Saturday, October 08, 2005

Profits Are Not Known A Priori

In Raise the Hammer: we find: "Unveiling the Gas ‘Conspiracy'," by Trevor Shaw

Adam Smith, an eighteenth-century economist, used the analogy of the baker. A baker doesn't provide bread out of charity but out of self-interest. In other words, if there is a lack of profit, the product isn't provided.

Regulating gas to an arbitrary price to keep it affordable for everyone will only put gas retailers out of business. Paying $2.50 per litre will be better than not having any gas at any price. Price capping will also have the same effect, temporarily closing gas stations for the duration of the price-cap.

Adam Smith's analogy isn't really applicable to oil extraction. Bread is a manufactured product, produced from raw grain and ovens that are made possible from energy. Bread is produced, but oil is extracted. The so-called 'invisible hand' of the free-market can't slide in and produce more oil in the ground.”


In Smithian markets the baker, or any other supplier of economic goods, does not know if there will be a profit. Trevor Shaw gets the sequence back to front; he talks as if the knowledge of the profit to be made is known a priori. A moment’s thought would expose the error of his (all too common) assertion.

Before there can be a decision as to whether a profit will be made, the customer and the baker have to negotiate a price for the bread. This cannot be decided by the pure self-interest of either party acting in isolation from the other. If they operated on that basis there would be no bargain concluded: the seller would demand a higher price and the buyer a lower price.

There can only be one price in a bargain and the evidence of the real world suggests that this tends to be lower than the seller would demand, if his self-interest was unconstrained, and higher than the buyer would offer if her self-interest was unconstrained. The settlement price is achieved by the parties mediating their self-interest by each taking account of the self-interest of the other.

Of the second paragraph I quote it only for context.

“Bread is produced, but oil is extracted”. Surely this is not a distinction that makes a difference. “Raw grain” is “extracted” from what is grown, an amount subject to seasonal variations. Once the season’s crop is collected, its supply cannot be increased until the following season, a slightly different but essentially the same as saying once an oil field’s oil is extracted by its current technology over a ‘season’ it supply cannot be increased until the next season or until exploration produces, in due course, a net addition to supply. Similarly, in the case of the capacity of existing bread ovens.

“The so-called 'invisible hand' of the free-market can't slide in and produce more oil in the ground.”

Well, we certainly agree with the use of ‘so-called’ in relation to the invisible hand, but Trevor Shaw’s use of ‘so-called’ misses the point. Adam Smith’s use of the invisible hand metaphor (Shakespeare’s actually: Macbeth: 3:2) had nothing to do with markets, for bread or oil. It was about human motivation (“Wealth of Nations”, IV.ii.9, page 456) and it said nothing about what causes changes in supply or demand. It is not involved in ‘sliding in’ to produce more of anything particularly.

Incidentally, for accuracy, Smith’s reference to the baker (actually “the butcher, the brewer and the baker”, “Wealth of Nations, I.ii.2: pages 26-7) was not an ‘analogy’ (to what was it an analogy?). It was a straight statement of an example of an everyday transaction in markets.


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