Economic System States, Feedback Loops, and Adam Smith’s Invisible Hand

Adam Smith, the builder of a majestic Gothic cathedral of economic thought.
by John Kay (1742-1826)/Library of Congress (PD-1996)

This is the second of two posts on the applicability of the metaphor of Adam Smith’s “Invisible Hand” to describe how demand for goods and services is matched by their supply in an efficient manner. The first half of this essay in the post Feedback Loops and Economic System States contains material that is absolutely necessary to understand this post. If you do not know what sociocultural homeostasis is, I strongly recommend you go back and read the first half of this essay.     

The two authors of the paper Exploring the concept of homeostasis and considering its implications for economics, Antonio Damasio and Hanna Damasio, have made the claim that mechanisms behind the invisible hand are specific to cultures with free-market economies, and they frankly doubt the applicability of the metaphor even in free-market cultures. As I wrote at the end of the last post, Adam Smith’s invisible hand is the economic mechanism that directs individual suppliers of goods and services to meet the economic demands of society with their industry. As Adam Smith wrote of these suppliers in An Inquiry Into the Nature and Causes of the Wealth of Nations, 

… 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 no 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.

The emphasis in the quote is mine. So what exactly is the mechanism by which this balance between the demand for a good or service and its supply is obtained? There are two sets of two values each that must be made the same: the first is the quantity and price of a good desired by the consumer, and the second is the quantity and price for that good the supplier is willing to sell. When I first wrote about this mechanism in the post Adam Smith’s Invisible Hand, I  produced an explanation purely in terms of the law of supply and demand. If you do not understand the law of supply and demand in terms of Alfred Marshall’s supply and demand curves, you should read the post The Law of Supply and Demand.  However, supply and demand curves are always changing with new technology, changing values of goods due to changing desires, new supplies of raw materials, etc. The description of such changes comes from the law of marginal utility. The mechanisms behind the invisible hand metaphor are the intertwining interactions between the law of marginal utility and the law of supply and demand in setting quantities and  prices of goods in the market place. The law of marginal utility provides the necessary feedback in a changing society to yield sociocultural homeostasis.

The first and most important thing to understand is that the economic value of a good is a purely subjective and psychologically determined thing that is different for every individual in the market place. It is not because of the values of inputs in making the good that I value it; it is the utility or usefulness of that good to me. You can put a huge amount of investment in producing something (as in digging holes and filling them back up), but if the product does absolutely nothing for me, it has no value as far as I am concerned. The value might be because of something completely essential to me, such as food to eat so I will continue to live. Or the value might be purely because of its aesthetically pleasing nature, such as an excellent recording of Dvorák’s New World Symphony. However, the exact value I place on any good, the price I am willing to pay for it, is something psychologically subjective and specific to me. This is true even for items absolutely necessary for my continued existence. I might eat lavishly at the best restaurants because I love great food. Or if I value other things more highly, such as books, I might save my money for the books by eating little and simply. Economic value is not an objective quality, but totally subjective.

This great fact about economic value produces a real difficulty in determining a price for a quantity of a good in the market place. How can I as a merchant set a price when a good’s value is slightly (or hugely) different for everyone? The answer ends up essentially being trial and error to sample how much of the good can be sold at different prices. My goal as a supplier is to make the largest profit possible, i.e. to maximize the product of the unit price times the quantity sold. Suppose I initially set the price high. If it is higher than the value most people have for the good, I will sell very little and only to those who value it the most. If I then lower the price, more people will value the good enough to buy it, including all those who would have bought it a higher price. By adjusting the price, I eventually find the price at which I maximize my profit. In doing this I will observe that as I reduce prices, the quantity consumers are willing to buy continually increases. The graph of the quantity people are willing to buy versus the sale price forms Alfred Marshall’s demand curve, sometimes called the demand schedule. It shows a quantity demanded that is a monotonically decreasing function of price.

On the other hand, I as a supplier would be willing to produce increasing amounts of the good if the price goes higher. Of course if the price went to zero, the supplier would not be willing to produce the good at all. Therefore, Alfred Marshall’s supply curve giving the quantity of the good a supplier would be willing to produce as a function of price shows a monotonically increasing function of price. If I were to plot both curves on the same graph, I would find  something like the figure below. The supply and demand curves are labeled with an S and a D, respectively.

The point in the price-quantity plane where the two curves intersect is a magical spot called the equilibrium market price point. It is the economically most efficient point at which the market could be. If the good is sold at that point, the amount bought will exactly equal the amount produced with no waste on the part of either the producer or the consumer. If the price is set too high at P_H, the quantity produced will be higher than the quantity bought and the supplier would have to go to the expense of warehousing the excess and will not immediately recoup his investment in producing the excess. If the price is set too low at P_L, the amount demanded would be higher than the quantity produced and there would be a shortage of the good. The equilibrium market price should also be the profit maximizing price for the supplier, since warehousing goods at higher prices creates costs and not selling the goods transforms the investments to produce into losses. At lower prices there is also a smaller quantity produced, creating a lower profit.

What if the factors of production change and in changing costs, shift and possibly distort the supply curve, or changing fashions shift the demand curve? The changes in the supply and demand curves are partially determined by the law of marginal utility. The law states that as the supply of a good  increases, the price of the last good sold (also known as the marginal utility) decreases. This is because the supply of a good becomes increasingly less useful as the consumer’s need is fulfilled. Once a consumer has no more need for the good, he will not pay anything for it. If you think upon it, you can see this explains the difference in price between an amount of water and an equal weight of diamonds, despite the fact water is much more needed by an economy than diamonds. Water is also much more available in greater quantities than diamonds. We can now invent thought experiments that can cause shifts in either of the two curves. For example, suppose the demand curve is initially given by D₁ as shown in the figure below.

We then suppose that for some reason that the supply of the good increases to an extent that the market is partially saturated with the good. Then the consumers would buy a smaller number of the good at the same price as before the change. This means the demand curve would be shifted to the left to some new demand curve D₂ as shown in the figure. Alternatively, conditions could cause the availability of the good to decrease. Then marginal utility working in reverse would cause the the demand curve to shift to the right. In fact if the availability of the good decreases, say because of more costly raw materials, then costs of producing the supply would require the supply curve to also move to the right, increasing the market price at which the curves intersect even higher.

This then is Adam Smith’s invisible hand: The laws of supply and demand and of marginal utility determine supply and demand curves that set the equilibrium market price, to which market forces in a free market inevitably push the actual price. It is the price at which consumers will buy all the goods produced and at which the supplier maximizes his profit. It is the price at which supply and demand are exactly balanced.

How then are we to evaluate the Damasios’ criticisms of the invisible hand, given what we now know about what the metaphor represents? Allow me to re-quote what they say about it.

Because there is a dual nature to human homeostatic control, and because conscious deliberation is a patent human reality, it is not likely that economic systems operating [Sic] well only on the basis of Adam Smith’s “invisible hand”( Smith, 1776). The invisible hand idea fits well the homeostatic world of bacterial cells, an un-minded world in which quorum sensing accomplishes a lot of good governance and is indeed invisible. But the invisible hand does not capture fully to the human case. The wide variety of cultural instruments that human conscious feelingness and intellect have created, are subject to their own cultural evolution. The responses they generate may or may not coincide with those that the evolutionarily older invisible hand devices would produce. 

Their criticisms center on the cultural compatibility of Smith’s invisible hand in any particular culture. In at least one particular set of cultures, they are absolutely correct. For the invisible hand to work, not only do the laws of supply and demand and of marginal utility have to work, but also a free market must exist to allow the price point to be pushed to the equilibrium market price. The natural working of supply and demand and of marginal utility are pretty much culturally independent, depending on the existence of an economy in which goods and services are exchanged. In the Union of Soviet Socialist Republics there was a rich history of what the law of supply and demand did to that state when the commissars set prices quite differently from the market equilibrium. Consumer prices like the price of bread were often set low causing massive shortages. Occasionally, prices for industrial goods were set high, causing large surpluses that had to be warehoused. But while the law of supply and demand and the law of marginal utility continued to work in the Soviet Union, one essential part of the invisible hand was absent. There was no free market to cause the setting of the market price.

Can any culture not using free markets in their economy have an economy that works well? Can they have an economy that employs a large fraction of everyone who wants a job, and that creates sufficient wealth to give everyone a comfortable living? The evidence of history gives strongly negative answers to these questions, as I discussed in Bending History.

There has been only one serious attempt to replace free markets and yet maintain its function of setting the market prices at the intersection of the supply and demand curves for the various goods. That attempt was the idea of market socialism developed by the Polish economist Oskar Lange. With his system, prices for goods would be set by a government board and then adjusted according to whether a surplus or a shortage was produced. The Soviet Union adopted this method for setting prices and tried mightily to make it succeed. Unfortunately for the Soviet Union and its empire, it never worked. One large problem was probably the huge scale of the number of prices that needed to be set together with the finite time a relatively small board would have to set the prices. In a free market prices are set by a large number of companies and merchants, who as a work force number in the many millions in the United States. (In 2010 there were 27.9 million small businesses in the U.S. In each business there would be at least one individual responsible for setting their prices, and for many businesses there would be several.) Even if a socialist price-fixing board had a work force in the thousands, it would be difficult for it to cover all prices in the economy over a realistic time-period. At any rate we know empirically that the effort failed because of the large number of shortages and surpluses that came out of the Soviet Union. I know of no other serious attempt to replace the functioning of Adam Smith’s invisible hand. Economies without free-markets simply will not and can not perform well in the sense of balancing demand with supply.

Let us then consider only those cultures that possess at least partially free markets. If that is the case, to what degree can the invisible hand succeed in its function in different cultures? The very heart of the invisible hand mechanism is the accuracy of the supply and demand curves in predicting quantities that would be bought and sold at different prices. As I described above, these curves would be empirically traced out in the neighborhood of the market equilibrium price. Would there be enough information in them to account for preferences for every economic good in any culture? The Damasios worry that the “wide variety of cultural instruments that human conscious feelingness and intellect have created, are subject to their own cultural evolution. The responses they generate may or may not coincide with those that the evolutionarily older invisible hand devices would produce.” But why would the supply and demand curves not reflect the population’s preferences in a given culture? The curves are determined empirically in the process of the suppliers’ and consumers’ mutual search for the one price at which the number of a good offered for sale is equal to the number bought. All of the cultural variations of beliefs, values, feelings, and desires in the population for various goods are summarized in the supply and demand curves. The consumers of goods in a particular society inform the suppliers of the kinds, quantities, and prices of goods through what they buy in what quantities and at what prices. The suppliers of these goods inform the consumers of what goods they are willing to produce in what quantities and at what prices through what they offer for sale. Far from not being responsive to cultural influences, Adam Smith’s invisible hand has cultural preferences built into the supply and demand curves. As the culture evolves with  companies offering new kinds of goods and the consumers changing what they demand, the supply and demand curves will be updated by the operation of the law of marginal utility.

I will close this essay with an observation I have made before at the end of the post Adam Smith’s “Invisible Hand” and Evolution. It is a very strong claim, but one justified by the human experience, by economic history. Not only does the invisible hand work miraculously well in setting quantities and prices of goods in all cultures using free-markets, we know of absolutely no other way in which these functions can be practicably performed. As for cultures that do not have free-markets, they will never perform well economically because of the shortages and surpluses they will constantly create.
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