Externalities: Where the “Invisible Hand” Gets Cramps

Adam Smith, in his economic philosophy book The Wealth of Nations, penned a famous passage that reads as follows:

[E]very individual necessarily labours to render the annual revenue of the society as great as he can. 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.

The first thing that a modern reader may notice about this passage is Smith’s assumption that an individual will prefer “the support of domestic to that of foreign industry,” which is observably not the case today. This may suggest that there is a flaw in the theory, and indeed there is.

Today, free-market advocates use the idea of the “invisible hand” to advocate leaving the market as free of government regulation as possible, asserting that it will inevitably regulate itself to the benefit of society, and that attempts by the government to shape it will inevitably produce a poorer result. This is taking the idea much further than Smith himself would have done. Smith recognized that for his “invisible hand” to operate, a structure of laws and government enforcement of contract obligations, property rights, and so on was required, but the idea that government is the foe of a free market rather than its enabler has become common currency on the economic right.

To what extent is Smith’s idea of an invisible hand directing self-interest to produce benign outcomes accurate? Under what circumstances does this in fact work? Under what circumstances does it fail to work?

Where The Invisible Hand Works

The mechanism behind Smith’s invisible hand idea is competition and the requirement that a business satisfy customers. This is what prevents a business from selling defective merchandise or charging exorbitant prices for it. If it does, a competitor will seize market share by offering a better product and/or charging a lower price. By seeking his own self-interest, a business owner will serve the interests of his customers as well, because the one is dependent on the other.

This does work to an extent. It clearly breaks down under monopoly conditions, where no effective competition exists. One finds that problem in the pharmaceutical industry, where customers are captive and patent law gives companies a monopoly over many of their products.

Aside from real competition, another necessity for the operation of the invisible hand is that the person making the decision to act owns both the benefits and the costs of that action. In the simple case of a company choosing to put in the time and effort to offer a good product for a good price, that’s so. The company will reap the benefit in increased sales and market share. (The consumer also benefits, but the company’s competitors do not.) The company also pays the cost by investing capital to improve its product, or by lowering per-transaction revenue by holding prices down.

As a technical term, we may say that the benefits and costs of the business decision are both internal to the business. The person making the decision pays those costs and reaps those benefits, and so the decision is informed by both.

But what happens when that’s not so?

External Costs

What happens when a decision by a business has consequences and costs that the business does not pay? For example, when a manufacturer dumps the wastes from the manufacturing process into the air, into a local river, or otherwise on public ground, the cost in the form of health consequences and other damaging effects of pollution is borne by the public.

A part of that cost is, in fact, borne by the business, in the sense that the business owner is part of the community and has to live in it, and its employees (or even its owner) may be impacted  by the negative public health effects of the pollution. But these costs don’t impact the business in particular. Most importantly, they don’t impact the business any more (or less) than they do its competitors. That being the case, the business has no incentive to reduce its pollution, since while that would slightly benefit the business itself, it would benefit the competition just as much, and hence provide no net gain.

There are many things that businesses do in pursuit of self-interest that are very much not to the public good. This includes trying to hold down wages, lobbying for government subsidies, collusion and price-fixing, allowing unsafe working environments, on and on. These things carry a cost far in excess of the benefits, lumping all of them together. But because the benefits are almost all realized by the business, but the costs are mostly paid by others, the business does them anyway — and that’s a perfectly rational, sound decision.

So there’s the first situation in which the invisible hand gets cramps. It doesn’t work when costs are externalized. Under those conditions, a business’ pursuit of self-interest will not accrue to the public good.

External Benefits

But costs aren’t the only thing that can be externalized. Sometimes benefits are external to the actor, too. In that situation, it’s not that a business will do something harmful, but that it will not do something needful. When the costs are internal but the benefits are mostly external, it makes no sense in terms of self-interest to take an action.

Let’s go back to the example of wages. A business pays wages to its employees because it has to. You can’t get people to work for nothing. Just won’t happen, sorry. Not usually, anyway. So the business pays the money (an internal cost) and gets the work done (an internal benefit).

But what about raising wages across the board? What about voluntarily deciding to pay its employees more? Obviously there’s a cost to that, but is there also a benefit?

Sure. Higher wages mean more consumer spending which generates more sales and boosts the economy. Everyone wins. But that’s exactly the problem. Everyone wins — a shared benefit — but the business foots the bill all by itself — a private cost. While the business will indeed benefit from raising its wages, so will its competitors, who will not be sharing in the cost (unless they also raise wages). Something that benefits you and your competitors equally, but that only you pay for, is not a net gain.

Externalized benefits cramp the invisible hand every bit as much as externalized costs. The same rule applies to things that we don’t expect a business to do, like defending the nation, enforcing the law, educating poor children, building highways, and so on. All of these things would benefit a business that took on the task. Invasion by a hostile power, public disorder, an ignorant workforce, and lack of infrastructure are all bad for business. But they’re equally bad for my business and my competitors’ businesses. It’s certainly in my self-interest for these things to be taken care of, but not for me alone to foot the bill for taking care of them. There’s no profit in that.

What It All Means

The invisible hand metaphor is in fact sometimes valid. But it’s not valid more often than it is. The invisible hand works without cramping up only in very limited circumstances and for very limited purposes. It works if and only if both costs and benefits are internal to the business or person making the decision. We can trust a business to make decisions in the public good wherever that holds true.

But where it doesn’t — and it doesn’t an awful lot of the time — something else, usually the government, must step in and either require the business to behave itself, or take on a task that business simply has no reason to do.