Society uses three types of organizations to manage resources to meet its needs: for-profit businesses, public organizations, and not-for-profit organizations. Contemporary history proves the critical role markets play in creating value for society, and it is impossible to be against markets in general. Markets are basically about exchange; freedom of exchange is both desirable in and of itself and also value enhancing. As Amartya Sen puts it, being generically against markets is as odd as being against conversations between people.
Social Value and Markets
An organization, be it for-profit, public, or not-for-profit, consumes resources—labor, materials, and capital—to provide goods to its clients. The social value created by the organization is equal to the value of the output as determined by the customers minus the value of the inputs. The goods are sold to the customers at a certain price. If this is a business organization, the market determines the price of the goods traded. When public and not-for- profit organizations provide the goods, they determine the price for the goods; this price is usually lower than what the market price would have been if this were a for-profit firm.
As figure 7.1 illustrates, the value of outputs minus the firm’s revenues is consumer surplus, and the revenues minus the cost of inputs are profits or, what the economists call, producer surplus. Social value created is equal to consumer surplus plus profits. Profits accrue to individuals, yet they are part of the social value created—individuals, after all, are part of society. In a public or not-for-profit organization, revenues are usually not adequate to cover costs, and the economic loss has to be subsidized by taxes or philanthropy.
In this discussion it is necessary to take into account the cost of capital used by the organization. The logic for determining the cost of capital is the opportunity cost of foregoing other alternative investments, adjusted for risk. The objective of private firms
Figure 7.1 Social value created is not just accounting profits, but rather economic profits, defined as accounting profits minus the opportunity cost of capital. The ability to generate accounting profits is not enough; economic profitability is necessary for the long-term viability of business. The rest of the chapter refers to economic profits, not accounting profits.
If markets are working well, then private profits and social value are aligned, and firms acting in their own self-interest will lead to a socially optimal outcome. Adam Smith wrote in The Wealth of Nations more than two hundred years ago,
every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually then when he really intends to promote it.1
The genius of Adam Smith was his understanding of the harmony between private interest and social value. Guided by Smith’s “invisible hand,” firms pursuing rational self-interest maximize social welfare. It is because this insight is empirically true that free market capitalism is the best path to economic prosperity, and the political ideology of the world has decisively shifted in the last thirty years toward market-oriented economics.