Tuesday, August 13, 2013

Adam Smith on Self-Interest, Bargaining and Invisible Hands

“greg” posts on  Another Amateur EconomistHERE 
 Regulating the "Invisible Hand'”
“The ‘invisible hand’ has come to imply the idea that the pursuit of narrow self interest by individuals results in the best social outcome.  Adam Smith, who first used the expression, more narrowly applied it to the concept of markets: “specifically that it is competition between buyers and sellers that channels the profit motive of individuals on both sides of the transaction such that improved products are produced and at lower costs.” http://en.wikipedia.org/wiki/Invisible_hand
The generalized idea is not valid.
In general, action by the members of a society must not only be self seeking, it must promote the well being and goals of that society. To put it in economic terms: Society must profit, and the action of individuals must, in that respect at least, be virtuous. Indeed, every prosperous and stable society has elevated the idea of virtue among its citizens, and devised means to encourage it.  Those most esteemed were those who contributed the most to society.  They were those who were held to be the most virtuous, and received the greatest rewards.  Those who were merely self serving were held in contempt, what ever their material income.
While an individual person may or may not be inclined to virtue, a corporation, however, cannot be virtuous, unless forced by law and circumstance of competition.  Only the pressures of competition make a productive corporation stay productive, that and the force of law required to make the corporation internalize its costs.” 
I selected these two paragraphs from the head of “greg’s” post as the possible source of his ideas that follow in the above Link. Judging by what follows and his side-bar, it seems that “greg” is familiar with a load of economic ideas.  On the above first paragraph he is woefully misled by his reading, albeit with the self-proclaimed label of “”amateur”, which suggests a familiarity with economics of which most college graduates would be proud.
Now to facts: Adam Smith was not the first educated writer to use the “invisible hand” metaphoric figure of speech.  It was widely I circulation in the 17th and 18th centuries, and was in evidence in even earlier times, mainly from its association with theology and occasional dramatic contexts (Shakespeare among others).
Adam Smith did not more narrowly apply the IH metaphor “to the concept of markets”.  In fact he did not mention its role in markets at all in any of the three (only) occasions in which he used it.  He certainly used it in a narrower context than today’s more general assertions as to what he referred to or meant. (Warning: Wikipedia is not always reliable)!
I suggest politely that “greg” look up where Smith used it in his “Wealth Of Nations” (Book IV, chapter 2, paragraphs 1 to 9, pages 252-56).   Smith referred to a merchant who was concerned about the security of his investments if he sent them abroad and therefore decided to confine his investments to “domestic industry” only.  It was his desire for “security” that motivated his decisions to invest locally, and his motivations were invisible to others of course, we cannot see into another person’s mind. 
Smith chose to describe the merchant’s motivations “in a more striking and interesting manner” by using the IH metaphor, which conforms to Smith’s own definition of the use of a metaphor in English in his “Lectures on Rhetoric and Belles Letters” that he delivered at Glasgow University (1751-64), and previously at Edinburgh from 1748-51. It also conforms to the definition of metaphors in the definitive Oxford English Dictionary (and all US dictionaries I have seen).
Now the motivations (the cause) of the individual merchant’s actions resulted in “unintended consequences” (the effect).  Quite simply the merchant’s domestically invested capital arithmetically added to the annual amount of domestic “revenue and employment”, which Smith regarded as a “public benefit” (simply: the ‘whole is the sum of its parts’). Nothing more complex than that!
It had nothing to do with “competition between buyers and sellers that channels the profit motive of individuals on both sides of the transaction such that improved products are produced and at lower costs.” That is a 20th century add-on to Adam Smith’s use of a simple metaphor; it had nothing to with general equilibrium, nor Pareto’s theorem nor any of the other invented constructions placed upon it by modern economists and in political manifesto’s.
In greg's" second paragraph, Adam Smith never suggested “self interest” was about “self seeking”. Self-interest must be realised through what modern theorists call “other regarding”.  The individual “butcher, brewer and baker”, in his famous example, also had self-interests as well as the person seeking her dinner goods.  Smith specifically advised the buyer to “address the self-love” of the sellers and not to talk only of her “own necessities”.   Smith called this “bargaining”.  In short, each party must persuade the other by mediating their self-interests to find a compromise on the initial asking  prices and offers acceptable to both of them: “Give me that which I want and you shall this which you want”. (see WN Book I, chapter 2, paragraphs 2 ad 3, pages 26-27) and also various references in Smith’s “Moral Sentiments” to moral persuasion.


Blogger greg said...

Thank you, Gavin. I appreciate your criticism, and your spirited defense of Adam Smith, and will try to respond constructively.

However, I did not intend to imply, and I do not think that I did, that my first sentence was Adam Smith's position at all. Or that he ever suggested "self interest" was about "self seeking."

Indeed, my intent was to disassociate his position, (as incorrectly expressed in Wikipedia) from the "idea that the narrow pursuit of self interest by individuals results in the best social outcome."

I regard one's "self interest" as necessarily including the interests of one's society. I do not claim that this is done by eschewing profits, or necessarily "trading for the public good."
But I do claim it is necessary for a company to internalize all costs. When all costs are internalized, the profits of a company are the measure of the net benefit to society of the company's activities. It is how much society comes out ahead. When costs are externalized, it is not certain that society is any better off for the company's actions.

I stand by my position on the necessity of virtue in a society, and the impossibility of corporations, unconstrained, to practice it.

As for the necessity of virtue, let me quote Adam Smith: Book 4, Chapter 7 Part III (pretty far into it):

"...But besides all the bad effects " (of monopoly) "to the country in general, which have already been mentioned as necessarily resulting from a higher rate of profit, there is one more fatal, perhaps, than all these put together, but which, if we may judge from experience, is inseparably connected with it. The high rate of profit seems everywhere to destroy that parsimony which, in other circumstances, is natural to the character of the merchant. When profits are high, that sober virtue seems to be superfluous, and expensive luxury to suit better the affluence of his situation. But the owners of the great mercantile capitals are necessarily the leaders and conductors of the whole industry of every nation; and their example has a much greater influence upon the manners of the whole industrious part of it than that of any other order of men. If his employer is attentive and parsimonious the workman is very likely to be so too; but if the master is dissolute and disorderly, the servant, who shapes his work according to the pattern which his master prescribes to him, will shape his life, too, according to the example which he sets him. Accumulation is thus prevented in the hands of all those who are naturally the most disposed to accumulate; and the funds destined for the maintenance of productive labour, receive no augmentation from the revenue of those who ought naturally to augment them the most. The capital of the country, instead of increasing, gradually dwindles away, and the quantity of productive labour maintained in it grows every day less and less. Have the exorbitant profits of the merchants of Cadiz and Lisbon augmented the capital of Spain and Portugal? Have they alleviated the poverty, have they promoted the industry of those two beggarly countries? Such has been the tone of mercantile expense in those two trading cities, that those exorbitant profits, far from augmenting the general capital of the country, seem scarce to have been sufficient to keep up the capitals upon which they were made. Foreign capitals are every day intruding themselves, if I may say so, more and more into the trade of Cadiz and Lisbon...."

"...It is thus that the single advantage which the monopoly procures to a single order of men, is in many different ways hurtful to the general interest of the country."

I'm no expert on Adam Smith. I got lucky. And I will heed your warning about wikipedia.

Also posted as comment on my own blog.

8:52 am  
Blogger Gavin Kennedy said...

Thank you for your clarification, with which I agree.
I am also grateful for the quotation from Wealth Of Nations, Book 4, Chapter 7, part 3, para 61: pages 612-613. It is about the monopoly of the colonial trade, with side comments on the virtues of parsimony over prodigality, a common theme of Smith's in WN.

3:35 pm  

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