Don't Read Wealth Of Nations too Quickly

Mark Thoma opens an interesting discussion on "Morality and Economics" on his brilliant and always readable Blog, Economist’s View.

There is too much to comment on (read his article and comments from readers here).

The following comment, I think it is from Mark Thoma, though it is between two statements from Kenneth Arrow, and may be Kenneth Arrrow’s:

‘I think that when Adam Smith was telling the story of getting his dinner from the butcher, the brewer, and the baker he was really thinking of a gentleman who has money to spend. He was not thinking of the struggles of those tradesmen to make a living. The price system can generate this kind of error.’

Comment
It is at the famous ‘butcher, brewer, and baker’ paragraph that much of what is misunderstood about self-interest in Smith’s Works starts to go wrong.

Here is the famous quote:

‘It is not from the benevolence of the butcher, the brewer, and the baker, that we expect our dinner, but from their regard to their own interests. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.” ((WN I.ii.2: pp 26-7)

It is not clear to me in what manner the ‘price system’ makes an ‘error’ in these circumstances, nor why ‘the struggles of those tradesmen to make a living’ is relevant to the transaction, any more than the ‘struggles’ of customers in search of the items for their dinner within their budgets are relevant to the ‘butcher, the brewer, or the baker’.

As we are enjoined to address the interests of the ‘butcher, the brewer, or the baker’, so they are enjoined to consider their customer’s interests. It was never the case, either in Wealth Of Nations, nor in Smith’s earlier Lectures at Glasgow University (1751-64), or in the ‘Early Draft’ (1763), which discuss the same transaction in almost the same terms, that Smith enunciated a doctrine that people should act from their own self-interest only, as if that is the end of it.

Markets involve transactions between two or more independent parties, who also happen to be dependent on each other, to serve their own interests, but they can only do this by addressing the other party’s interests, not their own.

Economists, especially in recent generations, do not seem to have grasped this point, including Nobel Prize Winners like George Stigler, Kenneth Arrow and Paul Samuelson. I know this is a risky charge to make from a lowly retired economist who will never be on anybody’s very, very long list for such acclaim as we rightly give to the giants of our profession, but retirement does allow one to ‘live dangerously’.

In markets, the two parties arrive at their transaction from entirely different perspectives. The seller is conscious of the costs involved in coming to market with something to sell, and the buyer is conscious of wanting something to buy within a limited budget.

If the agreed price does not meet the seller’s costs, he may conclude the bargain on that occasion, but will probably adjust his behaviour next time round, including lowering unit costs or withdrawing from the market, or, of course, entering in some collusion or scheme to narrow the competition in the market (a point often made by Adam Smith).

If the agreed price does not meet the buyer’s aspirations, she may conclude the bargain on that occasion (the family have to eat their dinner), but will probably adjust her behaviour next time round by raising the funds allocated to dinners (cutting something elsewhere in her budget), or withdrawing from buying items ‘too expensive’ for her budget and subsituting cheaper items, or seek another outlet where the competition among sellers impels them to lower their prices (a point often made by Smith when discussing the distorting effects of monopoly and protectionist behaviours and how they lead to ‘wrong’ allocations of capital).

But overall bargains are transacted by starting from different solutions to the same price problem (buyers wanting lower prices than sellers offer; sellers wanting higher prices than buyers demand); they may arrive at a solution that has a single price acceptable for both at that time and place.

The most efficacious way to arrive at that single solution is by conditional bargaining: ‘give me that that I want and you shall have this that you want’ (WN I.ii.2: p 26, which is only two lines before the ‘butcher, the brewer, or the baker’, enters the discussion.

The process of bargaining (completely ignored by John Nash’s 1950 paper, another Nobel Prize winner, assumes away the process by which prices are formed, and identifies the ‘ideal’ outcome only), involves each party mediating their self-interests by addressing not their own self interests, but by addressing each other’s.

Understanding this, as Smith wrote it and meant it, resolves Kenneth Arrow’s angst about the ‘errors’ of the price system. To the extent that individuals behave as if their self-interests are paramount in bargained transactions they make the process of negotiation a stressful and more difficult exchange that it needs to be.

Thirty years of observing, training and consulting with thousands of negotiators in the real world (not students playing games) has confirmed to me that Smith understood the price process much better than most economists understand it over 200 years later. Perhaps they read Wealth Of Nations too quickly? More likely, they cnanot model the bargaining process, so leave the dark alley for the lamplit pavement.