Adam Smith and the Rationality of Self-Interest


Since Adam Smith the prevailing view in economics has been that the free market operates through a principle of rational self-interest. Much as Darwin later identified the underlying mechanism for the variety and dynamism of nature operating at the individual level, so Smith atomised the creation of wealth to the individual’s self-interest: “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”. The notion of rational self-interest, though, needs to be subject itself to rational scrutiny, as it may contain assumptions about human nature which may limit the idea of the type of society which is possible.

Taking Smith’s own assertion at face value, what is it that constitutes the traders’ “own interest”? Clearly, making a living for themselves, which means the buying and selling of goods to and from others, the point being that trade presupposes the existence of others going about their business. Although we can safely assume that Smith had in mind an economy of more than three or four persons, and sustained by more than meat, beer and bread, pleasurable and sufficient as that may sound to some, for the purpose of this thought experiment let us assume a minimal economic model of four players, the butcher, the brewer, the baker and “I” representing the expectant diner. In such a model, it seems clear that whatever the self-interest of each individual is, it cannot be considered in isolation, but only in relation to the self-interest of others. The three traders and “I” rely on each other and can only participate in the market if each is solvent. Therefore, logically, trade in this state is not a zero-sum game, but depends on a certain level of parity, in which only incremental competitive gains are allowed.

Now, suppose that one of the traders defects from this cooperative model in order to gain an economic advantage over the other two. This could be due to simple greed, or it could be due to a fear that one of the others will jump first. In game theory, a branch of mathematics concerned with the logical outcomes of people behaving rationally under given conditions, this is known as the prisoners’ dilemma, based on a specific example, but generally states that when a player has more to gain individually by cheating than by cooperating with a partner, but more to gain by cooperating with a partner than by them both cheating, they will nevertheless both end up cheating and so end up with the worst result. The reasoning runs as follows: if I cheat I will end up with the best result (even though the other person will end up with little or nothing); I would like to cooperate, but if I can think of cheating so can my partner, and if my partner cheats I will end up with little or nothing; therefore, it is in my interest to cheat. The logical result of rational self-interest is that both partners cheat and end up with less than if they cooperated.

Suppose that the baker, in order to gain a competitive advantage over the butcher and the brewer, starts selling meat and beer, judging that “I” the customer will flock to his store for all my necessities; if he succeeds and drives the butcher and baker out of business, he will have gained all my custom and “I” will have gained a more convenient shop. On the downside the baker will have to diversify the business, which will require more work and may result in a loss of edge in the former area of expertise, opening the potential for targeted competition. The baker will also have lost two important suppliers and customers, and potentially made two enemies. From “my” perspective, disregarding the loss of esteem “I” may have had for the baker (for the moment), this places me in a more vulnerable position economically as, if the baker were to go out of business, “I” would have nowhere to buy my victuals.

There is another scenario: in this one the brewer and the butcher do not fold but respond to the baker by similarly diversifying, thus depriving the baker of any advantage gained by jumping first. They gain no advantage over the former cooperative scenario and take on the disadvantages that the baker had previously assumed; there is not even the prospect of my undivided custom. However, there is a payoff if the brewer, butcher and “I” conspire to deprive the baker of trade. Some experiments have looked at the relationship between our sense of fairness and spite. They turn on adding a new element to the prisoners’ dilemma. If the option for the exploited to pay for the punishment of those who defect is added the outcome is very different. Despite the exploited losing even more, they experience satisfaction at seeing the exploiters punished. Moreover, in future rounds group cooperation is far more common.

In real economies, as opposed to simplified models or experiments, there is a huge capacity to absorb the effects of defection, to the extent that the both perpetrators and victims might imagine that there are no consequences for the defector, hence no justice. This capacity is not unlimited, however, and the timescales for restitution – at least for exposure – are growing shorter in this increasingly connected world. Humans are highly attuned to fairness or the lack of fairness in a situation. This may be one of the reasons for the continuing appeal of socialism; it responds at a deeply atavistic level to the inherent injustice of so much of the world’s economic poverty and institutionalises grievance against those who are seen as unjustly favoured (such as bankers in the current climate). The same is probably true of the wave of populism sweeping the developed economies which harness, similarly through partial truths and vicarious appropriation, the dispossessed’s resentment against the winners from globalisation.

Keynes was one of the few economists who attempted to integrate human irrational impulses into his economic theory. Mostly, though, they have been ignored in the pursuit of pure rationality, exemplified by the extreme mathematization of orthodox economics. Rational self-interest as a real-world strategy does not exist in a solipsistic vacuum, however, but must take account of human feelings and sociality, even absorbing short-term disadvantages for longer-term benefits. Most economists despair at the irrationality of voters who turn their backs on the benefits of the free market, specifically global free trade, in favour of the planned economies of socialism or the protectionist policies of the right wing populists. In light of the scenarios considered, though, this does not necessarily violate the principle of rational self-interest, but it reveals that in open societies the concept is more complex and subtle than often thought. Swings in political culture, while manifesting irrational tendencies, may from a broader perspective be reinforcing economic rationality by reining in the irrational outcomes of defection from cooperation, that defection being entailed by supposedly rational objectives.

 It is a fact that free trade has had a beneficial effect on a global level by bringing millions out of poverty, but also that in doing so it has had a devastating effect on traditional jobs and communities in the developed world, not to mention the effect it is also having on the environment. It is little comfort to be told the truth midway through life that one must retrain for a new career in the digital economy because your job has been exported and be prepared to uproot oneself, family and community. These people vote; and in line with rational self-interest they will, in sufficient numbers, vote for those who promise an end to such deprivation, for this is less about declining standards than about economic survival. Among these voters there are true believers; yet probably many more vote with suspended disbelief to punish those in power and the rich even at the cost of punishing themselves. When the euphoria of populism dies down and the reality of broken promises sets in, there will be a reaction and hopefully this will see movement towards a more cooperative economic culture, in which social concerns are integrated into the market ethos.








One thought on “Adam Smith and the Rationality of Self-Interest

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s