I just bought an interesting book on behavioral economics. Prof. Dan Ariely has a fantastic blog/ podcast called “Arming the Donkey” (we are the donkeys) which I have followed for a while and I finally got his book “Predictably Irrational”. Chapter 2 in particular caught my attention, “the Fallacy of Supply and Demand”. By conducting experiments into how purchasing decisions are made he pulls the fundamental assumptions of our economic system up by the roots.
I have always had an interest in work that examines the real life implications of our faith in the so called “invisible hand” of the market place that is at the core of free market theory. Adam Smiths market ideology had noble intent but this moral philosopher would have been disgusted by the injustice and ecological destruction that is rationalized by his theory. Smith wanted to produce ideal outcomes for society by using market mechanism to maximize the utility of limited resources.
Wikipedia summed up the “invisible hand” like this:
The theory of the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. The reason for this is that self-interest will drive actors to beneficial behavior. Efficient methods of production will be adopted in order to maximize profits. Low prices will be charged in order to maximize revenue through gain in market share by undercutting competitors. Investors will invest in those industries that are most urgently needed to maximize returns, and withdraw capital from those that are less efficient in creating value. Students will be guided to prepare for the most needed (and therefore most remunerative) careers. And all these effects will take place dynamically and automatically.
It also works as a balancing mechanism. For example, the inhabitants of a poor country will be willing to work very cheaply, so entrepreneurs can make great profits by building factories in poor countries. Because they increase the demand for labor, they will increase its price; further, because the new producers will also become consumers, local businesses will have to hire more people in order to provide for them the things that they want to consume. As this process continues, the labor prices will eventually rise to the point at which there is no advantage for the foreign countries doing business in the formerly poor country. Overall, this mechanism will cause the local economy to function on its own.
Now there is plenty of reason to challenge this theory without the help of behavioral economics. Many have highlighted the implications of concentrations of wealth and the dangers of so called “externalities” that are caused by market forces. For example this is Noam Chomsky’s take on all of this:
Throughout history, Adam Smith observed, we find the workings of “the vile maxim of the masters of mankind”: “All for ourselves, and nothing for other People.” He had few illusions about the consequences. The invisible hand, he wrote, will destroy the possibility of a decent human existence “unless government takes pains to prevent” this outcome, as must be assured in “every improved and civilized society.” It will destroy community, the environment and human values generally – and even the masters themselves, which is why the business classes have regularly called for state intervention to protect them from market forces. (…)[1]
Ariely takes this critique to a whole new place by exploring “arbitrary coherence“. He shows that choices are more complex and the fundamental principles of free market theory based on the invisible hand are fundamentally flawed. The prices we are willing to pay have more to do with “anchoring” based on the initial price based decisions we make initially about a product (see the video below for more on this). To quote Ariely:
“It seems that instead of consumers willingness to pay influencing market prices, the causality is somewhat reversed and it is market prices themselves that influence consumer’s willingness to pay. What this means is that demand is not, in fact, a completely separate force then suply”
Furthermore Ariely goes on to highlight implications of his finding:
“Now, if we can’t accurately compute these pleasure values, but frequently follow arbitrary anchors instead, then it is not clear that the opportunity to trade is necessarily going to make us better off…. if anchors and memories of these anchors – but not prefference – determine our behavior, why would trading be hailed as the key to maximizing personal happiness (utility)”
I felt the need to share these ideas with you for a couple reasons. The first is that I just watched Micheal Moores new movie, Capitalism a Love Story. I felt like the film really missed the boat by not really making the case for the fallacy of supply and demand in and of itself.
What I did like about the film was the focus on the workers occupation of Chicago’s Windows and Doors Factory. This fascinating situation has a lot in common with the struggles in Argentina highlighted in Naomi Kleins film The Take. See my previous post on the Final Frontier of Democracy for more on this movement towards workers empowerment and workplace democracy. Unfortunately the implications of this movement was also not explored fully in Moore’s film.
I guess at the end of the day I wanted to post this not to critique capitalism but to highlight that it has never really existed as defined. Not only is supply and demand manipulated by those with a concentration of wealth (voting with your dollars means that some people have a lot more votes) but in fact the market mechanism doesn’t work they way Smith envisioned it.
On a practical level I want spark a dialogue on tactics for working towards change. As an environmental activist I am often frustrated by market based campaigns. Relying on our market choices to affect change assuming that supply and demand work they way Adam Smith intended. This piece adds further evidence that this strategy leaves much to be desired.
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Predictably Irrational
Review: When we make decisions we think we’re in control, making rational choices. But are we? Entertaining and surprising, Ariely unmasks the subtle but powerful tricks that our minds play on us.
Excerpted from Chapter 2 –The Fallacy of Supply and Demand
