Vernon Smith on Adam Smith and the Human Enterprise
Nov 17 2014

Nobel Laureate Vernon L. Smith of Chapman University talks to EconTalk host Russ Roberts about how Adam Smith's book, The Theory of Moral Sentiments has enriched his understanding of human behavior. He contrasts Adam Smith's vision in Sentiments with the traditional neoclassical models of choice and applies Smith's insights to explain unexpected experimental results from the laboratory.

Vernon Smith and James Otteson on Adam Smith
Vernon Smith and James Otteson talk with EconTalk host Russ Roberts about Adam Smith in front of a live audience at Ball State University. Topics discussed include Smith's view of human nature, the relevance of Smith for philosophy and economics...
Dan Klein on The Theory of Moral Sentiments, Episode 1--An Overview
Dan Klein, of George Mason University, talks with EconTalk host Russ Roberts about Adam Smith's lesser-known masterpiece, The Theory of Moral Sentiments, on the 250th anniversary of its initial publication. Klein highlights key passages and concepts of the book including...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Henry Makansi
Nov 17 2014 at 9:30am

A scintillating discussion with Vernon today Russ. When Vernon described the initial results of his experiment, I can’t say I was very surprised; because although like all economists I was neoclassically trained in the ideas of Marshall and Jevons, since then I’ve taken an interest in social psychology and have grown up in a society where empathy and give and take are the order of the day.
There’s a lot of overlap with Vernon’s work and the work of a former Econtalk guest Jonathan Haidt, who is one of the leading social psychologists around and has done a lot of work into morality and where it stems from. His first book the Happiness Hypothesis which while less controversial and headline grabbing than the Righteous mind references Smith’s Moral sentiments throughout. He also cites interesting research from neuroscience and social psychology which appears to have identified an isolated reciprocity organ that resides in the brain. While one should be skeptical of such early neuroscience results, I wonder if it would make sense to invite Haidt again to discuss his first book, The Happiness Hypothesis. I suspect given your recent book on Smith it would make for an interesting compare and contrast?
The experiments cited are particularly interesting since increasingly a lot of the trade is no longer hamburgers and haircuts but Airbnb, Uber, Yelp/Amazon recommendations and various other online services where more often than not we do not see the counterpart in our exchange.

[A few words changed in this comment per commenter agreement–Econlib Ed.]

Nov 17 2014 at 5:14pm

Great podcast! Which it was longer so you would’ve gotten more into the experiments with housing//stock market like transactions and their propensity to form bubbles and compare the different kinds of markets, found the distinction fascinating. Invite Jonathan Haidt! Thanks for the podcast.

Nov 18 2014 at 7:04am

Great discussion.

The concept Vernon Smith floated regarding a need for a different model to explain markets where products are reusable vs. markets where they are consumed is fascinating.

Walter Clark
Nov 18 2014 at 12:35pm

David Friedman is famous for what I think is one of the most powerful aphorisms in economics:
“Economists are often accused of believing that everything – health, happiness, life itself – can be measured in money. What we actually believe is even odder. We believe that everything can be measured in anything.”
One of Russ Robert’s interviews added an even more profound thought. (I wish I could remember which one.) It was that charity is a self-interested action in that the benefactor is actually a customer. His selection of what good-deed to “buy” is in competition with yet another car or house. And since houses and cars are in the economic sphere, charity is also part of the economy. I hope Russ sees this comment and adds charity and philanthropy to this discussion on human enterprise and the Theory of Moral Sentiments.

Eric Schubert
Nov 20 2014 at 11:03pm

About 10 minutes into the podcast, Vernon Smith talks about his discovery of the phenomenon of commodity bubbles in the 1980s. Charles Kindleberger’s published a book in 1978 titled Manias, Panics, and Crashes, described the phenomenon in great detail in a historical context, using the Minsky model of bubbles as a framework.

Bradley Calder
Nov 21 2014 at 2:55pm

Dear Professor Roberts,

Please post a few links to the papers that Vernon Smith mentioned regarding how people behave differently when they own assets such as homes where they can shift from buyer to seller rather than retaining a single role as buyer or seller as in the haircut example.

I’d really like to read this series of papers.

Thank you very much.


Julien Couvreur
Nov 22 2014 at 1:40am

Great interview. I would love more on Vernon Smith’s experiments.

One point confuses me however. I don’t see how the trust game invalidates the classic model of economics. And I especially don’t see that it shows the initial player not to be self-interested.
At best, you can say that the initial player is not naively self-interested and short-sighted, but has an understanding of psychology.

The question of psychology is what satisfies us (what constitutes utility).
Well, the trust game shows that the initial player is more satisfied with taking a risk and planting a seed of gratitude in the other player’s mind, for a greater expected (although uncertain) return.
The second player’s satisfaction is affected by this gratitude (short-changing the cooperating initial player makes me feel worse despite a materially superior outcome). In other words, utility != dollars. But we already knew that.

Nov 23 2014 at 9:22pm

To Walter Clark’s great point, economists tend to use monetary measures as a proxy for utility, and while that may work in most situations, it doesn’t capture behavioral components such as morality, and seems to break down whenever we internalize that there is a fellow human on the other end of the trade.

After relaxing the utility function to include not just the number of goats we own but also the happiness we gain from perceived “altruism” (a delusion in my view), we can maintain our assumption are still all selfish and self-dealing, and thankfully don’t have to materially alter the way in which we think of the world.

Graham Salzer
Nov 26 2014 at 11:29am

This was one of the best episodes ever for EconTalk. Fascinating discussion.

Nov 26 2014 at 12:02pm

One of the best podscasts so far!!!

SaveyourSelf:”The concept Vernon Smith floated regarding a need for a different model to explain markets where products are reusable vs. markets where they are consumed is fascinating.”

Agree with this opinion 100% percent.

I am delighted that Russ and Vernon question the scientific/methodological value of the Utility theory. I have long thought about these same issues myself: you can “introduce some kind of a utility function” to explain any choice – that is called the revealed preference.

You have eaten something poisonous (e.g. drunk too much) and felt bad for a couple of days – we can say that by revealed preference, you value the moment of consuming the poison much more than those days you have a headache.

Or, to take the experiments from the podcast – you decide to pass the game to the other individual instead of taking a guaranteed sum of money – that is because in day-to-day life you observe that reciprocity oftentimes leads to better outcomes, therefore in a lab you also reciprocate awaiting a better reward (and therefore, maximizing utility again).

As you see, MaxU can be used to explain ANY outcome at all, therefore, I think it is totally useless.

As Russ said in one of the previous podcast, it is more honestly to start with a demand curve right off, instead of constructing it from the weird MaxU concept.

Ron Crossland
Dec 3 2014 at 11:33am

Enjoyed this podcast for it’s insights, even if the reverence for Adam Smith was a bit overdrawn from my perspective. For his time, he was a profound thinker, yet many of his intuitions needed verification. Kahneman and Tversky, mentioned during the discussion, alert us to as much or more than Smith, with supporting research.

The discussion of social psychology could even grow further – for while an individual grows up in “society” – not all portions of the larger society impact the person equally. Tribal affiliations of all sorts filter larger social messages, sometimes yeilding dramatic distortion. What my immediate family believes, what my immediate neighbors believe, the cultural rules of whatever religion is at hand where and when I grow up, etc.

It would be fascinating to know if the exchange game Vernon Smith so adeptly analyzed enjoyed investigation with more than one dimension. The game is among strangers. They learn about each other shallowly through exchange. This doesn’t mirror the real world, even though it instructs us concerning some fundamentals of human social conduct. What if half the group was told that 50% of the people in the game were convicted felons? Or politicians, clergy, police, bankers, or Wall Street investors? To what degree would our basic social conduct be altered when just one more general factor of “reputation imparted via career choice” was involved.

Thanks, Russ, for an invigorating discussion and the range of the discussion. Very much enjoyed.

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Podcast Episode Highlights
0:33Intro. [Recording date: November 7, 2014.] Russ: Our topic for today is human motivation and behavior, as seen through the eyes of Adam Smith--particularly his book, The Theory of Moral Sentiments--and the implications for modern economics, particularly the theory of the consumer and more generally how economists should think about human behavior. I want to start with the so-called 'modern view,' the view that I was taught as a graduate student, and I think you were taught, as well--what Deirdre McCloskey calls 'Max U.' So, describe that for us. What's the Max U (Maximum Utility) approach? Guest: Well, what Deirdre means by Max U is that following essentially Jevons, William Stanley Jevons, and the other Marginal Revolutionists--marginal value revolutionists of the 1870s--we reduce all problems to asking, among the options that the individual faces, how can he or she maximize her utility or payoff or reward? And minimize costs, if it's a loss situation. And let me say that that model works well in in ordinary supply and demand markets--which are the kind of thing that it has to do with flows. And those really have to do with perishable commodities. I like to use an example: it's hamburgers and haircuts. They cannot be re-traded. Ordinary supply and demand, you go in there and you are either a buyer or a seller and you know that in advance. And also that's a world with perfectly enforced property rights. If I buy, you deliver exactly what it was that I bought. And if you sell, I deliver you the payment for that, without error. You see: that's a property rights world. That's a world where you are less dependent upon trust and trustworthiness, supported by a property-right and contract law situation. Now, so it works well there. But when you come to two-person interaction, it turns out that that doesn't work well at all. And I think that's the thing we will probably mostly focus on. I will say, though, that I, in my career, I've gone through--I've been involved in three kind of principal areas of experiment. And each of them have the characteristic that the data falsified my beliefs. Russ: You're very lucky. Guest: They were all failures. And it's important--very important. Experiments that fail are very important, because you have to ask why were our expectations so far off. Well, that was true of the supply-and-demand experiments, because when I did those, I didn't really think they would work. I accepted the view that, you know, you had to have complete information, or everyone had to be small relative to the entire market--you had to have a sea of buyers and sellers. That this was some kind of an ideal, a frictionless ideal that was not likely to be approached in practice. And so here I was doing experiments with 15, 20, 25 people; and we were getting convergence easily. And then I did them with smaller numbers, and those supply-and-demand markets worked really well. So that was a surprise. And I know it was a surprise to other economists, because I had trouble publishing the paper. They didn't believe it. See; but just look how--I just did more and more experiments and I realized these were not accidents. This is the way the world works. And people in that simple environment, where at every trade, the buyer enjoys whatever the value from that trade is, and the seller similarly gets their surplus--there's no re-trading; it's all over. Okay? That's a market basically for perishables; and it's not small. We're talking about, in my book with Steve Gjerstad, Rethinking Housing Bubbles, we discussed this stuff in some detail. But nondurable consumer goods--and of course a lot of those are also services--that's 75% of private product. If you take GDP (Gross Domestic Product) and subtract government consumption expenditures, you get private product; 75% of that is stuff that basically cannot be re-traded. And of course those, those kind of goods not only behave really well in the lab: they behave themselves in the economy. They hold up. Those kind of expenditures just do fine. They are not a problem. All of our macroeconomic instability comes from the other 25%. Mostly housing. Okay?
7:13Russ: But the point I want to emphasize, that I think you mentioned earlier--I think you are talking about the perishable part. But the other part is the market part. So, when I go get a haircut, I see the person cutting my hair. The place I go, she works in a shop, and the owner, I see him every day. He also cuts hair there. I don't see him every day, but when I go in, any time I'm in there, he's in there. So, I see them, face to face. But that transaction is taking place in a much broader context, because there are lots of places I can get a haircut. And if their price starts to vary dramatically from what I perceive as the market price, I'm probably going to stop going there. And a lot of that 75% that you're talking about, those are transactions that take place with relative strangers. Correct? In the sense that--a better way to say it is: I'm pretty self-interested. I'm looking for a good deal. I'm trying, as you say, to maximize my surplus, whichever side of the market I'm on. And that's the Max U model. Guest: Yes. Very good example. And also notice that you are never a seller in the haircut market. You are always a buyer. And the person who cuts your hair is commonly--I don't know who cuts her hair, or his hair, but she's a seller. You see, we're specialized in the roles. And that, see that's very different from the stock market, or even the housing market, where, depending upon the price, you may switch from being a buyer to a seller. And that accounts for a lot of the problems. What we observe is a lot of instability and erratic behavior of prices. And I think that's an insight that I think is very important, because we don't usually think very much about the nature of the commodity and how that might account for the good things in the economy as well as the sometimes ugly things that happen. Anyway, this is a little bit of a distraction, but I kind of wanted to give you the background. And then well, then of course we started--see I started studying supply and demand markets--that was in the late 1950s or 1960s. We then turned to asset markets in the 1980s, and we started with a very transparent market, an asset that could be re-traded but there was a yield, a dividend on it that was common information. And we thought that would be very simple. It would be transparent and people would trade at fundamental value. Well, wrong again. Okay. I was wrong the first time; wrong again 25 years later. These markets are very subject to bubbles in the lab. And people get caught up in self-reinforcing expectations of rising prices. We don't know where that comes from. It's incredible, but they do. It goes away with experience, in the lab. And you see, I now, then, can see very much the connections between that work that started in the 1980s and the Great Recession, where we have this massive housing bubble that's caused all of the pain. Well, then, you ask about trust games. So, now, starting in the late 1980s, early 1990s, we start to study two-person sequential move games. Russ: Explain how the trust game works. Guest: Okay. Well, you and I are matched and there's 12 people total in the room, say; and they're sitting--they've all been escorted to a terminal. And we read the instructions. So here's the way the trust game works. And let me give you an example that we studied early on, that we started with. I move first. And you and I both see that I can stop the game by giving each of us $10. Okay? And that's the end. Or, I can pass to you. If I pass to you, the $20 is doubled. Okay? It becomes $40. Now, we don't tell a story about that, but the idea is there's some sort of synergy in our actions, okay? So, the $20 becomes $40. Now, you can choose to give me $15 and take $25 of the $40. Or, you can just take all the money, and I get nothing and you get $40. Now, we deliberately chose rather extreme payoffs because you and I, we don't know each other. We are anonymously matched in a room with, say, a total of 12 people. And I'll never know who you are; you'll never know who I am. And so, we were giving this Max U it's best shot. And Max U says, well, that if I move first, I shouldn't move to you because $40 is better than $25, and you'll take all the money. So the equilibrium of that game is for me to just stop it and we'll each get $10. And so, we really thought that zero, the fact that you could take a dollar, would really give us a very strong tendency toward that Max U. Well, we were dead wrong. Half of the subjects moved down on that game. In other words, half of the people in the first-mover position passed to the other person. And two-thirds to three-quarters of those assigned $15 to the first mover and take $25. In other words, they do not defect and take all the money, predominantly. So that was a really dramatic thing to us. And you know, a number of experiments followed to try to explain why. And we varied the payoffs, you know. It turns out varying the payoffs made some difference, but not all that much. We're doing some games more recently where the opt-out payoff is $12-$12 rather than $10-$10; and so the $24 becomes $48; and then the second mover can choose between $18 for the first person and $30 for herself, or $6 for the first person and $42 for herself. So, we took the zero out. Still you get about half moving down, a little bit more than half in that case but not much more. But you get a very predominant move where we have two-thirds of those cooperating.
15:34Guest: Well, there were a number of responses to this. One of the first things--we tried to explain it with the idea that, well, this is really an exchange. Okay? And people see it as an exchange, and for me to move to you and for you to choose the cooperative outcome, it's reciprocity. Okay? Now, I no longer see that as a good explanation. It's not Adam Smith's explanation, and he's right. He's got a deeper explanation. Think about it. Reciprocity--what is that? That's just a name for what it is they're doing. It doesn't really explain anything. It's like in Keynesian economics, the liquidity trap. What's a liquidity trap? Well, it's a name for the ineffectiveness of monetary policy. It doesn't tell you--and certain curves when they teach you this stuff bend in a certain way. That's what it is. But there isn't any kind of deeper push into why people are doing this. And that's the beauty of Adam Smith. And let me just, since I really want to get at the Smith in here, let me point out that what Adam Smith does that is--he has some very strong propositions that turn out to apply directly to these kind of games. For example, he has a proposition, and I basically kind of know these [?]--he says that "Actions of a beneficent tendency, which proceed from proper motives"--his qualification is very important--"seem alone to require reward." Well, think about the trust game. You see, if I move first and pass to you, I'm benefiting you, Russ. I'm giving you a chance to do better than you would have done if I simply opted out of the game. Russ: It's a gift. Guest: Yes. And moreover: Why can we infer that the motives are proper? Well, because you can see what I could have done if I hadn't passed to you. You see? You can see that I could have chosen $12-$12, or $10-$10 in the original version of the game that I told you about. I could have done that, but I didn't. The fact that I didn't do it conveys meaning. See, that's the point in Adam Smith: that context and circumstances are very important and these actions--people, when they take actions, others are able to read those actions and make inferences. And so these games need to be looked upon as kind of a--the actions taken are signals that enable people to read intentions. And Adam Smith emphasizes over and over in The Theory of Moral Sentiments that intentions are central to understanding the meaning of actions. Well, you see, Russ, that wasn't in our original conception of these games coming from MaxU, you see. If I believe you're self-interested, you believe I'm self-interested--if that's common knowledge, then what's intentions got to do with it? Nothing. Russ: Or if I'm just a maximizer. If my goal is just to get the most out of any deal-- Guest: Yeah. Russ: You know, it reminds me of Milton Friedman's expression, statement, that we spend our own money on ourselves more carefully than we spend, say, other people's money on other people. That could fall[?] into Max U. But what doesn't fall into MaxU is that you might spend your own money that you've earned more carefully than if somebody gives you some money. And that isn't in MaxU at all. It can't be in there, almost by definition. And yet we often feel very differently about the money we receive that we worked for versus the money that might be a present or something else. It's just very different. Context matters. Guest: Yes. And by the way, there's been now a lot more experiments, in which the subjects don't get a freebie from the experimenter. An endowment. Which is the game that I just gave you. But there's been more interest in situations where people have to earn the money; and then what they do with it is their own. They are free to earn their money and leave. Now, generally people don't. They stay; of course and do the experiment after they've earned the money. But--I don't want to get off into that too much. But that can be a game changer. So, it's very important to explore that. In fact, I've written a paper in which I argue that all those experiments that we did earlier using experimental--experimental money--endowments, need to be replicated, you see, and see how robust they are with exactly this point that you are making, Russ. And that has been happening.
21:47Russ: A related point, which I think is so important is that another implication of the Max U model is that if I earn $50,000 a year, I'm just as happy as if someone gives me $50,000 a year. And I think that's not true. Guest: Yeah. No. I agree. There's a satisfaction associated with that, that is easy to overlook. There is a pride in that. Russ: Yup. Guest: And we look more favorably upon ourselves when we do things that are proper. Okay? And earning the money is a proper way to do it: I gave value and I received value. And even though people don't--they have a lot of trouble with that always in understanding markets. The average person on the street, they get that. Russ: Yes, they do. Guest: They get that because it's part of our emotional makeup, part of our sentiments. And, you know, The Theory of Moral Sentiments is all about fellow-feeling. It's interesting; this is before the word 'empathy' was in the language. Adam Smith is talking about empathy. But it would be 150 years after he wrote before that word would enter the English language. It turns out it entered the English language very early in the 20th century. And in some ways, I appreciate that. Because it always spills[?] about. He talks about the pleasures of fellow feeling, you see. And so he mentions--and when he uses these great metaphors in which he--and I love it--in fact you may quote this one in your book, in which Adam Smith--well, I call it his great mental experiment. He says, imagine a person, a member of the species being brought up entirely isolated, never--he's another human being. He says that person can no more understand what it means for his mind to be deformed than for his face to be deformed. And Smith says--I'm paraphrasing--bring him into society and you give him the mirror he needed before. In other words, the looking glass in which we are able to see ourselves as others see us. And it's an incredible work. Smith's book is an incredible work of psychology. And particularly it is social psychology. Because there is no self unless there is a we. You see what I mean? Russ: Yup. Guest: That is--what does that mean, for your face to be deformed, if you are entirely an isolated individual? You'd say, no way to know. We all get that by being brought up in the presence of others. So that humans are very much social animals. And our psychology is very much a social phenomenon.
25:45Russ: Vernon, you argue--I'm going to put two things together and ask you to tie them together from a recent paper you wrote. You wrote that motivation, human motivation, is not utilitarian. And you also wrote that The Theory of Moral Sentiments is all about rules. Explain what you mean by those two statements, because I think they go together. Guest: Yes. Well, Smith doesn't--he assumes that we're all self-loving. That in terms of the modern preference theory, we're non-satiated, in the sense more is better, less is worse. That's his--I call it his stoic axiom of self-love. And he talks about that in more than one place. But, that is not the way people make decisions. I now realize that the reason why he needs kind of common knowledge that we're all self-loving is to be able to know when an action is a benefit to someone or it's hurtful. So, in the trust game, if I pass to you, I enable you to be benefited. You can make a choice that also benefits me; but this definitely improves your situation no matter what you see, what you do. Well, we can immediately see that. Both of us understand that. We don't even have to ask a question about that because we automatically know that. Well, that's why, that's the reason why you need the self-love. But our decisions are all based upon issues about whether the choice--Smith says, We desire praise and to be praise-worthy. We desire to avoid blame, and blame-worthiness. So in other words, it's the social criteria that drives and governs our choice. And Adam Smith. Now, I'm not saying that it isn't possible to introduce some kind of a utility function. Of course. But the point is, you don't need it. You can tell a really good story about the dynamics of interaction, as Smith does. And he describes the process, what it is people feel, you see. So, if player 2 in the trust game responds with a cooperative outcome, Smith predicts that lots of people will do that, because of the gratitude they feel. The first mover didn't have to do what he or she did. And in fact, for different motivations, back in the, oh, late 1980s or early 1990s, we did some comparison experiments. We did a trust game where one hadn't allowed sight[?] option. He just had to move to two. Okay? And then two had the same choice outcomes as in the game where one did have an outside option. Well, if two doesn't see what one gave up because they gave up nothing--they had to do what they did--then there is far more defection. It's now--whereas in the game where I see what you gave up and I can read meaning into your action, the cooperation is twice as high as the defection. If the player two can't see that, then the defection is twice as high as the cooperative outcome. It completely changes, you see. It tips the balance. And, well, Smith would say, if he were--he would say: What else is new? That's because you can't read the meaning. You can't read intentions. And intentions are everything. Well, he's just so right.
30:41Russ: So, what do you mean by 'the rules' part? In what sense is--explain that. Guest: Well, I think, the rules come from--for example one sort of rule comes from this first proposition, where actions of a beneficent tendency to proceed from proper motives alone require reward. Well, the rule that people generally follow is to reciprocate kindness. Okay? So, that's a kind of rule that you get from Adam Smith. And also, he has another proposition, which is the reverse of the beneficent. And this has to do with the hurtful action. He says,
Actions of a hurtful tendency which proceed from improper motives seem alone to deserve punishment.
In other words, what does it mean to be improper? Well, you intended to be hurtful. If it was just an accident, um, Smith says, you know, if it was just an accident, that's different. But if it's intended, then this is hurtful. And people feel resentment to that. Just as they feel gratitude toward actions that intended to be beneficent, so they feel resentment when you deliberately make a choice, take an action that is hurtful to me. And that excites resentment, Smith tells us; and I am motivated--if I have an opportunity, I will punish you for that. And that, by the way--that proposition is the basis of property rights in The Theory of Moral Sentiments. The Theory of Moral Sentiments develops beautifully a theory of property rights, and it comes from that second proposition. And it's because we have these rules in our small group to respond in a resentful way toward deliberately hurtful actions, he says, When it comes time for civil government we just move those rules over and they become the law. You see. The law originates long before, in cultural groups, long before we have the civil law of government. And he develops that, very, very nicely. He says it's kind of a--it's not only a motivation to punish from resentment, but it's sort of a proportional punishment, you see, depending upon the severity of the resentment. And he says this is why, under the civil order of government, that murder has the greatest punishment. Because what could be more serious than murder? And he also points out that, in that development, that theft and robbery carry a greater punishment than a violation of promises. In other words, contracts. And he says, Why? He says, because robbery and theft take from us what we have already acquired. Violation of contract merely frustrates our expectation of gain. Okay? And he says that's different. And indeed, theft and robbery are criminal offenses. Violation of contract are only civil offenses. You can get redress, of course, but they are considered less serious. And he gets that from another fundamental proposition in Adam Smith, and that's the asymmetry between gains and losses. Russ: It's incredible. Guest: He says, we suffer, and I can tell you this one almost verbatim: He says, 'We suffer more when we fall from a better to a worse state than we ever gain when we arise from a worse to a better.' And he goes on, explains this, that it's loss of fortune, of reputation, of esteem. I mean, it isn't just money and fortune. He mentions, as I recall, three other things, but they have to do with our rank, our status-- Russ: People don't pay as much attention to us. And that's a huge factor for Smith. Guest: Yes. And we will be very careful to avoid that. And so this notion of the asymmetry between gains and losses is not only clearly stated more than one place in Adam Smith, but it's actually used to derive some of his results. And my good friend Danny Kahneman, winner of the 2002 Nobel Prize Award, you see he was recognized--well, for a number of different things. But probably the best known were, of Kahneman-Tversky, was the documentation of this asymmetry between gains and losses. And that was mostly in individual decision-making. But they generalized it further than that. And I say, Good thing. So did Adam Smith. And they came to that, too.
37:13Russ: Vernon, let me try to step back a second and take this set of observations. I want to expand it beyond the exchange setting. So, you take the desert island metaphor, right? We don't grow up on a desert island. We grow up in this social soup that we're constantly getting signals and giving signals, sending signals, receiving signals--and learning about the norms of propriety: what's expected of us, what's proper. And if I understand you correctly, you're saying that as we learn those norms, we do our best--if we had to say, what's our model of behavior: It's not that we try to do what's best for ourselves, although that self-love of course is always operating. It's that we're constantly striving to meet the expectations of those around us to comply with these non-legal, extra-legal norms and rules and expectations of those around us. Because when we do, things go well. People are then free to make their choices, pursue their desires, without bumping up against other people in destructive ways. And this goes way beyond haircuts and hamburgers. And haircuts and hamburgers might be 75% of the economy. But these daily interactions we have with others are a huge portion of how we spend our time. And that model--I don't want to use, I hesitate to use the word 'model'--that perspective on human behavior is so much richer than just our commercial dealings. React to that summary. Guest: Yes. It's a great summary. And, you see, Adam Smith's The Theory of Moral Sentiments is about human betterment. Social betterment. Human betterment in the social sense. And all the ways in which we interact and make life meaningful for each other, by following these unwritten rules. He talks about them being we do things 'insensibly.' That is, a lot of what we do is just kind of built in. He is trying to think through the meaning behind them, of course. And we may not even think about these. Take the phrase, common in our language, 'I owe you one.' You see, that is the recognition that you did something for me, and, you know what--I'm going to remember that. It's just one of those automatic. Where did that come from? You see, if it didn't come from the notion that we are constantly changing things at the personal level which increases our happiness and we have better lives as a result. And this, I think, is entirely [?] from human economic betterment. He wrote two books. The second one is about economic betterment. The first one is about social betterment. In this important sense. And even in The Theory of Moral Sentiments, he has, he has many points where he makes it clear--part of the asymmetry between gains and losses. The average person that has done reasonably well, you see: What can he do to better his life? Very little. He's kind of there. And that's the reason why, you know, more adds something. The thing that is really devastating is to have a big loss. And-- Russ: That's partly why he emphasizes prudence, I think. Guest: Yes.
41:55Russ: As one of his--I call it the Big Three--Prudence, Justice, and Beneficence. With prudence, what you think of, if you are not careful is you could think of prudence as being just: oh, just leading a narrow life; don't take too many chances. What he's really reminding us--and this reminds me a little bit of Nassim Taleb--and of course Taleb has a stoic side to him, which is: The worst thing that can happen is to lose dramatic portion of where you are now. That can be devastating. And so you want to put yourself in a position, both emotionally and financially where either that's less likely to happen; and if it does, you know how to cope with it. Guest: Yes. And also that you are looked down on if you are not properly prudent, by others, because you do have an obligation to take care of yourself. Not at the expense of the others: you should always humble the self-interest and bring it down to what other people will go along with, which is kind of a literal quotation of what he says. But that doesn't mean that you aren't responsible for yourself. And people will look down on you if you are behaving in ways that doesn't give you good survival value. And of course that's one reason why, of course, we don't like it when people use drugs. We see that as diminishing their lives, and we're trying to stop it, you know, in ways that are--that just don't work very well, as you've written about, and many of us believe-- Russ: But your point explains why it is that people persist, in an urge, to, say, fight the drug war, even when there is zero evidence that it's helping people's lives. Guest: Exactly. Yes. And it gives--it adds to violence and law-breaking--all of these things. Of course, we went through that during Prohibition. And remarkably, as I look back on it--it's amazing--we actually repealed Prohibition. Russ: Yeah, it's shocking really. Guest: That tells you, Russ, that it was failing miserably. For anyone to get that kind of effort out, to go back and change the Constitution. When do we ever make legislative mistakes and then go back and correct them. Russ: Pretty rare. Guest: It's kind of rare. And it's just--and you know, people on this drug business, it's just been something that it's just been so hard to get rid of. All the violence and everything that has been created around it. But you are right. Smith explains kind of why these things can get started.
45:03Russ: Vernon, I want to take us in a different direction. I want to tell you a little story and get your take on it. I saw years ago, this may be 15 or so years ago, there was a symposium in honor of Gary Becker. And I've told this story before, I think here. But I want to share with you and follow up on it. So, at the end of it, people made a lot of presentations. And at the end, Gary stood up and people asked him some questions. One of the questions they asked him was: Who are your biggest influences? And he said: Adam Smith and Alfred Marshall. And I was kind of shocked by that. I was a student of Gary's. And I would never have predicted those answers. And over the years--and I'm sad, he passed away recently; and I've been thinking about his work recently because of that. In many ways, his enterprise, much of his research agenda, was an attempt to take Smith's insights to enrich the more sterile view of utility maximization and the theory of the consumer. He put altruism, into, or the happiness of others, into the consumption of others, into one's own utility function. He was interested in all kinds of social phenomena that most economists ignored. You mentioned earlier that, you sort of said--it was a remark you made in passing--you said: Well, of course you could put such and such into the utility function. What do you think of that--to me there's something Quixotic about it. I have come to believe that it's not really--and I did this myself, by the way. My earliest work was very much in that vein. But I've come to believe now that these two approaches are almost orthogonal: that utility maximization and the Smithian approach. Because as you point out, motivation is not utilitarian. And yet, mainstream economics view people as maximizers. As people who are trying to get stuff. And of course, in many parts of our life, we do. But in so many other parts of our life, that's not what the enterprise is about. And to twist in a convoluted way, the traditional model, to take account of this--in a way, it seems like the wrong approach. What do you think? Guest: Russ, I agree. It all goes back, you know, we inherited this kind of stuff from the neoclassicals. Jeremy Bentham, [?] basically I think as the guy who started it all. He overlapped Adam Smith. But of course he's mostly a 19th century thinker. And it was the greatest goods for the greatest number. He believed that even institutions that have come to us through tradition, they need to be analyzed from the perspective of this utility calculus. And if they are not creating a utilitarian welfare, then we should change them. That's maybe a little bit of an oversimplification. But it's kind of the message in Jeremy Bentham. And that was picked up by Jevons, you see. And Jevons and the other contributors to the marginal revolution made an important advance. And that was all connected with this notion of marginal utility and its relationship to marginal values determining price; that wasn't clear, crystal clear at all [?] classical economists. But I've come to see, though, that you see--that wasn't just added to what the classical economists like Smith did. It displaced them. Russ: Yeah. Guest: And you see, it turned Adam Smith's theory--it turned Adam Smith's Wealth of Nations on its head. What it did was establish this idea that out there, there are preferences and there's technology and there's resources and what an economy does, a competitive economy, is define prices that allow people to satisfy their preferences and get stuff done at lowest cost. And we get specialization out of that. And Adam Smith is just the other way around. You see. And Hayek, of course. And his critique of the neoclassical model emphasizes this. But it's in Adam Smith. Adam Smith--what is that[?]. In Wealth of Nations, what is the first axiom? It's the propensity to truck, barter, and exchange. He said, that's what drives everything. He said, I can't explain that, really. He speculates about why that is, why we are the only species that does that. He mainly wants to get that propensity to trade. And notice that just comes out of our sociality. David Hume distinguished between interested and disinterested commerce. Disinterested commerce is like in The Theory of Moral Sentiments. Interested commerce is like in the Wealth of Nations. Okay? It's driven by economics, and more the self-seeking stuff. Adam Smith--what happens--tendency to trade. What does that do? It leads to prices. Price, then, become known. If they are not public, people learn about them through gossip. People talk about stuff. If you made a deal and a trade, you talk about it with your friends. And as soon as there's prices, people can start to make comparisons. You see it age[?] calculation. Now you say, oh, with the price of corn out there, and there's a price of hogs: I wonder if I should be producing more hogs and less corn? Or the reverse. People start to ask questions they didn't ask before. Theoretically, they could have done it before, but they didn't. And I think that's very important, because if you read what Smith says about specialization--he says, it's not so [?] it exists out there already, and then as a result of prices it comes forward. No. He says it's because of [?] and everything, and in our maturations[? machinations?] we make decisions that differentiate the boss[?] from the common street porter. Okay? Even though they started out and they were playfellows together originally. So, it's a process that transforms people, that exists in some markets, the fact that you don't have to satisfy all of your needs on your own. That creates opportunities for the individual that leads to specialization. Well, you see that in the modern neoclassical view, and we just continued that. I think that has been lost. And, well, it's high time, you see, that we recognize that. And I think your story about reducing everything to utility maximization, I think distracts from that. And why are they doing it? Why do people do that? And I, like you, I did it, too. It was a long struggle of escape from it. But I did it because you want to be able to make an efficiency statement. You want to be able to see if, well, is this outcome efficient or is it not? And I think Adam Smith would say, hey, there's time enough for that; let's first find out, on the ground, why people do this. What is their immediate motivation? What are their emotions? You see. And I think he's absolutely right.
54:07Russ: Do you think a modern graduate student should read The Theory of Moral Sentiments? Guest: By all means. And stay with it until they understand it. I didn't understand it the first time. And another thing: my colleague Bart Wilson, we've been using it and teaching--we teach jointly, classes, and have been since we were at GMU (George Mason University). So, it's kind of transformed our thinking. And Bart got me into using Samuel Johnson's Dictionary of the English Language. This is the first dictionary of the English language. It was published in 1755, four years before The Theory of Moral Sentiments. And the neat thing about it is you find the words and how people used them in that day. See, 'behavior' had a different meaning then. It was not--and you'll notice when--Adam Smith used the word 'behavior' in The Theory of Moral Sentiments, but it's not alone. It's always about conduct and behavior, countenance and behavior. His real word, the word that counts, is 'conduct.' And conduct has to do, is a thing that involves rule-following. How do we conduct ourselves? And that involves not just the outcome of our actions, but the circumstances that are behind our actions. And so--and I think it's exactly the right sort of emphasis. Let me tell a story about--Candace and I, this was some years ago-- Russ: That's your wife. Guest: Yes, my wife, Candace, and I flew into Seoul, South Korea; and we were picked up and delivered to a hotel, nice hotel. And it was really very good service. Two people took our bags and everything up to the room, and they were so polite and everything. Well, I offered a gratuity to each of these two individuals, and they very graciously declined. And they made it quite clear in their gracious declination of that offer that I was a valued guest, and they were doing their job. This was what they were there to do. And any additional gratuity was not required, and not expected. You see, that, it just tells you about the rules, how they can be very cultural. And local. And as you think about that, each of us knew that the other preferred more money to less. Right? Russ: Yeah. No doubt. Guest: There wasn't any question in their mind or my mind that money was good to them and they always preferred more to less, other things equal. But there, that wasn't equal. And of course here I was, aware of that, willing to give up some of that money in order to recognize and reward this as I thought, beneficent act, that they wouldn't have had to have done. Okay. But they're coming back and saying, Oh, no, there's no way we would ever do anything except treat you this way. So, you see how rich that environment was? And I was following the rules in my environment, back in the United States, where you reward actions you see of a beneficent character, above and beyond the call of duty; and you reward that. Okay? These people were telling me it wasn't above and beyond their call of duty. So, I just found that so interesting. Russ: Well, they didn't want your charity. They saw it as charity. You saw it as a payment. What I love about the story is that on the surface, both parties were irrational. You were irrational for offering to tip in a place you'd probably never go again. Guest: Yes. Yes. Russ: There's no reason to think you're going to get these particular--even if you go back to that hotel in the future, you're not going to get these people to carry your bags in. So, you were giving money that you didn't need to give. And they refused it. It would have made them "better off." But they wouldn't have been better off. They wouldn't have--as you say--what's fascinating to me is that I want to impose my utility framework on this, about better off. But it's really not about that. It's about what you said--it's about conduct. It's about propriety. It's about, 'Well, this just isn't done, Sir. We've done our duty and we don't want your money.' Guest: Yes. Russ: It's a fascinating little example.
59:59Russ: I want to close with--I want to defend mainstream economics for a minute, because, you and I both have the luxury of not being quite a part of it, part of that mainstream. I'd a podcasting, rap-video making, unusual, bizarre--I'm not a normal academic. And you've won a Nobel Prize--a slightly different reason for being outside the mainstream in this sense: you can do whatever you want; you don't have to play by the rules any more of the economics profession. But if you look at our profession--and I love your going back to Jevons--for the last 140 or so years, we've created this magnificent, mathematical edifice that leads to these grand, sweeping summaries about efficiency, as you said. And then we can look at what leads to breakdowns in efficiency, and asymmetric information, and imperfect information. Imperfect competition, etc., etc. And much of the last 40 years have been an attempt to mathematicize these imperfections, with the concomitant implications for public policy and advice that economists like to give. And that's the standard view. Now, you and I come along--you more than me--and say: Yeah, this is kind of a sterile view of human beings. It doesn't capture a lot of what's important. And in fact, I would suggest it leads to a false confidence in our ability to make people better off by manipulating the levers of public policy. But I think the response would be--so I'm going to play devil's advocate here; and then I'll let you close us out--oh, all this stuff that you're talking about with Adam Smith, that's fine for how we behave maybe in a small, relatively unimportant transaction in a hotel and stuff in Korea. Maybe it's relevant for how I deal with a tragedy in my life--because Smith has marvelous things to say about tragedy and success. So, that's fine; that's sociology; and psychology. That's not really economics. So, economics, it's more rigorous and it should just ignore all this other stuff you're talking about and stick with this beautiful edifice we've created. It's more scientific; it's more mathematical; and it deals with the stuff that economics deals with: buying and selling, prices, markets, and so on. Respond to that. Guest: Well, Russ, the way I would respond to it is that there's a time and place for everything. And there's still a time and place for the mathematical framework, and for a lot of that kind of traditional stuff. Let me give you an example. When my colleague, Steve Rassenti and I started studying the electric power industry and designing experiments to see, to explore the possibilities for organizing that industry around markets rather than centralized control, we needed all of that framework. We need auction theory. We needed the stuff, we needed those tools. And we were doing basically an engineering application of those tools. In fact, as you may know, I have an undergraduate degree in electrical engineering. Steve Rassenti's Ph.D. is in systems engineering. And when we went to Australia, when they asked us to come, it's because they'd heard about this stuff we had been doing, and the experiment, and what we were showing. It was a coalition of buyers that took us to Australia--let's see, it was the second largest distribution company, what was it's name? Proveda. It was the commercial buyers and the industrial buyers. They felt that the government owned electric power industry was not giving them low energy costs. And particularly, one of the stories that we heard was that the industrial guys were trying to compete in world markets. And we have all these energy-intensive products; and so a low energy cost is important to us and competitive. So that's why they were looking at alternatives. And we faced, everywhere people that did not believe--that was true of New Zealand, too, when I went there--they did not believe that you can make a market in electric power, and certainly not organizing an industry around it. Well, we could put these people into experiments. It turns out they made a market just fine. And we could show them the results. And we'd ask them, Well, tell us what's wrong with the experiment? Well, they would have a few things, but they never had anything--because we were always willing to make it more relevant. I tell you what--we won a series of battles. And the war. In Australia. The Australians created the National Grid Management Council. See, each state owned its own electric power industry there. The Federal Government there created National Grid Council, and basically they wanted to push the states into creating a wholesale market for power. And they started trading in some individual states--let's see, that was 1996, and 1998 they were all creating a market. It was a simple four-node network; it's not a very complicated network. And that whole thing started to change. So there was a place for that. But it's not everything, Russ. I could tell that story, but I can't understand all the things that I'm trying to understand about the human enterprise with just that story and just that kind of framework and that kind of modeling. And so there's a place for that modeling. But I need a much better, a broader view if I'm going to understand the human enterprise. And wow, there isn't a better model than Adam Smith, because he was trying to do the same thing.