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Friday, November 8, 2013

The Two Faces of the Market

In my academic life I often think about how the relationships we develop with people we know very well relate to the weak ties we form in the market with strangers. The rules, norms, and conventions we follow with friends and family differ in crucial ways from those that we follow when dealing with people we don’t know. Keeping these realms of action separate in our minds while striking a proper balance between the personal and the impersonal can be challenging. But not doing so is asking for big trouble in our personal lives and in the health of the market order.

Let’s Start with “The Adam Smith Problem”

In my last column I quoted Adam Smith twice. Because these quotations are once again germane to my point, I beg your indulgence while I reproduce them here. The first is from his famous book The Wealth of Nations (WN):

It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.

The second is from his earlier and much-less-known work The Theory of Moral Sentiments (TMS):

How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it.

Adam Smith in the first quotation says that self-interest, not beneficence, is responsible for putting food on our table, while in the second he says that it is both natural and necessary to take pleasure (and nothing else) in the happiness of others. So by nature we are both self-regarding and other-regarding.

Now, WN develops the social implications of the principle of self-interest, and TMS develops the social implications of other-regarding behavior. But while it’s clear that self-regarding and other-regarding complement each other to promote social order, Adam Smith never really explained how these two forces, selfishness and beneficence, could derive from a common principle. It’s a well-known paradox in the history of economic ideas called “The Adam Smith Problem.”

The Vernon Smith Solution

Vernon Smith (no relation to Adam but an admirer of Ludwig von Mises) tries to resolve the paradox in his essay, “The Two Faces of Adam Smith” (PDF). He draws on anthropological as well as economic theory, supported by data from the kind of laboratory experiments that won him the Nobel memorial prize in economics in 2002, to explain how beneficence and selfishness could both come from what Adam Smith described as our “propensity to truck, barter, and exchange.” It has to do in part with how we learn about “reciprocity,” both positive (do good to me now and I’ll do good to you later) and negative (do bad to me now and I’ll fix you later), among family and friends, and how that enables us under the right conditions to extend reciprocity to strangers. Likewise, what we learn from our impersonal relationships may also impinge on our personal relationships.

On the one hand, in close relationships we’re able to see directly how positive and negative reciprocity work in conjunction with our self-regarding behavior: Self-interest leads us to help our friends because a true friend will eventually in some way reciprocate. (Of course, if she just stops reciprocating, it will jeopardize the friendship because then self-interest would tell us to end it.)

On the other hand, in the realm of impersonal relationships that involve many strangers—just the sort of global-market scenario Leonard Read describes in his beautiful essay “I, Pencil”—it’s much harder to see how self-interest not only puts food on my own table, but also on the tables of the butcher, the brewer, and the baker—but it does. Indeed, it takes the science that Adam Smith helped to establish—economics—to correctly explain how markets coordinate the plans of countless strangers while at the same time make everyone better off. It’s counterintuitive to a lot of people who haven’t studied economics, and that can cause big problems.

The Vernon Smith Problem

Toward the end of his essay Vernon Smith writes:

We are able to appreciate the benefits of social exchange, that doing good accomplishes good because that is our experience in friendships. Not knowing of the invisible good accomplished by the self-interest in markets, but knowing of the good we accomplish by doing things for friends, we are led to believe we can do good by intervening into markets.

We learn from those close to us when and how to intervene into their lives if they need help. If my brother is in a tight spot, I’ll step in and give him some cash. Now, if we then think that the economy runs according to the same rules as our family (which of course it doesn’t), we might believe that intervening where we see what looks like a similar problem—such as unemployment—would help in the same way. But the impersonal market is orders-of-magnitude more complex than our family network, and intervening directly—via income transfers, price ceilings, and other regulations—will have serious unintended consequences that we will have no inkling about if we don’t understand economics. Giving a good customer a price break creates goodwill; putting a legal maximum on what sellers can charge creates shortages.

Which is why it’s important to keep the personal and impersonal realms conceptually separate and balanced.

First, the way we relate to people in our personal life isn’t typically centered on money and profit. A caricature of the free market, one addressed briefly in my previous column, is that the free market transforms personal relationships into market relationships. The “nexus of exchange” that rewards buyers and sellers on the impersonal market with monetary profit creeps into friendships and even family. Caricature or no, I’ve heard about people who have actually tried to substitute monetary calculation for affection and other needs deep into their relationships with their children and spouses. Why hug when a payout will do? The results aren’t pretty.

The second problem, the reverse of the first, is the one Vernon Smith identifies: extending the norms and expectations of family into the larger social order. As long as we are aware that the market is a very different, much more complex animal from the family, then we will be more cautious about trying to “do good” in the same way we might help a sibling. The familial obligation to reciprocate is absent under forced redistribution policies, along with the (Adam) Smithian “pleasure of seeing” it make recipients happy; at the same time, the taxes and subsidies involved discourage both “benefactors” and beneficiaries from working.  

But if we don’t know that, if we’re ignorant of economics, then bad consequences will probably follow. Or as the title of economist Christopher Coyne’s new book puts it, it will be a case of Doing Bad by Doing Good.

  • Sanford Ikeda is a Professor and the Coordinator of the Economics Program at Purchase College of the State University of New York and a Visiting Scholar and Research Associate at New York University. He is a member of the FEE Faculty Network.