May 03, 2001

Groping Toward a Way of Thinking About the Information-Age Economy

Speculative Microeconomics for Tomorrow's Economy

by Michael Froomkin and Brad DeLong

Two and a quarter centuries ago the Scottish moral philosopher Adam Smith used a particular metaphor to describe the competitive market system, a metaphor which still resonates today. He saw the competitive market as a system in which:

"...every individual... endeavours as much as he can... to direct... industry so that its produce may be of the greatest value.... neither intend[ing] to promote the public interest, nor know[ing] how much he is promoting it.... 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 that was no part of his intention.... By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it..."

Adam Smith's claim back in 1776 that the market system promoted the general good was new. Today it is one of the most frequently-heard commonplaces. For Adam Smith's praise of the market as a social mechanism for regulating the economy was the opening shot of a grand campaign to reform how politicians and governments looked at the economy. The campaign waged by Adam Smith and his successors was completely successful. The past two centuries have seen his doctrines woven into the fabric of how our society works. It is hard to even begin to think about our society without basing one's thought to some degree on Adam Smith. And the governments that have followed the path Adam Smith laid down today preside over economies that are more materially prosperous and technologically powerful than ever before seen.

Belief in free trade, an aversion to price controls, freedom of occupation, freedom of domicile, freedom of enterprise, and the other corollaries of belief in Smith's invisible hand have today become the background assumptions for thought about the relationship between the government and the economy. A free-market system, economists claim and most participants in capitalism believe, generates a level of total economic product that is as high as possible--and is certainly higher than under any alternative system that any branch of humanity has conceived and attempted to implement. It is even possible to prove the "efficiency" of a competitive market--albeit under restrictive technical assumptions.

The lesson usually drawn from this economic success story is laissez-faire, laissez-passer: in the overwhelming majority of cases the best thing the government can do for the economy is simply to leave it alone. Define property rights, set up honest courts, perhaps rearrange the distribution of income, impose minor taxes and subsidies to compensate for well-defined and narrowly-specified "market failures"--but otherwise the economic role of the government is to disappear. The main argument for a free competitive market system is the dual role played by prices. On the one hand, prices serve to ration demand: anyone unwilling to pay the market price because he or she would rather do other things with his or her (not unlimited) money does not get the good (or service). On the other hand, price serves to elicit production: any organization that can make a good (or provide a service) for less than its market price has a powerful financial incentive to do so. Thus what is produced goes to those who value it the most. What is produced is made by the organizations that can make it the cheapest. And what is produced is whatever the ultimate users value the most.

You can criticize the market system because it undermines the values of community and solidarity. You can criticize the market system because it is unfair--for it gives good things to those who have control over whatever resources turn out to be most scarce as society solves its production allocation problem, not to those who have any moral right to good things. But--at least under the conditions economists have for two and a quarter centuries first implicitly and more recently explicitly assumed--you cannot criticize the market system for being unproductive.

Adam Smith's case for the invisible hand so briefly summarized above will be familiar to almost all readers: it is one of the foundation-stones of our civilization's social thought. Our purpose in this chapter is to shake these foundations--or at least to make readers aware that the changes in technology now going on as a result of the revolutions in data processing and data communications may shake these foundations. Unexpressed but implicit in Adam Smith's argument for the efficiency of the market system are assumptions about the nature of goods and services and the process of exchange--assumptions that fit reality less well today than they did back in Adam Smith's day. Moreover, these implicit underlying assumptions are likely to fit the "new economy" of the future even less well than they fit the economy of today...

Posted by DeLong at May 3, 2001 04:22 PM | TrackBack

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