PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 3

 - Counting the Fingers of Adam Smith's Invisible Hand


Professor Rae introduces Adam Smith’s notion of the “invisible hand” of the market. Several preconditions must be met for the invisible hand to work. Markets must be open, and there cannot be just one buyer or one seller who can control product prices. No producer can hold a pivotal private technology, and there must be more or less truthful information across the whole market. Governments must enforce property and contracts. However, many of these preconditions are at odds with the Porter Forces, which represent general rules of thumb, or principles, for a firm trying to make above average profits. These principles include avoiding direct competition, establishing high barriers to entry, and avoiding powerful buyers and powerful suppliers. Professor Rae suggests that submission to Adam Smith’s invisible hand may be contrary to basics of corporate strategy. Corporations can leverage powerful political influence to affect the movements of the “invisible hand.” Guest speaker Jim Alexander, formerly of Enron, discusses problems of very imperfect information, as well as the principal-agent problem. Professor Rae also discusses Adam Smith’s complicated ideas about self-interest and morality.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 3 - Counting the Fingers of Adam Smith's Invisible Hand

Chapter 1. Course Recap [00:00:00]

Professor Douglas W. Rae: Since we are still in the shopping period and some turnover, I thought it might be good if I spent the first three or four minutes recapitulating from meeting one, and then a little more on meeting two, and then we’ll feather that into today’s topic, which is the great work of economics, and the great — the greatest and most thoughtful normative tract about markets and capitalism. I will — I’ll begin, as I said, with a recapitulation. Then we’ll talk about some basic components of Smith’s argument, then I’ll turn the slides off for awhile and we’ll talk informally, and I’ll include Jim Alexander in the conversation about the way Smith and Smithism plays out in today’s world, and how it contradicts in many respects what the great man actually said and meant to say.

Before meeting two, meeting one. Meeting one really just said this: That the enormous surge in human wealth over the past 250 years has a great deal to do with capital, with the intelligent use of accumulated wealth in fresh production. That capitalism is a subset of the ways you can use capital, even socialism uses capital, even fascism uses capital, even squirrels and spiders in some sense or another use capital. But capitalism is the subspecies where wealth accumulated is deployed so as to create new wealth, and to do so in a competitive environment. And that second piece, capitalism, was not invented by some smart guy like Adam Smith, but rather evolved organically by trial and error, by experimentation, by failure.

Indeed, if you look at a market society, one of its great features is that its history is littered with failure. Learning to analyze past success and past failure becomes a key part of it. That’s the — one last point, and the “ism” in capitalism is not something, which originally was invented by its friends, by rather by its enemies. It was Marxism and other left wing movements in the early and middle nineteenth century whence the rhetoric of capitalism appeared. Indeed the word had no appearance whatever before that era.

In meeting two we looked at the kinetic structure of the world economy. With this Hans Rosling diagram animated, it’s still today, but animated so that life expectancy and income per capita could be seen moving dynamically across years, we discovered that the typical story is a surge north in the diagram, representing increased life expectancy, with slow progress in income per capita, and then a surge around the horn, so to speak, into the area upper right of long lives and relative affluence. And I asserted, and many of you agreed, that there’s something unambiguously good about that change, that the world is a better place because that change happened.

Now I didn’t in the lecture lay any great stress on the caveats that people might attach to that. One of them is that it was accomplished, in considerable measure, through capital intensive industry, and highly capital intensive forms of transportation. And that these were, first of all, disruptive of the natural environment. There could be no doubt whatever that the revolution in the world economy left the planet more fragile than it found it. Indeed, poverty is a marvelous environmental policy, because where there is no demand there is very little disruption.

Now we also looked at the world demographic transition. The world demographic transition, representing changes in rates of birth and death, death here in purple and birth in green, and the old Malthusian world, which still exists on parts of the globe but hasn’t existed in the western world for a couple of hundred years, was characterized by very high birthrates and very high death rates. So you have essentially static total population, and very few people lived to be old. Then you have the change in the death rate occasioned by infrastructure, most of all, related to clean water. And when the death rate falls, the birthrate doesn’t track with it. The birthrate lags in its change so there is a period, Phase II here, when deaths are falling sharply and births are statically high. In that period you get an enormous surge, you get indeed population growth at an increasing rate. You get the spike, which brought world population to its present level, is occasioned largely by Phase II. Phase III is the period during which the birthrate adjusts to the death rate. You still get growing population, but now at a diminishing rate. At Stage IV there’s an equilibrium between births and deaths, and both have lower rates. So population is again static, and lives are much longer.

Underneath that process, and this I merely hinted in meeting two, is a surge in the supply of labor, which occurs in Stages II and III and creates a buyer’s market for employers. And by creating a buyer’s market for employers it drives down wages. Real wages are really quite low during Phase II and Phase III in the history of the country. Capital, which is only in part related to demography, it has an independent life of its own, but capital begins to appreciate and be agglomerated in large quantities only late in this history. The places where you get huge build up of capital are typically places which are beginning or well into Stage IV, and if you want to be precise about it there is a Stage V, which is where the birthrate has actually fallen below the death rate, so that, as with Japan, Italy, Russia, and much of Eastern Europe, you have falling total population.

Now there is another aspect to this that we’ll pick up a month from now, which has to do with the age profile of the existing population. You can yourself what percentage of all the people in the country are of working age? You can figure from that a so-called dependency ratio. How many people too old to work and too young to work have to be supported by those who can work, who are of working age? And that ratio turns out to be a big determinant of economic growth. Whereas with China today, Ireland in the very recent past, you have a demographic sweet spot where there are relatively few old and young people, and almost everybody is in the working years. It’s — that’s a really low resistance profile. And then at the other side, the Japanese, where the number of elderly people who need to be supported is out of proportion to the size of the actual workforce.

Beneath this — these curves related to capital and labor are just a few other things you want to think about. One is that you get much higher incomes in Phase IV than in earlier phases. It’s partly because of capital concentration, but it’s also because human capital in the form of trained ability, educated people, it becomes much easier to build a massive educational apparatus, a formal apparatus, and also an applied apparatus in the workforce where in 40 years of working in a given trade, people get really good at it. So that — that’s another way in which the later stages of the world demographic transition are profitable, quite literally, to a country. Inequality tends to be highest in the emerging markets, because typically what you get is a mass of very poor people, and relatively small elite, which has found its way into capitalist development.

Labor abundant, capital scarce, we talked about that. Insourcing and outsourcing, this is a very obvious point; Stage IV countries outsource tasks to Stage II and III countries because labor is much cheaper. The obverse of that is insourcing at the other end. And the main movement in Stage II and III countries actually has two parts: One is from countryside to city, because the opportunities of capital intensive enterprise are concentrated in cities; and from an out of Stage II and II countries into Stage IV countries. This is a classic pattern, which is highly visible today with the borders of the United States and Europe being crowded and not entirely controlled. And it was the same story 100 years ago, when southern and Eastern Europe were in Stage III and the United States was approaching Stage IV and immigration was enormous. My own family, on my father’s side, were immigrants in the early twentieth century.

Chapter 2. When Is the Invisible Hand Truly Invisible? [00:13:19]

Okay, so Smith’s invisible hand. The question is: If its invisible how can we know it’s there? There are various — there are several good New Yorker cartoons about that problem. One shows a group of well-dressed people gathered in a farm field Darien Connecticut looking out with binoculars to find the invisible hand, which has been reported to have appeared there. Another is a store with a sign across the front, “Store closing,” and then a caption under the “store closing” sign: “Bitch-slapped by the invisible hand.”

The condition under which the invisible hand works is actually — there are several things that have to be there for it to happen and let’s just kind of inventory those. First is, you have to have an open market. It has to be a market where people can come in and begin to produce, or arrive and begin to consume. If it is regulated, for example, by tariffs or by a mafia, then that is the visible hand, and the invisible hand is blocked from its work. There needs to be no seller big enough to drive down — to control prices by, say, withholding product. There needs, third, to be no buyer — I’ve left out a step — no seller and no buyer able to control prices. What would make that — what kind of distribution of production and buying would be required to do that? Somebody near a mic. Got a mic?

Student: A monopoly.

Professor Douglas W. Rae: A —

Student: A monopsony and a monopoly.

Professor Douglas W. Rae: Okay, those are the things you don’t want if you want the invisible hand to work, right? What you want is somebody else?

Student: Perfect competition.

Professor Douglas W. Rae: Yes?

Student: Perfect competition.

Professor Douglas W. Rae: Okay, and perfect competition occurs when what?

Student: When no buyer is big enough to control the market.

Professor Douglas W. Rae: Okay, but that’s circular. So we need to put one step in between there.

Student: When prices are independent. So the market itself sets the price.

Professor Douglas W. Rae: Well let’s work at this. I showed a picture when I started this of a wheat field and I didn’t show a picture of a car factory or Microsoft. The key fact is that you have a fine grain division of production and consumption so there are thousands and thousands of producers, thousands and thousands of consumers, no one of them big enough to game the market. If you’re making — if you’re producing wheat or rice, and you say, “The world price is too low. I’m going to drive it up by withholding this year’s crop from my 100 acres,” that’s like, “Hit my hand,” because you have no market power. No producer holds a pivotal private technology. And it’s pretty obvious what’s meant by that; a patented technology, or a trade secret which allows one producer to differentiate him or herself from other producers and dominate the market. There are the buyers. And perfect information, more or less truthful information across the whole market, and government to enforce property and contract.

So with all those conditions in place, what Smith says about the invisible hand is, more or less, true. Let’s see if I can find the quote. He talks about producers who are in this, “And many other cases, led by an invisible hand to promote the end, which they have no part of in intention. By pursuing his own interest, he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good to come from people trading in the name of the public good.” The — on both the producer and the consumer side, there is a peculiar power vacuum. There is no one who can be said to have set the price of the good or determined its quality. It is decided collectively, and the Smithian idea there is actually the idea of general equilibrium in a market economy. The next phase of economic theory, neoclassical economics, formalizes this idea and makes it mathematically precise, and we’ll look at it in a little while, but here it’s important, first, just to get the context in which Smith writes about the invisible hand in The Wealth of Nations. Anybody able to provide us with the exact point he’s trying to prove? Is there a hand somewhere? You’re trying to set this guy up, I know that. Was there? Wave it please. Yes, you need the mic. Come on, guys, we got to manage the mic better. Where is it?

Student: [inaudible]

Professor Douglas W. Rae: Just — it doesn’t work without the mic. Would one of you guys, just, kind of, stay standing and get it to people?

Student: [inaudible] point that nations shouldn’t impose tariffs.

Professor Douglas W. Rae: Okay, he’s arguing against tariffs and for free trade, right? And why do — why is that an argumentative point for him? Why are there tariffs?

Student: Because the nations thought that they were protecting their economies by enforcing [inaudible].

Professor Douglas W. Rae: Okay, and who were they helping to reach that — who helped the nations to reach that conclusion?

Student: Other economists?

Professor Douglas W. Rae: Well, yeah, sort of. I’m fishing for something a little different. Let’s pass the mic over to — is it “The violin question?” “The viola question;” okay, my wife is a violist.

Student: Well, I guess the predominant economic philosophy at the time when Adam Smith was writing was mercantilism —

Professor Douglas W. Rae: Mercantilism, yes.

Student: [inaudible] mercantilism, which is, you know, accumulate as much gold as possible; become the richest, you know, individual through that regard, which means, you know, not really importing much, and thus, really focusing on supporting domestic development.

Professor Douglas W. Rae: Okay, good, that’s excellent. Smith was anti-mercantilist. He was a free trader. And the people who had a concrete interest in tariff imposition — who would have a strong self interest in that? Let’s get the mic over here. I think one of you TAs really needs to just stand up and MC the thing.

Student: Domestic merchants and manufacturers.

Professor Douglas W. Rae: Well, certainly manufacturers, right? Domestic manufacturers, who are in some way or another, not competitive with imports. And Smith has this wonderful passage, I think it’s near this, where he talks about how you could, in Scotland, produce good wine. You’d have to have hot houses and many other special and very expensive accoutrements. But for about thirty times the price — the production price of France, Spain, or Italy, you could produce Scottish wine. But it would be a foolish betrayal of the public interest to put up a tariff so that you could then sell that wine, worth $2, for $200. And that’s the center of his argument, right. He begins at the micro level with the butcher, the baker, and the brewer, which is a metaphor that rings true for most of us, right? Why is the produce fresh in the little market on Orange Street in New Haven? The main reason is because there are two little markets in New Haven. If it were just one, thirty-six hour old lettuce would be marketable. But with two, one of whom drives to New York every morning at 3:00, that just doesn’t work. So that Smith talks about the self-interest axiom as the driver for promoting the common good.

Chapter 3. Smith and Smithism in Today’s World, with Jim Alexander [00:23:48]

Now I’m going to invite Jim Alexander to come on up and we’ll just stand and — let’s actually sit and talk. Some of you have been introduced to Jim Alexander, and for others, I’ll introduce him now. Jim is a good friend, and was — had a twenty year career in investment banking, and after that a stint as Chief Financial Officer of Enron Global Power & Pipeline, which was indeed one of the famous partnerships in the Enron meltdown. He was a straight shooter; as the best book on the Enron meltdown calls him, the “fly in the ointment,” and went off to co-found Spinnaker Exploration, which later became a public company. Jim is going to be part of this course from time to time and I thought maybe, to bring the discussion down from the clouds here, I would ask Jim: Is the ghost of Adam Smith alive in the boardroom in corporate America?

Jim Alexander: Well, the self-image of Adam Smith is alive. The ideology that would be espoused is that of Adam Smith. The substance is not there, I believe, but most of the people would pass the polygraph test that they believe it’s there.

Professor Douglas W. Rae: Okay, that’s good. Now let’s — here’s an interesting exercise. There are about a dozen MBAs in the group here. Every MBA — every MBA period, has learned the Porter Forces. What are the Porter Forces? The Porter Forces are the rules of thumb you need to make above average profits within a firm. One of them is: You don’t want too much competition — direct competition. Direct competition erodes profits. You want high barriers to entry. You don’t want powerful buyers who can drive down your price through negotiating. For example, tire companies face very powerful buyers in automobile manufacturers. You want to avoid situations like that. You also want to be able to control your suppliers so they can’t see you making profits and then demand their share. Now just think for a second. How do the Porter Forces align with the conditions that I sketched five minutes ago for the operation of the invisible hand? In the back, you’ve got to be really loud because the —

Student: They’re the exact opposite.

Professor Douglas W. Rae: They are essentially the exact opposite. The name in business speak for operating under the control of the invisible hand is “commodity hell.” Commodity hell being that you’re producing something which thousands of other people can produce, and they can produce it as cheaply and as well as you can, and so the available pricing strategies to you are — none of them involve high profits. One of the fundamental axioms of business management — and I’m not making a moral condemnation, I’m just making an observation that there is a strong tension here — that the pursuit of actual — the actual submission to the invisible hand — is contrary to the very basis of corporate strategy. Jim, talk a little from your experience about the intelligent use of the Porter Forces by management strategists — or unintelligent.

Jim Alexander: Well from the latter — but basically no one ever wants to get into an Adam Smith type of market, and if you’re in it, you get out of it. Because there’s — it’s ruinous. And the only way you can affect change in that type of market is to do what Adam Smith suggested, and that is make some sort of national security argument why — in fact, while Smith’s views are very well and fine in general, you need, and the country more especially needs, to have defense against foreign imports or ruinous competition. I think the sugar producers were able to pull that off pretty neatly and can make a national security argument for it for sugar quotas, but you never tolerate an Adam Smith level of competition.

Professor Douglas W. Rae: Okay, and if you look at — I ordered Thank You For Smoking, Christopher Buckley’s book, as an option for this course, but I’m told all of you have seen the movie, which I haven’t. Is the movie any good?

Student: Yes.

Professor Douglas W. Rae: Okay, you should all look at the movie. And the book is all about the way corporations, including those which make, in this case, cigarettes, booze, and firearms, but mostly cigarettes, have elaborate representation in Washington and promote their own interests through the law. It’s not a big surprise. But the tension between the idealized theory of the market and that practice is a very strong one. Incidentally, Smith was very critical of the corporations, which existed in his time, and he was critical of them for partly the reason we just articulated: That they can control pricing and impose their product by that method. But more, Smith thought, that the people running the corporations, which existed at that time were thoroughly incompetent. And that’s, of course, because the Yale School of Management had not yet been founded. In actual fact there is a fundamental problem about corporations and their management called the principal-agency problem. The gist of that problem is that managers, left to their own devices, will tend to take a company where — in a direction which is best for them individually and not necessarily for the broad body of shareholders, and so the control over that tendency gets to be one of the major dramatic themes in business life. Jim you’ve been near some management, which had rent seeking tendencies.

Jim Alexander: Well, let me come back to something else, and that is that at least one of the sections Smith has revolves around the butcher, the brewer, and the baker, and how it’s much more reliable to rely on their self interest than their benevolence, which is true. There is — I think there is an embedded assumption which he doesn’t go into, and that is: he cites examples of what are — at least at the time, where a single proprietor sort of business is marketing a product which was directly consumed by individuals who knew the proprietors well, and understood what good meat was from meat that wasn’t good. And that also is increasingly irrelevant since his time, because one of the most important things, I thought, in one of your slides, was that there be perfect information. And on top of that, an embedded assumption there is that there has to be perfect information perfectly understood.

Professor Douglas W. Rae: Absolutely.

Jim Alexander: In fact one of the — and having come from finance, it’s sort of the highest form of art is to have information which in retrospect can be defended as reliable, but prospectively is virtually meaningless. One of the ways we can — that it really becomes very important in practice, forget about Smithian ideals, is to make sure that you have colorable information, colorable voluntary transactions, but in fact, they are, practically speaking, not voluntary, and, practically speaking, not informed. On top of that you start having principal-agent issues. Let’s take the butcher, for example, one butcher in a little village deals with people he knows, so there’s social constraints, and there’s also — it’s fairly easy if it’s one butcher, to trace any illnesses that result. And he has a relatively unmarketable asset, which is his interest in his private butcher shop; very hard to sell, so he must count on long term profit maximization; not short term, but long term. Now let’s imagine that you had a — I don’t think (inaudible) processer is public at this point but let’s imagine that you had a butcher business which was owned by the public, controlled by a small group of managers. And furthermore let’s assume, and it’s actually a pretty good assumption, that you had a group of semi-knowledgeable mutual fund managers who rewarded people with huge gains in their share value if they were able, reliably, to hit their quarterly earnings estimate and punish them, of course, if anything went wrong.

Under those circumstances, assuming that the investing public really didn’t understand the dynamics of the business, and assuming that you could make satisfactory short term goals, maybe making 100 times the average income of the typical worker every couple weeks, then you would be incentivized, unless you were very risk adverse to, for example, being able to buy tainted meat and then be able to make some extra pennies, beat your numbers, get a big upgrade in your stock, if you have a lot of options you have a very highly leveraged wealth situation, then make enough money in the short term, where you could live — maybe buy a small country or live with gravy for the rest of your life on a basis which was sufficiently confusing that you’re unlikely to be prosecuted.

That’s my experience as to how it works. I realize that it’s a small sliver and it is oriented toward finance, which is the worst part of American business, but that’s in fact how I’ve seen it work. No theories, it’s just how it works, so people believe, and yet the same people who would do this would spout and believe every bit of it the same type of Smithian idealism you see here: the invisible hand. My experience is that the invisible hand typically is picking someone’s pocket, not creating value. And in fact, the last — I remember talking to the senior Republic staffer at The House Energy and Commerce Committee and making —

Professor Douglas W. Rae: Jim is, by the way, I believe you are a Republican.

Jim Alexander: Used to be.

Professor Douglas W. Rae: Okay.

Jim Alexander: Used to be; this is kind of why I used to be. I’m up talking to the lead Republican staffer at The House Energy and Commerce Committee and saying at one point that capitalism justifies itself by creating real, not illusory, value. To which he replied, “Well you’re nothing but a communist.” That, in fact, is the problem. Under Smithian assumptions about long-term honesty, long-term interests in real value creation, it worked perfectly. It’s just that when those assumptions start to erode, it turns into a nightmare.

Professor Douglas W. Rae: Okay terrific. Georgios, I’m going to call on you in a moment for a one sentence read. Here’s the proposition that we now want to look at. Smith — here’s an apparent but not real paradox. Adam Smith says self-interest is the main motive for what people actually do. And yet, he led a life, which didn’t begin to maximize his own material interests. He lived modestly, he worked diligently, and he never became a wealthy man, so if he believed it for mankind, how come he didn’t practice it for himself? Well, Richard —

Student: I just wanted to add I think it’s probably the way you define self-interest. Self-interest to one person may not be the same to another, so while you just associate it with wealth and material goods, to someone else it’s not necessarily someone else’s definition of self interest.

Professor Douglas W. Rae: Fair enough, that’s a good point. The other side of it is that Wealth of Nations was Smith’s second main book, and it wasn’t the book, which made him famous in his own lifetime. The Theory of Moral Sentiments is the book, which made him famous in his own lifetime. And Georgios, will you read us, please, in good strong voice, the first sentence of Smith’s first book? Thanks very much Leslie.

Student: “How selfish, so ever, man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”

Professor Douglas W. Rae: Okay, now read it one more time.

Student: “How selfish, so ever, man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”

Professor Douglas W. Rae: Okay, so Smith actually believed that we were a complicated mix, and I think he’s right. He believed that there is a pro-social element in almost every human being. There is an innate sympathy for others, which almost everyone has, and at the same time, a tendency to feather one’s own nest. Now I don’t know anyone who is just one of those two things. I don’t know anyone who is a pure egotist.

Jim Alexander: Me.

Professor Douglas W. Rae: You do? My goodness; not even generous to his aged mother or —

Jim Alexander: What’s she done for him?

Professor Douglas W. Rae: Okay, well there may be some but there aren’t a hell of a lot. Smith — this is characteristic of Smith — Smith is not a dogmatist. Smith is a careful observer who draws as much from the evidence as is there. Now this is a map which links Smith forward to the next historical period, namely the period when world trade got serious, and the period, which we will discuss in Monday’s class, when Marx and Engels were writing The Communist Manifesto. The picture on the board is the world railroad grid, and if you think about Smith’s story about how wealth depends on the division of labor, it works only where you have a large market, and he makes that point at length. In the period, which begins in the middle 1800s, it really begins about 1840, in that period really large markets became accessible to everyone located in the dense part of the world railway grid. And toward the end of the semester, we’ll be dealing with the problem of economic development in places like these. If you look at the way the railroads developed there, they all developed to reach ocean ports for the export of products to world markets. The density of connection required for the internal development of large markets was by and large missing.

Okay, now — I think I’ll just finish with Adam Smith’s story about the pin making, and what happened in the pin-making story. I actually didn’t have you read this because it’s something everybody — I think everybody learns this one in high school. The division of labor for Smith is illustrated by a group of artisans making pins. One person gets really good at drawing the wire out straight, another person at hammering a head onto the wire, another person at making the point sharp, another person at polishing the shaft. And by division of labor and development of expertise, they can produce more pins of higher quality than a single artisan doing each of those operations by himself could possibly have done. It’s a good illustration. And if you think about all the professions and occupations in an economy, that kind of profiting — that way of profiting from specialized expertise is foundational to market societies, foundational to their wealth.

Now the actual fate of the pin machine is interesting, and personal to my family. It turns out that in 1831, a New York physician named John Ireland Howe began to tinker with the idea of making a machine where wire went in one end and polished pins came out the other in their thousands. By 1851 he perfected what was called the Howe Pin Machine. There’s a room in the Smithsonian to this day where a Howe Pin Machine sits and a movie of its operation goes on behind it. Well John Ireland Howe, I won’t brag again in this semester, was my five over great grandfather, and the family began pissing away the money right away, and completed the task just in time for my birth. The slides include a formalization of equilibrium theory with an Edgeworth box and indifference curves, and all that, but I don’t think we have time to do them here, and I urge you to review them before the midterm, on ClassesV2. On Wednesday — on Monday, rather, we’ll do The Communist Manifesto, and on Wednesday we’ll do Hayek and The Constitution of Liberty, so we’ll see two ends of the ideological perspective in a single week, and after that we’ll spend four straight weeks on business cases.

[end of transcript]

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