Tuesday, July 26, 2011

Adam Smith On Bargaining (Again)

Philip Pilkington writes on Naked Capitalism (HERE):

In a part of his piece, Philip Pilkington, a journalist living in Dublin, makes a strong case that is worth reading in its own rights (follow the above link) against neoclassical economics, especially in the form of rational expectations theory, but he also links neoclassical theories, originating in the 1870s and in ‘marginalism’, to Adam Smith’s (died 1790) alleged complicity in neoclassical doctrine, largely based on its applying elementary calculus from imagined (heroic) assumptions about individual maximising behaviours under the guidance of a so-called ‘invisible hand’, and at once buys into modern, deeply flawed and utterly false assertions about the IH metaphor in Adam Smith’s thinking. This is a sample:

Philip Pilkington: Neoclassical Dogma: How Economists Rationalise Their Hatred of Free Choice”

“Rational expectations theory expects people to act, well, rationally. More specifically it assumes that people always act in order to ‘maximise their utility’ and that such actions result in optimal behaviours that ensure that prices are always perfectly in keeping with what they ‘should be’ – that is, an equilibrium price that perfectly balances supply and demand.”

Whatever relevance this paragraph has for rational expectations theory it has absolutely no relevance for Adam Smith’s theory of ‘market’ and ‘natural’ prices (WN Books I and II). Smith did not have an equilibrium theory of prices – quite the opposite! Disequilibrium was a more noted feature of markets, within which its powerful affects work through. Not only did Smith's explanation of ‘natural’ and ‘market’ prices 'gravitate' towards each other, but they do not necessarily (if ever) meet in a durable equilibrium. I refer to his explanation claim that his description of the real word, though it does express an important feature of it in the minds of buyer's and sellers, which is buried within it and mostly overlooked in price theory.

By ‘natural price’, Smith meant a price that covered a product’s costs plus a profit. The price that covered its costs often varied from one ‘neighbourhood’ to another. In the real world described by Smith a single stable market price did not exist. By ‘market price, Smith meant the ‘actual price’ at which a commodity was sold, which may be above, the same as, or below its ‘natural' price. Sellers do not always get the price that they want because they are not in unilateral control of exchange prices when they negotiate prices with buyers.

When economists dropped Smith's distinction between ‘natural’ and ‘market’ prices we may have gained in succinctness but we lost an important distinction that lies at the root of the frustration of planned outcomes, particularly the outcomes of bargaining in real markets between real buyers and real sellers, who are not present in the mathematics of price among sellers and buyers. Buyers are uninterested in a seller’s costs but sellers are constrained in their bargains by their costs which they hope (intend) to recover, which they have already expended, and by the profit that sellers hope (expect) to gain. Buyers hope to achieve lower prices than sellers hope to achieve.

Smith summed the offered bargain: ‘Give me that which I want and you shall this which you want’. The bargaining problem is that both the buyer and the seller can (and do) seek exactly the same form of the bargain yet each side’s idea of the content of the bargaining offer the hope to achieve can (and usually is) quite different from when the offer with which they open the negotiation. That difference is the agenda for their ‘higgling and haggling’, which is a process considered (rightly) to be widespread both in bargaining (WN) and in general persuasion (TMS).

Smith advised each bargainer to each ‘address’ the other’s ‘self love’ (not their own!) and ‘never to talk to them’ of their own ‘necessities ‘ but of the ‘advantages to the other of concluding a bargain (WN I.ii.2: 26-27). Sellers receive considerable, regular, and mainly expensive, training in the appropriate language, deportment, and manners of the selling process. Major buyers also receive training, though in my experience this less intense and less expensive than accorded to sellers.

Just why the outcome of all the myriad bargains occurring each day (hour!) should provide a single and distinct ‘equilibrium’ price all along all of the supply chains is not evident, except by heroic assumptions. Truly a triumph of credulity over observed experience, observed in a classroom, but not in the real world among business negotiators. Anybody believing that there is an equilibrium price for something does not undertake much bargaining.

Adam Smith's brief treatment of the bargaining process was succinct and closer to events in the real world than much of the mathematical attempts of neoclassical economists, including the efforts of Edgeworth's box diagrams and the coercive sanctions and convergence focus of theorists from Zuethen and Hicks in 1931, and Nash, Pen, Shackle, Harsanyi, Cross, Coddington, plus many others from the 1950s onwards.



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