Adam Smith's Fallacy of Composition

[nicomachus]

I have seen in-print discussion of the experiments discussed in this NOVA episode, MIND OVER MONEY:

video.pbs.org/video/1479100777/

Human beings simply do not act rationally in market transactions.

Smith was operating with an Aristotelian definition when he wrote WEALTH OF NATIONS (man is the rational animal). He therefore thought that as markets are human phenomena, they would follow rational rules.

The problem is that human beings do not always act rational. In fact, when it comes to certain things (money, sex, food and alcohol, etc) we tend to act irrationally.

So although the market is made up of rational components, it would seem that it itself is not rational.

Many experiments (see link above) would verify this, although others still disagree.

The major consequence of this distinction is that those who put any "trust" in market phenomena because they expect a rational progression of events may be making a most dire mistake.

Thoughts?

[olderstill]

In my opinion Adam Smith was not a neophite, trusting soul. For one thing he did not think it beneficial to hire someone to run a business if they were not vested in the enterprise. As we say today, no skin in the game. Lax and careless judgement would result in unprofitable decisions which might ultimately capsize the enterprise. If the manager is one of the owners, he'd be a lot more likely to take the time to see that the decision is the best for the company. Does that sound like he believed that people were "irrational". He may have believed that their behavior was determined by patterns traceable to and observable in others. But, that too, stops short of calling them rational.

Yes, he was a classically trained writer as were all of the educated people in that day. As a matter of actual fact, you were considered illerate all the way through the 19th century if you did not study the "Classics" which were the Latin and Greek writers. Nothing wrong with that as long as you didn't expect to walk the streets of London and find the garbage man spouting quotations from Homers Iliad.

I was in high school before WWII, anticipating college, and was advised to take a couple of years of Latin which I did. So, the Classical studies were not out of date here in the US at that time.

The transition to an esier - i.e., less "classical" curriculum occurred soon after WWII when education took a couple of steps away from the rigors of mental activity implied in classical studies. Along about the sixties, after the uprisings, riots, burnings and sit-ins, two things happened. First, students tested their new-found power by insisting that they determine what they would study and not be forced to study what the faculty chose. There was a compromise on that which made both sides feel they won and actually both lost out. Second, at the same time, university doors were opened to admit all who wanted to attend. Many of the new class of students were not prepared for the rigors of college study and spent a great deal of time in remedial studies which then meant there was not enough faculty or time available for what had been considered the standard curricula. So, it was judged that the classics would be dropped. I had one year of college before I was drafted and might have been in one of the last classes to study the classics when I returned from my tour of duty. Yes, I studied Aristotle - along with other classics in Greek and Roman literature.

To tell the truth, it didn't hurt at all. I have no scars, I walked as upright as I could considering what the service subjected me to, and I don't speak with a strange accent. Additionally, I believe my thought, at least while I was still working and interacting with contemporary folks, reading the daily newspaper, paying attention to the radio and TV (as it evolved), was kept relatively up to date.

Nicomachus, you are right, humans do not always act rationally. . As a matter of fact, between the ages of about 11 and 18, it's difficult to find a rational thought in their minds except for rare moody periods when they want something that being without would be an embarrassment in their social circles. Some never get over that period.

Thoughts on the rational movement of markets? I think if you poll the savvy, experienced investors here, you'll find they tend to agree with you to a point. In support of this I'd mention the contrarian investors who claim they make more money betting against general market movement than if they go with the flow. And, you'll find that most people active in the market know more about the underlaying business they're betting on than they pretend. And, if they find a really good opportunity, they won't tell you about it until they're into it as far as they dare. That's the time to start broadcasting what a good deal that find is.

[nicomachus]

Thank you for your comments.

I wish to make a few remarks as well as ask a couple of questions.

First, I never read WEALTH OF NATIONS in its entirety. In high school we were required to read a couple of standard passages (something about making sewing needles). The economic theory with which I work is heterodox, largely grounded in Aristotle and western medieval ethical theory. In the 20th century, it was championed by the under-rated E F Schumacher. It comes down to the very point you make: The best workers are those who are vested in the company. My fear is that in the centuries since Smith, this vesting has taken the form of servitude: You work for your boss, or you starve. The owners can outlast a strike a lot longer than the strikers can. This leads to low wages, shabby production and lower efficiency, not to mention dehumanization of labor.

So I would like to take a look at those passages wherein Smith states that the best managers are owners, because I wonder if his argument for the claim could be extended: The best workers are also owners. This is the point of my economic theorizing. I wonder if you might be able to point me to the sections of A. Smith wherein the claim is found. If you (or anyone else reading this) run across the reference, perhaps you would send it to me via private message or post it here if this thread is still active.

The only way I think we can ever expect rational markets is if ownership and market activity is decentralized. The experiment in which a $20 bill is auctioned off and the second highest bidder must pay out would suggest that emotion is very dominant in a short term game; but in a long term in which market activity is not abstract and far away but near and dependent upon the people you know and communicate with daily, I wonder if the same emotions can't be transformed into sounder economic decisions.

"I was in high school before WWII, anticipating college, and was advised to take a couple of years of Latin which I did."

How I yearn for the days when Latin was a standard part of education. I have now been studying Latin for exactly half of my life and part of my job requires translating medieval texts. I wish my skills with the language weren't so mediocre. I am constantly in need of correction.

I agree with you about the causes of the decline of higher education. So, I think, does nearly every professor I have ever known.

[traelin0]

nico,

Wealth would make a lot more sense if one prefaces it with Theory of Moral Sentiments. One does not go without the other. Adam Smith believed that free markets cannot exist separate from morals. Rational/irrational was not the problem.

[olderstill]

Touche, traelin. A point most people overlook.

And, the philosophical aspect might have found a beginning with Smith, but didn't end there. A forerunner to Smith was Cantillon, a scotsman who spent most of his productive years in France and wrote Essaie sur la Commerce en Generale and never saw it in print. He died in 1734.

Today the success or failure of the Austrian School basics hinges on that point of morality. . . And, it is the prinipal reason I believe it would have no success whatsoever in the US where our "business is business" mantra discards any flight to reason or morallity if it counters the good business deal.

Secondly, Smith himself considered Theory of Moral Sentiments his magnum opus.

Truth was, he wrote Wealth as an advertising venture to sell Mercantilism and to support the British Industrial Revlution to British export clients at the request of an acquaintance.


And, nicomachus. . . it was a straight pin in Wealth. . . , not a needle, if you think back carefully. I'll see if I can find that passage in re management you missed and post the lead here.