Monday, January 13, 2014

Particle Physics is a Poor Analogy to Human Markets

Adam Smith, the 18th century father of modern economics, said that there was an “invisible hand” that guided players in a market, always seeking their own gain, to act, nevertheless, in a way that led to a better distribution of goods and better prices for the consumer than any effort specifically in that direction could have.
The laws of physics have it that any particle, stationary or in motion, interacts with other particles so that the energy of motion that it brings stays constant — either retained or passed on to the other particle. The other particle also follows this principle and the first particle may end up with more energy than it started with, but thanks to something given up by another particle. The result is that the speeds of millions of particles in motion — for example, the molecules of a gas distribute themselves so that there are very few particles with high energy or with low energy, but with a great many at a point in between. And this point can be shown to be the one where there is the greatest number of different ways for the particles, with various speeds of motion, to have the same total energy. It could also be called the point of most equitable distribution of energy, given the dynamics of collisions and the conservation of total energy.
The comparison of economic activity with the properties of the molecules of a gas comes about by treating the money with an individual as equivalent to the speed of a molecule. In transactions between individuals, like in collisions of molecules, there would be an exchange and redistribution of money. The comparison is valid because the total money in a system, like the total energy in a gas, is conserved or stays constant. The proposition then was that, after allowing for the possibility of debt, which does not exist in molecules of a gas, money also distributes itself, with mathematical precision, in the same way as the speed of molecules. In studies of actual distribution of money, to verify the notion, there is a difficulty of different currencies and purchasing power, in cross-border comparison. Studies have, hence, been made of the distribution of income in the USA, UK, Australia, European Union countries, Romania and others, and the results have been that the distribution of the number of persons in increasing income ranges, in most cases, over a group of 97 per cent of the population, is exactly like in the case of a gas.
Adam Smith did not say “that there was an “invisible hand” that guided players in a market, "always seeking their own gain, to act, nevertheless, in a way that led to a better distribution of goods and better prices for the consumer than any effort specifically made in that direction could have”.
That is a later conclusion of some modern economists who did not read clearly the relevant pages and the specific paragraphs in Wealth Of Nations and instead to have rushed to conclusions that were not justified by the written evidence. 
Smith’s actual conclusion from his example where he used the metaphor of “an invisible hand” was in fact fairly modest metaphorical description of a motivation and did not justify the construction placed on it.  
First, Smith used the metaphor to “describe in a more striking and interesting manner” the motive of a merchant, who faced with considerable concerns about the extra risks involved in sending his capital out of his own country to a foreign one, in which he was unsure about the probity of those he dealt with abroad and the consequent extra risks of using a foreign legal system to obtain redress, should he be deceived, took the more secure route of investing his capital to trade with merchants in his own country.
Secondly, the merchants, who for these reasons preferred investing in “domestic industry”, arithmetically added to the domestic capital that itself added to the domestic total of “annual revenue and employment”.   That is all.  There is nothing about it “led to a better distribution of goods and better prices for the consumer than any effort specifically in that direction could have.”
Thirdly, this misreading (I believe non-reading is a better description of proponents of “Petracrch’s” assertion) was extended by modern economists to cover the best of all worlds, including ideas of “harmony” and ideas that even “selfish” motivations (after Paul Samuelson, 1948; which he later explicitly qualified) would lead to this economic nirvana.
Adam Smith’s arithmetical point was fairly modest because obvious – if you add to total domestic investment then you get more total product from enhanced domestic investment.  It was not about “general equilibrium” or Pareto’s Law. 
This makes “Petracrch’s” analogy of the supposed behaviour of the “invisible hand” of the market with the universal behaviour of “the laws of physics” highly suspect, especially the analogy of decisions by the million, billions of “the molecules of a gas distribute themselves so that there are very few particles with high energy or with low energy, but with a great many at a point in between” analogous with the price mechanisms in a market.  Particles on earth and elsewhere in the universe can be identified mathematically in the sure knowledge that particles behave the same everywhere.
However, self-interested individuals are not all identical at all, if at any, times.  For a start, self-interested individuals may, and often do, behave differently at different times and places.  Their behaviour is not predictable mathematically (despite years of teaching our students that they are predictable).  If they were it would be a one-way bet for everybody who could write the maths, but nobody has managed so far. 
Self-interests can be in conflict across a range of degrees and for economies, and self-interests are and must be mediated by “persuasion” and by what Smith called the higgle, haggle of bargaining (‘Wealth Of Nations’ and ‘Moral Sentiments’). Markets are messy, always have been, always will be, and they are a vast improvement where the operate than anything that preceded them in the history of the species.
There is no “hidden” or “invisible hand” miraculousy working with deliberate intent in markets.  Which is why Smith also pointed, on the two (only) occasions where he used the “invisible hand” as a metaphor, that individually motivated actions by individuals had "unintended consequences”. And these “unintended consequences” are interesting to economists and historians.  They are also of interest to theorists of evolution, which is blind, undirected, and unpredictable.  Much like atomic particles, including isotopes, and sub-particles, unless you believe in a grand designer intending the universe to be guided, though who or what designed the grand designer?  


Blogger airth10 said...

I think if an alien came from outer space and asked about our world and how it functions a good starting explanation would be Adam Smith's IH metaphor. That metaphor describes quite well how things fall into place.

But that metaphor is more than a metaphor. It is the real thing, describing a real activity that is going on around us. The invisible hand is like a magnet that brings scattered iron filings on a paper into order.

12:12 pm  
Blogger airth10 said...

I don't think the article in The Statesman went far enough with the idea of thermodynamics and its link with the invisible hand. More should be said about thermodynamic's entropy effects on economics and how the abstraction of the invisible hand is the best way to combat it.

The invisible hand is first and foremost linked to the individual and about the individual pursuing self-interest. It is through individual pursuits that entropy is best combated, not through the collective, like we saw under communism, which allowed the economy to deteriorate and collapse. Ideas to combat entropy and its effects on economics come first from individuals who pursuit self-interests, not first from collectives that stifles individual interests.

" For best results, cultivate individuals, not groups." So to counter the negative effects of thermodynamics- economic entropy, cultivate individuals and their inner resources. The enigma of the invisible hand and the abstraction wrapped up in it plays well to that idea, which focuses on the individual. In progression, the group develops and balances itself on the pursuits of individuals.

For economic sustainability, which is the combating of entropy, cultivate the individual, not the group. In being cultivated the individual grows aware of the world and thus becomes enlightened and responsible. In this way the the individual is optimized and thus serve the whole of society better.

2:15 pm  

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