WEBVTT

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Prof: Since we are still
in the shopping period and some

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turnover,
I thought it might be good if I

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spent the first three or four
minutes recapitulating from

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meeting one,
and then a little more on

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meeting two,
and then we'll feather that

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into today's topic,
which is the great work of

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economics,
and the great--the greatest and

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most thoughtful normative tract
about markets and capitalism.

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I will--I'll begin,
as I said, with a

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recapitulation.

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Then we'll talk about some
basic components of Smith's

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argument,
then I'll turn the slides off

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for awhile and we'll talk
informally,

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and I'll include Jim Alexander
in the conversation about the

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way Smith and Smithism plays out
in today's world,

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and how it contradicts in many
respects what the great man

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actually said and meant to say.

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Before meeting two, meeting one.

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Meeting one really just said
this: That the enormous surge in

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human wealth over the past 250
years has a great deal to do

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with capital,
with the intelligent use of

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accumulated wealth in fresh
production.

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That capitalism is a subset of
the ways you can use capital,

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even socialism uses capital,
even fascism uses capital,

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even squirrels and spiders in
some sense or another use

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capital.

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But capitalism is the
subspecies where wealth

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accumulated is deployed so as to
create new wealth,

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and to do so in a competitive
environment.

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And that second piece,
capitalism, was not invented by

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some smart guy like Adam Smith,
but rather evolved organically

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by trial and error,
by experimentation, by failure.

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Indeed, if you look at a market
society, one of its great

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features is that its history is
littered with failure.

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Learning to analyze past
success and past failure becomes

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a key part of it.

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That's the--one last point,
and the "ism"

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in capitalism is not something,
which originally was invented

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by its friends,
by rather by its enemies.

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It was Marxism and other left
wing movements in the early and

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middle nineteenth century whence
the rhetoric of capitalism

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appeared.

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Indeed the word had no
appearance whatever before that

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era.

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In meeting two we looked at the
kinetic structure of the world

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economy.

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With this Hans Rosling diagram
animated,

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it's still today,
but animated so that life

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expectancy and income per capita
could be seen moving dynamically

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across years,
we discovered that the typical

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story is a surge north in the
diagram,

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representing increased life
expectancy,

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with slow progress in income
per capita,

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and then a surge around the
horn, so to speak,

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into the area upper right of
long lives and relative

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affluence.

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And I asserted,
and many of you agreed,

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that there's something
unambiguously good about that

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change,
that the world is a better

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place because that change
happened.

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Now I didn't in the lecture lay
any great stress on the caveats

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that people might attach to
that.

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One of them is that it was
accomplished,

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in considerable measure,
through capital intensive

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industry,
and highly capital intensive

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forms of transportation.

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And that these were,
first of all,

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disruptive of the natural
environment.

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There could be no doubt
whatever that the revolution in

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the world economy left the
planet more fragile than it

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found it.

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Indeed, poverty is a marvelous
environmental policy,

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because where there is no
demand there is very little

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disruption.

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Now we also looked at the world
demographic transition.

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The world demographic
transition, representing changes

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in rates of birth and death,
death here in purple and birth

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in green,
and the old Malthusian world,

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which still exists on parts of
the globe but hasn't existed in

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the western world for a couple
of hundred years,

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was characterized by very high
birthrates and very high death

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rates.

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So you have essentially static
total population,

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and very few people lived to be
old.

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Then you have the change in the
death rate occasioned by

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infrastructure,
most of all,

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related to clean water.

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And when the death rate falls,
the birthrate doesn't track

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with it.

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The birthrate lags in its
change so there is a period,

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Phase II here,
when deaths are falling sharply

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and births are statically high.

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In that period you get an
enormous surge,

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you get indeed population
growth at an increasing rate.

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You get the spike,
which brought world population

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to its present level,
is occasioned largely by Phase

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II.

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Phase III is the period during
which the birthrate adjusts to

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the death rate.

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You still get growing
population, but now at a

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diminishing rate.

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At Stage IV there's an
equilibrium between births and

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deaths, and both have lower
rates.

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So population is again static,
and lives are much longer.

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Underneath that process,
and this I merely hinted in

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meeting two,
is a surge in the supply of

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labor, which occurs in Stages II
and III and creates a buyer's

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market for employers.

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And by creating a buyer's
market for employers it drives

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down wages.

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Real wages are really quite low
during Phase II and Phase III in

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the history of the country.

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Capital, which is only in part
related to demography,

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it has an independent life of
its own,

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but capital begins to
appreciate and be agglomerated

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in large quantities only late in
this history.

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The places where you get huge
build up of capital are

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typically places which are
beginning or well into Stage IV,

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and if you want to be precise
about it there is a Stage V,

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which is where the birthrate
has actually fallen below the

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death rate,
so that, as with Japan,

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Italy, Russia,
and much of Eastern Europe,

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you have falling total
population.

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Now there is another aspect to
this that we'll pick up a month

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from now, which has to do with
the age profile of the existing

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population.

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You can yourself what
percentage of all the people in

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the country are of working age?

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You can figure from that a
so-called dependency ratio.

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How many people too old to work
and too young to work have to be

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supported by those who can work,
who are of working age?

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And that ratio turns out to be
a big determinant of economic

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growth.

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Whereas with China today,
Ireland in the very recent

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past,
you have a demographic sweet

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spot where there are relatively
few old and young people,

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and almost everybody is in the
working years.

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It's--that's a really low
resistance profile.

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And then at the other side,
the Japanese,

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where the number of elderly
people who need to be supported

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is out of proportion to the size
of the actual workforce.

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Beneath this--these curves
related to capital and labor are

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just a few other things you want
to think about.

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One is that you get much higher
incomes in Phase IV than in

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earlier phases.

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It's partly because of capital
concentration,

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but it's also because human
capital in the form of trained

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ability,
educated people,

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it becomes much easier to build
a massive educational apparatus,

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a formal apparatus,
and also an applied apparatus

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in the workforce where in 40
years of working in a given

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trade,
people get really good at it.

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So that--that's another way in
which the later stages of the

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world demographic transition are
profitable, quite literally,

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to a country.

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Inequality tends to be highest
in the emerging markets,

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because typically what you get
is a mass of very poor people,

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and relatively small elite,
which has found its way into

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capitalist development.

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Labor abundant,
capital scarce,

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we talked about that.

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Insourcing and outsourcing,
this is a very obvious point;

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Stage IV countries outsource
tasks to Stage II and III

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countries because labor is much
cheaper.

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The obverse of that is
insourcing at the other end.

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And the main movement in Stage
II and III countries actually

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has two parts:
One is from countryside to

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city,
because the opportunities of

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capital intensive enterprise are
concentrated in cities;

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and from an out of Stage II and
II countries into Stage IV

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countries.

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This is a classic pattern,
which is highly visible today

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with the borders of the United
States and Europe being crowded

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and not entirely controlled.

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And it was the same story 100
years ago,

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when southern and Eastern
Europe were in Stage III and the

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United States was approaching
Stage IV and immigration was

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enormous.

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My own family,
on my father's side,

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were immigrants in the early
twentieth century.

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Okay, so Smith's invisible hand.

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The question is:
If its invisible how can we

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know it's there?

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There are various--there are
several good New Yorker

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cartoons about that problem.

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One shows a group of
well-dressed people gathered in

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a farm field Darien Connecticut
looking out with binoculars to

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find the invisible hand,
which has been reported to have

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appeared there.

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Another is a store with a sign
across the front,

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"Store closing,"
and then a caption under the

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"store closing"
sign: "Bitch-slapped by

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the invisible hand."

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The condition under which the
invisible hand works is

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actually--
there are several things that

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have to be there for it to
happen and let's just kind of

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inventory those.

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First is, you have to have an
open market.

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It has to be a market where
people can come in and begin to

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produce, or arrive and begin to
consume.

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If it is regulated,
for example,

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by tariffs or by a mafia,
then that is the visible hand,

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and the invisible hand is
blocked from its work.

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There needs to be no seller big
enough to drive down--to control

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prices by, say,
withholding product.

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There needs,
third, to be no buyer--I've

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left out a step--no seller and
no buyer able to control prices.

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What would make that--what kind
of distribution of production

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and buying would be required to
do that?

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Somebody near a mic.

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Got a mic?

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Student:  A monopoly.

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Prof: A--
Student:  A monopsony

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and a monopoly.

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Prof: Okay,
those are the things you don't

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want if you want the invisible
hand to work,

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right?

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What you want is somebody else?

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Student:  Perfect
competition.

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Prof: Yes?

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Student:  Perfect
competition.

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Prof: Okay,
and perfect competition occurs

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when what?

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Student:  When no buyer
is big enough to control the

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market.

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Prof: Okay,
but that's circular.

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So we need to put one step in
between there.

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Student:  When prices
are independent.

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So the market itself sets the
price.

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Prof: Well let's work at
this.

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I showed a picture when I
started this of a wheat field

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and I didn't show a picture of a
car factory or Microsoft.

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The key fact is that you have a
fine grain division of

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production and consumption so
there are thousands and

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thousands of producers,
thousands and thousands of

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consumers,
no one of them big enough to

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game the market.

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If you're making--if you're
producing wheat or rice,

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and you say,
"The world price is too

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low.

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I'm going to drive it up by
withholding this year's crop

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from my 100 acres,"
that's like,

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"Hit my hand,"
because you have no market

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power.

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No producer holds a pivotal
private technology.

17:21.730 --> 17:30.210
And it's pretty obvious what's
meant by that;

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a patented technology,
or a trade secret which allows

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one producer to differentiate
him or herself from other

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producers and dominate the
market.

17:40.990 --> 17:43.960
There are the buyers.

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And perfect information,
more or less truthful

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information across the whole
market, and government to

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enforce property and contract.

17:57.759 --> 18:04.489
So with all those conditions in
place, what Smith says about the

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invisible hand is,
more or less,

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true.

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Let's see if I can find the
quote.

18:12.700 --> 18:22.390
He talks about producers who
are in this,

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"And many other cases,
led by an invisible hand to

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promote the end,
which they have no part of in

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intention.

18:29.608 --> 18:34.298
By pursuing his own interest,
he frequently promotes that of

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society more effectually than
when he really intends to

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promote it.

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I have never known much good to
come from people trading in the

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name of the public good."

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The--on both the producer and
the consumer side,

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there is a peculiar power
vacuum.

18:56.608 --> 19:01.618
There is no one who can be said
to have set the price of the

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good or determined its quality.

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It is decided collectively,
and the Smithian idea there is

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actually the idea of general
equilibrium in a market economy.

19:16.490 --> 19:18.600
The next phase of economic
theory,

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neoclassical economics,
formalizes this idea and makes

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it mathematically precise,
and we'll look at it in a

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little while,
but here it's important,

19:30.316 --> 19:36.736
first, just to get the context
in which Smith writes about the

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invisible hand in The Wealth
of Nations.

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Anybody able to provide us with
the exact point he's trying to

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prove?

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Is there a hand somewhere?

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You're trying to set this guy
up, I know that.

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Was there?

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Wave it please.

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Yes, you need the mic.

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Come on, guys,
we got to manage the mic

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better.

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Where is it?

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Student:
>

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Prof: Just--it doesn't
work without the mic.

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Would one of you guys,
just, kind of,

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stay standing and get it to
people?

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Student:
>

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point that nations shouldn't
impose tariffs.

20:38.460 --> 20:41.860
Prof: Okay,
he's arguing against tariffs

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and for free trade,
right?

20:43.930 --> 20:49.500
And why do--why is that an
argumentative point for him?

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Why are there tariffs?

20:50.880 --> 20:53.600
Student:  Because the
nations thought that they were

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protecting their economies by
enforcing

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>

20:56.750 --> 20:58.820
Prof: Okay,
and who were they helping to

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reach that--who helped the
nations to reach that

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conclusion?

21:01.608 --> 21:04.338
Student:  Other
economists?

21:04.338 --> 21:07.748
Prof: Well,
yeah, sort of.

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I'm fishing for something a
little different.

21:09.818 --> 21:12.928
Let's pass the mic over to--is
it "The violin

21:12.930 --> 21:14.010
question?"

21:14.009 --> 21:18.139
"The viola question;"
okay, my wife is a violist.

21:18.140 --> 21:20.300
Student:  Well,
I guess the predominant

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economic philosophy at the time
when Adam Smith was writing was

21:23.286 --> 21:25.646
mercantilism--
Prof: Mercantilism, yes.

21:25.650 --> 21:27.820
Student:
>

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mercantilism,
which is, you know,

21:28.748 --> 21:29.848
accumulate as much gold as
possible;

21:29.848 --> 21:31.958
become the richest,
you know, individual through

21:31.963 --> 21:33.443
that regard,
which means,

21:33.435 --> 21:35.955
you know, not really importing
much,

21:35.960 --> 21:39.720
and thus, really focusing on
supporting domestic development.

21:39.720 --> 21:41.660
Prof: Okay,
good, that's excellent.

21:41.660 --> 21:44.330
Smith was anti-mercantilist.

21:44.329 --> 21:46.469
He was a free trader.

21:46.470 --> 21:51.670
And the people who had a
concrete interest in tariff

21:51.665 --> 21:57.775
imposition--who would have a
strong self interest in that?

21:57.779 --> 21:59.299
Let's get the mic over here.

21:59.298 --> 22:02.708
I think one of you TAs really
needs to just stand up and MC

22:02.712 --> 22:03.422
the thing.

22:03.420 --> 22:06.210
Student:  Domestic
merchants and manufacturers.

22:06.210 --> 22:09.080
Prof: Well,
certainly manufacturers,

22:09.082 --> 22:09.632
right?

22:09.630 --> 22:13.220
Domestic manufacturers,
who are in some way or another,

22:13.219 --> 22:15.279
not competitive with imports.

22:15.278 --> 22:19.808
And Smith has this wonderful
passage, I think it's near this,

22:19.809 --> 22:23.359
where he talks about how you
could, in Scotland,

22:23.357 --> 22:25.017
produce good wine.

22:25.019 --> 22:29.789
You'd have to have hot houses
and many other special and very

22:29.794 --> 22:34.654
expensive accoutrements.
But for about thirty times the

22:34.652 --> 22:37.812
price--the production price of
France, Spain,

22:37.809 --> 22:41.039
or Italy, you could produce
Scottish wine.

22:41.038 --> 22:46.408
But it would be a foolish
betrayal of the public interest

22:46.411 --> 22:51.781
to put up a tariff so that you
could then sell that wine,

22:51.782 --> 22:53.992
worth $2, for $200.

22:53.990 --> 22:58.060
And that's the center of his
argument, right.

22:58.058 --> 23:02.358
He begins at the micro level
with the butcher,

23:02.357 --> 23:07.707
the baker, and the brewer,
which is a metaphor that rings

23:07.708 --> 23:10.668
true for most of us,
right?

23:10.670 --> 23:16.200
Why is the produce fresh in the
little market on Orange Street

23:16.200 --> 23:17.560
in New Haven?

23:17.558 --> 23:22.308
The main reason is because
there are two little markets in

23:22.308 --> 23:23.308
New Haven.

23:23.308 --> 23:27.198
If it were just one,
thirty-six hour old lettuce

23:27.199 --> 23:29.019
would be marketable.

23:29.019 --> 23:32.189
But with two,
one of whom drives to New York

23:32.194 --> 23:35.744
every morning at 3:00,
that just doesn't work.

23:35.740 --> 23:42.440
So that Smith talks about the
self-interest axiom as the

23:42.439 --> 23:47.189
driver for promoting the common
good.

23:47.190 --> 23:52.540
Now I'm going to invite Jim
Alexander to come on up and

23:52.538 --> 23:57.688
we'll just stand and--let's
actually sit and talk.

23:57.690 --> 24:04.170
Some of you have been
introduced to Jim Alexander,

24:04.167 --> 24:09.587
and for others,
I'll introduce him now.

24:09.588 --> 24:14.878
Jim is a good friend,
and was--had a twenty year

24:14.877 --> 24:21.377
career in investment banking,
and after that a stint as Chief

24:21.378 --> 24:25.488
Financial Officer of Enron
Global Power &

24:25.493 --> 24:29.633
Pipeline,
which was indeed one of the

24:29.628 --> 24:34.278
famous partnerships in the Enron
meltdown.

24:34.279 --> 24:41.009
He was a straight shooter;
as the best book on the Enron

24:41.013 --> 24:45.603
meltdown calls him,
the "fly in the

24:45.602 --> 24:49.582
ointment,"
and went off to co-found

24:49.584 --> 24:53.964
Spinnaker Exploration,
which later became a public

24:53.957 --> 24:54.527
company.

24:54.529 --> 25:01.179
Jim is going to be part of this
course from time to time and I

25:01.176 --> 25:06.866
thought maybe,
to bring the discussion down

25:06.873 --> 25:11.733
from the clouds here,
I would ask Jim:

25:11.730 --> 25:17.150
Is the ghost of Adam Smith
alive in the boardroom in

25:17.147 --> 25:19.377
corporate America?

25:19.380 --> 25:24.910
Jim Alexander:
Well, the self-image of

25:24.906 --> 25:27.606
Adam Smith is alive.

25:27.608 --> 25:31.938
The ideology that would be
espoused is that of Adam Smith.

25:31.940 --> 25:36.940
The substance is not there,
I believe, but most of the

25:36.936 --> 25:42.406
people would pass the polygraph
test that they believe it's

25:42.406 --> 25:43.346
there.

25:43.349 --> 25:45.229
Prof: Okay, that's good.

25:45.230 --> 25:48.670
Now let's--here's an
interesting exercise.

25:48.670 --> 25:51.730
There are about a dozen MBAs in
the group here.

25:51.730 --> 26:01.890
Every MBA--every MBA period,
has learned the Porter Forces.

26:01.890 --> 26:05.710
What are the Porter Forces?

26:05.710 --> 26:09.940
The Porter Forces are the rules
of thumb you need to make above

26:09.943 --> 26:12.133
average profits within a firm.

26:12.130 --> 26:15.080
One of them is:
You don't want too much

26:15.075 --> 26:17.705
competition--direct competition.

26:17.710 --> 26:20.250
Direct competition erodes
profits.

26:20.250 --> 26:23.520
You want high barriers to entry.

26:23.519 --> 26:28.609
You don't want powerful buyers
who can drive down your price

26:28.611 --> 26:30.511
through negotiating.

26:30.509 --> 26:33.339
For example,
tire companies face very

26:33.340 --> 26:36.960
powerful buyers in automobile
manufacturers.

26:36.960 --> 26:39.820
You want to avoid situations
like that.

26:39.818 --> 26:43.778
You also want to be able to
control your suppliers so they

26:43.779 --> 26:47.879
can't see you making profits and
then demand their share.

26:47.880 --> 26:51.430
Now just think for a second.

26:51.430 --> 26:55.000
How do the Porter Forces align
with the conditions that I

26:54.997 --> 26:58.757
sketched five minutes ago for
the operation of the invisible

26:58.756 --> 26:59.326
hand?

26:59.328 --> 27:03.638
In the back,
you've got to be really loud

27:03.644 --> 27:06.734
because the--
Student:  They're the

27:06.730 --> 27:07.510
exact opposite.

27:07.509 --> 27:10.729
Prof: They are
essentially the exact opposite.

27:10.730 --> 27:16.270
The name in business speak for
operating under the control of

27:16.265 --> 27:20.965
the invisible hand is
"commodity hell."

27:20.970 --> 27:26.580
Commodity hell being that
you're producing something which

27:26.582 --> 27:30.622
thousands of other people can
produce,

27:30.618 --> 27:33.508
and they can produce it as
cheaply and as well as you can,

27:33.509 --> 27:39.169
and so the available pricing
strategies to you are--

27:39.170 --> 27:41.120
none of them involve high
profits.

27:41.118 --> 27:47.728
One of the fundamental axioms
of business management--

27:47.730 --> 27:49.950
and I'm not making a moral
condemnation,

27:49.950 --> 27:53.130
I'm just making an observation
that there is a strong tension

27:53.134 --> 27:57.864
here--
that the pursuit of actual--the

27:57.861 --> 28:03.691
actual submission to the
invisible hand--

28:03.690 --> 28:10.250
is contrary to the very basis
of corporate strategy.

28:10.250 --> 28:18.310
Jim, talk a little from your
experience about the intelligent

28:18.306 --> 28:25.416
use of the Porter Forces by
management strategists--or

28:25.423 --> 28:27.843
unintelligent.

28:27.838 --> 28:30.658
Jim Alexander:
Well from the latter--

28:30.660 --> 28:34.400
but basically no one ever wants
to get into an Adam Smith type

28:34.402 --> 28:36.292
of market,
and if you're in it,

28:36.291 --> 28:37.331
you get out of it.

28:37.329 --> 28:40.259
Because there's--it's ruinous.

28:40.259 --> 28:49.129
And the only way you can affect
change in that type of market is

28:49.131 --> 28:56.151
to do what Adam Smith suggested,
and that is make some sort of

28:56.154 --> 29:01.294
national security argument why--
in fact, while Smith's views

29:01.290 --> 29:04.830
are very well and fine in
general,

29:04.828 --> 29:08.218
you need, and the country more
especially needs,

29:08.220 --> 29:14.170
to have defense against foreign
imports or ruinous competition.

29:14.170 --> 29:16.920
I think the sugar producers
were able to pull that off

29:16.916 --> 29:19.916
pretty neatly and can make a
national security argument for

29:19.923 --> 29:24.483
it for sugar quotas,
but you never tolerate an Adam

29:24.478 --> 29:27.518
Smith level of competition.

29:27.519 --> 29:30.609
Prof: Okay,
and if you look at--

29:30.608 --> 29:34.148
I ordered Thank You For
Smoking,

29:34.150 --> 29:37.510
Christopher Buckley's book,
as an option for this course,

29:37.509 --> 29:40.549
but I'm told all of you have
seen the movie,

29:40.549 --> 29:42.169
which I haven't.

29:42.170 --> 29:44.480
Is the movie any good?

29:44.480 --> 29:45.830
Student:  Yes.

29:45.828 --> 29:47.338
Prof: Okay,
you should all look at the

29:47.336 --> 29:47.606
movie.

29:47.608 --> 29:53.268
And the book is all about the
way corporations,

29:53.269 --> 29:56.199
including those which make,
in this case,

29:56.200 --> 29:58.950
cigarettes, booze,
and firearms,

29:58.951 --> 30:03.461
but mostly cigarettes,
have elaborate representation

30:03.461 --> 30:08.441
in Washington and promote their
own interests through the law.

30:08.440 --> 30:09.850
It's not a big surprise.

30:09.848 --> 30:17.168
But the tension between the
idealized theory of the market

30:17.172 --> 30:22.442
and that practice is a very
strong one.

30:22.440 --> 30:25.070
Incidentally,
Smith was very critical of the

30:25.070 --> 30:28.990
corporations,
which existed in his time,

30:28.990 --> 30:35.320
and he was critical of them for
partly the reason we just

30:35.323 --> 30:41.883
articulated: That they can
control pricing and impose their

30:41.883 --> 30:45.053
product by that method.

30:45.048 --> 30:48.528
But more, Smith thought,
that the people running the

30:48.531 --> 30:51.541
corporations,
which existed at that time were

30:51.536 --> 30:53.376
thoroughly incompetent.

30:53.380 --> 30:56.580
And that's, of course,
because the Yale School of

30:56.577 --> 30:59.107
Management had not yet been
founded.

30:59.108 --> 31:03.638
In actual fact there is a
fundamental problem about

31:03.637 --> 31:07.527
corporations and their
management called the

31:07.532 --> 31:10.162
principal-agency problem.

31:10.160 --> 31:16.080
The gist of that problem is
that managers,

31:16.078 --> 31:21.698
left to their own devices,
will tend to take a company

31:21.703 --> 31:24.443
where--
in a direction which is best

31:24.443 --> 31:28.203
for them individually and not
necessarily for the broad body

31:28.204 --> 31:32.694
of shareholders,
and so the control over that

31:32.692 --> 31:38.892
tendency gets to be one of the
major dramatic themes in

31:38.888 --> 31:40.838
business life.

31:40.838 --> 31:46.368
Jim you've been near some
management, which had rent

31:46.365 --> 31:48.635
seeking tendencies.

31:48.640 --> 31:51.600
Jim Alexander:
Well, let me come back to

31:51.596 --> 31:56.046
something else,
and that is that at least one

31:56.046 --> 32:02.446
of the sections Smith has
revolves around the butcher,

32:02.450 --> 32:07.100
the brewer, and the baker,
and how it's much more reliable

32:07.098 --> 32:11.748
to rely on their self interest
than their benevolence,

32:11.750 --> 32:14.360
which is true.

32:14.358 --> 32:17.728
There is--I think there is an
embedded assumption which he

32:17.727 --> 32:20.487
doesn't go into,
and that is:

32:20.490 --> 32:26.580
he cites examples of what are--
at least at the time,

32:26.575 --> 32:31.125
where a single proprietor sort
of business is marketing a

32:31.125 --> 32:35.835
product which was directly
consumed by individuals who knew

32:35.836 --> 32:39.946
the proprietors well,
and understood what good meat

32:39.950 --> 32:42.070
was from meat that wasn't good.

32:42.068 --> 32:50.828
And that also is increasingly
irrelevant since his time,

32:50.828 --> 32:53.928
because one of the most
important things,

32:53.930 --> 32:57.240
I thought, in one of your
slides, was that there be

32:57.241 --> 32:58.701
perfect information.

32:58.700 --> 33:01.850
And on top of that,
an embedded assumption there is

33:01.853 --> 33:04.943
that there has to be perfect
information perfectly

33:04.942 --> 33:05.892
understood.

33:05.890 --> 33:07.660
Prof: Absolutely.

33:07.660 --> 33:09.610
Jim Alexander:
In fact one of the--

33:09.608 --> 33:13.798
and having come from finance,
it's sort of the highest form

33:13.795 --> 33:17.755
of art is to have information
which in retrospect can be

33:17.762 --> 33:21.702
defended as reliable,
but prospectively is virtually

33:21.698 --> 33:22.588
meaningless.

33:22.588 --> 33:27.228
One of the ways we can--that it
really becomes very important in

33:27.226 --> 33:29.926
practice,
forget about Smithian ideals,

33:29.932 --> 33:33.332
is to make sure that you have
colorable information,

33:33.328 --> 33:36.858
colorable voluntary
transactions,

33:36.855 --> 33:41.225
but in fact,
they are, practically speaking,

33:41.233 --> 33:44.433
not voluntary,
and, practically speaking,

33:44.426 --> 33:45.386
not informed.

33:45.390 --> 33:49.670
On top of that you start having
principal-agent issues.

33:49.670 --> 33:52.720
Let's take the butcher,
for example,

33:52.720 --> 33:57.370
one butcher in a little village
deals with people he knows,

33:57.368 --> 34:00.528
so there's social constraints,
and there's also--

34:00.528 --> 34:02.168
it's fairly easy if it's one
butcher,

34:02.170 --> 34:06.460
to trace any illnesses that
result.

34:06.460 --> 34:10.250
And he has a relatively
unmarketable asset,

34:10.253 --> 34:14.953
which is his interest in his
private butcher shop;

34:14.949 --> 34:18.739
very hard to sell,
so he must count on long term

34:18.744 --> 34:23.474
profit maximization;
not short term, but long term.

34:23.469 --> 34:28.169
Now let's imagine that you had
a--I don't think (inaudible)

34:28.168 --> 34:32.948
processer is public at this
point but let's imagine that you

34:32.949 --> 34:37.649
had a butcher business which was
owned by the public,

34:37.650 --> 34:39.540
controlled by a small group of
managers.

34:39.539 --> 34:43.329
And furthermore let's assume,
and it's actually a pretty good

34:43.333 --> 34:45.733
assumption,
that you had a group of

34:45.726 --> 34:49.526
semi-knowledgeable mutual fund
managers who rewarded people

34:49.525 --> 34:53.385
with huge gains in their share
value if they were able,

34:53.389 --> 34:57.869
reliably, to hit their
quarterly earnings estimate and

34:57.871 --> 35:00.281
punish them,
of course, if anything went

35:00.275 --> 35:00.565
wrong.

35:00.570 --> 35:04.060
Under those circumstances,
assuming that the investing

35:04.061 --> 35:08.281
public really didn't understand
the dynamics of the business,

35:08.280 --> 35:14.140
and assuming that you could
make satisfactory short term

35:14.139 --> 35:17.339
goals,
maybe making 100 times the

35:17.344 --> 35:22.354
average income of the typical
worker every couple weeks,

35:22.349 --> 35:27.269
then you would be incentivized,
unless you were very risk

35:27.268 --> 35:29.428
adverse to,
for example,

35:29.432 --> 35:34.022
being able to buy tainted meat
and then be able to make some

35:34.019 --> 35:36.529
extra pennies,
beat your numbers,

35:36.534 --> 35:38.644
get a big upgrade in your
stock,

35:38.639 --> 35:41.219
if you have a lot of options
you have a very highly leveraged

35:41.219 --> 35:43.849
wealth situation,
then make enough money in the

35:43.853 --> 35:46.893
short term,
where you could live--maybe buy

35:46.889 --> 35:51.159
a small country or live with
gravy for the rest of your life

35:51.155 --> 35:54.545
on a basis which was
sufficiently confusing that

35:54.552 --> 35:57.302
you're unlikely to be
prosecuted.

35:57.300 --> 35:59.940
That's my experience as to how
it works.

35:59.940 --> 36:04.460
I realize that it's a small
sliver and it is oriented toward

36:04.456 --> 36:06.866
finance,
which is the worst part of

36:06.871 --> 36:09.891
American business,
but that's in fact how I've

36:09.889 --> 36:10.829
seen it work.

36:10.829 --> 36:13.429
No theories,
it's just how it works,

36:13.429 --> 36:16.769
so people believe,
and yet the same people who

36:16.766 --> 36:21.286
would do this would spout and
believe every bit of it the same

36:21.289 --> 36:25.959
type of Smithian idealism you
see here: the invisible hand.

36:25.960 --> 36:28.640
My experience is that the
invisible hand typically is

36:28.643 --> 36:31.073
picking someone's pocket,
not creating value.

36:31.070 --> 36:36.140
And in fact,
the last--I remember talking to

36:36.143 --> 36:43.103
the senior Republic staffer at
The House Energy and Commerce

36:43.103 --> 36:47.273
Committee and making--
Prof: Jim is,

36:47.273 --> 36:49.443
by the way, I believe you are a
Republican.

36:49.440 --> 36:50.990
Jim Alexander:
Used to be.

36:50.989 --> 36:52.189
Prof: Okay.

36:52.190 --> 36:53.350
Jim Alexander:
Used to be;

36:53.349 --> 36:55.539
this is kind of why I used to
be.

36:55.539 --> 36:58.659
I'm up talking to the lead
Republican staffer at The House

36:58.664 --> 37:01.794
Energy and Commerce Committee
and saying at one point that

37:01.789 --> 37:04.529
capitalism justifies itself by
creating real,

37:04.530 --> 37:05.950
not illusory, value.

37:05.949 --> 37:08.169
To which he replied,
"Well you're nothing but a

37:08.173 --> 37:08.963
communist."

37:08.960 --> 37:13.570
That, in fact, is the problem.

37:13.570 --> 37:17.850
Under Smithian assumptions
about long-term honesty,

37:17.849 --> 37:21.449
long-term interests in real
value creation,

37:21.445 --> 37:23.495
it worked perfectly.

37:23.500 --> 37:27.240
It's just that when those
assumptions start to erode,

37:27.244 --> 37:29.264
it turns into a nightmare.

37:29.260 --> 37:32.140
Prof: Okay terrific.

37:32.139 --> 37:34.799
Georgios, I'm going to call on
you in a moment for a one

37:34.804 --> 37:35.584
sentence read.

37:35.579 --> 37:39.079
Here's the proposition that we
now want to look at.

37:39.079 --> 37:44.509
Smith--here's an apparent but
not real paradox.

37:44.510 --> 37:50.190
Adam Smith says self-interest
is the main motive for what

37:50.190 --> 37:52.320
people actually do.

37:52.320 --> 37:57.050
And yet, he led a life,
which didn't begin to maximize

37:57.050 --> 37:59.640
his own material interests.

37:59.639 --> 38:04.449
He lived modestly,
he worked diligently,

38:04.449 --> 38:13.029
and he never became a wealthy
man, so if he believed it for

38:13.032 --> 38:16.592
mankind,
how come he didn't practice it

38:16.585 --> 38:17.415
for himself?

38:17.420 --> 38:21.310
Well, Richard--
Student:  I just wanted

38:21.313 --> 38:24.583
to add I think it's probably the
way you define self-interest.

38:24.579 --> 38:27.659
Self-interest to one person may
not be the same to another,

38:27.659 --> 38:31.889
so while you just associate it
with wealth and material goods,

38:31.889 --> 38:34.069
to someone else it's not
necessarily someone else's

38:34.070 --> 38:35.380
definition of self interest.

38:35.380 --> 38:37.150
Prof: Fair enough,
that's a good point.

38:37.150 --> 38:40.660
The other side of it is that
Wealth of Nations was

38:40.659 --> 38:43.669
Smith's second main book,
and it wasn't the book,

38:43.666 --> 38:46.546
which made him famous in his
own lifetime.

38:46.550 --> 38:49.230
The Theory of Moral
Sentiments is the book,

38:49.231 --> 38:51.641
which made him famous in his
own lifetime.

38:51.639 --> 38:54.959
And Georgios,
will you read us,

38:54.960 --> 39:01.380
please, in good strong voice,
the first sentence of Smith's

39:01.378 --> 39:03.038
first book?

39:03.039 --> 39:14.179
Thanks very much Leslie.

39:14.179 --> 39:16.369
Student:  "How
selfish, so ever,

39:16.367 --> 39:18.607
man may be supposed,
there are evidently some

39:18.605 --> 39:21.655
principles in his nature which
interest him in the fortune of

39:21.657 --> 39:24.507
others,
and render their happiness

39:24.512 --> 39:27.362
necessary to him,
though he derives nothing from

39:27.362 --> 39:29.202
it except the pleasure of seeing
it."

39:29.199 --> 39:32.129
Prof: Okay,
now read it one more time.

39:32.130 --> 39:33.910
Student:  "How
selfish,

39:33.909 --> 39:37.589
so ever, man may be supposed,
there are evidently some

39:37.585 --> 39:41.745
principles in his nature which
interest him in the fortune of

39:41.746 --> 39:44.226
others,
and render their happiness

39:44.231 --> 39:47.351
necessary to him,
though he derives nothing from

39:47.349 --> 39:50.089
it except the pleasure of seeing
it."

39:50.090 --> 39:54.180
Prof: Okay,
so Smith actually believed that

39:54.179 --> 39:58.519
we were a complicated mix,
and I think he's right.

39:58.518 --> 40:02.958
He believed that there is a
pro-social element in almost

40:02.963 --> 40:04.583
every human being.

40:04.579 --> 40:10.059
There is an innate sympathy for
others, which almost everyone

40:10.059 --> 40:15.269
has, and at the same time,
a tendency to feather one's own

40:15.266 --> 40:16.086
nest.

40:16.090 --> 40:20.730
Now I don't know anyone who is
just one of those two things.

40:20.730 --> 40:25.380
I don't know anyone who is a
pure egotist.

40:25.380 --> 40:27.720
Jim Alexander:  Me.

40:27.719 --> 40:29.439
Prof: You do?

40:29.440 --> 40:36.430
My goodness;
not even generous to his aged

40:36.427 --> 40:39.387
mother or--
Jim Alexander:

40:39.385 --> 40:40.575
What's she done for him?

40:40.579 --> 40:44.909
Prof: Okay,
well there may be some but

40:44.914 --> 40:47.974
there aren't a hell of a lot.

40:47.969 --> 40:51.939
Smith--this is characteristic
of Smith--Smith is not a

40:51.940 --> 40:52.840
dogmatist.

40:52.840 --> 41:00.470
Smith is a careful observer who
draws as much from the evidence

41:00.467 --> 41:02.187
as is there.

41:02.190 --> 41:07.970
Now this is a map which links
Smith forward to the next

41:07.971 --> 41:14.101
historical period,
namely the period when world

41:14.099 --> 41:18.159
trade got serious,
and the period,

41:18.159 --> 41:21.769
which we will discuss in
Monday's class,

41:21.768 --> 41:24.468
when Marx and Engels were
writing The Communist

41:24.467 --> 41:25.347
Manifesto.

41:25.349 --> 41:30.649
The picture on the board is the
world railroad grid,

41:30.650 --> 41:36.100
and if you think about Smith's
story about how wealth depends

41:36.097 --> 41:40.347
on the division of labor,
it works only where you have a

41:40.353 --> 41:43.393
large market,
and he makes that point at

41:43.389 --> 41:44.059
length.

41:44.059 --> 41:47.499
In the period,
which begins in the middle

41:47.503 --> 41:50.743
1800s,
it really begins about 1840,

41:50.739 --> 41:55.569
in that period really large
markets became accessible to

41:55.574 --> 42:01.204
everyone located in the dense
part of the world railway grid.

42:01.199 --> 42:06.729
And toward the end of the
semester, we'll be dealing with

42:06.726 --> 42:11.556
the problem of economic
development in places like

42:11.563 --> 42:12.553
these.

42:12.550 --> 42:18.140
If you look at the way the
railroads developed there,

42:18.144 --> 42:24.174
they all developed to reach
ocean ports for the export of

42:24.170 --> 42:27.400
products to world markets.

42:27.400 --> 42:31.990
The density of connection
required for the internal

42:31.989 --> 42:37.129
development of large markets was
by and large missing.

42:37.130 --> 42:44.480
Okay, now--I think I'll just
finish with Adam Smith's story

42:44.481 --> 42:50.191
about the pin making,
and what happened in the

42:50.186 --> 42:52.846
pin-making story.

42:52.849 --> 42:56.509
I actually didn't have you read
this because it's something

42:56.507 --> 43:00.417
everybody--I think everybody
learns this one in high school.

43:00.420 --> 43:05.410
The division of labor for Smith
is illustrated by a group of

43:05.413 --> 43:07.363
artisans making pins.

43:07.360 --> 43:14.150
One person gets really good at
drawing the wire out straight,

43:14.150 --> 43:17.630
another person at hammering a
head onto the wire,

43:17.630 --> 43:20.210
another person at making the
point sharp,

43:20.210 --> 43:22.360
another person at polishing the
shaft.

43:22.360 --> 43:27.440
And by division of labor and
development of expertise,

43:27.440 --> 43:31.170
they can produce more pins of
higher quality than a single

43:31.173 --> 43:34.713
artisan doing each of those
operations by himself could

43:34.711 --> 43:36.221
possibly have done.

43:36.219 --> 43:39.849
It's a good illustration.

43:39.849 --> 43:44.929
And if you think about all the
professions and occupations in

43:44.925 --> 43:48.635
an economy,
that kind of profiting--that

43:48.635 --> 43:52.685
way of profiting from
specialized expertise is

43:52.693 --> 43:56.033
foundational to market
societies,

43:56.030 --> 43:58.240
foundational to their wealth.

43:58.239 --> 44:02.709
Now the actual fate of the pin
machine is interesting,

44:02.708 --> 44:05.068
and personal to my family.

44:05.070 --> 44:11.520
It turns out that in 1831,
a New York physician named John

44:11.519 --> 44:17.519
Ireland Howe began to tinker
with the idea of making a

44:17.518 --> 44:24.308
machine where wire went in one
end and polished pins came out

44:24.309 --> 44:28.269
the other in their thousands.

44:28.268 --> 44:33.218
By 1851 he perfected what was
called the Howe Pin Machine.

44:33.219 --> 44:37.079
There's a room in the
Smithsonian to this day where a

44:37.079 --> 44:41.309
Howe Pin Machine sits and a
movie of its operation goes on

44:41.309 --> 44:42.349
behind it.

44:42.349 --> 44:44.759
Well John Ireland Howe,
I won't brag again in this

44:44.759 --> 44:47.269
semester,
was my five over great

44:47.268 --> 44:50.498
grandfather,
and the family began pissing

44:50.500 --> 44:54.410
away the money right away,
and completed the task just in

44:54.414 --> 44:55.624
time for my birth.

44:55.619 --> 45:02.389
The slides include a
formalization of equilibrium

45:02.389 --> 45:10.289
theory with an Edgeworth box and
indifference curves,

45:10.289 --> 45:12.429
and all that,
but I don't think we have time

45:12.425 --> 45:15.165
to do them here,
and I urge you to review them

45:15.172 --> 45:20.232
before the midterm,
on ClassesV2.

45:20.230 --> 45:23.520
On Wednesday--on Monday,
rather, we'll do The

45:23.518 --> 45:28.348
Communist Manifesto,
and on Wednesday we'll do Hayek

45:28.346 --> 45:32.226
and The Constitution of
Liberty,

45:32.230 --> 45:36.950
so we'll see two ends of the
ideological perspective in a

45:36.945 --> 45:40.195
single week,
and after that we'll spend four

45:40.197 --> 45:42.377
straight weeks on business
cases.

45:42.380 --> 45:43.000
back to top

45:43.000 --> 45:48.000