QUICK BITS no 17

S. Subramanian, a professor of economics in India posts 20 June HERE

The Market: In theory, fact, and lore

“The "informal" understanding of the theory underlying the market's supposed virtues is to be found in Adam Smith's account of the Invisible Hand of private rationality and self-interest which, it is suggested, leads to a spontaneous order of collective optimality, in which economic allocations are arranged in such a way that an improvement in any one person's welfare can only be achieved at the cost of reducing some other person's welfare. (This outcome has subsequently been characterized as "Pareto efficiency", after the Italian sociologist Vilfredo Pareto.) Private egotism, in this view, will lead to public beneficence.  It has taken years of hard analytical work in the fields of Welfare Economics and General Equilibrium Theory to distil this piece of folk wisdom into something like a set of formal propositions in terms of which the "Invisible Hand" account of the economy could make sense.” 

Comment

 Adam Smith’s ‘account of the Invisible Hand of private rationality and self-interest which, it is suggested, leads to a spontaneous order of collective optimality, in which economic allocations are arranged in such a way that an improvement in any one person's welfare can only be achieved at the cost of reducing some other person's welfare” has nothing to do with Pareto’s welfare theorem. 

Therefore the ‘Invisible Hand’ account of the economy " does not make any sense. Smith and Pareto were talking about quite different things.  Smith was talking about markets as a process; Pareto talked about markets in a sort of end-state, when everything in the process was decided. Apart from this distinction, Pareto’s theorem was unproven empirically. It was an assumed outcome that ignored the actual process by which its assumptions and assertions were somehow brought about. 

Economics went down a dead-end when end-state theories were assumed. The maths of them look elegant but were quite fallacious when claimed to have real world relevance. Nobody every showed or can show that they actually exist in the real world.

“the Invisible Hand of private rationality and self-interest which, it is suggested, leads to a spontaneous order of collective optimality” is a myth and disconnected to Adam Smith’s use of a metaphor to describe what happens when the self-interest of merchant motivates him to protect his capital by investing locally rather than risking it abroad. iInvesting locally intentionally adds to “domestic revenue and employment” (WN IV.ii.). 

These actions are intentionally motivated by his fears of risking his capital abroad. But by intentionally acting thus, the merchant’s motivated actions have unintentional consequences. The ‘invisible hand’ is not a force somehow acting in markets; it has nothing to do with ‘supply or demand’, or ‘market forces’. The metaphor of ‘an invisible hand’ describes how self-interest may have unintended benefits that may be public benefits. Equally, the self-interested intentional actions of merchants may, and often do, produce public dis-benefits as when merchants clamour for the imposition of domestic tariffs on foreign competitors (even outright prohibitions) to reduce domestic competition to enable merchants to raise prices.

Theorists like Pareto - and people who quote his First Theorem - even prove it mathematically - led economics up a garden path. Neither do they understand what Adam Smith meant by his use of the ‘invisible hand’ metaphor.