Sunday, October 09, 2005

Implications of Profit

Webpronews.com publishes an exchange about a foundation to promote ‘social impact’. It (slightly edited) is not always clear about its context, but it mentions Adam Smith and I comment on that:

"Started a foundation. Trying to make the world a better place in the traditional way. Started thinking that if you want to have an impact in the real world, why do you have to in this sector? When you look at eBay, after 10 years, 150 million customers have learned they can trust a complete stranger. That a business can have this very social impact of a slightly higher level of trust was intriguing. JBat: Now in the VC Biz? A little different, it's a mission based fund. We are about fostering individual self-empowerment. The fund is $400M, all my money, going to do something good with this, investing over 5 years. Looking for businesses that can only be successful if they have a positive social good. We are building tools with new technology to bring people together. Adam Smith: given the right environment with people pursuing their self interest leads to an increase in the general welfare. In fact, look at the profit generated in an economic system, if the environment is right, then the existence of profit is evidence of general welfare. If the baker can sell bread to a shoemaker, he can feed his family, and also apply the profit to buy shoes. It's more complex than that, but the principle holds true. We look for three things: does it have a level playing field? does it foster interaction, connecting and communication around shared interests? do the participants have a sense of ownership for what is going on? Then we look at the business model. Is there a revenue model that can only be successful if it maintains the three values and enables the social impact. For instance with a business about trade, and you need people to trust one another, the model predicated if the trade going through. We are pretty rigorous (I can testify to that) in due diligence. Tighter screen because of the mission fit, which also limits the number of opportunities. We are doing this for a social impact on the world. Need to examine the business model that has the social impact. In the social sector there has been a lot of work on trying to measure the social return. Some things easy to measure (how many people did you feed), but the game changing things you can't measure. Going back to Adam Smith, with the right environment (criteria for investment), then evidence of profit is fulfilling the mission.”

Comment

Looks interesting. Assuming the “right environment” includes the rule of law and independent justice, at the first level “people pursuing their self interest leads to an increase in the general welfare” is fair enough and representative of Smith’s views. However, he went a lot further and this must be understood in case false images produce wrong approaches.

Smith focussed his early chapters of “Wealth of Nations” on ‘the propensity to truck, barter and exchange’. (WN I.ii.2: page 26-27) In commerce, its characteristic even today is on parties negotiating to exchange something voluntarily. If we look at the act of negotiation we find a familiar mechanism, which I call the ‘impartial competitor, reflecting the role of the impartial spectator in “Moral Sentiments”.

His famous exposition, and most famous quote, is:

“It is not from the benevolence of the butcher, the brewer and the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our necessities but of their advantages.” (WN I.ii.2; p. 26-7)

This is the most misunderstood statement of Adam Smith (among many other competing candidates). Even the great George Stigler misread it.

If two parties to a transaction care only for their self-interest, there would never be a negotiated agreement. The seller would always open higher and not move, and the buyer would open lower and not move either. If there is to be a single agreed price either or both of them have to move because negotiation is the management of movement. The dynamics of movement involves each party addressing the interests (or ‘advantages’) of the other. They have to modify their own self-interest by serving the self-interest of the other.

The buyer gets her family’s dinner and the butcher, brewer and baker, receive income to buy whatever serves their self-interests. In competitive markets the penalty for not moving is for the seller to lose to a competitor and the buyer to have to try again with another seller. Hence, like the impartial spectator modifying the display of excess passions, the excess demands of negotiators are modified by considering the other’s self-interest as well as their own.

I agree with the writer’s statement that “If the baker can sell bread to a shoemaker, he can feed his family, and also apply the profit to buy shoes” but just in case this is read as a one way gain to the baker, etc., let me add the rider: “If the buyer’s family receives bread at an acceptable price (constrained by open competition), they can restore their health needs and return to earning their living the next day; if they purchase their bread at a price that reduces their real income (what they can buy with their wages) they may miss out on being able to afford meat from the butcher, which reduces the butcher’s ability to buy shoes, or whatever.”

The agreed price has impacts all round and any hint of monopoly exercised by the baker undoes the benefits of markets. Raising prices and thereby profits through monopoly restrictions has a deleterious effect on the growth in wealth, warned Smith. Unrestrained self-interest need not result in improving the general welfare. The best restraint on self-interest is not regulation, but competition. In this sense, ‘evidence of profit’ may have more than one implicit meaning.

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