Market institutions and economic development: an invisible hand or a prisoner's dilemma?
A well known expert in game theory has written about the Prisoner's Dilemma: "Models derived from Prisoner's Dilemma point to a clear refutation of a basic assumption of classical economics, according to which pursuit of self-interest under free competition results in collectively optimal equilibrium".1 If this statement were true, the foundations of not just classical economics but also of market economics at large should be rejected. A free market economy could still be an efficient system, even the most efficient economic system; but new principles based perhaps more in a Kantian categorical imperative approach than in the utilitarian approach used by most economists in the last two hundred years should be found to explain such efficiency.
The thesis of this paper, however, is that such an argument is incorrect and derives from a misunderstanding of the orthodox economists' message. What mainstream economists say is not that the pursuit of self-interest results in an efficient solution for society in every instance, but that economic agents in pursuit of personal gain will produce a social optimum if, and only if, society has laws and institutions that reward effort and honest behaviour.
To explain this alternative perspective of the problem of social cooperation in this article I shall utilise the work of Adam Smith. The conclusion that the institutional framework is a fundamental factor for understanding the efficient functioning of markets certainly goes well beyond the work of Smith, encompassing current economic perspective on the role of law and institutions in economic development; but the foundations of the model can be found in the works of Smith and most developments of the theory are founded on his analysis.