On Revisiting the Invisible Hand Theorem

By Sreejith Sasidharan Nair

ABSTRACT

This paper analyses the invisible hand theorem and the possibility of dual interpretations arising out it, both of which have different implications for individual freedom and available choices in a market. The primary emphasis of this paper is in drawing out the circumstances under which two interpretations are possible and how one of them, does not go against government intervention, contrary to the beliefs of market fundamentalists who cite the theorem to support a free market. Furthermore, this paper also looks at the conditions required for Smith’s theory to hold good namely, the competitiveness of the market, the criteria of technical conditions, rational self-interest and finally the alleged Pareto Optimality leading to social optimality. The paper examines the different scenarios that questions the practical viability of the invisible hand theorem and provides arguments as to why beyond being a mathematical truism, the theorem may actually be devoid of any normative content. In equating the equilibrium of the market to optimality, morality is not considered, besides ignoring the initial endowments of wealth associated with privileges that allow certain strategic agents to exert disproportionate influence in the market compared to others. The paper concludes that the alternate interpretation, restricting the freedom of individuals is a better way of stating Adam Smith’s invisible hand theorem.

PARETO OPTIMALITY

The novelty associated with Smith’s invisible hand theorem was the proposition that free market acts like an invisible hand, in orchestrating the behavior of numerous individuals, each of them concerned with maximizing their own self-interests, so as to bring about an outcome that is socially optimal and efficient. This left open ambiguities related to the meaning of ‘efficiency’ and ‘socially optimal’. However, by the 20th century, Smith’s wisdom was established as the first fundamental theorem of welfare economics. Let us examine the alleged Pareto Optimality and its equivalence to the equilibrium as understood from the invisible hand theorem.

Pareto Optimality is a scenario in which it is impossible to reallocate resources in such a way that it makes any one individual better off, without making another individual worse off. Let us consider the example of resource allocation of India before and after the release of the Annual Financial Statement (Budget) FY 2018-2019. For argument’s sake, say allocation of resources before budget 2018, is considered to be represented as X and the allocation of resources after budget 2018, be considered as Y. For a considerable chunk of the population, the resource allocation before budget 2018 would have been a much better deal compared to their gains post budget. In other words, social state X is better for them compared to social state Y. This is often true because, there are always people in an economy who are well off in one social state compared to the other. However, for everyone in the population considered, if nobody is better off in social state Y compared to X, and at least one person is better off in state X compared to state Y, there X is Pareto Superior to Y. Therefore, for a given resource base of 100   X (53, 40) is Pareto non comparable to Y (92, 0) whereas Z (50, 50) would be Pareto Optimal because it is impossible to reallocate resources at Z (50,50) where it makes one person better off without making the other worse off.

ALTERNATE INTERPRETATION OF THE INVISIBLE HAND THEOREM

If we have a competitive economy, where the freedom of individuals is restricted so that they are not allowed to choose from all the alternative actions available to them but instead are simply allowed to choose a point from their budget set, then (given a few technical conditions) the resultant equilibrium will be Pareto Optimal. “

Analyzing the dual interpretation of Invisible Hand Theorem

The above passage statement arises from a possible ‘dual interpretation’ of Adam Smith’s Invisible Hand Theorem. The fundamental difference in stating the argument in this way, is the emphasis on curtailment of individual freedom. Smith’s theorem is seen by market fundamentalists and often economists in general, as a celebration of individual freedom, whereas Kaushik Basu, in his book “Beyond the Invisible Hand: Groundwork for a New Economics “comes up with the above passage statement, which can be viewed as a restriction of individual freedom. Let us examine why this is the case.

The original theorem is often stated as “…all individuals choosing freely according to their rational self-interest “.

In other words, the theorem is seen as an expression of individual freedom. Any individual in the market, who is either a buyer or a seller, has a rational self-interest, determined by the quantity of goods he/she buys or sells in order to maximize his/her well-being, happiness, or utility. This notion of individual freedom is significant because, the prediction of Pareto Optimality relies on the freedom of individuals to maximize their own self-interest.

The range of choices available to individuals in a market

However, this throws open the question – what are the choices available to an individual in making his/her decision? Is he/she limited by any conditions or can we assume that the individual has unfettered choices? In answering these questions, it is important to take stock of deals and barter in modern day capitalist market exchanges. Often times, the quid pro quo involved in crony capitalism, does not deal with tangible exchanges. In fact, the barter system that Kaushik Basu talks about in his book, offers evidences of journalists toeing the political line of government, in return for information worthy of breaking news. The membership to an exclusive club, maybe facilitated in exchange for a suitable business deal at a later date.

Moreover, individual actors in a market too, have a whole range of options other than the restrictions placed by their own budget set. For instance, stealing, abuse of power, corruption, nepotism etc. are all well within an individual’s choice in dealing with a market scenario. Once this is established – possible alternative ways in which human beings act within the markets, it immediately gets acknowledged that the freedom to choose in their own rational self-interest, is not absolute but should be restrained. It is in this context, that the dual interpretation of the Invisible Hand Theorem says not allowed to choose from all the alternative actions available to them’. These alternative actions have distorted the alleged social optimality in the case of 2G spectrum auctions, coal block allocations, and oligopolistic nature of telecommunications market – where the single most important player Jio entered and disrupted the market in India.

At the root of most of these socially non-optimal outcomes, lie the fact that corruption, nepotism, quid pro quo thrive as individual’s actions and choices. A significant aspect of this interpretation is the fact that it makes a strong case for government intervention. When the larger set of choices, available to individuals and companies operating in the market is acknowledged, unfettered freedom to pursue those choices may be understood to certainly provide a challenge to social optimality. The necessity to provide for laws and to enforce them to prevent ‘nods and winks’ and the use of exchange of favours, provide grounds for arguments against market fundamentalists who see the role of governments as an evil. This interpretation therefore, provides a possible entry for governments in regulating the market, to promote competition, technological innovation and minimize information asymmetries in its role as the ‘science of the legislator’.

How possible is a perfectly competitive economy in practice?

A perfectly competitive economy can be defined as one where no one individual is powerful enough to change the prices prevailing in the market, by either coercion or any other behaviour. In other words, every person is considered to be too small an agent to bring about a substantial change. For instance, my decision to buy or not buy a Jio 4G internet connection, should not alter the market price of obtaining the internet connection. In other words, every individual in the market is a ‘price taker’. Although this is true, it does go against the fundamental law of demand and supply. If a sizeable number of consumers decided to buy a Jio 4G internet connection, the price would rise.  However, it is often seen that some agents in the markets have a certain leverage over the others. These are known as strategic agents and the disruption of telecommunications market by Jio is an evidence for it being a strategic player.

An oligopolistic market, or one with strategic agents goes against the idea of a ‘competitive economy’. If this first criteria of invisible hand theorem (competitive market) itself does not hold good, what remains of its applicability? Equally puzzling is the question of when exactly a consumer becomes a ‘price taker’? This is illustrated by what is popularly known as the Heap Paradox. If beginning with one grain of sand, a grain is added one at a time, at what point does it stop being a grain and become a heap? Similarly, when there is only one consumer in the market, he is the ‘price maker’, but as the number of consumers increase one by one, at what exact point do the consumers become ‘price takers’? These are significant questions that raise doubts about the practical existence of a perfectly competitive market.

Are ‘technical conditions ‘often ignored?

Market fundamentalists, who vouch for free markets and minimal role of governments in regulating the same, have often overlooked the technical conditions required for the invisible hand theorem to hold good. The problems associated with this theorem and its application to the real world, is examined in detail by Arrow and Hahn in General Competitive Analysis. The technical conditions, often ignored in vehement praise to the theorem, include no information asymmetry, no producer holding a pivotal technology privately (thus giving him centrifugal advantage) etc. However, crony capitalism, corruption and nepotism not only paves way for information asymmetry, but also leads to some individuals starting out a better place than the rest so that their choices in the market are more well informed than the others. For example, companies investing in property with prior information of the nature of government infrastructural projects coming up in those areas, insider trading etc. are all maladies of information asymmetry.

Sum total of individual interests is not always socially optimal

Even if one were to ignore the alternate interpretation of the invisible hand theorem, worded so as to curtail individual freedom, there are other possible standard critiques of the model. Let us start with the most famous of the game models – The prisoner’s dilemma. In a situation where there is sufficient evidence to implicate two different prisoners involved in the same crime together, there arise four possibilities. If X and Y both do not confess to their crimes, the police interrogating the case, would be found wanting for evidence, and they both end up serving only 1 year in jail for a minor crime.  The police secretly offers a deal to either of the individual prisoners. If X were to provide evidence against Y, he would be let go and vice versa. In other words, if X confesses, he serves only 1 year in jail and Y serves 20 years. However, if Y confesses, X serves 20 years. If both X and Y confess, they end up serving 5 years each. In such a scenario, it is interesting to note that, both prisoner’s X and Y are likely to confess irrespective what the other prisoner chooses. This is because both of them know that not confessing, puts each of them at a risk of serving a 20 year term. Each prisoner also knows that, the obvious choice in the rational self-interest of the other prisoner is to turn his fellow prisoner in. Thus, both X and Y end up confessing, thereby serving a term of 5 years each.  In this example, although both X and Y acted in their own rational self-interests, they ended up serving a longer term in jail than they otherwise would have (1 year each). Therefore, it may be argued that each individual acting in his/her own rational self-interests, does not automatically lead to a socially optimal outcome.

Normative aspects of Invisible Hand Theorem

Even if one were not to consider the standard criticisms offered by game theory, chainstore game and traveler’s dilemma, the theorem does have questionable ethical value. Abram Bergson, in his 1938 Quarterly Journal Of Economics and Paul Samuelson in his 1947 book Foundations of Economic Analysis, offer a brilliant perspective that the idea of Pareto Optimality as a sufficient condition or a state of allocation of resources, where the society must move towards, maybe have no ethical appeal at all.

It is significant to elaborate this with examples. Let us for a moment think of India as a two person country, with two possible kinds of resource distribution say X, Y. Assuming the resource base to be 100, where X denotes resource allocation (91, 92) and Y denotes allocation (100, 0) among two people (A, B). If we were to go by the invisible hand theorem, it would have been sufficient to have reached a societal state similar to that in Y, since it is Pareto Optimal. This is because it is impossible to change the allocation of (A, B) from 100, 0 to 99, 1 or 98, 2 without making A worse off. However, intuitively it is easier to see why state of allocation X is better than Y – at (A, B) = (91, 92) even though X is not Pareto Optimal. Having established this, the normative usefulness of the Invisible Hand Theorem falls flat on the ground, because all it propounds is to ensure that market equilibrium, under certain conditions give rise to a Pareto Optimal outcome, whether or not it maybe an ethical socially optimal outcome. This criticism is often cited as a retort to the theological free marketers. In other words, the outcome should be considered socially optimal only if the allocation of initial resources was also made in a way that is socially desirable.

CONCLUSION

The arguments presented in this paper do not call for vehement government interventions nor does it question the arithmetic usefulness of the invisible hand theorem – which is still a mathematical truism. However, behavioral economics cannot avoid the human tendencies operating in the market or for that matter, statistically proven situations on how combined individual interests may not always be in the interests of the society. While Pareto Optimality may indicate a certain state in the allocation of economic resources, it does not make it a sufficient ideal condition for a socially optimal outcome – which is what welfare economics seeks to achieve. Therefore, it would not be wrong in saying that, curtailment of individual freedom, in a certain sense, may lead to a Pareto Optimal outcome with better societal optimality than individuals freely pursuing their rational self-interests – which albeit leading to Pareto Optimality, may not be socially optimal.

REFERENCES

Arrow, K. F., and F. H. Hahn. 1971. General competitive analysis. San Francisco, CA: Holden Day.

Basu, K. 2010. Beyond the invisible hand. Princeton University Press, Princeton.

Bergson, A. 1938. Quarterly Journal of Economics. 52(2): 310-334.

Buchanan, J. M. 1994. Ethics and economic progress. Norman, OK: University of Oklahoma Press.

Evensky, J. 1993. Ethics and the invisible hand. Journal of Economic Perspectives 7 (2): 197–205.

Khalil, E. L. 1990. Beyond self-interest and altruism. A reconstruction of Adam Smith’s theory of human conduct. Economics and Philosophy 6 (2): 255–73.

Pack, S J. 1991.Capitalism as a moral system. Adam Smith’s critique of the free market economy. Brookfield: Edward Elgar.

Smith, A. 1976. An Inquiry into the Nature and Causes of the Wealth of Nations. 2 vols. Ed. R.H. Campbell, A.S. Skinner, and W.B. Todd. Oxford: Oxford University Press.


Sreejith Sasidharan Nair is a post graduate student at Jindal School of International Affairs.

Featured Image Source: steemKR

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