Monday, April 10, 2006

Invisible Hand, no 34

A central assumption of the general equilibrium model is that all individuals possess perfect information, which explains how free markets result in optimum outcomes. In “The Wealth of Nations,” Adam Smith uses the “invisible hand” metaphor to describe this model. Stiglitz believes that the assumption of perfect information and in-turn the conclusion that free markets create optimum outcomes are both invalid. Speaking on his reluctance to put absolute faith in the free market, Stiglitz remarks, “the reason that the hand may be invisible is that it is simply not there—or at least if it is there, it is palsied.”

(A Report by Kendal Burgemister, an economics major at Boise State and a Top Ten Scholar, in (Boise State’s Independent Student Newspaper, 10 April)

I can understand why Kendall Burgemister, like many other bright and accomplished students of economics, repeats without question what he understood a Noble Prize Winner from the Bank of Sweden to have said. As students we sit at the feet of men and women of great learning and of justly established reputations in their fields, and not many come as high in the well earned and justified respect of colleagues and students towards scholars as does Joseph Stiglitz.

However, Joseph Stiglitz would be wrong if he attributed to Adam Smith a familiarity, let alone an affinity, with a model of general equilibrium, either in its primitive form (as it would have had to be in the mid-18th century) or in a modern form (of which he absolutely no knowledge); he did not describe, and certainly did not prescribe, anything like the assumptions of ‘perfect information’ and ‘free markets, or ‘optimum outcomes’ in “Wealth of Nations”.

Smiths remarks about markets showed he understood them as varying from their ‘natural prices’ through the oscillations of their ‘market prices’. There were as many markets as there were goods in different ‘neighbourhoods’. Smith never used the metaphor of the invisible hand to ‘describe’ such a model.

Indeed, his use of the metaphor was not related to markets at all – it was used (once only!) to comment on individual motivations expressing preferences to trade locally rather than abroad for the security of their ‘capital-stock’ having unintended consequential effects on local growth.

The assumptions about general equilibrium models, perfect information, and free markets remain just that: assumptions as a prelude to a demonstration of mathematical elegance, in the manner of John Nash’s theory of the ‘Bargaining Problem’ (Econometrica, 1950).

These assumptions are unlikely to apply in real world markets (despite which, sorry chaps, you still have to learn about General Equilibrium models and demonstrate your understanding in your examinations).

I agree with Joseph Stiglitz “the reason that the hand may be invisible is that it is simply not there—or at least if it is there, it is palsied.” Now, if only more academic tutors would ditch the nonsense that Smith had something real in mind in his use of the Invisible Hand metaphor (first used by Shakespeare in 1605 and Defoe in 1722) and the belief that it had anything to do with markets, then fewer students would pass on this myth to the next generation.

[Read the interesting report at:}


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