Tuesday, October 4, 2011

Adam Smith v Charles Darwin: Regulation and Competition

September 28, 2011 ROBERT FRANK American Interest

I was born in 1945. When someone my age forecasts something that will happen fifty or a hundred years from now, he needn’t worry about being teased by friends if it doesn’t pan out. Without trepidation, then, I offer the following prediction: One century hence, if a roster of professional economists is asked to identify the intellectual father of their discipline, a majority will name Charles Darwin.

If the same question were posed today, of course, more than 99 percent of my colleagues would name Adam Smith.

My views about Darwin’s significance reflect no shortage of admiration for Smith. On the contrary, reading any random passage from the 18th-century Scottish moral philosopher’s masterwork, The Wealth of Nations, still causes me to marvel at the depth and breadth of his insights.

I base my prediction on a subtle but extremely important distinction between Darwin and Smith’s views of the competitive process. As I’ll explain, it’s a distinction that sheds a bright light on a still raging debate about the nature and desirability of government regulation.

The Competitive Process

Today, Smith is best remembered for his invisible hand theory, which, according to some of his modern disciples, holds that impersonal market forces channel the behavior of greedy individuals to produce the greatest good for all. This characterization is an oversimplification, but it nonetheless captures an important dimension of Smith’s narrative.

In any event, the invisible hand theory’s optimistic portrayal of unregulated market outcomes has become the bedrock of the worldview of libertarians and other anti-government activists. They believe that economic regulation is unnecessary—indeed, generally counterproductive—because unbridled market forces can take care of things quite nicely on their own.

In fairness to Smith, he was well aware—as many of his latter-day acolytes are not—that unregulated markets didn’t always produce the best outcomes. For the most part, the market failures he recognized involved underhanded practices by business leaders in a position to wield power. Thus he wrote:

To widen the market and to narrow the competition, is always in the interest of [those who live by profit]. . . . [Such interest] comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

When markets failed, in Smith’s view, it was because of an absence of effective competition. A firm might deceive its customers about the quality of its offerings, or it might cut prices to drive rivals out of business, only to raise them again once they were gone. Such abuses were common in Smith’s day, and Smith himself did not object in principle to government action to curtail them.

Such abuses are less frequent now, but their continuing presence has led social critics on the Left to focus on anti-competitive behavior as the key to understanding why markets fail. The late John Kenneth Galbraith, for example, stressed the contrast between the “traditional sequence” envisioned by Adam Smith’s modern disciples and a “revised sequence” that Galbraith saw as a more accurate portrayal of the modern marketplace.

In the traditional sequence, consumers enter the market with well-formed preferences and firms struggle to meet their demands as well and cheaply as possible. But in Galbraith’s revised sequence, powerful corporations first decide which products would be most convenient and profitable for them to produce and then hire Madison Avenue hucksters to persuade consumers to want those products.

Many economists remain skeptical about Galbraith’s revised sequence, citing conspicuous examples of corporate failure, such as the Ford Edsel in Galbraith’s day.3 Ford introduced the Edsel with great fanfare in September 1957. It was named for Edsel B. Ford, son of company founder Henry Ford, and its outsized promotional budget included a widely viewed national television special, The Edsel Show. But customers lacked enthusiasm for the car, and its production ceased in 1960. More recently, Microsoft spent almost a billion dollars to develop and promote the Kin, a smartphone targeted at the youth market. The phone, which hit stores in April 2010, was unceremoniously pulled from shelves just 45 days later because of abysmal sales.

Notwithstanding such failures, there is little doubt that advertising can shift consumer tastes. But advertising wizardry is a double-edged sword.

The driving force behind the invisible hand is greed, and if producers are currently selling inferior products at inflated prices, there’s cash on the table. If a rival producer can persuade consumers that a better, cheaper model is available, that producer can make lots of money. Modern marketing methods are surely up to that task. Competition is obviously still far from perfect, but today’s markets are much closer to the perfectly informed, frictionless ideal than were those of Adam Smith’s day.

In time, I predict the invisible hand will come to be seen as a special case of Darwin’s more general theory of competition, which was fundamentally different. Darwin trained his sights on competition not among merchants but among individual members of plant and animal species.

But the two domains, he realized, share deep similarities. His observations revealed a systemic flaw in the dynamics of competition: The interests of individual animals were often profoundly in conflict with the broader interests of their own species or larger subgroups within it.

The failures he identified resulted not from too little competition but from the very logic of the competitive process itself. Many of the most cherished beliefs held by libertarians, while perfectly plausible within Smith’s framework, don’t survive in Darwin’s.

Darwin’s central premise was that natural selection favored variants of traits and behaviors insofar as they enhanced the reproductive fitness of the individual animals that bore them. If a trait made the individual better able to survive and reproduce, it would proliferate.

Otherwise, it would eventually vanish. In many cases, Darwin recognized, the same variant that served the individual’s interest would also serve the interests of larger groups within its species. But he also saw that many traits promoted individual interest to the detriment of larger groups.

As an example in the former category, consider the speed of the gazelle. Mature members of this species can sustain speeds of thirty miles per hour for extended periods and can reach sixty in short bursts. How did they become so fast? It might seem that being faster would be unambiguously better from an evolutionary point of view, but that can’t be true or else all species would be fast.

Tapeworms are slow. In their particular environmental niche, being fast never mattered. Gazelles are fast because they evolved in an environment in which being faster than others was often decisive for survival. The gazelle’s predators, which include the cheetah, are also very fast, and there are few places to take shelter on the terrain where both groups evolved. Slower genetic variants among the modern gazelle’s ancestors were more likely to be caught and eaten.

Since the selection pressure that forged speed in gazelles was the threat of being caught by predators from other species, greater speed posed no conflict between the interests of individual gazelles and the interests of gazelles as a species.4 Up to some point, being faster conferred advantages for both individual and species. With respect to this particular trait, then, Darwin’s natural selection narrative closely parallels Smith’s invisible hand narrative about the proliferation of cost-saving innovations and attractive new product designs.

Many other traits, however, increase the reproductive fitness of an individual while simultaneously imposing significant costs on the species as a whole, or on large subgroups of the species. Such conflicts are especially likely for traits that confer advantage in an individual’s head-to-head competition with members of its own species.

A case in point is the outsized antlers of bull elk. These antlers function as weaponry not against external predators but in the competition among bulls for access to females. In these battles, it’s relative antler size that matters. A mutation that coded for larger antlers made a bull more likely to defeat its rivals.

It was quick to spread, since winning bulls gained access to many cows, each of whose calves would then carry the mutation. Additional mutations accumulated over the generations, in effect creating an arms race. The process seems to have stabilized, with the largest antlers of North American bull elk measuring more than four feet across and weighing more than forty pounds.

Although each mutation along this path enhanced individual fitness, the cumulative effect of the mutations was to make life more miserable for bull elk as a group. Large antlers compromise mobility in densely wooded areas, for example, making bulls more likely to be killed and eaten by wolves. A bull with smaller antlers would be better able to escape predators, but because he’d be handicapped in his battles with other bulls, he would be unlikely to pass those smaller antlers into the next generation.

In short, bull elk face a collective action problem. One bull’s larger antlers make him more likely to win a fight, and they also make his rivals more likely to lose that same fight. The individual payoff for having bigger antlers is thus substantially larger than the collective payoff. As a group, bull elk would be better off if each animal’s antlers were much smaller.

In the natural environments that were Darwin’s concern, the kinds of impediments to competition that worry traditional market skeptics were almost completely absent. Yet Darwin’s understanding of the competitive process supports a profound measure of skepticism about market outcomes. It is instructive to examine more closely how that understanding causes the invisible hand account to falter.

Relative Position

In contrast to the Darwinian narrative, which emphasizes the link between individual success and relative performance, Adam Smith’s invisible hand narrative assumes that individual success depends primarily on absolute income, not relative income. Available evidence should lead any reasonable person to question that assumption.

As Darwin saw clearly, life is graded on the curve. For a genetic mutation to be favored, it is not sufficient that it enable the individual to generate large numbers of offspring. It must enable him to produce more offspring than rivals who don’t carry the mutation. Reproductive fitness is thus a quintessentially relative concept. To survive and prosper, an individual need not be the strongest, fastest or smartest animal in the universe. He may be weak, slow and stupid. What matters is that he be able to compete successfully against members of his own species vying for the same resources.

To do so, his nervous system must absorb information about the local environment and calculate the extent to which different behavioral options will contribute to his ability to achieve various goals. But his nervous system must also perform another important function, which is to rank those goals. Which goals are most important? Which ones should be abandoned during times of duress?

Human motivation resides in the brain, which has been evolving for millions of years. The brain’s proximate purpose in every generation was to guide its bearer to take the actions that would best promote the transmission of its genetic blueprint into the next generation. The Darwinian framework is the only scientific framework available for trying to understand how brains steer humans and other animals to behave as they do.

When economists try to model human motivation in an attempt to understand how markets work, we adopt stick-figure simplifications. Traditional economic models assume that the satisfaction people take from consumption depends only on the absolute amount of it. Yet compelling evidence suggests that relative consumption also matters.

Since reproductive success has always depended first and foremost on relative resource holdings, it would be astonishing if the evolved brain didn’t care deeply about relative position. Most vertebrate societies, including the vast majority of early human societies, were polygynous, meaning that males claimed more than one mate when they could. It was the high-ranking males in those societies who claimed multiple mates. And given the inexorable logic of musical chairs, it was the low-ranking males who were left with none.

Famines were also a frequent survival threat in early environments. But even in the worst famines, there was always some food available. And the question of who got fed was almost always settled by relative income. Then as now, the poorest in every group were most likely to starve.

Against this backdrop imagine two genetic variants—one that codes for a brain that cares strongly about relative position, and the other for a brain that doesn’t care at all about it. In general, caring more strongly about something inclines you to expend more mental and physical energy to acquire it. So individuals who care more about relative position would be more likely to muster the behaviors necessary to acquire and defend positions of high rank. That, in turn, would make them more likely to survive famines and marry successfully, thus increasing their genotype’s frequency in the next generation.

The current environment is of course very different from the ones in which our ancestors evolved. But relative position still matters, often for purely instrumental reasons. When you go for a job interview, for example, you want to dress presentably, but the standards for looking good are almost purely relative. An interviewer may have no conscious awareness of how different candidates are dressed, but if you show up in a $500 suit, you would be more likely to get a callback if other candidates were wearing $200 suits as opposed to ones costing $2,000.

Similarly, parents who want to send their children to good schools must outbid other parents for houses in good school districts. Their ability to do so depends almost entirely on relative income. Here, too, we see the logic of musical chairs: No matter how much money people earn, only half of all children can attend schools ranked in the top half.

Explicit recognition of the importance of relative position completely transforms our understanding of how markets function. Adding this simple feature reveals the key to understanding why the invisible hand often breaks down, even if consumers are fully informed and interact with employers and sellers under conditions of perfect competition.

Not understanding why markets fail, many on the Left claim that regulation is necessary to protect us from too little competition in the form of exploitation by sellers and employers with market power. But the real reason we regulate, or should regulate, is to protect ourselves from the consequences of excessive competition with one another.

The essence of the problem is nicely captured in a celebrated example devised by Thomas Schelling.6 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 that edge trumps more remote 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.7 And it clearly doesn’t 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—won’t solve their problem. They need a mandate.

Schelling’s example, which embodies Darwin’s insight that the interests of individuals and groups are often squarely in conflict, also illustrates that humans can often resolve such conflicts in ways that other animals cannot. Bull elk lack the cognitive and communication skills to implement a rule requiring each bull to trim his antlers by half. But people can easily enforce rules that solve analogous collective action problems.

How might dispassionate observers decide which vision of reality is more compelling, Smith’s or Darwin’s? One powerful test is to explore what the competing narratives imply about economic regulations. A particularly instructive example is the question of whether it’s a good idea to regulate safety in the workplace. Adam Smith’s modern disciples insist that the answer must be no. The Darwinian narrative counters that workers favor safety regulation not because of insufficient competition, but because of the consequences of excessive competition among themselves. Let’s weigh these competing accounts.

Although the invisible hand narrative’s critique of safety regulation ultimately proves unpersuasive, it’s far more powerful than most of its critics realize. To appreciate why the invisible hand falls short here, it’s important to be as clear as possible about its strengths.

Consider a woodworker at risk of injury because the employer’s table saw has no guard over the blade. Should the employer have installed one? Any intelligent answer to that question must rest on a comparison of the costs and benefits of the device. Many critics of the invisible hand narrative object that cost-benefit analysis is a morally reprehensible way to resolve safety decisions. But that objection doesn’t withstand scrutiny. Safety devices cost money that could be used to purchase other things people value. It’s impossible to create a world in which the risk of unfavorable outcomes is zero. When deciding which safety steps to take, then, we must compare costs and benefits.

If you disagree, I pose two simple questions: Did you get your car’s brakes checked today? If so, do you plan to get them checked again tomorrow? No sensible person answers yes to both questions. If the brakes on your car have just been found to be in good working order, the odds of them failing the next day are vanishingly small. Getting them checked takes time and costs money, so reasonable people do it only at intervals.

States that have automobile inspection programs usually specify yearly checks. Most people don’t get their brakes checked more often than that because doing so would be expensive and wouldn’t yield significant benefits. If the cost-benefit framework is the right way to think about how often to get your brakes checked, why isn’t it also the right framework for thinking about whether there should be a blade guard on a table saw?

If the worker owned the business and had to decide about the safety device on his own, the cost-benefit calculation would be straightforward. The cost of the device is easy to measure, and for the sake of discussion let us assume it to be $50 a week. The benefit of the device is the largest dollar amount he would be willing to sacrifice to gain the blade guard’s protection, which of course depends on how dangerous it is to operate the saw without one.

If he would pay up to $100 a week, say, then installing the blade guard would clearly make sense. But if it’s worth, say, only $30 a week to him, then he would choose not to install it.

The logic of the decision is no different when the woodworker is employed by a firm. It’s still necessary to compare the blade guard’s cost with its benefit. The fact that the employer would be writing the check for the device does nothing to change its cost. And its benefit is still the value, in the worker’s eyes, of the protection it would provide. Suppose the blade guard meets the cost-benefit test.

If it’s worth $100 a week to the woodworker and costs only $50 a week to install and maintain, then the employer has every incentive to provide it. Failure to do so would be to forgo the $50 a week of economic surplus it could have created.
Skeptics of the invisible hand narrative often insist that the capitalist employer’s greed motivates him to withhold the safety device. But that charge misses the essence of Adam Smith’s argument.

If an employer failed to install a safety device that met the cost-benefit test, there would be cash on the table available to any rival employer willing to install one. The device costs only $50 a week, remember, and the woodworker values it at $100 a week. So if a rival employer offered him a saw with a blade guard at a salary only $75 less than his current salary, he would accept the offer.

After the move, the woodworker would enjoy $25 in additional economic surplus each week (the $100 value he assigns to the blade guard less the $75 cut in salary). And his new employer would also be better off by $25 a week (assuming his costs were otherwise similar to those of the current employer). So any time an employer refuses to install a piece of safety equipment that passes the cost-benefit test, there will always be cash on the table.

Many social critics on the Left remain deeply skeptical about the invisible hand. Some concede that the narrative would be valid if markets really were competitive, but insist that markets fall far short of the textbook ideal. Unless we regulate safety, they argue, workers will be exploited by powerful economic elites. At first glance, the claim sounds plausible. The owners of enterprises, after all, often have more money than they can possibly spend, while their workers risk life and limb each day for barely a living wage.

That certainly looks like exploitation.

But it’s also an account that implies that some individuals persistently fail to take advantage of available options that would benefit them. Markets aren’t perfect, but profit opportunities in the information age seldom go unrecognized for long. Any theory that implies that entrepreneurs are persistently leaving cash on the table is a fatally flawed theory. The imperfect competition rationale for safety regulation is such a theory.

According to the invisible-hand narrative, then, safety regulation shouldn’t be necessary, because unfettered market forces should serve up the optimal amount of workplace safety. If someone’s current employer is not providing a safety device that workers value at more than its cost, there are lucrative profit opportunities available to rival entrepreneurs.

What barriers could be powerful enough to prevent them from taking advantage of those opportunities? The answer is that although jobs may often be unreasonably dangerous, such profit opportunities seldom materialize in the first place. Because earning extra income enhances an individual worker’s relative position, most workers would be reluctant to move to a safer job at lower pay, even though each might prefer a world in which everyone was required to do so.

In the standard invisible hand account, the fact that a worker is willing to tolerate risk on the job implies that the risky job’s higher wage was sufficient compensation for reduced safety. But the invisible hand narrative assumes that extra income is valued only for the additional absolute consumption it enables. A higher wage, however, also confers a second immediate benefit—namely, the ability to consume more relative to others.

That fact is most important with regard to parents’ desires to send their children to the best possible schools. A worker might well accept a riskier job at a higher wage because doing so would cover the monthly payments on a house in a better school district. But the same observation applies to other workers. And because school quality is an inherently relative concept, when others also trade safety for higher wages, no one will move forward in relative terms. They will succeed only in bidding up the prices of houses in better school districts.

Hence the attraction of safety regulations, even in perfectly competitive labor markets in which all workers are perfectly informed about the risks they face. 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.

Merely knowing that individual actions are mutually offsetting doesn’t eliminate the incentive to take those actions. Societies around the globe have settled on a similar set of policies to encourage greater workplace safety than unregulated private labor markets would provide.

In the United States, for example, the Occupational Safety and Health Administration prescribes detailed safety procedures that must be followed in different industries. Firms are also required to carry workman’s compensation insurance, whose rates rise sharply with the number of injury claims filed. These instruments are far from perfect, but there’s little doubt that workplace safety levels are higher because of them.

Virtually every society continues to require greater levels of workplace safety than unregulated labor markets would provide. Antigovernment activists view that fact as conclusive evidence of government overreach. But that interpretation doesn’t follow if people’s ability to achieve important goals depends heavily on relative income. In that case, as we’ve seen, all bets regarding the efficacy of the invisible hand are off.

Regulation’s Upside

Anti-government activists insist that all or most regulation is bad, and there are certainly many vivid examples of bad regulation. But it’s instructive to consider the Darwinian hypothesis that many regulations exist for good reasons. Taking that view, we can learn something by observing the kinds of regulations that democratically elected representatives choose to implement. Regulations are, in this instance, data.

To take but one example: Most jurisdictions in the United States require a child to start kindergarten in a given school year if he or she will have turned five years of age before a specified date during the fall term of that year. What’s the purpose of this regulation?

If parents were free to choose their own child’s enrollment date, each might see advantage in holding their child back a year. He would then be older, smarter, bigger, stronger and more emotionally mature than his classmates. And since school performance is graded on the curve, he would be more likely to do well, more likely to succeed in athletic competition, more likely to win admission to a selective university, and so on.

But once some parents began “redshirting” their kindergartners, others would feel pressure to do likewise. In the end, most children might start school a few years older, but no more of them than before would win admission to selective universities. Under the circumstances, it’s easy to see why people might want their elected representatives to impose mandatory kindergarten start dates.

Whenever reward depends on relative performance, as in the examples just described, we invariably witness “positional arms races” as contestants jockey to increase their odds of winning. The plausibility of the Darwinian perspective is underscored by the omnipresence of institutional arrangements that attempt to limit positional arms races. Auto racing associations, for example, limit engine displacement; sports leagues impose roster limits; soap box derbies limit the amount contestants can spend; rival nations sign agreements to limit armaments; and so on.

For the same reasons that people find self-imposed restrictions of this sort attractive, voters around the globe have embraced precisely analogous forms of economic regulation. As noted, most societies regulate workplace safety. Most also have programs either to stimulate additional savings or to transfer additional income to retirees.

These programs help compensate for the pressure many parents feel to divert their savings into mutually offsetting bidding wars for houses in better school districts. Many countries have programs that attempt to equalize expenditures on schooling across different geographic areas that serve a similar purpose. Most countries make some attempt to limit the workweek, and many set minimum requirements for worker vacation allowances, both of which attenuate positional arms races for higher relative income.

These regulations to deal with collective action problems are squarely consistent with the Darwinian view that life is graded on the curve. And as I have argued elsewhere, most competing explanations for these regulations are self-contradictory.8 Many suffer from the no-cash-on-the-table objection, which is decisive in today’s highly competitive economies. Those on the Left who offer exploitation as an explanation of market failure when competition is strong need to explain the jarring implication of their argument—namely, that entrepreneurs are consistently failing to take advantage of lucrative profit opportunities.

Similarly, anti-government activists need to explain why societies around the world have uniformly embraced such economic regulations. If markets are as competitive as evidence suggests, and if satisfaction depends only on absolute consumption levels, there should be little need for them. Adam Smith’s invisible hand would take care of everything.

Market failures in Adam Smith’s framework occur only when competition is limited. The Darwinian framework, in contrast, holds that market failures can occur even when everyone has taken full advantage of all available opportunities for potential gain. As I explain in The Darwin Economy, simple, non-intrusive changes in tax policy can free up trillions of dollars annually that are currently wasted in mutually offsetting spending patterns.

Darwin’s view of the competitive process will prevail over Smith’s in the end because it offers a far more parsimonious explanation of the behavior patterns we observe. We are, after all, not stick figures seeking only to consume more and more, but emotional beings strongly attached to and affected by our relative position in society.

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