Tuesday, December 26, 2006

Wrong assumptions about Adam Smith Lead to Wrong Conclusions

If you start from a wrong assumption, you end with a wrong conclusion, sometimes masquerading as a complete muddle.

I found a clear example of this truth in a Blog: Civilisation Fanatics Centre, entitled:

“Adam Smith's pin factory vs. his invisible hand” by ‘WilJ’.

A few short extracts (I have quoted the relevant ideas from Wealth of Nations many times here and you may scroll back to read them, though Will J only quotes the division of labour on the pin factory and not the far more important division of labour example of the manufacture of the day labourer’s woolen coat), which I focus on his examples of the ‘contradiction’ that baffles him:

“What makes the system work is competition. All that is necessary for it to function smoothly is that everyone should be free to enter and leave the market, and change trades as often as he pleases---"perfect liberty," as Smith calls it. Intelligent self-interest will take care of the rest. People will seek to sell whatever they can at the highest price the market will bear, and buy at the lowest, and it will all balance out over time.Markets thus understood will, for the most part, be self-regulating, as a result of myriad little understandings of self-interested individuals in competition with one another. As every individual, therefore, endeavours ... to employ his capital ... so ... that its produce may be of the greatest value ... He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. ... [H]e intends only his own gain, and he is in this ... led by an invisible hand to promote an end which was no part of his intention. ... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

The problem is that the two fundamental theorems of Adam Smith lead off in quite different and ultimately contradictory directions.

These are the bifocals of Adam Smith. Through one lens, specialization (as in the Pin Factory) leads to the tendency we describe as monopolization. The rich get richer; the winner takes all; and the world gets pins, though perhaps not enough to satisfy its need for them. Through the other lens, the situation we describe as "perfect competition" prevails. The Invisible Hand presides over the situation among pinmakers (and all others).


“The problem is that the two fundamental theorems of Adam Smith lead off in quite different and ultimately contradictory directions. The Pin Factory is about falling costs and increasing returns. The Invisible Hand is about rising costs and decreasing returns. Which is the more important principle? When Paul Romer read back over the literature, he found that one of his teachers had seen the dilemma perfectly clearly as a young man. The problem is that the two fundamental theorems of Adam Smith lead off in quite different and ultimately contradictory directions


“The problem is, I don't follow his logic. I don't see any contradiction between the pin factory and the invisible hand. David Warsh is just a journalist, so I would have reason to be skeptical, except that George Stiger and Paul Romer (two major economists) also saw a contradiction.”

”On the other side of the paradox, I cannot see how the invisible hand necessarily implies diminishing returns to scale.”

and finally:

“There is no contradiction, as far as I can tell, between benefits from specialization and benefits from competition. Can anyone show me what I'm missing here?”

Read the full pirce plus comments at:


has bought the assertions of Stigler that Smith stated a ‘theory’, or ‘theorem’ even, about ‘an invisible hand’ and this ‘theorem’ (which appears to be neoclassical ‘perfect competition’) ‘contradicts’ the division of labour. From this association he finds himself trapped in a contradiction of his own( or rather George Stigler’s) making.

Fact: there is no ‘theorem’ of an invisible hand in Wealth of Nations. That is a construct built on a simple literary metaphor (again I have rehearsed the solid arguments to show this n + 1 times on Lost Legacy).

Fact: Smith did not advance the neoclassical theory of perfect competition (that came about 100 years later, out of Walras and Edgeworth’s mathematical work in search of ‘general equilibrium’ economics from their mechanical transfer of some early and now outdated mathematical models from physics).

Fact: the allusion to ‘an invisible hand’ (never ‘the invisible hand’) in Wealth of Nations was about the unintended consequences of risk aversion of merchants between investing their scarce capitals local, where they knew the people they dealt with and had confidence in the rule of law and justice versus investing it distantly abroad to import for sale locally, including in the carrying trade. He was not referring to markets, nor how they worked in Book 4, which subjects he had dealt with in Book I of Wealth of Nations.

His point was blindingly simple (so simple he did not express it other than in a literary manner):

The aggregate consequence of the actions of the individuals of which it is composed is the sum of the parts which each individual contributes to the total: if each individual maximizes his local contribution by directing all of his capital locally and not dispersing it abroad, the sum of the contributions of all those involved will be greater than otherwise. Smith’s metaphor reduces to the arithmetic whole is the sum of its arithmetic parts. Nothing more; nothing less.

WillJ gives himself a redundant contradiction in respect of Adam Smith, thanks to the fantasies of George Stigler and the Chicago Adam Smith he and his colleagues created.

Smith’s US counterpart bears little resemblance to the Kirkcaldy Adam Smith who lived just across the Firth of Forth from where I live, in a place called Edinburgh.


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