Why does the invisible hand, “which says that competition challenges self-interest for the common good” break down?
Without question, Adam Smith's invisible hand was a genuinely ground breaking insight. Producers rush to introduce improved product designs and cost-saving innovations for the sole purpose of capturing market share and profits from their rivals. In the short run, these steps work just as the producers had hoped. But rival firms are quick to mimic the innovations, and the resulting competition quickly causes prices to fall in line with the new, lower costs. In the end, Smith argued, consumers are the ultimate beneficiaries of all this churning.
But many of Smith's modern disciples believe he made the much bolder claim that markets always harness individual self-interest to produce the greatest good for society as a whole. Smith's own account, however, was far more circumspect. He wrote, for example, that the profit-seeking business owner “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 [emphasis added].”
Smith never believed that the invisible hand guaranteed good outcomes in all circumstances. His skepticism was on full display, for example, when he wrote, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” To him, what was remarkable was that self-interested actions often led to socially benign outcomes.
Like Smith, modern progressive critics of the market system tend to attribute its failings to conspiracies to restrain competition. But competition was much more easily restrained in Smith's day than it is now. The real challenge to the invisible hand is rooted in the very logic of the competitive process itself.
Charles Darwin was one of the first to perceive the underlying problem clearly. One of his central insights was that natural selection favors traits and behaviors primarily according to their effect on individual organisms, not larger groups. Sometimes individual and group interests coincide, he recognized, and in such cases we often get invisible hand-like results. A mutation that codes for keener eyesight in one particular hawk, for example, serves the interests of that individual, but its inevitable spread also makes hawks as a species more successful.
In other cases, however, mutations that help the individual prove quite harmful to the larger group. This is in fact the expected result for mutations that confer advantage in head-to-head competition among members of the same species. Male body mass is a case in point. Most vertebrate species are polygynous, meaning that males take more than one mate if they can. The qualifier is important, because when some take multiple mates, others get none. The latter don't pass their genes along, making them the ultimate losers in Darwinian terms. So it's no surprise that males often battle furiously for access to mates. Size matters in those battles, and hence the evolutionary arms races that produce larger males.
Elephant seals are an extreme but instructive example.10 Bulls of the species often weigh almost six thousand pounds, more than five times as much as females and almost as much as a Lincoln Navigator SUV. During the mating season, pairs of mature bulls battle one another ferociously for hours on end, until one finally trudges off in defeat, bloodied and exhausted. The victor claims near-exclusive sexual access to a harem that may number as many as a hundred cows. But while being larger than his rival makes an individual bull more likely to prevail in such battles, prodigious size is a clear handicap for bulls as a group, making them far more vulnerable to sharks and other predators.
Given an opportunity to vote on a proposal to reduce every animal's weight by half, bulls would have every reason to favor it. Since it's relative size, not absolute size, that matters in battle, the change would not affect the outcome of any given head-to-head contest, but it would reduce each animal's risk of being eaten by sharks. There's no practical way, of course, that elephant seals could implement such a proposal. Nor could any bull solve this problem unilaterally, since a bull that weighed much less than others would never win a mate.
Similar conflicts pervade human interactions when individual rewards depend on relative performance. Their essence is nicely captured in a celebrated example by the economist Thomas Schelling. Schelling noted that hockey players who are free to choose for themselves invariably skate without helmets, yet when they're permitted to vote on the matter, they support rules that require them. If helmets are so great, he wondered, why don't players just wear them? Why do they need a rule?
His answer began with the observation that skating without a helmet confers a small competitive edge—perhaps by enabling players to see or hear a little better, or perhaps by enabling them to intimidate their opponents. The immediate lure of gaining a competitive edge trumps more abstract concerns about the possibility of injury, so players eagerly embrace the additional risk. The rub, of course, is that when every player skates without a helmet, no one gains a competitive advantage—hence the attraction of the rule.
As Schelling's diagnosis makes clear, the problem confronting hockey players has nothing to do with imperfect information, lack of self-control, or poor cognitive skills—shortcomings that are often cited as grounds for government intervention. And it clearly does not stem from exploitation or any insufficiency of competition. Rather, it's a garden-variety collective action problem. Players favor helmet rules because that's the only way they're able to play under reasonably safe conditions. A simple nudge—say, a sign in the locker room reminding players that helmets reduce the risk of serious injury—just won't solve their problem. They need a mandate.
What about the libertarians' complaint that helmet rules deprive individuals of the right to choose? This objection is akin to objecting that a military arms control agreement robs the signatories of their right to choose for themselves how much to spend on bombs. Of course, but that's the whole point of such agreements! Parties who confront a collective action problem often realize that the only way to get what they want is to constrain their own ability to do as they please.
As John Stuart Mill argued in On Liberty, it's permissible to constrain an individual's freedom of action only when there's no less intrusive way to prevent undue harm to others. The hockey helmet rule appears to meet this test. By skating without a helmet, a player imposes harm on rival players by making them less likely to win the game, an outcome that really matters to them. If the helmet rule itself somehow imposed even greater harm, it wouldn't be justified. But that's a simple practical question, not a matter of deep philosophical principle.
Rewards that depend on relative performance spawn collective action problems that can cause markets to fail. For instance, the same wedge that separates individual and group interests in Darwinian arms races also helps explain why the invisible hand might not automatically lead to the best possible levels of safety in the workplace. The traditional invisible-hand account begins with the observation that, all other factors the same, riskier jobs tend to pay more, for two reasons. Because of the money employers save by not installing additional safety equipment, they can pay more; and because workers like safety, they will choose safer jobs unless riskier jobs do, in fact, pay more. According to the standard invisible-hand narrative, the fact that a worker is willing to accept lower safety for higher wages implies that the extra income was sufficient compensation for the decrement in safety. But that account rests on the assumption that extra income is valued only for the additional absolute consumption it makes possible. When a worker gets a higher wage, however, there is also a second important benefit. He is able to consume more in absolute terms, yes—but he is also able to consume more relative to others.
Most parents, for example, want to send their children to the best possible schools. Some workers might thus decide to accept a riskier job at a higher wage because that would enable them to meet the monthly payments on a house in a better school district. But other workers are in the same boat, and school quality is an inherently relative concept. So if other workers also traded safety for higher wages, the ultimate outcome would be merely to bid up the prices of houses in better school districts. Everyone would end up with less safety, yet no one would achieve the goal that made that trade seem acceptable in the first place. As in a military arms race, when all parties build more arms, none is any more secure than before.
Workers confronting these incentives might well prefer an alternative state of the world in which all enjoyed greater safety, even at the expense of all having lower wages. But workers can control only their own job choices, not the choices of others. If any individual worker accepted a safer job while others didn't, that worker would be forced to send her children to inferior schools. To get the outcome they desire, workers must act in unison. Again, a mere nudge won't do. Merely knowing that individual actions are self- canceling doesn't eliminate the incentive to take those actions.