The invisible hand in the age of minimum government

In light of the fundamental belief that the invisible hand of free markets leads to optimal outcomes, Basu boldly questions the very basis of modern economics and talks about the way economists think about issues of economic theory and the role of markets and government interventions. As modern economists, we use Adam Smith’s ‘invsible hand’ metaphor without understanding it in its totality. We define it as ‘All individuals pursuing their respective self-interest leads society to an outcome that is socially optimal and efficient.’

By the 20th century, the first theorem of welfare economics was taken to be an analytical confirmation of Adam Smith’s invisible hand conjecture. The theorem states that – ‘A competitive market equilibrium is pareto optimal.’ This implies that there is no way any one individual can be made better off when an equilibrium is established within a competitive market. If a reallocation of resources were to be made, there would be unequal distribution of resources.

Basu gives us an alternative explanation to the theory which is based on the curtailment of individual freedom. We imply that an individual is allowed to choose from a set of actions provided. This ‘restricted’ bundle of actions comes in the form of government intervention to stop people from stealing, corruption and other unethical choices. This poses a challenge to pareto optimality as defined above.

It is important to note that this theorem comes with its own set of idealistic assumptions (like most economic models) such as complete knowledge of information by all individuals, wide array of choices given to ‘rational’ people and constant tastes and preferences. All these assumptions are questioned by Basu and put to test. Even if we don’t accept Basu’s dual interpretation of Adam Smith’s theory, he argues that a well-known game theory model called Prisoner’s Dilemma does not lead to a socially optimal outcome when two individuals are pursuing their own self interests. Lot of policy makers who advocate free markets have overlooked the rudimentary assumptions of the invisible hand theorem.

Let’s look at this in the context of India; since the liberalization of India post 1991 we have seen an emergence of free markets albeit with political difficulties which lead to a deepening of income inequality. The Gini coefficient measured in terms of consumption for rural India increased marginally from 0.29 in 1993-94 and to 0.31 in 2011-12. There was a significant rise in the Gini coefficient for urban areas from 0.34 to 0.39 during the same period. However, the consumption-based Gini underestimates inequality. If we use income data from the National Council of Applied Economic Research’s India Human Development Survey, the Gini coefficient in income (rural and urban) was 0.52 in 2004-05 and marginally increased to 0.55 in 2011-12. Clearly, inequality is much higher in India if we use income rather than consumption. If we consider non-income indicators like health and education, inequalities between the poor and rich are much higher.

It is evident we haven’t taken ethical social preferences into consideration. ‘Minimum government’ must also tackle problems like crony capitalism and nepotism instead of advocating policies which have a way of creeping into much of the information asymmetry problems we face today. Such negative externalities, which is defined as a cost to the third party as a result of an economic transaction, will continue to produce market failures. Lobbying for privatization tend to overlook the fact that private companies operate with government bribery for various licenses. Unless this is tackled with there can be no pareto optimality with minimum government.

For any government to truly bring about ‘Sabka Saath, Sabka Vikas’ it has to do more than what it has promised in its current manifesto which tends to treat the symptoms instead of its underlying causes. As is often stated, good policies are driven out by bad politics as also is the reverse case. But we have some really good policies in place, the only vehement problem faced by India is implementation. One good action can have a ripple effect and only then we can have ‘maximum governance, minimum government’ in its true sense.  

Niyusha Bolar