Wednesday, July 07, 2010

General Equilibrium and the Myth of Invisible Hand

‘endeavour15’ writes on Article
Properties of a Competitive General Equilibrium HERE

These conditions are obviously an idealized situation. But were such an economy to exist, it would be one in which Adam Smith’s invisible hand could rule without any impediment from externalities or imperfect competition.
 For this economy, we can describe consumer behavior and producer behavior and then show how they dovetail to produce an overall equilibrium. First, consumers will allocate their incomes across different goods in order to maximize their satisfactions. They choose goods such that the marginal utilities per dollar of expenditure are equal for the last unit of each commodity.

The original source of this connection between Adam Smith’s use of the invisible hand metaphor and general equilibrium was Paul Samuelson in his popular text, ‘Economics: and Introductory Analysis’, McGraw-Hill, 1948 (19th edition, 2010).

The connection had absolutely no basis in anything written by Adam Smith (see Kennedy, G. 2010. ‘Paul Samuelson and the Invention of the Modern Economics of the Invisible hand’, Journal of the History of Ideas, forthcoming, December, 2010).

The metaphor had nothing to do with perfect competition, or anything like it. Smith used the metaphor once only in Wealth Of Nations and once only in Moral Sentiments, and in neither case, it had nothing to do with markets.

‘Rich landlords’ in pre-commercial society fed their serfs and retainers from the produce of their fields because they had no choice – starving peasants could not work the landlords’ land; some, but not all traders preferred to use their capital domestically in 18th-century Great Britain which was riddled with the mercantile competitive restrictions of and direct prohibitions on we now call ‘mercantilism’ (chartered monopolies in every town, tariffs and direct prohibitions on imports, restrictions on the mobility of labour, prohibitions on settlement outside the parish in which labour was born, prohibitions on engaging in trades without serving 7-year apprenticeships, and the Navigation Acts monopolising British foreign trade), none of which are remotely competitive, let alone ‘perfectly so).

For General Equilibrium to operate in maths, it cannot operate in real world. There is no ‘invisible hand’; Adam Smith used is as a metaphor for ‘necessity’ and ‘risk aversion’.

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