Four Central Theories of the Market Economy

Conception, evolution and application

Farhad Rassekh

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9780415622028
• eBook ISBN: 9781134864669
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This highly original work offers an intellectual history of four central theories underlying the market economic system, focusing on their conception, evolution, and applications.

Four Central Theories of the Market Economy traces the root of the theories, their conception and articulation, as well as their evolutions to the present time. It focuses on the four theories that are generally recognized as fundamental to the discipline of economics: the invisible hand, comparative advantage, the law of markets, and the quantity theory of money. These theories have profoundly influenced the world. Chapters explore their rich intellectual history from classical Greece to today, drawing on the original works of the great economic minds of the classical era and other thinkers who prepared the path for them, as well as those who refined their works or challenged them. This volume will leave the reader with a deep understanding of these pillars of the market economic system in the context of their historical development.

This book will be of great interest to all scholars and students of economics who are interested in the intellectual history of their discipline as well as scholars and students of intellectual history who are interested in economics.

1 The invisible-hand proposition

DOI: 10.4324/9781315543109-2

“A common man marvels at uncommon things. A wise man marvels at the commonplace.” (Confucius)

Chapter contents

• 1. Introduction 2
• 2. The theory of market before Adam Smith 4
  • 2.1. From antiquity to the sixteenth century 4
  • 2.2. From the sixteenth to the eighteenth century 4
• 3. Self-love and the invisible hand 8
  • 3.1. Hobbes' challenge 9
  • 3.2. Early responses to Hobbes 10
  • 3.3. A tale of two literary works 11
  • 3.4. The economic response 14
• 4. Smith's method of inquiry 15
• 5. Smith's contribution to the economic response 17
• 6. Smith and his contemporary philosophers on the invisible hand 21
• 7. Self-interest versus benevolence 25
• 8. The invisible-hand passages in Smith's writings 27
• 9. Interpretations, qualifications, and objections 30
  • 9.1. The classical interpretation 30
  • 9.2. The neoclassical interpretation 36
  • 9.3. The evolutionary interpretation 42
• 10. The invisible hand and the science of complexity 44
• 11. A final note 49
• Appendix I: the invisible hand and the theory of natural selection 49
• Appendix II: the invisible hand of science 51
• Appendix III: other interpretations of the invisible hand 52
• Notes 54
• Bibliography 62

1 Introduction

The phrase “invisible hand” serves as a metaphor for the proposition that market order arises and evolves from interactions of economic agents pursuing their own ends. More specifically, households and business firms engage in micro-planning that – although decentralized and dispersed throughout the economy – creates a macro-order which is neither designed (arguably, cannot be designed) nor intended. According to the invisible-hand proposition, the micro-plans, like the pieces of a puzzle, fall into place and produce the macro-order. Expressed in this way, the invisible hand constitutes the most fundamental proposition underlying the market economic system, for the utility and even the viability of the system rest on the validity of this proposition. If the invisible hand did not hold true – that is, if the voluntary actions and interactions of individuals did not produce a stable and beneficent, although not necessarily a perfect, economic order – the whole edifice of the market system would collapse.

This chapter delves into the fascinating intellectual history of the invisible-hand proposition and presents its conception, articulation, evolution, interpretations, and applications. Adam Smith (1723–1790), a leading figure of the Scottish Enlightenment, deserves the central place in this intellectual odyssey, for, although the phrase “invisible hand” predates him, and many other scholars have contributed to its elucidation, he is the first thinker who invoked it in economic discourse, and – more importantly – provided a systematic analysis of the market economy to which the workings of the invisible hand are fundamental. In a later section we will thoroughly review and analyze the use of the phrase “invisible hand” in Smith's writings; here, it suffices to note that Smith invoked it for the first time in a non-economic context in an essay in the early 1750s. He then used it once in The Theory of Moral Sentiments (1759/1984, p. 184) and once in The Wealth of Nations (1776/1981, p. 456). In both books he invoked it while explaining that self-interested economic behavior – unintentionally and unbeknown to the agents – promotes society's interest.

Although economists generally invoke the invisible hand as a metaphor for the market order, no consensus exists among the historians of economic thought on what Smith meant by the phrase or why he used it. In fact the invisible hand remains remarkably controversial and even elusive.¹ Peter Minowitz (2004, p. 411) writes, “Centuries after Smith's death, we are still struggling to fathom a two-word phrase that stands out in a thousand-page book.” However, the invisible-hand proposition pervades Smith's writings and plays a fundamental role in his scholarly project. In an influential analysis of the invisible hand, Emma Rothschild (2001, p. 121) argues that Smith “used words which were to him slightly comical, or slightly unpleasant – the words ‘invisible hand’ – to describe an idea which was of profound importance to his theoretical system. The idea of the invisible hand can thus be distinguished, as far as it is possible, from the words in which it is described” (italics in original). The present chapter focuses on the concept of the invisible hand and uses the phrase only as a reference for the concept.

But the concept has also been subject to controversy. Gerard Debreu (1987, p. 216) notes that Smith had wondered “why a large number of agents motivated by self-interest and making independent decisions do not create social chaos in a private ownership economy.” Similarly, Amos Witztum (2010, p. 159) – while noting that interdependence among individuals arises from specialization and trade – argues, “the question whether this interdependence leads to a continuous conflict or to some order that may or may not be beneficial is paramount to Smith's overall agenda.” The views of many prominent scholars on the invisible hand range from praise to suspicion and even ridicule. James Tobin (1992, p. 117) refers to the invisible hand as “one of the great ideas of history and one of the most influential” and Friedrich Hayek (1967a, p. 99) hails the invisible hand as a “profound insight into the object of all social theory.” But Frank Hahn (1982, p. 16) argues, “both on purely logical considerations as well as on the basis of quite simple observations, the invisible hand is likely to be unsure in its operations and occasionally downright arthritic” and Joseph Stiglitz (2002, p. 460) confidently asserts, “the reason the hand is invisible is that it is simply not there – or at least if it is there, it is palsied.” We shall return to such views on the invisible hand.

Although the invisible hand embodies unintended consequences, human actions and public policy often produce unintended consequences with no relation whatsoever to the invisible-hand proposition. For an unintended consequence to count as the outcome of the invisible-hand process several conditions must hold. First, it must gradually arise and evolve from the interactions of individuals who pursue their own ends and are oblivious to the unintended outcome of their actions. Second, the emergent outcome should embody the contributions of interacting individuals in the process. Third, the interactions must lead to an order that Hayek (1973, p. 36) has described as “a state of affairs in which a multiplicity of elements of various kinds are so related to each other that we may learn from our acquaintance with some spatial or temporal part of the whole to form correct expectations concerning the rest, or at least expectations which have a good chance of proving correct.” Finally, the structure of the emergent order must be different from the sum of its parts. (The last condition is called the principle of organic unity, to which we will return in a later section.)

Thus, as Amartya Sen (1999, p. 254) has pointed out, “the discovery of penicillin from a leftover dish not intended for that purpose” and “the destruction of the Nazi party caused by – but not intended in – Hitler's military overconfidence” constitute examples of unintended consequences but not of the invisible hand. Unintended consequences can be reprehensible, such as China's “one-child family” policy that has resulted in “sex-specific abortions” (Ibid., p. 258).² As an example of unintended consequences of public policy, consider the Three-Strikes Law passed in 1994 in California that had intended to reduce crime. Radha Iyengar (2008, p. 25) has documented that this law “imposed 50,000 crimes on other states due to the migration of criminals out of California.” This unintended consequence does not qualify as an example of the invisible hand because it did not result from an evolutionary process involving interactions that produce an order in the Hayekian sense (noted above) and most importantly, it does not satisfy the principle of organic unity.

Examples of emergent phenomena that do qualify as the outcome of the invisible-hand process, as Hayek (1988, p. 24) has noted, include law, language, money, morals, markets, and even biological evolution.³ But the extent of the invisible hand has gone beyond Hayek's list. Craig Smith (2006, p. 1), in his book The Invisible Hand and Spontaneous Order, writes, “spontaneous order-inspired arguments can be found in the fields of biology, science, epistemology, language, economics, history, law, theology, sociology, anthropology and even recently in management studies and computing.”

There are only few and sporadic references to the phrase “invisible hand” in the nineteenth century's economics literature.⁴ Since the early twentieth century, however (especially after the Second World War), the phrase has become quite popular, often invoked by economists and even non-economists in diverse settings.⁵ Focusing on the concept, and not so much on the phrase, Hayek made the self-formation (his phrase) of social institutions the centerpiece of his scholarly project and gave a new life to the invisible-hand proposition. Contributions to general equilibrium theory (originating with Leon Walras in 1874), which – as we shall see later – attempts to model the workings of the invisible hand, also played an important role in reviving the proposition. More recently many scholars have turned to the insights and tools of the science of complexity – which focuses on self-organization in a number of natural and social phenomena – in order to understand the invisible-hand process. Similarly, evolutionary game theory – which studies the endogenous emergence of social institutions – has also attracted the attention of many scholars to the operation of the market.

Two intellectual developments gave birth to the invisible-hand proposition: first, contributions to the theory of market which originated in classical Greece and Rome; second, a controversy over human nature, launched by Thomas Hobbes' Leviathan in 1651. The next two sections present the contributions of these developments to the conception of the invisible-hand proposition.⁶

2 The theory of market before Adam Smith

The theory of market evolved throughout history as numerous thinkers, not all in favor of commercial activities, analyzed the consequences of market transactions...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Detailed contents
• Illustrations
• Acknowledgments
• Introduction
• 1 The invisible-hand proposition
• 2 The theory of comparative advantage
• 3 The law of markets
• 4 The quantity theory of money
• Index