Continuing Conversation... Vernon Smith on Adam Smith and the Human Enterprise

EconTalk Extra
by Amy Willis
Vernon Smith on Adam Smith and... Smith Lessons: What I've learn...

Nobel laureate Vernon Smith joins EconTalk host Russ Roberts this week on EconTalk to discuss Adam Smith's approach to economics and human behavior.

And now we'd like to hear from you...Use the prompts below to share your reactions to this week's conversation in the comments. Or use them to start your own face-to-face conversations, and let us know how it goes.

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1. What is the Max U approach to economics, and what does Vernon Smith mean when he says it works perfectly well, but only for "hamburgers and haircuts?" What kinds of goods does Max U struggle to deal with according to Vernon Smith? How does Adam Smith's approach compare to Max U?

2. Vernon Smith describes Adam Smith's "stoic axiom of self-love." What does this axiom entail, and what does it suggest about human motivation, according to Vernon Smith?

3. Vernon Smith argues that The Theory of Moral Sentiments is "all about the rules." What sort of rules does he have in mind, and how do they govern human social behavior? What are some examples you've witnessed of such rules in action?

4. Vernon Smith argues, perhaps counter-intuitively, that man's tendency to truck, barter, and exchange, or his experience in markets, leads to specialization, not the other way around. How does his allow one, according to Vernon Smith, to differentiate between the street porter and the philosopher, though each began as fundamentally equal?

5. Are Max U and Smith's emphasis on rules really orthogonal? Put another way, how do you reconcile Adam Smith's approach in The Theory of Moral Sentiments with his approach in The Wealth of Nations?

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COMMENTS (6 to date)
SaveyourSelf writes:
1a. What is the Max U approach to economics.
In [good] economic models, decisions occur at the level of the individual. Understanding the way an individual makes decisions is therefore key to making the models work. Here are some individual assumptions:
  • A. Individuals have unlimited wants;
  • B. There are not enough resources in the universe to satisfy unlimited wants;
  • C. The next best thing to everything is “as much as possible.”
Thus modern economic models assume individuals, in every decision made, seek to increase the resources under their control. The Marginalist revolution modified this simple set of assumptions by noting that, at the margin, the additional value of additional resources paradoxically decreases [an application of the law of diminishing returns]. The recognition of and logical response to the law of diminishing marginal returns became a 4th assumption. It explains why “maximizers” always seem to seek a varied basket of goods rather than to ceaselessly acquiring greater and greater quantities of the same item. [Interestingly, there are some people who do just that. We call them “hoarders.” Presumably there are not many of them because that behavior is contrary to survival. Hoarders are culled by natural selection.] Anyway, that is my understanding of Max U. It is the assumption that all human decisions are made in such a way as to increase resources as much as possible while also recognizing that there are diminishing returns at the margin of each potential acquisition.
1b. What does Vernon Smith mean when he says it works perfectly well, but only for "hamburgers and haircuts?"
He means that, so far as he can tell, the predictions made from the MaxU assumptions always hold in markets where the products cannot be re-sold, but do not always predict behavior accurately in markets where products are reusable.
1c. What kinds of goods does Max U struggle to deal with according to Vernon Smith?
According to Vernon Smith, the MaxU assumptions do not always give reliable predictions in markets where products can be re-sold. His support for this argument is that the recent worldwide recession circa 2007 originated in the housing market and the stock market which both contain products that are reusable and re-sellable.
1d. How does Adam Smith's approach compare to Max U?
I have not read the whole of the Wealth of Nations, so I cannot say with confidence that I know what assumptions Adam Smith made about economic actors. However, in Russ’s new book, “How Adam Smith can Change your Life”, there is a quote from Adam Smith that reads, “…It is chiefly from this regard to the sentiments of mankind, that we pursue riches and avoid poverty” (pg 141). This suggests that Smith modeled individual decision on an assumption that they were a response to the sentiments of mankind. Put another way, people make decisions that increase their standing among other people and avoid decisions that reduce said standing. Apparently he also believed that obtaining riches was socially rewarded and poverty was socially penalized. In a very real sense, therefore, Adam Smith’s position does not conflict with the MaxU model. It simply adds another resource to the pool that people will try to maximize—sentiment.
SaveyourSelf writes:

1b [expanded]. What does Vernon Smith mean when he says it [MaxU] works perfectly well, but only for "hamburgers and haircuts?"

The assumptions listed in my first post [above] from which MaxU—maximum utility—decision modeling is derived, lead to predictions about the expected changes in supply and demand as prices fluctuate. For example when prices rise, demand falls but supply increases. When prices fall, demand rises but supply decreases. Those behaviors, when aggregated, form the supply and demand curves.

Vernon Smith’s statements during the podcast suggest that the normal predictions of the supply and demand curves always hold for markets where goods are consumed. He explicitly states that they do not always hold in markets where the goods are not rapidly consumed and can therefore be re-sold. To my knowledge, this is a new insight in to the question about why markets sometimes appear to make temporary mistakes of allocation—ie. where rising prices do not seem to decrease demand or increase supply. He labeled this phenomenon “a bubble”. No model that I know of is universally accepted to predict or explain bubbles. I think the underlying question in this and many other podcasts is whether the MaxU model and its assumptions might be suboptimal for modeling individual decisions.

I think MaxU is still valid. I hypothesize that people are always trying to maximize something, even when they are in the midst of a market bubble, it just isn’t the product.

A significant portion of the buying and selling of houses in the housing-bubble was speculative, not consumptive. Investors were buying houses they never intended to use in order to hold them and sell them later when prices rose. Such speculation is strange in that it requires the suspension of disbelief regarding many laws of nature and economics. First it assumes that the rising prices will not stimulate more home production and drive prices DOWN. It also assumes that houses, which degrade over time, will gain value even as their projected lifespan DECREASES. So these speculators are not thinking about the real world when they are investing in housing. They are thinking about something else. Since supply and demand models do not explain a continuous rise in housing prices year after year, speculators abandoned those models in favor of a new model which was much simpler but seemingly more accurate—housing prices always rise over time.

So the product they were trying to maximize, apparently, was a continuous rise in prices which seemed unique to the housing market. The way to maximize a continuous rise in price is to buy as much product as possible. That way any change in price is multiplied by the quantity of product owned. In addition, if they expected a 10% increase in housing prices per year and could borrow money at 6% per year, then they could further maximize their gains by not only buying homes to the limit of their savings but also by borrowing money to acquire even more homes. So the speculators were still operating under MaxU assumptions even while within the bubble.

Just as important, the influx of money from both speculators' savings and borrowing meant that there was a large increase in the supply of money in that market. Inflation is the increase in the supply of money in the absence of an increase in the quantity of product. That scenario always leads to an increase in prices, independent of the changes to supply and demand of the underlying product.

So there were four markets operating simultaneously through a single price: There were people buying homes for use; there were speculators buying the rise in price of homes; there were yet more people buying the unusually low interest rate available exclusively through the housing market; and all three groups were unknowingly buying higher inflation.

All of these markets were acting through a single price point which led to a SHIFT in the demand curve for homes. That is why the housing market seemed to behave so oddly—rising prices did not decrease demand, demand increased! In retrospect, that makes sense because the entire demand curve moved when the housing market was joined by several other markets. Even so, the general laws of supply and demand were still healthy, functioning, and predictive. The speculators buying homes literally DECREASED the supply of homes in the market while they sat on them, which predictably led to an increase in the price for homes. The addition of speculators to the normal pool of homebuyers increased demand, which increased the prices for homes. Tapping savings and borrowing money through the housing market led to inflation in that market which, again, led to predictable increases in prices. And homebuilding is a slow process, so the supply of homes could not increase rapidly to meet the new demand, leading to an increase in prices. That said, housing construction did expand, and eventually caused the price of housing, in spite of all the other factors pushing prices up, to fall, which was the signal for all the speculators, as one, to exit the market—shifting the demand curve abruptly back to its original position. The bubble burst.

Now, back to Vernon Smith’s original proposition: if homes were consumed quickly, would the housing bubble have occurred? No. Speculators would not have been able to use them for a buy and hold strategy. They would not have entered the market. They would not have shifted the demand curve. Thus, the changes in supply and demand we typically see following price changes would have occured. So is the fact that homes are re-sellable the explanation for the housing bubble? In part, yes, but that does not invalidate MaxU. Modern supply and demand relationships are still valid and predictive. Vernon Smith’s observation regarding the risks of speculation on products with long life cycles is simply a nice addition to an already incredible model.

Daniel Barkalow writes:

It seems to me that people's distaste for ill-gotten gains scales with the size of those gains, which means that any time there's a Moral Sentiments downside to some option, the magnitude of that downside is going to be greater than U, whatever U is. If someone feels that receiving a tip is inappropriate, they won't just reject a $1 tip on account of a dollar not being worth their discomfort, they'll reject $10 as being even more inappropriate, and $1000 as being horrifying. As such, the Max U approach of adding up factors in order to determine which option has the best net utility isn't helpful, even including a factor for moral value, because breaking the rules (whatever the person feels the rules to be) is always worse that not breaking them, so you might as well model the process as "First, throw out any option that breaks the actor's rules. Then, compare the remaining options." There's no point in elaborating a theory where you maximize between a 0-value option and a variable negative value, so Adam Smith doesn't bother.

SaveyourSelf writes:

@Daniel Barkalow

I can imagine scenarios where all options are bad. Doesn't the fact that an individual in that situation would likely choose the least bad option suggest that MaxU functions for negative expectations in the same way as it does for positive expectations?

Sheldon Richman writes:

Excellent! Encore! Encore!

Julien Couvreur writes:

Following the podcast, I read the EconLib article on experimental economics.
It would be great to find more guests to discuss this topic and in particular experiments that evaluate how well political solutions work ("public choice in a lab", if that's possible).

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