All Commentary
Monday, November 1, 1999

Invisible Hand Obsolete?

The Invisible Hand Depends on a System of Natural Liberty

Allen Murray’s Wall Street Journal article “Pushing Adam Smith Past the Millennium” (June 21, 1999) purports to discuss the relevancy of Adam Smith’s invisible hand for the 21st century. In reality, Murray is not talking about Smith or his invisible-hand metaphor at all. The assumption beneath his conclusion that “Smith’s ideas will need some rethinking in the years ahead” is based on a false premise, namely, that Smith’s ideas are valid only when markets conform to the world of perfect competition.

The validity of the invisible hand does not depend on market structures or “excludability” in the provision of goods or any of the other “problems” addressed by Murray and associated with perfectly competitive markets. Smith was drawing out the implications of a Lockean world based on “natural liberty.” In this world, property is privately owned and freely exchanged. The idea that in pursuing their own interest people will be led as if by an invisible hand to promote the well-being of others is a logical implication of this institutional setting.

In Smith’s system of natural liberty, if someone wants to significantly advance his material wealth he must produce things that will advance the well-being of others, and hence society’s wealth. If Murray wanted to investigate whether the invisible hand would be an appropriate metaphor for the 21st century, he should have focused on the extent to which private property and freedom of exchange will be secure. Amazingly, this fundamental issue wasn’t even raised.

Unrealistic Conditions

Perfect competition is an unrealistic set of conditions which, when present in all markets simultaneously, leads to an economy operating with “perfect efficiency”—that is, with all firms producing at the lowest possible cost. These conditions include perfect knowledge by all market participants, many price-taking buyers and sellers, complete homogeneity within product lines, and zero transaction costs. When one or more of these conditions are absent, most contemporary economists argue that markets are “failing.” The obscure and otherworldly conditions of perfect competition are used as a benchmark to judge the success of real-world markets.

Murray implicitly takes this benchmark, illegitimately equates it with the invisible hand, and converts the neoclassical theory of market failure into a theory of “invisible hand failure.” With no textual reference, Murray characterizes Smith’s views with the following three statements: “In Smith’s economy, if you consume a good, I cannot”; “In Smith’s world [rapidly declining marginal cost] leads to monopoly”; and “In order for Smith’s economy to work, sellers must be able to force consumers to become buyers and pay for what they use.” This analysis all came about 150 years after Smith wrote and is integral to the world of perfect competition, not the world of The Wealth of Nations.

The invisible hand and perfect competition have little to do with each other. This is easily seen in the “problems” that Murray associates with the markets and technologies he expects will dominate the next century. He argues that “The cost to Microsoft of developing Windows software may be huge; but the marginal cost of putting it on one more computer is virtually zero.” But this is only a problem within the realm of perfect competition, where efficient pricing requires that firms sell at marginal cost—an illogical result for any real-world market. Under perfect competition, if marginal cost is zero, a positive price generates “market failure.”

But this has nothing to do with the invisible hand. The fact is, unless he uses force, a person selling a product whose marginal cost is zero cannot sell to anyone who doesn’t value it more than the price asked. No matter how far above zero the price, the seller—even one as powerful as Bill Gates—cannot make himself better off without making someone else better off. Nothing Murray says negates that fact.

Murray goes on to suggest that this zero-marginal-cost world could lead to monopolies in industries where network effects are important. He states that “in the network economy . . . tens of millions sharing the same e-mail system may have distinct advantage over those who don’t. . . . In Smith’s world, that leads to monopoly.” Murray conflates Smith’s world with the world of perfect competition and presents no historical evidence to support his claim. Under Smith’s natural liberty, this “monopolist” would still have to make others better off in order to make himself better off. And so long as there were no legal barriers to entry, he would always have to be concerned about innovations and potential competitors.

Murray states that “the danger comes . . . if the pace of innovation slows and temporary monopolies become more permanent.” But this is only a danger in the absence of entrepreneurial freedom. The real threat comes from governments that are likely to create barriers to entry with protectionism, franchises, or regulations that allow large firms to operate free of any threat from the outside. This real and historically relevant danger, which was Adam Smith’s most important concern, goes completely unrecognized by Murray.

Free-Rider Problem

Finally, Murray frets about “the absence of excludability.” His concern? “Digital data are cheap and easy to copy.” To the extent that this is true, it may be too costly to exclude nonpayers from using software once it is in use. The theory of perfect competition suggests that this will cause the product to be “underproduced.”

The “problem” is that the assumption of zero transaction costs is being violated. The costs of excluding free riders are too high. To the extent that these costs make production of the good less profitable, the good will not be produced. But, of course, this is true of transportation costs, labor costs, and all other costs. Outside the world of perfect competition there is no logical reason for placing transaction costs in a separate category. To the extent that the good facing free-rider problems is not produced, resources are freed for other productive endeavors. Resources will flow to where the full costs of production, including transaction costs, are perceived to be less than the potential revenues.

Furthermore, Murray offers no historical evidence to support the underproduction hypothesis. Indeed, his point has been true of software from the beginning, and yet this is one of the fastest growing areas of commerce in the world. To some extent, “non-excludability” has always been present for all kinds of products—radio and television broadcasts, books and magazines, fashions. Indeed, non-excludability to some degree may be the rule rather than the exception. Yet, those preoccupied with perfect competition seem unswayed by the lack of real-world verification of their theory.

The invisible hand may not be an appropriate metaphor for the workings of economies in the next century. But this would be for the same reasons that it has not been an appropriate metaphor for most economies in the twentieth century. Liberty and the invisible hand are corollary. If liberty is treated with the same disdain in the next century as it has been in the present one, then the invisible hand may indeed be a relic of days gone by.

—Roy E. Cordato
Lundy Professor of Business Philosophy
Campbell University
Buies Creek, North Carolina.

  • Roy Cordato is Vice President for Research and resident scholar at the John Locke Foundation in Raleigh, NC. He is also a part time faculty member at NC State University where he teaches a primarily Austrian course called Political Economy of the Market Process and is faculty advisor for the Austrian Economics Forum made up of graduate and undergraduate students. He is a member of the FEE Faculty Network.