Information and Market (Dis)Equilibria in Adam Smith

Readers of this blog will know that I am a fan of Adam Smith. His Theory of Moral Sentiments is a fascinating look at the importance of both self-interest and sympathy in producing moral behavior. And his Wealth of Nations remains a hugely influential touchstone for modern economic thinking, and certainly for other key thinkers in the last 200 years. Unfortunately, people read Smith as saying all sorts of nonsense. Perhaps the most pervasive is what Gavin Kennedy calls “The Myth of the Invisible Hand“. This myth attributes to Smith the idea that markets are perfectly and efficiently coordinated by the workings of the “invisible hand” which equilibrates supply and demand around the market price. The phrase “invisible hand” is used exactly once in Wealth, and as Kennedy shows, the usage there has very little to do with markets.* But even if the invisible hand had nothing to do with markets, we can still reasonably ask whether or not Smith really had such great faith in their workings, and specifically, in their self-equilibrating capacity.

In Book I, Ch. VII, “Of the Natural and Market Price of Commodities”, Smith describes the forces that generally push market prices towards their natural price. Natural price here is defined as the price it would ordinarily cost to compensate laborers, landlords, and owners – that is, ordinary wages, rents and profits required to produce the good. Smith argues that the “quantity of every commodity brought to market naturally suits itself to the effectual demand” (64**) and that the “natural price, therefore is, as it were, the central price, to which the prices of all commodities are continually gravitating.” (67) These two statements together seem like a nice assertion of the equilibrium properties of markets – market prices converge to natural prices, which are in turn defined by ordinary profits, wages, and rents, and thus producers tend to make as much as demanders want (and can pay for, hence the effectual bit). But why and how?

Smith offers a very straightforward mechanism to explain this equilibrium tendency – and then to explain when it fails. Smith notes that if the price for a good is lower than its “natural” price***, then someone in the chain is getting underpaid – the workers, the landlords or the owners. Whoever it is will figure out that they are not getting what they need, and could make elsewhere, and will withdraw from the market. Their withdrawal will lower supply, which will raise prices, and return the market to its natural state. There is nothing mysterious in this process and, most importantly, there is nothing infallible about it either. In fact, all manner of accidents, and intentional schemes, may keep the market price and the natural price far apart for some time:

When by an increase in effectual demand, the market price of some particular commodity happens to rise a good deal above the natural price, those who employ their stocks in supplying that market are generally careful to conceal this change. If it were commonly known, their great profit would tempt so many new rivals to employ their stocks in the same way, that, the effectual demand being fully supplied, the market price would soon be reduced to the natural price, and perhaps for some time even below it. If the market is at a great distance from the residence of those who supply it, they may sometimes be able to keep the secret for several years together, and may so long enjoy their extraordinary profits without any new rivals. (67-68)

Smith goes on to identify other ways that merchants and manufacturers may prevent the market and natural price from converging, such as trade secrets:

Secrets in manufactures are capable of being longer kept than secrets in trade. A dyer who has found the means of producing a particular colour with materials which cost only half the price of those commonly made use of, may, with good management, enjoy the advantage of his discovery as long as he lives…(68)

Smith goes on to discuss monopolies, unusual land (such as particular vineyards in France whose wine is highly prized), and more, all of which can keep the market and natural price apart for years, even centuries.

So, at the end of the day (or at least, the end of the post) where does Smith stand on the market? He loves it, but for what it is, not for what it isn’t. The market isn’t perfect, and its ability to bring supply and demand together is contingent on a whole host of conditions which may never obtain. In particular, if market actors can conceal the true situation (which they have every incentive to do), supply and demand may become out of whack. And if market actors can gain a more lasting advantage through a trade secret or monopoly (on a unique resource, or one granted by a government), then markets may never equilibrate. In other words, markets work well.. except when someone can force them not to. A far cry from “the invisible hand” of perfect competition, but a much more realistic view of things.

* Specifically, the invisible hand refers to “unintended consequences” more broadly, and was a commonly used literary metaphor in the 17th and 18th centuries. In Wealth, Smith describes how merchants will often invest close to home as opposed to abroad, even when the profits abroad are higher, because they like to be able to keep watch over their money. This risk-averse investment pattern has the unintended effect of stimulating domestic commerce, and thus merchants are “led by an invisible hand to promote an end which was no part of [their] intention.” See also Rothschild’s Economic Sentiments for her take on the invisible hand as a “mildly ironic joke”.
** All quotes to the Stigler edition, University of Chicago press.
*** Two things worth noting here. Be careful in how you read “natural” in Smith’s work – I’m not entirely sure of how to do it myself, or if there is a consistent meaning across usages, but it’s not the same sense of natural as we tend to use I think. It’s more like “long-run average” or “ordinary” much of the time. All this relates to the second point – Adam Smith does not use the word “normal”, which hadn’t taken on its modern meaning yet (see Canguilhem, Hacking, etc.). I wonder if it had if he might have replaced “natural price” with “normal price”, which is very close to the sense he means by “the central price, to which the prices of all commodities are continually gravitating.” In other words, in anachronistic terms, Smith is arguing that the normal price of any commodity will, barring the problems discussed later in the chapter, converge to the normal cost of its production in terms of the normal wages, rents, and profits required to produce it.

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