the result of the analysis of all available data related to the transaction. This of course is not possible--most people can't know if a cotton shirt at Target is cheaper than one at Walmart--but you will try! Maybe you ask your friends that shop at both places; maybe you know that milk is cheaper at one place than the other and you assume that all prices at that place are cheaper; maybe you're rich and you hire a private shopper to investigate and get you the best price. In any case, the Chicago school model still might be the best model to use because it just might be the best predictor of what you're going to do.
Free-Market advocates don't have to worry--there is still room on your right bicep for Hillary's initials tattooed inside a heart.