May 9, 2010

The Invisible Hand versus The Invisible Foot

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. -- Adam Smith, The Wealth of Nations

It's arguably the most delectable idea in all of economics -- the notion that markets, particularly free markets, harness the drive for private wants into the establishment for public needs. How would this happen? Robin Hahnel, in his excellent book The ABCs of Political Economy: A Modern Approach summarizes thusly:

Suppose consumers' taste for apples increases and their taste for oranges decreases -- for whatever reason. Assuming consumers know best what they like, how would we want the economy to respond to this new situation? If there were an omniscient, beneficent God in charge of the economy she [Ed note: Yeah! Go, gender equity!] would shift some of our scarce productive resources -- land labor, fertilizer, etc. -- out of orange production and into apple production. What would a system of free markets do? These changes in consumer tastes would shift the market demand curve for apples out to the right indicating that consumers now would demand more apples at each and every price of apples than before, and the market demand curve for oranges back to the left indicating that consumers would now demand fewer oranges at each and every price than before -- leading to excess demand for apples and excess supply of oranges at their old equilibrium prices. The micro law of supply and demand would drive the price of apples up until the excess demand would drive the price of apples up until the excess demand for apples was eliminated and the prices of oranges down until the excess supply of oranges was eliminated. At the new higher price of apples, the law of supply tells us that former apple growers, and any new ones drawn into the industry by the higher price of apples, would increase production of apples by purchasing more land, labor, fertilizer, etc. At the new lower price of oranges the law of supply tells us that oranges growers would decrease their production of oranges by using less land, labor, and fertilizer, etc. to grow oranges. Bingo! As if guided by an invisible hand, without anyone thinking or planning at all, the free market does what a beneficent God would have done for us!

This idea of the invisible hand sound tempting ideologically. But this is tempered by its nightmare cousin within markets -- what economists E.K. Hunt and Ralph D'Arge in 1971 called the "invisible foot". It's predicated on the idea that markets exchanges ignore certain dimensions of the exchange, lumped into the catchall category "externalities". The archetypal example is purchasing a car. If I buy a car from a local car dealership, I get a BRAND NEW CAR and the car dealer gets a bunch of my money. But there are effects of my purchase that extend beyond, sometimes well beyond, the immediate transaction between buyer and seller, and thus ignored by markets. It's easy to rattle off a list of some of the bad effects, or negative externalities:

  • Increased air pollution
  • Increased noise pollution
  • Increased greenhouse gases in the atmosphere, hastening the climate crisis and all the negative results thereof.
  • Increased wars, since our oil got under the sand of distant countries who have this crazy idea that our oil belongs to them, so we have to persuade them.
  • If I crash my car into a bus full of schoolchildren, killing most of them and hospitalizing or traumatizing the rest, that'd be some serious negative consequences, perhaps for the lifetimes of those schoolchildren and those families.

But there are also some positive externalities to my car purchase. For example:

  • I can give rides to political activist friends of mine, thus saving valuable time that would otherwise be potentially wasted by using slower, public transit.
  • I can enter into a wider number of social circles by using my car as a conversation piece, and thus introduce them to ideas they wouldn't have known about otherwise.

Whether or not good externalities outweigh bad externalities, these externalities represent costs which one may argue should be reflected in the transaction cost between the buyer and seller, but don't by definition. Perhaps if these externalities were insignificant, as Adam Smith and many economists since have assumed, one might make the case that externalities can safely be ignored. But as my first off-the-cuff list demonstrates, externalities can be very significant, and very negative. (Remember those schoolkids.)

Which brings us back to the idea of the "invisible foot" -- namely, the idea that negative externalities outweigh the positive externalities and the immediate benefits. But it's worse than that. To quote from one of the economists who coined the term, E.K. Hunt:

If we assume the maximizing economic man of bourgeois economics, and if we assume the government establishes property rights and markets for these rights whenever an external diseconomy [ed: a negative externality] is discovered [the preferred "solution" of the conservative and increasingly dominant trend within the field of public finance], then each man will soon discover that through contrivance he can impose external diseconomies on other men, knowing that the bargaining within the new market that will be established will surely make him better off. [Ed. note: It's ironic that this otherwise very progressive passage still smells of recidivist sexism. That said, I doubt that any sane woman would want to claim dibs on what's to follow in this passage.] The more significant the social cost imposed upon his neighbor, the greater will be his reward in the bargaining process. It follows from the orthodox assumption of maximizing man that each man will create a maximum of social costs which he can impose on others. D'Arge and I have labeled this process "the invisible foot" of the laissez faire ... market place. The "invisible foot" ensures us that in a free-market ... economy each person pursuing only his own good will automatically, and most efficiently, do his part in maximizing the general public misery. "

There's another quote of E.K. Hunt's that's worth sharing here, on the question of whether or not externalities are pervasive:

When reference is made to externalities, one usually takes as a typical example an upwind factory that emits large quantities of sulfur oxides and particulate matter inducing rising probabilities of emphysema, lung cancer, and other respiratory diseases to residents downwind, or a strip-mining operation that leaves an irreparable aesthetic scar on the countryside. The fact is, however, that most of the millions of acts of production and consumption in which we daily engage involve externalities. In a market economy any action of one individual or enterprise...constitutes an externality. Since the vast majority of productive and consumptive acts are social, i.e., to some degree they involve more than one person, it follows that they will involve externalities. Our table manners in a restaurant, the general appearance of our house, our yard or our person, our personal hygiene, the route we pick for a joy ride, the time of day we mow our lawn, or nearly any one of the thousands of ordinary daily acts, all affect, to some degree, the pleasures or happiness of others. _The fact is...externalities are totally pervasive._ Only the most extreme bourgeois individualism could have resulted in an economic theory that assumed otherwise

In other words, in market competition, you're looking to maximize profits and minimize costs, and those competitors will thus look to pass off costs where possible to the public and other parties. Those costs, even though they're ignored by those in the immediate transaction, are widespread and carry significant negative effects all the same (sometimes very significant). With the scale of technologies and global cataclysms that may await humanity on the horizons (melting icecaps, rising sea levels, ocean acidification, increased nuclear waste, chemical toxins, rising rates of garbage, et cetera, et cetera), those externalities can be more significant still.

On the question of which is larger -- the number and amount of negative externalities versus the number of positive externalities in an economy -- the only way to arrive at a definitive empirical answer is to find all the externalities, assess them as positive or negative, figure out their costs and add them up. Problem: markets provide no way to gauge that answer. The model of participatory economics, however, does -- through its use of "indicative prices" which gauge as closely as possible the full spectrum of costs for consumption and production (which I would divide into four components -- labor, environmental, social, supply-and-demand). But in a market, because externalities are pervasive, and negative externalities are passed off and positive externalities (when they occur) are kept, the invisible foot ends up bigger than the invisible hand. A lot bigger.