Reflections on the Markets‘
Invisible Hand
Arnis Vilks
HHL Leipzig Graduate School of Management
31/08/2021
Bahir Dar University
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Agenda
1.
2.
3.
4.
Lots of Quotes
The First Fundamental Theorem of Welfare Economics
Discussion
The Inverse Invisible Hand
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The Gradual Encroachment of Ideas
“…the ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly
understood. Indeed the world is ruled by little else. Practical men, who
believe themselves to be quite exempt from any intellectual influences, are
usually the slaves of some defunct economist. Madmen in authority, who
hear voices in the air, are distilling their frenzy from some academic scribbler
of a few years back. I am sure that the power of vested interests is vastly
exaggerated compared with the gradual encroachment of ideas. Not, indeed,
immediately, but after a certain interval; for in the field of economic and
political philosophy there are not many who are influenced by new theories
after they are twenty-five or thirty years of age, so that the ideas which civil
servants and politicians and even agitators apply to current events are not
likely to be the newest.” (John Maynard Keynes)
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The Invisible Hand
“As every individual .. endeavours as much as he can both to employ his capital in
the support of domestic industry, and so to direct that industry that its produce
may be of the greatest value; every individual necessarily labours to render the
annual revenue of the society as great as he can, he generally, indeed, neither
intends to promote the public interest, nor knows how much he is promoting it. …
by directing that industry in such a manner as its produce may be of the greatest
value, he intends only his own gain, and he is in this, as in many other cases, led by
an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own
interest he frequently promotes that of society more effectually than when he
really intends to promote it.” (Adam Smith, 1776)
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The Butcher and the Brewer
“...man has almost constant occasion for the help of his brethren, and it
is in vain for him to expect it from their benevolence only. He will be
more likely to prevail if he can interest their self-love in his favour, and
show them that it is to their own advantage to do for him what he
requires of them. Whoever offers to another a bargain of any kind,
proposes to do this. Give me that which I want, and you shall have this
which you want, is the meaning of every such offer. ... It is not out of
the benevolence of the butcher, the brewer, or the baker that we
expect our dinner, but from their regard to their own interest.”
(Adam Smith, 1776, again)
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In Managerial Economics
“…the most famous inference from Adam Smith’s Wealth of
Nations is that as each of us seeks our own personal gain we
are led by an ‘invisible hand’ to promote the overall good of
society” (Hirschey & Bentzen, 2014)
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In Managerial Economics, Continued
“Smith is saying that by pursuing its self-interest – the goal of
maximizing profits – a firm ultimately meets the needs of
society... Profits signal to resource holders where resources
are most highly valued by society. By moving scarce resources
toward the production of goods most valued by society, the
total welfare of society is improved. As Adam Smith first
noted, this phenomenon is due not to benevolence on the
part of firms’ managers but to the self-interested goal of
maximizing the firms’ profits” (Baye & Prince, 2013)
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In Highbrow Economics
“…from Adam Smith’s invisible hand on, the classical
economists held that competitive equilibrium yielded what
was in some none-too-well-defined sense an optimal
allocation of resources”
(Arrow and Hahn, 1971)
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The First Fundamental Theorem of Welfare Economics
…is regarded as “a formal expression of Adam Smith’s
‘invisible hand’” (Mas Colell et al., 1995), and the invisible
hand is described as, e.g., the “intuition, that decentralized
competitive markets produce out of the self-interested
behavior of economic agents an optimal distribution of
resources” (Aliprantis et al., 1989)
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The Arrow-Debreu Model
…describes an economy of the following kind:
It consists of consumers and producers, where each consumer has
preferences over the commodity bundles he might consume, and he
chooses a most preferred one that he can afford. What he can afford,
depends on the prices, on the resources the consumer owns, and
possibly profit income from firms that he has shares in.
Each firm, on the other hand, choose a production plan that maximizes
profits subject to the constraints which are due to their technological
knowledge. Profits are then distributed to the firms’ shareholders.
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General Competitive Equilibrium
Such an economy is “competitive” in the sense that all consumers and
producers are so-called “price takers”: For given preferences,
endowments, firm shares, and technologies, they all base their plans
what to buy and sell solely on the market prices for all the goods.
The individual, decentralized plans will not in general be consistent
with each other. A general equilibrium is said to obtain, if the system of
market prices ensures that they do: At equilibrium prices aggregate
supply for each good just equals aggregate demand.
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The First Fundamental Theorem of Welfare Economics
… says that an allocation of goods that is induced by competitive
equilibrium prices must be efficient in the sense of Vilfredo Pareto
(often called Pareto-optimal).
An equilibrium allocation is called Pareto-efficient, if there is no other
technologically feasible allocation that would be preferred by all
consumers to the equilibrium one.
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Pareto-Efficiency is not „Social Optimality“
The older terminology „Pareto-optimal“ should be used with utmost
caution: Efficiency neglects many criteria most people would require of
something called „optimal“. In particular, it completely neglects
distributional justice. If all our consumers are selfish, then an allocation
of goods that gives everything to a few, but lets all others starve – is
Pareto-efficient.
In the age of increasing inequality of the global wealth distribution, it
would seem absurd to ignore distribution and identify social optimality
with mere efficiency.
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The Paretian Liberal
A famous paper by Amartya Sen considers the following case:
Lewd and Prude have to decide whether to read „Lady Chatterley‘s
Lover“ – considered as a great work of art by many, but as obscene and
pornographic by others. The preferences are as suggested by the
names, but: if only one of the two can read the book, Lewd prefers
Prude tor read it in disgust, and Prude abhors the thought of Lewd
reading and enjoying the book.
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The Paretian Liberal
One will expect that Lewd reads the book, and Prude does not: That is the
Nash and market outcome. One may argue that everybody should decide
only for himself – not for the other one. This can be regarded as a “liberal
principle”. However, the example shows that it may conflict with the Paretian
principle – to regard a change as “beneficial for society”, if it makes
everyone better off.
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Externalities Prevent Pareto-Efficiency
The second problem with the „fundamental theorem“ is that
consumers‘ preferences are only defined for the commodity bundles
they buy or sell. If instead consumers‘ well-being depends on the
choices of others – as in Sen‘s example, not even Pareto-efficiency of
the competitive equilibrium allocation can be expected.
And of course – in the age of environmental pollution and global
warming such „external“ effects are of utmost importance. And they
are quite ubiquitous.
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Public Goods
… are just a special case of external effects. And just like externalities
they are traditionally regarded as a case of „market failure“.
The very terminology of „market failure“ suggests that competitive
markets are still often regarded as the benchmark – and that one
should look for remedies whenever markets fail. Deregulation of state
monopolies and attempts to „internalize“ external effects are cases in
point.
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Monopolies
… may sometimes be technologically more efficient than competitive
markets: Imagine a technology, that allows one to produce with L
workers L² units of a product – then a monopoly that uses L=2 workers,
can produce 4 units of the product, but if you „deregulate“ and split up
the monopoly in 2 competing firms, they jointly can produce only
1²+1²=2 units of the product.
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Adam Smith again:
“Whoever offers to another a bargain of any kind, proposes to do this.
Give me that which I want, and you shall have this which you want, is
the meaning of every such offer. ... It is not out of the benevolence of
the butcher, the brewer, or the baker that we expect our dinner, but
from their regard to their own interest.”
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Bahir Dar University
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Agreement for mutual benefit
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Invisible Hand, stylized:
Individuals‘ behaviour motivated by
self-interest
Benefit for others („society“)
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The Inverse Invisible Hand, stylized:
Individuals‘ behaviour motivated by
the wish to benefit others („society“)
Benefit for individuals so motivated
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Heuristics in Managerial
Decision-Making
Dominant heuristics:
„Maximize profits!“
Alternative heuristics:
„Try to help others!“
E.g., „Bottom-of-the Pyramid“-Approach,
„Social Business Approach“.
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Thank you for your attention!
VILKS@HHL.DE
31/08/2021
Bahir Dar University
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