Before reading this article, one is advised to carefully read the article on the blog of Miranda titled “Is the Invisible Hand Trembling?” by Mita Chaturvedi. The purpose of what follows is to explode the fallacies stated therein and also to clear some common confusions which generally prevail in discourse relating to market.
1.) Free Market
The article begins by asking the question “What does the term free-market mean to most of us?” and does not offer a single definition of it in the entire piece. We are only told that it’s “next-to-impossible to spot a free market outside a textbook,” which, frankly, leaves the reader scratching his/her head.
The term free market means a situation or a framework within which:
- People are free to exchange commodities, and within which
- they can own, control and operate private property..
Period. It’s silly to utter that free markets aren’t real or that they don’t exist in the real world. What doesn’t exists in the real world is perfect competition, not free markets.
2.) Incorrect Understanding of Adam Smith
The article then continues the tradition of misinterpreting Adam Smith. In doing this, it uses the most clichéd case of the invisible hand.
To the surprise of many, the term invisible hand appears only once in Wealth of Nations. But as most have not read Smith’s Wealth of Nations they don’t know the context in which Smith used the term. Smith believed that due to “Home Country Bias,” a producer, out of his interest, will prefer to employ his capital domestically. And in doing this, he will be led by an invisible hand to benefit the home country which was no part of his intention.[See pg. 456 of An Inquiry Into the Nature and Causes of Wealth of Nations, Glasgow edition.]
The invisible hand doesn’t mean a blanket rule that the market “will sort things out” as the author claims. Smith only meant in a metaphorical sense, that it “frequently” happens that when an individual pursues his self-interest instead of intending to do public good, his actions lead, in many cases, as if by an invisible hand, to serve interests of society “more effectually than when he intends to promote it. I have never known much good done by those who affected to trade for the public good.” [See pg. 456 of An Inquiry Into the Nature and Causes of Wealth of Nations, Glasgow edition.]
The author also sets herself to the task of seeing how “practical is this belief for a typical market.” The word belief meaning the belief in invisible hand to sort things out. Smith, unlike neoclassical economics, didn’t aim at creating an abstract model with arbitrary assumptions to predict the market process. Instead, he took the problem of un-designed order of the market, which he aimed to explain through the causal chain. Asking whether Smith’s invisible hand is practical is a hallmark of total confusion.
3.) Equilibrium Analysis
We are told then told that Demand and Supply– [are]the very foundation stones of economics. Why? Because it is primarily Demand and Supply that sets equilibrium prices and quantities in a market.
Equilibrium analysis is important in Neo-Classical tradition of economics and therefore demand and supply, which help in equilibrium analysis, are foundation stones of neoclassical economics. Not of the Austrian School of economics for example.
Then follows a logical confusion:
Despite being called the most efficient way to set market equilibrium conditions, an economy may not wish to completely rely on the market settings of Demand and Supply to set equilibrium conditions for several reasons.
Now market equilibrium conditions can be brought about by market only. If non-market methods are used to arrive at equilibrium, then the equilibrium is not a market equilibrium. These errors can be avoided by not using the prefix market with equilibrium.
It is also argued that equilibrium wages are set where labour demand is equal to labour supply. Equilibrium wages are not set, they emerge out of separate actions of individuals in an abstract model.
4.) A Misunderstanding of Prices
The author uses an abstract model inspired by neo-classical economics with unrealistic assumptions and without empirical evidence to arrive at her conclusion to understand the real world. Let us come out of the equilibrium analysis and see-through a priori reasoning why price control fails.
As argued by Austrian Nobel Laureate Economist Friedrich August von Hayek, prices are information signals that condense widely dispersed decentralized knowledge of facts (which are time and situation-specific) and individual preferences. This knowledge, being decentralized, dispersed and subjective by its very nature cannot be amassed by any single individual or entity, and so the task of setting price by the government, a price which reflects the underlying conditions of the market, is practically impossible. Moreover, an information signal which condenses knowledge cannot be corrected. It reflects underlying conditions and state of affairs. In a free market, if the price of a commodity is high, its an information signal indicating a scarcity of that commodity. It is luring the existing producers to produce more, inviting new producers to produce the commodity, and telling the consumers to economize. Fixing the price below the market price makes the commodity more scarce instead of ensuring more availability of commodity at an affordable price. This is not quantum mechanics. Understanding this simple fact doesn’t require the silly game of equilibrium analysis or using the concept of deadweight loss for that matter.
There’s a common misconception about free-market economics, answering which I will end this piece. Analysis of the free market doesn’t furnish the conclusion that the free market creates a land of Cockaigne. It merely demonstrates what happens in a market. It may be fair or unfair. Just or unjust. Pleasing or appalling. What those who advocate free markets merely argue is that an attempt to intervene in the market, to make outcomes fair, just, or pleasing, will end up, more often than not, creating a worse situation than what market offers.
The critics of free-market should keep this in mind instead of creating a straw man of the market whose invisible hand automatically sort things out.