THE IMMORTAL ADAM SMITH, PART 4

Let’s pick up where we left off — with Adam Smith’s Second Law, i.e. the counter-intuitive claim that a group of people will be better off overall when each person keeps busy pursuing his own self-interest. To prove this claim, Smith makes two further sub-claims in Book IV, Chapter 2 of The Wealth of Nations:

Subclaim #1 — Owners of capital prefer local markets over more distant ones: “First, every individual endeavours to employ his capital as near home as he can, and consequently as much as he can in the support of domestic industry; provided always that he can thereby obtain the ordinary, or not a great deal less than the ordinary profits of stock.” (WN, IV.ii.5)

Pause. Why do the owners of capital prefer to employ their capital in domestic markets over foreign markets? The father of economics provides one major reason why “every individual” generally prefers local markets over more distant ones: the fear of being defrauded. In the timeless words of Adam Smith (WN, IV.ii.6), “In the home-trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.” In other words, capitalists can keep a close eye on their capital and can more quickly enforce their contract and property rights in local courts when they “employ [their] capital as near home as [they] can” (WN, IV.ii.5).

Subclaim #2 — Owners of capital want to extract the most value from their capital: “Secondly, every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry that its produce may be of the greatest possible value.” (WN, IV.ii.7) In support of this sub-claim, Smith makes the following reasonable observation:

“The produce of industry is what it adds to the subject or materials upon which it is employed. In proportion as the value of this produce is great or small, so will likewise be the profits of the employer. But it is only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods.” (WN, IV.ii.8)

Adam Smith then combines these two sub-claims in the ninth paragraph of Book IV, Chapter 2 of The Wealth of Nations to postulate of the most surprising and original and controversial claims in all of social science:

“But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry …. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry [cf. sub-claim #1], and so to direct that industry that its produce may be of the greatest value [cf. sub-claim #2]; every individual necessarily labours to render the annual revenue of the society as great as he can [cf. Smith’s Second Law].” (WN, IV.ii.9)

The Scottish philosopher-economist then illustrates this surprising conclusion, a conclusion I have christened “Smith’s Second Law“, with a quasi-divine metaphor that would revolutionize our understanding of the world, the invisible hand:

“He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, 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. 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. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.” (ibid.)

In other words, by employing their capital in local markets and by trying to squeeze the most value out of their capital, the owners of capital end up indirectly benefiting the local economy as a whole! As an aside, Smith’s Second Law has important consequences for contemporary debates about “corporate social responsibility” (CSR). After all, if the pursuit of profits really “is most advantageous to the society” (WN, IV.ii.4), then the study of business ethics is not only a total waste of time; it is also a counter-productive diversion from activities that are far more beneficial to society overall!

What do you think of Smith’s Second Law or the invisible hand metaphor? We are now just four posts into my new series on Adam Smith and just nine paragraphs into Book IV, Chapter 2 of The Wealth of Nations, and we already have a lot of ideas to contemplate and digest. After a brief pause, I will further explore the “Immortal Adam Smith” when I resume my series on Tuesday, Feb. 11. In the meantime, check out the legendary Milton Friedman in the short video posted below. Does Professor Friedman’s explanation of the invisible hand mechanism accord with Adam Smith’s?