Wednesday, May 26, 2010

On the Genesis of the Myth of the Invisible Hand, no. 7

David Begg, Stanley Fisher and Roger Dornbush Economics (1984) New York: McGraw-Hill (British Edition of a popular US text)

‘The Invisible Hand’

‘Smith argued that individuals pursuing their self-interest would be led “as if by an invisible hand” to do things that are in the interests of society as a whole …
Smith argued that the pursuit of self-interest, without any central direction could produce a coherent society making sensible decisions’ (p 11-12).

‘Market Failure
We begin by showing that in the absence of any distortions a freely competitive equilibrium ensures allocative efficiency. We use the term market failure to cover all circumstances in which equilibrium in free unregulated markets (i.e., markets not subject to direct price or quality regulation by the government) will fail to achieve an efficient allocation. Market failure describes the circumstances in which distortions prevent the invisible hand from allocating resources efficiently” (333).

‘If every market in the economy is a perfectly competitive free market, the resulting equilibrium through out the economy will be Pareto-efficient. Formulating Adam Smith’s remarkable insight of the Invisible Hand, this result is the foundation of modern welfare economics’


Assertions do not a theory make.

Smith did not link the metaphor of an invisible hand to perfect competition (a 20th-century idea unknown to Smith; his ideas from 17th-century moral philosophy on ‘natural liberty’ are often confused with modern ideas of perfect competition).

His examples of the invisible hand were from anything but competitive economies. In Moral Sentiments he referred to ‘rich landlords’ having to feed the ‘thousands whom they employed’ under feudal conditions (they had no choice but to do so – whom else would labour in their fields under feudal – and pre-feudal – tutelage? Those times were not competitive labour markets nor competitive employers.

In Wealth Of Nations he referred to merchants in 18th-century, mercantile Britain who preferred to invest at home – investing abroad carried higher risks – and they did not operate in perfectly competitive markets. Quite the reverse: the Guilds and Incorporated towns, the Settlement Acts, the Apprenticeship Statutes, the Poor Laws, the tariff regimes, prohibitions and the Navigation Acts, were nowhere near perfectly competitive institutions. Smith was referring to these merchants in these circumstances and only lack of knowledge of the context could lead modern economists to link the metaphor in Smith’s name to perfect competition and Pareto-welfare theories.

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