Economic Coordination: Adam Smith’s Argument

ADAM SMITH
• Adam Smith was born in Scotland in 1723.
• He was a philosopher and an economist.
• He was one of the founder of classical school of economics. “An inquiry into the nature and causes of the wealth
of nations” (1776) represents the first tried to study the economy as a separate doctrine from policy, ethics and
law and a first description of what builds nations’ wealth.
SMITH’S ARGUMENT: THE INVISIBLE HAND
In his book Smith pointed out the power he thought dominates a market economy:
THE INVISIBLE HAND.
• “Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... He
intends only his own gain, and he is … led by an invisible hand to promote an end which was no part of his
intention.” (Theory of Moral Sentiments)
• Smith is saying that participants in the economy are motivated by self-interest and in this they are guided by a
supreme power - the invisible hand - which takes on the balancing role between demand and supply.
• So the invisible hand is able to make the market reach the equilibrium point (quantity demanded and quantity
supplied are equal) because it has the ability to coordinate the millions of households and firms that make up
the economy.
• The price it determines is considered acceptable by both the seller and the buyer and the exchange
advantageous as well. The selfish behavior of each household and firm acting in the market will eventually
provoke the maximum general economic well-being.
• The role of the State According to the great abilities of the invisible hand to make the market efficient the
governments have very few tasks: The State has no say in the economy because any action would restrain the
economic development and the general well-being. However, it should ensure its institutional functions such as
national defense, safety and justice.
• "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their
regard to their own interest.” (Wealth of Nations)
DECENTRALIZATION:
Competitive Market Mechanism- A competitive market is one where there are numerous producers that compete with
one another in hopes to provide goods and services we, as consumers, want and need. In other words, not one single
producer can dictate the market. Competitive markets will emerge under certain circumstances, including;
1. The profit motive
 Free markets are formed when the possibility of making a profit provides a sufficient incentive for
entrepreneurs to enter a market. In simple terms, profits are earned when producers earn and amount
of revenue which exceeds the costs of production.
2. Diminishability of private goods
 Markets are more likely to form when wants and needs are best satisfied by the production of private
goods. Private goods have some important characteristics, the first being that as more of a product is
consumed fewer are available for others.
 This is referred to as the principle of diminishability. Over time stocks will diminish and as this happens,
price will be driven up. Higher prices create an incentive for the producer to increase production.
3. Rivalry
 Free markets are only likely to form when consumers are forced to compete with each other to obtain
the benefit of the product.
  This is called the principle of rivalry, and is closely related to the principle of diminishability. Indeed,
many consider it to be just another way to explain the need for consumers to compete when stocks
diminish
4. Excludability
 For markets to form it is essential that consumers can be excluded from gaining the benefit that comes
from consumption. Consumers may be excluded for many reasons, including if they are unable or
unwilling to pay.
 This is called the principle of excludability. If consumers cannot be excluded they may become free
riders and, as will be seen later, the possibility of free riders can prevent the formation of fully fledged
market.
5. Rejectability
 For markets to form it is also necessary that consumers can reject goods if they do not want or need
them.
 For example, a supermarket employee could not place an unwanted product into a shopper’s basket
and expect the shopper to pay for it at the checkout. This is called the principle of rejectability.
6. Positive Marginal Cost
 In supplying private goods a marginal cost is created.
 The use of scarce resources creates a marginal cost and as more consumers enter the market, more is
produced and a marginal cost continues to be created.
 As we will see, with public goods no further marginal cost exists once the good is supplied to one
consumer.
7. Ability to charge
 When the conditions of diminishability, rivalry, excludability, rejectability and a positive marginal cost
are present it is possible for a market to form because the seller can charge for the product and the
buyer can accept or reject that price.
 It is also possible for the buyer to make a bid for a good or service, and for it to be accepted or rejected
by the seller. The ability to charge at the point of consumption is central to market formation.
8. No information failure
 For markets to work effectively there can be no significant information failure affecting the decisions of
consumers and producers.
 Information failure arises when decisions are taken on the basis of limited or inaccurate information.
9. No time lags
 For markets to form and work effectively there will be no significant time lags between the purchase of a
product and the net benefit derived by the consumer.
 For example, if a consumer buys a newspaper with their morning coffee they can read it immediately.
Would anyone bother to purchase a newspaper if they could not read it for several days?
10. No externalities
 Markets are also said to be efficient when there are no significant effects on parties not directly involved
in the market transaction.
 This means that during the production of the good, and during its consumption and disposal after use,
there is no positive or negative impact on other citizens.
 A positive impact is called a positive externality or external benefit, and a negative impact is called a
negative externality or external cost.
11. Property rights
 It is a well-established principle of market analysis that for markets to form and operate successfully,
consumers and producers must have property rights.
 Property rights mean that individuals have the right to own private property and protect it from theft or
damage, or from other people’s waste or pollution.
12. Incentives for entrepreneurs
 The combined effects of the above characteristics means that markets are likely to form because
entrepreneurs will be willing to take risks associated with production and supply.
  When some of these conditions are absent it is unlikely that markets will form, or solve the economic
problem effectively.
Decentralization- is the process by which the activities of an organization are distributed or delegated away from a
central, authoritative location or group.
Centralization- the concentration of control of an activity or organization under a single authority.