Sudhir Mulji: Adam Smith and infrastructure

Smith's solution to infrastructure problems was to give a short-period monopoly.

It is instructive to consider how Adam Smith expected society to develop and finance infrastructure. For, although he had relegated public works to "the third and last duty of the sovereign or commonwealth" after the duty of providing defence and justice, he emphasised "erecting and maintaining those public institutions and those public works, (like bridges and canals) which are in the highest degree advantageous to a great society", despite the fact that they are "such that the profit could never repay their expense to any individuals or group of individuals."

In other words Adam Smith recognised building roads, canals, bridges, and harbours though a necessity for a great commercial society, could not be provided simply by relying on a competitive system. Further, in spite of the importance he attached to public works he was unwilling to spend such money "from public revenue where the collection and application are in most countries assigned to executive power".

He had just as healthy contempt for the bureaucracy as many critics have today. Like them, he had no reason to believe in the benevolence and integrity of rulers and firmly held to the view that a very small proportion of social public expenditure devolves to the intended. Like the famous Rajiv Gandhi quip, Smith would have readily accepted that only 24 per cent of the money was applied to the purpose intended.

He lived in a corrupt age where the sanctity of public service was not the norm expected of men in authority. The popular doctrine was that they were ruled by their passions, one of which was avarice. It therefore followed that they could not be relied upon in the expenditure of public revenue to spend money for public good.

A sovereign was expected to limit himself to defray funds in national self-defence and the provision of justice""the first two duties of the sovereign""but in his third duty""that of promoting public works or the infrastructure of building roads canals, ports, etc.""the essential problem was that the specific beneficiaries of these goods could not in their individual capacity put together the investment that would yield benefits later.

Adam Smith realised that such public goods were commonly beneficial but that did not justify a burden on public revenue. He believed, "The greater part of such public works may easily be so managed as to afford a particular revenue sufficient for defraying their own expense without bringing any burden upon the general revenue of the society." That is to say, a method should and could be devised whereby the expenditure on potentially revenue-yielding projects was recovered from the user.

Historically, prior to Smith's Wealth of Nations, sovereign rulers of England encouraged risky enterprises by giving exclusive monopolies to particular corporations ""that is by granting royal charters. Thus, the Russia company (1555), the East India Company (1600), and the Hudson Bay Company were given exclusive rights to trade with these countries without competition.

When it became necessary to set up special commercial authorities, patent letters were given to the Bank of England (1694) and the London Assurance Company (1720). Thus, the notion of a monopoly for the development of trade was well established.

These exclusive monopoly rights were supported by Smith on the grounds that certain activities could not develop or flourish under competition and had to be supported by monopoly power to enable entrepreneurs develop the riskier trades which needed time to make them profitable. Further, the capital needed to undertake these risks could be so large that it was likely be beyond the capacity of individual entrepreneurs.

With the introduction of joint stock companies Smith saw an opportunity for individuals to undertake bigger enterprises with limited liabilities. It was now possible to spread risks among a larger number of entrepreneurs; but there were two unresolved issues.

The first was: Could these joint stock companies undertake public works under competitive conditions? Second, in the management of these enterprises would the managers have the same incentives, that self-interest, that provided the driving force to individuals whose fortunes were linked with their businesses?

In subsequent economics, the first issue has developed into an economic debate on the role of the public sector, and, on the second question, the debate has centred round the principal-agent problem.

On the first issue, Smith was clear that the government should not undertake the enterprise but there was still the problem of avoiding competition in the formative years of riskier enterprises. Smith concluded that a limited monopoly could be given to the enterprise; the monopoly would exclude competition but only for a short period of time.

Thus, free competition could be delayed until the original risk takers had earned a sufficient reward. This, I think, was the basis of Smith's support of the Navigation Acts, which he recognised and approved though they were designed to give exclusive privilege to English ship owners in the trade between the colonies and England. In modern times, special cartels in scheduled trades have sought the same privileges under a Conference system.

The nature and reason for such cartels are best understood in considering civil aviation. To develop services, aviation operators want licence and regulation so that they can invest money not just in aeroplanes but also in facilities required to provide a scheduled service regardless of the passenger load.

If a flight is scheduled daily it must take off, regardless of the number of passengers on the given flight. On many occasions such a regulated flight will not yield sufficient revenue, but if the flight did not take off at all because of a lack of passengers this would prove inconvenient to the development of traffic between different destinations.

However, if an aviation operator agrees to fly daily regardless, he can only meet his costs by ensuring that competition cannot come in whenever demand is high and disappear when it is low.

Thus, there is a conflict between the demand for a regular service, and one that is interrupted by the accidental entry of those who will adjust supply to immediate demand. The scheduled service operator wants a monopoly while the accidental supplier wants freedom to provide service when demand is sufficient.

On one side of the argument we would acknowledge the need for monopoly to the provider of the schedule service. Only then can he plan to guarantee a service in the hope of developing the trade.

On the other side of the argument lies the difficulty of eliminating competition and thereby developing a permanent monopoly will lead to a gradual deterioration of service that lack of any potential competition leads to.

Smith's solution was to give a short-period monopoly limited in time that would eventually wither away. The difficulty is to determine how long the provider of such services should enjoy monopolistic privileges and when they should wither away.

To economists the analogy of this reasoning to that of infant industry arguments will seem all too familiar. However, the alternatives are either to develop commercial enterprises out of public revenue or not to have them at all. The sad part of it all is that we use one theoretical argument to defeat another without considering the overall damage of doing nothing.

The views here are the author's, and not of any organisation