Tuesday, August 13, 2013

Regulating the ‘Invisible Hand’

Regulating the "Invisible Hand'

The ‘invisible hand’ has come to imply the idea that the pursuit of narrow self interest by individuals results in the best social outcome.  Adam Smith, who first used the expression, more narrowly applied it to the concept of markets: “specifically that it is competition between buyers and sellers that channels the profit motive of individuals on both sides of the transaction such that improved products are produced and at lower costs.” http://en.wikipedia.org/wiki/Invisible_hand

The generalized idea is not valid.

In general, action by the members of a society must not only be self seeking, it must promote the well being and goals of that society. To put it in economic terms: Society must profit, and the action of individuals must, in that respect at least, be virtuous. Indeed, every prosperous and stable society has elevated the idea of virtue among its citizens, and devised means to encourage it.  Those most esteemed were those who contributed the most to society.  They were those who were held to be the most virtuous, and received the greatest rewards.  Those who were merely self serving were held in contempt, what ever their material income.

While an individual person may or may not be inclined to virtue, a corporation, however, cannot be virtuous, unless forced by law and circumstance of competition.  Only the pressures of competition make a productive corporation stay productive, that and the force of law required to make the corporation internalize its costs. 

For instance, we hear about banks, and other corporations, ‘socializing costs while privatizing profits.When this happens, it is no longer certain that the activities of the corporation are actually of benefit to the economy.   These activities may actually harm society, that is make society poorer, and everyone, on average, worse off.  (Though the owners and some of the employees of the corporation may, of course, be better off.)  Indeed, it is always the case that society is the poorer when the externalized costs are greater than the profits the corporation makes.

For the act of production requires the internalization of cost. The very act of production requires the benefits of production outweigh the costs, and if many of those costs are externalized, their weight is no longer determined by the market.  Thus, while the corporation may reap a profit, the costs to society may outweigh the benefits society receives.

This can be seen from the fact that, when all costs are internalized, the net benefit a company makes to society is equal to that company’s profit. That is, society comes out ahead by the profits of the company. If, when all costs are internalized, the company breaks even, then society breaks even.  But if costs are externalized and the company breaks even, then society pays these costs, and loses.

The profits a company makes are what society is willing to pay the company above the company’s costs.  (Note that in a situation with perfect competition, where there are no profits, there is no growth.)  If society is not willing to pay the company above its costs, its activity is only of use to society to maintain society, and the company itself, in their current state of economic activity. The company makes no profits, and does not grow, and society does not grow. 

If costs are internalized, and the costs are greater than society is willing to pay, then society will cut back on that activity.  That is the company is operating at a loss, and it will contract. 

If there are any externalized costs, and these are less than the total profit, then society will grow at a rate less than the company. 

If externalized costs are greater than the profit, then the company will grow, but society will contract. 

Now  the officers of a corporation can only pursue that corporation’s narrow profit.  In a free but limited market, this may yet be beneficial to society.   However, producing corporations are at a competitive disadvantage to corporations which do not produce, but manipulate the economy to enhance their collection of rents from that economy.  Corporations which do not produce need have no real costs, except those they inflict on society for profit. 

Given the opportunity, then, the officers of a corporation must externalize, or socialize, costs, where it increases profits, no matter the harm inflicted on the larger society.  Thus there is always the pressure on a corporation to change into something which is non-productive, a rent collecting corporation, and a parasite on society.    

And while the producer, constrained by competition, might be virtuous naturally, the monopolist and the rent seeker will not be.  The monopolist, unconstrained, will provide a service, perhaps essential to that society, at a cost that society may ill afford, a cost possibly greater than the benefit that service provides.  The rent seeking corporation will extract resources from society without net benefit to that society.

Regulation is necessary, and should be designed to force corporations to internalize costs, which would otherwise be externalized, and discourage the collection of rents, or excess profits. (And one might argue that that is all regulation should be designed to do.  One might also argue that the conservation of stocks of resources is a separate reason for regulation, although this might be under the cover of internalizing all costs.)

Where these costs cannot be directly internalized, they should be countered by government activity, supported by corporate tax. 

Since regulated industries are less competitive, they should be protected against unregulated, and subsidized, competition, especially foreign competition, by tariff, if needed. Indeed, failure to do so results in an economic race to the bottom.  Domestic producers are forced to externalize costs onto their society, or go out of business. This process is essentially the taking of resources out of the market, destroying it. It is the exportation of demand.

A nation should in any case be more concerned with securing its domestic market for its own industry than securing foreign markets.  All countries cannot be net exporters, but all countries can balance their trade. 

Virtue is corrupted where virtue has become a measure of success at self-serving.  A society requires its members to include social costs in the calculation of their profit in order to survive, (since society as a whole must also make a profit) and corporate society, a la Milton Friedman, cannot do this. See:  http://anamecon.blogspot.com/2012/06/milton-friedman-social-responsibility.html

The expansion of the idea of markets to other activities of society is destructive to those activities. And those activities are essential to the function, and even the identity, of society.

Indeed, the idea of the self-serving ‘invisible hand’ is inadequate to explain the stability and persistence of societies. Virtuous behavior, in particular on the part of a society’s leaders, is required for that society to maintain itself and prosper.   Since it may be impossible for the law, even where not co-opted, to restrain corporate behavior, in particular the indiscriminate externalization of costs, the corporate state may be unstable, and incapable of sustaining itself in the long, or even the medium run. The structure of corporations, and their place in society, far from encouraging virtue, may even exert a corrupting influence on their officers, who are also many of society’s leaders.  This is especially true as society’s competitive structure is increasingly replaced by oligopolistic and monopolistic structures.  These structures naturally seek rent and externalize costs.

Unlike people, corporate persons, except as they are constrained by law, cannot be good citizens.  Thus, if the law is inadequate to constrain them, 'Corporate Society' may only exist as a transition state to a decapitalized future.

Regulation may be inadequate to secure the future, but it is nonetheless necessary.


  1. “greg” appears to be familiar with a load of economic ideas, which suggests a familiarity with economics of that most college graduates would be proud, but in my view he is woefully misled by his reading of Adam Smith’s ideas.
    The facts: Adam Smith was not the first educated writer to use the “invisible hand” metaphoric figure of speech. It was widely I circulation in the 17th and 18th centuries, and was in evidence in even earlier times, mainly from its association with theology and occasional dramatic contexts (Shakespeare among others).
    Adam Smith did not more narrowly apply the IH metaphor “to the concept of markets”. In fact he did not mention its role in markets at all in any of the three (only) occasions in which he used it. He certainly used it in a narrower context than today’s more general assertions as to what he referred to or meant. Warning: Wikipedia is not always reliable!
    I suggest politely that “greg” look up where Smith used the “invisible hand” in “Wealth Of Nations” (Book IV, chapter 2, paragraphs 1 to 9, pages 252-56). Smith referred to a merchant who was concerned about the security of his investments if he sent them abroad and therefore decided to confine his investments to “domestic industry” only. It was his desire for “security” that motivated his decisions to invest locally, and his motivations were invisible to others of course; we cannot see into another person’s mind.
    Smith chose to describe the merchant’s motivations “in a more striking and interesting manner” by using the IH metaphor, which conforms to Smith’s own definition of the use of a metaphor in English in his “Lectures on Rhetoric and Belles Letters” that he delivered at Glasgow University (1751-64), and previously at Edinburgh from 1748-51. It also conforms to the definition of metaphors in the definitive Oxford English Dictionary (and in all US dictionaries I have seen).
    Now the motivations (the cause) of the individual merchant’s actions resulted in “unintended consequences” (the effect). Quite simply the merchant’s domestically invested capital arithmetically added to the annual amount of domestic “revenue and employment”, which Smith regarded as a “public benefit” (simply: the ‘whole is the sum of its parts’). Nothing more complex than that!
    It had nothing to do with “competition between buyers and sellers that channels the profit motive of individuals on both sides of the transaction such that improved products are produced and at lower costs.” That is a 20th century myth about Adam Smith’s use of a simple metaphor; it had nothing to with general equilibrium, nor Pareto’s theorem, nor any of the other invented constructions placed upon it by modern economists.
    In greg's" second paragraph, Adam Smith never suggested “self interest” was about “self seeking”. Self-interest must be realised through what modern theorists call “other regarding” behaviours. The individual “butcher, brewer and baker”, in his famous example, also had individual self-interests as sellers as well as the person seeking to buy her dinner goods. Smith specifically advised the buyer to “address the self-love” of the sellers and not to talk only of her “own necessities”. Smith called this “bargaining”.
    In short, each party must persuade the other by mediating their self-interests to find a compromise on the initial asking and offer prices acceptable to both of them: “Give me that which I want and you shall this which you want”. (see WN Book I, chapter 2, paragraphs 2 ad 3, pages 26-27) and also various references in Smith’s “Moral Sentiments” to moral persuasion.

  2. Thank you, Gavin. I appreciate your criticism, and your spirited defense of Adam Smith, and will try to respond constructively.

    However, I did not intend to imply, and I do not think that I did, that my first sentence was Adam Smith's position at all. Or that he ever suggested "self interest" was about "self seeking."

    Indeed, my intent was to disassociate his position, (as incorrectly expressed in Wikipedia) from the "idea that the narrow pursuit of self interest by individuals results in the best social outcome."

    I regard one's "self interest" as necessarily including the interests of one's society. I do not claim that this is done by eschewing profits, or necessarily "trading for the public good."
    But I do claim it is necessary for a company to internalize all costs. When all costs are internalized, the profits of a company are the measure of the net benefit to society of the company's activities. It is how much society comes out ahead. When costs are externalized, it is not certain that society is any better off for the company's actions.

    I stand by my position on the necessity of virtue in a society, and the impossibility of corporations, unconstrained, to practice it.

    As for the necessity of virtue, let me quote Adam Smith: Book 4, Chapter 7 Part III (pretty far into it):

    "...But besides all the bad effects " (of monopoly) "to the country in general, which have already been mentioned as necessarily resulting from a higher rate of profit, there is one more fatal, perhaps, than all these put together, but which, if we may judge from experience, is inseparably connected with it. The high rate of profit seems everywhere to destroy that parsimony which, in other circumstances, is natural to the character of the merchant. When profits are high, that sober virtue seems to be superfluous, and expensive luxury to suit better the affluence of his situation. But the owners of the great mercantile capitals are necessarily the leaders and conductors of the whole industry of every nation; and their example has a much greater influence upon the manners of the whole industrious part of it than that of any other order of men. If his employer is attentive and parsimonious the workman is very likely to be so too; but if the master is dissolute and disorderly, the servant, who shapes his work according to the pattern which his master prescribes to him, will shape his life, too, according to the example which he sets him. Accumulation is thus prevented in the hands of all those who are naturally the most disposed to accumulate; and the funds destined for the maintenance of productive labour, receive no augmentation from the revenue of those who ought naturally to augment them the most. The capital of the country, instead of increasing, gradually dwindles away, and the quantity of productive labour maintained in it grows every day less and less. Have the exorbitant profits of the merchants of Cadiz and Lisbon augmented the capital of Spain and Portugal? Have they alleviated the poverty, have they promoted the industry of those two beggarly countries? Such has been the tone of mercantile expense in those two trading cities, that those exorbitant profits, far from augmenting the general capital of the country, seem scarce to have been sufficient to keep up the capitals upon which they were made. Foreign capitals are every day intruding themselves, if I may say so, more and more into the trade of Cadiz and Lisbon...."

    "...It is thus that the single advantage which the monopoly procures to a single order of men, is in many different ways hurtful to the general interest of the country."

    I'm no expert on Adam Smith. I got lucky. And I will heed your warning regarding wikipedia.

    Crossposted to: Adam Smith's Lost Legacy http://adamsmithslostlegacy.blogspot.com/