Adam Smith (1723-1790)

1. Adam Smith(1723-1790) “The Invisible Hand”

2. The “Invisible Hand” • The Wealth of Nations (1776). • There is a benevolent deity who administers the world in such a way as to maximize human happiness. • In order to do this he has created humans with a nature that leads them to act in a certain way. • The world as we know it is pretty much perfect, and everyone is about equally happy. In particular, the rich are no happier than the poor. • Although this means we should all be happy with our lot in life, our nature (which, remember, was created by God for the purpose of maximizing happiness) leads us to think that we would be happier if we were wealthier. • This is a good thing, because it leads us to struggle to become wealthier, thus increasing the sum total of human happiness via the mechanisms of exchange and division of labor.

3. The “Invisible Hand” • Economics can be understood as a process involving acting agents • There is no explicit agreement between the acting agents • The process is not intentional • The agents' aims are not coordinated nor identical with the actual outcome • The process should work even without the agents having any knowledge of it

4. The “Invisible Hand” • In order for this economic process to work, the following pre-conditions must be met: • contracts must be enforceable • people must have good access to information • the rule of law must hold

5. The “Invisible Hand” • The result of this economic process: The “Free Market” • consumers seek the lowest price (by making their excess or insufficient demand known through market prices, consumers “direct” entrepreneurs' investment money to the most profitable industry)

6. The “Invisible Hand” • Producers seek the highest rate of profit (by producing the goods most highly valued by consumers, overall economic well-being is increased) • Why is this the best system? • What are the alternatives? • We could get people to cooperate with our needs by appealing to their benevolence and goodwill (aside from being utopian, this would require people to be servile)

7. The “Invisible Hand” • We could devise a system of forced economic interactions (a command economy) to ensure that everyone’s needs are met • Instead, we construct a system wherein we appeal to each other’s self-interest in a series of “exchanges”. In proposing an exchange, we attempt to show each other that what we can do, or what we have, than can be of use to the other

8. The “Invisible Hand” • When we carry out these exchanges, it means the other person recognizes that what we can do or that what we have is of value • This is why so much of a person's self-esteem is bound up in their job: a well-paid job is supposed to be a sign that others value our contribution and find it worth exchanging their own resources for

9. The “Invisible Hand” • Positive Externalities: • Prices and Wages • Supply and Demand • The “Trickle Down” Theory • Collective Utility • Provides public goods • Solves Government Failure: Government sometimes provides for an inefficient allocations of public goods • By interjecting competition, efficient delivery of public goods by private entrepreneurs, via the free market, is possible

10. The “Invisible Hand” • Some Problems with the theory • The “Prisoner’s Dilemma”: Two people in asimple situation, acting in an un-informed manner, both attempting to maximize their well-being, and yet making choices that lead to an unnecessarily poor outcome for both. • Free Riders • Negative Externalities • Low wages • Poor working conditions • Pollution • Market Failure • Monopolies • Insufficient allocations of a public good: no profit incentives to provide for it • Information costs: Insufficient information for producers AND consumers

11. The “Invisible Hand” • Regulated free markets: • Supply-side vs. Demand-side economics • The role of fiscal and economic policy • Economic, consumer, and environmental regulation