The Market’s Invisible Hand

2017-02-13 17:44:09


While waiting for a connecting flight at Amsterdam’s Schiphol, I noticed that my departure gate was designated as an “X-gate”: selected for experimenting with new airport equipment and procedures. Nearby was a board with short description of innovation projects along with photos of participating employees. In the corner was a sticker, saying: “If you have never failed, you have never tried something new.”

In Kazakhstan, I often come across the belief that “failing is not an option”. The usual explanation I hear is that this is because of the mentality: people who fail are losers.

If this is true, no wonder that we do not see often people taking initiatives. “Quiet mouse gets the cheese”, saying goes. Initiatives are risky; taking them is calling for trouble.

Some time ago I participated in a roundtable discussion on how to reform Kazakhstan’s civil service. The summary was: “Civil servants should be more independent (самостоятельные) and willing to take initiative.” The rule today seems to be: “Do not stick out your head from the crowd and do not argue with your boss.” The conclusion was: We need somehow to change the cautious mindset and reactive behavior into bold mindset and proactive behavior.

I agree. But it would be naive to assume that employee training and education or new mission statement (some of the proposed measures) would be sufficient. The economist inside me was saying: It’s not enough to tell young civil servants: “This is how civil servants work in some model countries, please, take initiative, be proactive, and do not worry – everything will be fine.”

Economists believe that the key driver of human behavior is incentives. I remember my horse riding coach saying: “A horse is most happy when it doesn’t have to move. To make it move, you need to kick it or give it some sugar”. In this regard, people are not much different. Why would anybody exert effort, if there are no obvious benefits in doing so? An economist once said: “Economics is all about incentives.”

The key to change the behavior of people is to give them the right incentives. As water always flows down and not up, people will always follow their interests and respond to incentives. Economists believe that the society will prosper only if individual interests are aligned with society’s interests.

To make civil servants willing to take initiatives, we have to make sure that they benefit from any successful initiatives and also are not punished when these do not work out (especially if they could do little to influence the outcome). In other words, failing is OK!  And, of course, the more we try to innovate, the more often we will fail, as the sticker at the airport pointed out.

Now you might say: “Then we need supervisors that support proactive employees, reward success, and tolerate failure. Let’s educate the supervisors.”

Not really. Supervisors are also people. They will change their behavior only if they have incentives to do so. We cannot hope one day to wake up to the world of enlightened, understanding super-bosses, just because they received a well-intended directive.

Here comes the point. As a liberal economist, I believe in a powerful mechanism that produces the desired result (here, change of behavior) automatically. This mechanism is the “invisible hand” of a free market (a term coined by the “father of economics”, Adam Smith, in 1759).

We just need to have many competing companies, organizations, institutions etc. The invisible hand will do the rest. If an initiative employee achieves success and is not rewarded, he/she will seek better opportunities elsewhere. Similarly if he (she) fails and is punished.

Unhindered competition among companies (institutions, political parties etc.) ensures the Darwinian “natural selection of the fittest”. Successful products, ideas etc. will prevail, unsuccessful will be weeded out. Products and ideas favored by the majority will determine the winners. (Adam Smith introduced this idea 100 years before Charles Darwin applied it to the evolution of species!)

At the roundtable, I summarized it in a short statement: It is the abundant presence of alternatives that is necessary for the reform to be successful. If people can easily find alternative job, they will be more proactive. Alternatives provide potential reward for employee’s successful but unrewarded initiatives and protection against punished initiatives. As long as people have alternatives and freedom of choice, they will be economically motivated to take risks.

If the economy is demonopolized and privatized, the entrepreneurs, companies and organizations will have to compete for human talent. The relative easiness to change jobs removes the existential fear. Having such “insurance”, people are more willing to experiment.

It is important, so let’s see how it works. Nobody is requiring me to write newspaper articles. It is my own initiative. But I hear people say: “You are calling for trouble by writing provocative articles!”

I am willing to take the risk because: 1. There is also an upside potential: I may be rewarded for writing a provocative article – who knows? 2. I have alternative job opportunities if something goes wrong.

In other words, I am reasonably protected from negative consequences, while keeping the upside potential. In the language of finance I have a “call option payoff pattern”. Option contracts have always positive value; it makes economic sense to take risks!

In a diverse system with free competition, what some find bad others find valuable. If I am fired, my value may even increase. It may hint to a courageous spirit, and open a door to new exciting opportunities.

One can see the role the presence of alternatives plays in academic studies, stories of famous people, even history of civilization.

One study found that women who are less likely to report sexual harassment are either near the bottom or the top of their organization’s hierarchy. It makes sense. Low-ranking workers are often afraid to defend themselves as they cannot afford to lose their job. They have fewer alternatives: low-skilled jobs are nowadays fewer and low-skilled workers many. Highly successful women have also fewer alternatives: there are not so many top jobs. Workers in-between can find alternative jobs, which makes them stronger defenders of their rights.

The world of corporate management is full of stories of people making fortune by challenging the organization they worked for, being fired, then working for a competitor or starting their own business. The company started by Walt Disney has today valuation of 90 billion dollars. Yet, early in his career Disney was fired from his job at a small newspaper. The “failure” opened for him an exciting alternative.

One explanation why Europe dominated and colonized the medieval world is that the European continent provided a unique physical landscape which supported alternatives. Europe has a long and wiggly coastline with many peninsulas and islands, and mountains and dense forests inland. These natural barriers led to segmentation: creation of many, relatively small, separate kingdoms. This provided alternatives to the oppressed or discriminated, be it individuals or whole nations, within sufficiently short geographical distance. They could more easily flee their tyrants and start a new life, thus preserving the diversity of ideas and beliefs. The competition between ideas and beliefs led to the best scientific knowledge (in engineering as well is in ways how to organize the society), which provided political and military supremacy.

It does not mean that we have to live painful lives of constant firing and hiring in order for the society to achieve prosperity. The mere threat of the invisible hand is often sufficient. If an employer fails to appreciate proactive employees, the goods/services they produce will eventually become costlier and of lower quality. In the private sector, the company will start losing money and eventually go out of business. In the public sector, the opposition politicians will expose the weaknesses of the governing politicians and voters will have an opportunity to vote for an alternative. This way, as long as there is competition, companies and organizations have incentives to perform and reward initiative.

Let me now make a broader point. The laws of economics play the dominant role in motivating people’s behavior and deciding whether the country achieves prosperity.

Americans are more entrepreneurial and willing to test new ideas because the institutional and economic environment ensures that they are rewarded if successful and not ruined if not. It all started way back. Early settlers enjoyed bigger autonomy than in their home countries. There was a plenty of natural resources, but relatively few people. There was no oppressive aristocracy (the slavery of the South appeared later and was later defeated by the ideals of the North). The early settlers had to rely on themselves and were often fighting for survival with nature. This forced them to be hard working and innovative. But they had a free will and free choice and nobody would confiscate the fruits of their labor. From these modest beginnings emerged the most powerful economy in the world. This happened because the “invisible hand” was allowed to do the work. The government was aware of the need to limit its power and not to intrude too much into peoples’ lives. The Darwinian selection (not the government bureaucrat) determined the successful projects, initiatives, individuals, and companies. The entrepreneurial spirit thrived without government involvement, perhaps even because the government stayed away.

Entrepreneurial behavior cannot be created by a decree or government program. It needs to be facilitated by an environment that incentivizes it.

The right incentives are provided only in free, competitive markets. The role of government is secondary: to support and protect the “invisible hand”. Taxes should not be too high so that those who create value keep most of it. Goods and services should be provided, and investment decisions (what and how much to produce) made by the private companies. Authorities should ensure that markets are unhindered and demonopolized; their participants equal before the law. Government should only provide goods that are not efficiently provided by the private sector due to economic externalities: infrastructure (hospitals, schools, roads, basic research, public lighting etc.), law enforcement and external security (courts, police, army). Whenever possible, public-private partnerships should be used.

Why is government a poor entrepreneur? The government does not compete with anybody, it has a monopoly. Thus, the invisible hand cannot do its work. Democracies try to overcome this by creating competition inside the government (through constitutional checks and balances), the rule of law and independent courts (which can even sue the government if the government breaks the law), and competition “for the market”, if “in the market” is not possible (elections).

It may seem that liberal economic principles are out of favor these days. One can hear voices against liberalism, and in favor of more government protectionism. I will just say: Nothing is more powerful in creating long-run prosperity than to build the country on liberal principles. Yes, we need to deal with new challenges and threats. There are people who are more vulnerable in a globalized economy, and we need to understand how we can help them. The world is changing, no doubt about it. But the impact of incentives on human behavior has not changed. The invisible hand of free markets is always working; it is just less apparent to some people at times that it works (and how it works). The important role of the government is to let the “invisible hand” work, and of educators to explain it.


Marek Jochec

Associate Professor of Finance, Nazarbayev University