The Limits of Free Contract

Economics and liberal philosophy intersect on the question of liberty. The economist might argue that minimum wage laws reduce welfare by banning Pareto dominant transactions between two agents that would make each better off without leaving anyone else for the worse. The philosopher might argue that it is our freedom to work for whichever wage rate we command: surely volunteerism should not be banned?

A similar and more resonant argument emerges in the market for sex: banning it is not just illiberal, but destroys value created in a transaction that makes both solicitor and prostitute the worse off without bettering anyone else, so long as the activity is private and unseen. This is an overwhelmingly popular argument among intellectuals, left and right, but faces severe limits. Indeed, much of the argument falls prey to what we might call the fallacy of marginalism or confusing marginal benefit with average benefit.

I am not arguing that prostitution should be illegal, per se, but want to provide a framework that will be more amenable to modern liberals and libertarians than the moralistic nonsense offered by social conservatives and can hopefully extend that reasoning to more salient topics like minimum wage, immigration control, and other illiberal regulation.

First, let’s state the philosophical argument, or what Kaushik Basu calls the “principle of free contract”

which asserts that when two or more consenting adults agree to a contract or an exchange that has no negative externalities on uninvolved individuals, then government has no reason to intervene and prohibit such a transaction. This principle is the product of two more fundamental ideas: the Pareto principle and consumer sovereignty. The Pareto principle asserts that if a change is such that at least one party is better off and others are no worse off, then that change is desirable. Consumer sovereignty asserts that each (adult) individual is the arbiter of that individual’s own welfare.

(I have not read this particular Basu paper, but enjoy his phrase and definition of free contract from his book Beyond the Invisible Hand – a book I read a long time ago, which inspired my love for economics.)

Therefore, if we aggregate over all such transactions, welfare and social good is maximized if and only if humans are free to contract. For this reason, economists are far less critical of moneylending at obscene – “usurious” – interest rates. But once we consider social norms the principle of free contract (PFC) is on substantially weaker footing.

Let’s use an example of prostitution to see how. Using a story from a TV favorite, The West Wing, imagine a young women paying her law school tuition through weekend prostitution. There is nothing morally repulsive about this scenario by itself, and it is a commendably efficient way to earn good money on a law student’s (presumably) busy schedule. To make the logical structure of the argument a little more transparent, let’s suppose Laurie – the prostitute – was actually using the money not to get through law school, but for LSAT prep to get into law school. This is not structurally different, but more intuitively forceful.

Laurie is now better off and ready to crack any exam and interview thrown at her as a result of elite prep classes affordable only to the few. However, seats at the top law schools are effectively zero sum: Laurie’s acceptance translates almost directly into her colleague’s rejection. This makes the application pool just a little more competitive on the margin. Now imagine a girl who just barely made it into law school without prep classes and, like Laurie, can neither afford to pay for elite classes or work in a normal job to finance resulting loans.

This girl, and everyone like her, will now be rejected because they only just made it. They would each all make it were they to also engage in a low time, high reward activity like prostitution. This argument continues: in the real world only several times because markets are not perfect, but theoretically ad infinitum.

Eventually, everything would be okay if all concerned were morally okay with prostitution. But Laurie is, let’s say, atheist – all of her compatriots that are practicing Catholics, Muslims, or just were morally uncertain about prostitution would be left behind. We know that within a capitalist system that those who do not work hard are left behind, and that is its greatest strength. But the assumption that contracts do not carry externalities is violated when others – to maintain the same standard of living – are compelled to do something that is against their moral code.

This argument can be terribly abused. I can stipulate it is against my moral code to work more than ten hours a week, and hence the government should ban everyone from doing so. That would be dumb, economically and morally, because most people do not hold this view.

But this is a more tenuous argument relative to prostitution. How many parents would say they are okay with their children participating in sex markets – with full and total consent – so that everyone else is better off, as liberal economic theory stipulates. My guess would be very few.

The side effect of free contract is forced homogeneity of the most aggressive principles.

In the sense of a “Protestant work ethic” that can be good, even great, by making once lazy and poor countries rich and prosperous – to summarize the nuances of economic history in five words!

The macroeconomist might say that both marginal and average welfare increase under free contract. Certainly if, between two convenience stores, the one owned by a hardworking immigrant stays open twenty-four hours, and the other closes at eight, competition will buoy per capita GDP, providing an illusion of a richer society. In reality, the microeconomist will reply, total utility – which is the cause of contention – is a tradeoff between work (dollars) and leisure. The higher GDP of the harder working country may not reflect a similarly higher utility if the value of leisure is high.

In fact, working hours are the clearest example of capitalism homogenizing the aggressive behaviors of hard work. This is most evident in the comparison of two similar economic structures – the United States and Europe – where the former is far richer by per capita GDP and works far harder whereas the latter is riddled with required vacations and regulated work hours. The United States being the more capitalist if the two, work ethic diffuses more rapidly from those innately or morally predisposed to such and those compelled into such through competition. But GDP does not account for the value of reading Shakespeare alone or watching NFL with your friends.

We can make this argument within the neoclassical structure as well by reconsidering the definition of “free”. If we no longer assume that the existence of choice implies the void of compulsion, it becomes clear that most contracts may not be free. For example, if I am providing my family a lifestyle commensurate with an income of $50,000 a year, and an immigrant moves and undercuts my prices, I can either choose to work the same hours for less income. But social commitments and a responsibility to family will encourage me to sacrifice leisure instead. Then, we may say, externalities exist to every contract making the idea of aggregated free contract a red herring in the case for liberalism.

Undercutting my personal wage rate is formally the same as working harder: indeed, if I choose to work for $4 instead of $8, hourly, I must spend twice as much time to maintain the same lifestyle.

This line of argument not only challenges the economic assumption that free contract is everywhere and always superior but also redefines the frame of a philosopher’s case for liberty. That is, under social obligations, am I really free to work less in the face of competition?

Ultimately, it is unlikely this argument can – or even should – change the mind of economists for most things. I, myself, am not convinced, but rather outlining what started out as a Devil’s Advocate case against prostitution or drug legality. In any case, for issues of social importance like prostitution, it bears (I think) significantly on the idea of externalities from the economic and social, rather than physical, outcomes of a contract. By definition, these are largely removed from standard economic analysis, but still follow similar principles of welfare and utility maximization.

I have touched, but not discussed, some philosophical pondering for another day. For one, what exactly constitutes “freedom”? This question has compelling implications, particularly so in markets for organs, surrogate mothers, and even plain, old, work.

  1. Reardon said:

    I realize you don’t even come close to wholly endorsing the argument, but I have a few criticisms that weren’t stressed in your framing.

    First, there’s clearly some ad populum happening here, though you seem agnostic on the liberty/efficiency debate, so that’s perfectly appropriate.

    The really rub is with the lack of consideration for supply effects. The Law School example assumes a fixed supply and for a given school in a given year this may even be true. But obviously, the more people who earn extra income for the purpose of bidding up higher education, the more seats and schools become available. This is exactly what we’ve seen over the last 40 years, who ever misses the cut when they might have made it before will have options and only receive marginally lower utility for a marginally smaller contribution to social welfare.

    Jonathon Wolff has a paper on whether libertarianism actually endorses a competitive free market (is competition a violation of your competitors property right?). I think seeing the issues with his argument, which are rather plain in my view, illuminates where this line of argument against free contract goes awry.

    • asdf said:

      Except it didn’t open up more seats. Slots at elite institutions, including most elite educational institutions, have remained pretty stable despite increased demand for them. Elite employment opportunities after graduation are much the same story.

      Most of the new people shoved into education ended up dropping out or getting worthless degrees with poor employment prospects.

  2. Why are we sure the problem is with contact and not the social externalities themselves? Although this argument is misanthropic.

  3. asdf said:

    There are about a million different ways to attack the “consenting adults agreeing to something (with no externalities, though in practice this just means no really obvious and immediate externalities) is always good” idea, and you’ve chosen one. I’d consider another.

    People don’t always know what’s good for them. That should be obvious enough I don’t have to elaborate further. Areas like sex, drugs, etc are particularly nasty in this regard. It’s pretty spergy to treat something with as profound an effect as sex and prostitution like its selling a pack of gum to someone. The actual life outcomes of prostitutes should show this, and you would think its the kind of moral intuition most people would pick up naturally. This would be true whether prostitution was legal or not.

    If thinking about this in the abstract is not helpful try looking up a movie called “The Great Happiness Space” on Netflix. It’s about some male prostitutes in Japan and many of their clients are female prostitutes. Japan is very permissive on this stuff (legal crackdown isn’t these peoples problem) and nothing particularly direct happens to these people (they aren’t the victims or violence or something really obvious). However, I think as you watch it you will realize the immense damage this lifestyle has done to these people. Many of them, if they could go back to the beginning, if they could exercise more self control, would certainly not have gone down that path.

    This used to be taken as given, that people were sinful and they needed help to make better choices in their lives. That doesn’t always have to come in the form of the government making something illegal or regulated, though it might. It could also be the subject of social pressures, condemned by popular institutions, etc. The problem with your argument is that you elevate a sometimes correct argument (the government shouldn’t be involved in this particular agreement between two people) to a moral stance (your against liberty if you don’t think two people are morally justified to engage in a transaction that will leave them worse off because they are as vulnerable to sin and irrationality as we all are). And while its perfectly true that decisions like these tend to end up harming society at large in the long run that’s attacking a downstream symptom rather then getting into the original problem.

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