Adam Smith Revisited: Beyond the Invisible Hand

The writing of the father of modern economics is, 250 years later, still very much worth reading - especially beyond the snappy, but sometimes selective, quotes

Koenfucius (the online moniker of Koen Smets) is one of the most prolific bloggers on behavioural economics, discussing the details of research results in the area and their relevance for people’s everyday life. In 2016, his first blog post was titled “We are all economists”, in which he pointed out how Adam Smith’s insights were often misunderstood. In this joint post, we revisit this idea.

Adam Smith is most often associated with his notion of an invisible hand guiding individuals’ selfish motives and decisions towards mutual benefits through market forces. As such he has been associated with free market capitalism by its proponents and its critics.

However, the association of Adam Smith with the “invisible hand” of the market has often led to a simplistic interpretation of his intellectual contribution. In this post, we discuss how, rather than advocating unbridled capitalism, he described and annotated with great perspicacity the human interactions he observed at individual and societal level, and people’s ingenuity and creativity to work more productively through collaboration. His observations were both much more subtle and much richer than the quote that is so often wheeled out. More importantly, they are as relevant today as they were then, because they tap straight into the foundations of human life in society.

Adam Smith, apologist for modern free-market capitalism?

Adam Smith clearly saw the benefits in the workings of market mechanisms. His first famous insight, still valid today, is the enormous gains to productivity made from specialisation in a large market. He illustrates this idea with the production of pins. A small market may only require the production of a small number of pins that have to be produced by a few individuals that each perform the several steps of production. In a large market, it makes much more sense to produce the required volumes of pins in a factory where workers collaborate: each one specialises in one of the steps in the manufacturing process, which leads to substantial productivity gains.

Division of labour in a pin factory.

On the gains from such division of labour, Smith wrote:

It is the great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people. - Smith, The Wealth Of Nations, Book I, Chapter I

The integration of markets within a country therefore creates the opportunity for gains in productivity, and thus well-being. People could generate more wealth with less effort. The same logic applies to international trade, which further extends the division of labour across international markets.

By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland? - Smith, The Wealth Of Nations, Book IV, Chapter II

This was not entirely new: even before the industrial revolution, tradespeople had been specialising, as it is more efficient (and hence more productive, and leading to cheaper output) for butchers to turn cattle into sirloin steaks, for brewers to convert yeast, malt and hops into ale, and for bakers transform flour into bread. But Smith clearly saw how this would deliver much larger advantages when applied at a countrywide scale as international trade expanded. 

In addition to the size of the market, Smith appreciated that the aim to make profit led producers to produce and bring to the market the goods that people are interested in. In that sense, even without an organisation like a bureaucracy or a church, markets can lead people who naturally pursue their own best interest to produce a positive social outcome. This is the very essence of his quote about the famous invisible hand:

Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... 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. - Smith, The Wealth Of Nations, Book IV, Chapter II

So, isn’t this proof that Smith is defending the benefits of unfettered free market capitalism? Well, not so fast. That is only one aspect of Smith’s views on the economy.

Adam Smith, the critic of oligarchic economic capture

One of the tell-tale signs that there is more to Smith than the defence of capitalism and markets as they are, is the fact that he is also praised by one of the most famous left-wing intellectuals of the last half-century, Noam Chomsky.

Given the quotes in the previous section, you may be perplexed and wonder whether Chomsky has read Adam Smith properly. Well, perhaps he has, at least more than many who just quote the “invisible hand”. Adam Smith was not a defender of the big fortunes of his time. While he argued the benefits of a market economy, he was not asking for more freedom for the powerful members of the economic elite. Smith was positive about the benefits from market competition, but he fostered no illusions that powerful manufacturers would not try to subvert this competition by colluding and lobbying, so they could depress wages and thus increase profits.

Masters are always and every where in a sort of tacit, but constant and uniform combination, not to raise the wages of labour above their actual rate. - Smith, The Wealth Of Nations, Book VIII, Chapter VIII

The proposal of any new law or regulation of commerce which comes from [businessmen] ought always to be listened to with great precaution. [They] have generally an interest to deceive and even to oppress the public. - Smith, The Wealth Of Nations, Book III, Chapter XI

Indeed, contrary to the naive view that the pursuit of self-interest always brings the common good, Smith was a candid critic of the purpose of social elites whose self-interest may conflict with the interest of the bulk of the population.

All for ourselves and nothing for other people seems, in every age of the world, to have been the vile maxim of the masters of mankind. - Smith, The Wealth Of Nations, Book III, Chapter IV

In that context, market mechanisms are often in the interest of the broad public, while the absence of market competition often benefits powerful members of the elite. This take by Adam Smith makes sense given the concern he expressed about high levels of social inequality in society:

No society can surely be flourishing and happy of which by far the greater part of the numbers are poor and miserable. - Smith, The Wealth Of Nations, Book I, Chapter VIII

So, wait a minute, is Smith a socialist?! No, not really. Smith was a liberal from the 18th century, prior to the Industrial Revolution. Smith’s books were not written to defend the type of market capitalism with large corporations, where the hand is often very visible. He saw, and espoused, the huge potential of the market to serve the population, not the powerful manufacturers who might attempt to subvert these market mechanisms with self-serving motives.

In his famous book, Alfred Chandler argued that the visible hand of managers has replaced the invisible hand of market forces in shaping the American economy.

Adam Smith, behavioural economist

Adam Smith’s views are also misperceived in another important dimension. He was not the proponent of the view that we follow our self-interest in a narrow, cold-hearted and hyper-rational way. Instead, he had a very astute understanding of human psychology and of the complexity of human interactions.

Rereading Adam Smith now, it is surprising to see how he anticipated several phenomena that would later appear in the literature on behavioural economics. Let’s look at five of them.

One of the most well-known concepts put forward by Kahneman and Tversky—whose work is at the origin of behavioural economics as a discipline—is the notion of loss aversion: the idea that losses loom larger than (similar) gains in our mind. This idea was already described in the Theory of Moral Sentiments, 200 years before Kahneman and Tversky’s papers:

Adversity, …, necessarily depresses the mind of the sufferer much more below its natural state, than prosperity can elevate him above it. - Smith, Theory of Moral Sentiments, Book I. Chapter iii

Another big area of research in behavioural economics has been our tendency to exhibit present-biased preferences, whereby we overly focus on present rewards, which leads to decisions that may hurt us in the long term.

The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy today, the passion which the first excites, is naturally so weak in comparison with that violent emotion which the second is apt to give occasion to, that the one could never be any balance to the other, unless it was supported by the sense of propriety… - Smith, Theory of Moral Sentiments, Book IV, Chapter ii

A third concept that gained the attention of behavioural economists is the fact that people tend to exhibit overconfidence and form beliefs about themselves that are too positive or flattering. Adam Smith describes this aspect of human psychology in a very explicit manner:

The over-weening conceit which the greater part of men have of their own abilities, is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune, has been less taken notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth. - Smith, The Wealth of Nations, Book I, Chapter X.

Smith also identified the outcome bias: the fact that we tend to judge actions based on their outcome (often due to chance) rather than on their soundness at the time when they took place.

That the world judges by the event, and not by the design, has been in all ages the complaint, and is the great discouragement of virtue. Every body agrees to the general maxim, that as the event does not depend on the agent, it ought to have no influence upon our sentiments, with regard to the merit or propriety of his conduct. But when we come to particulars, we find that our sentiments are scarce in any one instance exactly conformable to what this equitable maxim would direct. The happy or unprosperous event of any action, is not only apt to give us a good or bad opinion of the prudence with which it was conducted, but almost always too animates our gratitude or resentment, our sense of the merit or demerit of the design. - Smith, Theory of Moral Sentiments, Book II Chapter iii

Finally, contrary to the often-held view of Smith championing individual selfishness, he instead saw people as filled with moral concerns. Indeed, Adam Smith was a moral philosopher, too.

How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it. - Smith, Theory of Moral Sentiments, Book I Chapter i

To feel for others, to restrain our selfishness and exercise our benevolence, constitute the perfection of human nature. - Smith, Theory of Moral Sentiments Book I Chapter i

Man naturally desires, not only to be loved, but to be lovely. - Smith, Theory of Moral Sentiments, Book I Chapter ii

In Adam Smith’s original texts, we get to appreciate the rich and subtle understanding he had of social life and social institutions. It is the wealth of these insights that explains why economists have shown a renewed interest in his writing, looking beyond the “invisible hand” summary description of his work.

Recent books on Adam Smith: Adam Smith’s System (2023) and How Adam Smith Can Change your Life (2015)

It is a feature of Adam Smith’s great insights that he is still worth reading, two hundred and fifty years after he wrote. But beware of selective reading, and only narrowly seeing what you think he wrote.  Look beyond the snappy quotes, and you will see that he was not should not be read as a naive apologist for unfettered market capitalism, but a lucid observer of social and economic interactions, aware of the possible gains from large-scale cooperation through markets, as well as of the potential power dynamics in society that can lead to the capture of these gains by a minority.

References

Ashraf, N., Camerer, C.F. and Loewenstein, G., 2005. Adam Smith, behavioral economist. Journal of economic perspectives, 19(3), pp.131-145.

Chandler, A., 1977. The Visible Hand: The Managerial Revolution in American Business. Cambridge, MA, Harvard University Press.

Ortmann, A. and Walraevens, B., 2022. Adam Smith’s System: A Re-Interpretation Inspired by Smith's Lectures on Rhetoric, Game Theory, and Conjectural History. Springer Nature.

Roberts, R., 2015. How Adam Smith can change your life: An unexpected guide to human nature and happiness. Portfolio.

Smith, V.L., 2015. Adam Smith: Homo socialis, yes; social preferences, no; reciprocity was to be explained.