Friday, December 22, 2006

Muddle About Adam Smith on Real Markets

In the Blog,, 21 December’, somebody writes a piece: ‘The Invisible Hand of Adam Smith’ (no credit by-line given):

“Like mainstream Libertarians, John [Stossel] has a great respect for the invisible hand of Adam Smith and the way it can produce wonderful products and markets without an obvious plan. I also respect the ability of a free marketplace to distribute goods and services and encourage growth and innovation. However, free markets almost never exist in the sense that Adam Smith probably had in mind.

John Stossel
is a lively and punchy columnist whom I have praised for some of his pieces on this Blog (passim), but I wonder if he goes so far as to anthropomorphise a metaphor!

‘[W]onderful products and markets without an obvious plan’ are not ‘produced by so-called ‘invisible hands’; they are produced by, er, markets, the human propensity to truck, barter, and exchange’ things that humans want from other humans who want something from them. Given that this propensity is prehistoric, i.e., goes back to the what Smith called the ‘rudest’ of rude societies, there is plenty of evidence supporting the notion that its consequences are not ‘miraculous’, nor ‘mysterious’, nor even ‘magical’.

The ‘free markets almost never exist in the sense that Adam Smith probably had in mind’ is a problematic statement. From the whole of the piece in it would appear that its author is discussing the neoclassical model of ‘perfect competition’, which is not quite what Smith was discussing in Wealth of Nations. In Book I Smith discusses markets as he observed them in mid-18th-century Scotland (and confirmed from markets he visited in London). These were street markets, of which there are a fair number of excellent representations in contemporary prints (I have some good ones of Edinburgh markets in the High Street at Smith’s time).

Read Book I and you will note he talks of agricultural produce on sale and how its ‘natural price’ – that which earns sufficient to pay the landowner his rent, the labour his wage, and the owner of capital (who made the necessary ‘advances’ to the labourer before the food was planted, harvested and taken to market) – may vary upwards or downwards from its ‘market’ price’ – that which is determined by excess effectual demand or excess actual supply. Where Natural Liberty obtained, owners of land, labour and capital reacted to differences between natural and market prices, or the revenues earned by them in competitive markets. If a factor did not earn its ‘natural price’, it reduced its commitment, and when it earned above its natural price it increased its commitment, to that product or switched to another, without impediments from regulations, monopoly, statutes and other interferences in Natural Liberty.

Markets in Smith’s ‘sense’, ‘free’ or ‘constrained’, were very much in his mind. That allegedly he considered them to be ‘free’ in practice is most problematical. He showed how they worked when they were ‘unfree’, how they worked when they were ‘free’ and how they worked in practice. He did not advance the idea that so-called ‘free’ markets operated and existed as some kind of norm, like the model of perfect competition purports to demonstrate. That is an abstraction. It would be more correct to have written the sentence: ‘free markets almost never exist in the sense that [the authors of neoclassical perfect competition] probably had in mind’.
The assertion that he envisaged markets on perfect competition has nothing to do with his detailed analysis in Wealth of Nations. He wrote about the imperfections of markets in the real world than the conflation of Adam Smith with Perfect Competition credits to him.

“A free market requires a lot more than simply a place to buy and sell goods. The underlying assumptions include such things as a large number of sellers such that no one seller or cooperating groups of sellers can command a significant share of sales. Similarly, the market must have a large number of independent buyers. Another condition that is often overlooked is that both the buyers and sellers must have immediate access to all relevant information about the market.”

The problem is that Smith wrote about markets as ‘simply a place to buy and sell goods’. Compared to modern markets those in the mid-18th century were primitive. Signals over vast distances were muted – it took many months to bring goods, including bullion, from overseas.

As the conditions of a free market are approximated in real life, profits decrease. Since the nature of a business is to maximize profits, a popular tool of businesses is to manipulate markets such that they are not truly free. Businesses in a free market are motivated to prevent the market from acting as it should. That is why businesses buy their competitors and obfuscate as much as possible to keep customers and their supposed friend, the government, from obtaining information which would permit smart decisions.”

Exactly! Nobody needed to tell Smith about the perfidious roles of some ‘merchants and manufacturers’ and their propensities to monopolies and anti-competitive behaviours. Book III and IV are about precisely that problem.

The muddle arises because non-readers of Smith’s books take the preference Smith had for free markets (not the recognition that they existed widely), assume the economy he wrote about was as instantaneous in its responses as implied in neoclassical models, and attribute to him the verities of perfect competition.

If the world that Smith wrote about was perfectly competitive, he would have written a different book; it wasn’t, so he didn’t.


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