Adam Smith and Evolutionary Economics

In this article, I endeavor to take you through words from 18th-century Scottish philosopher and economist Adam Smith regarding the “invisible hand.” This metaphor comes from his 1776 book, The Wealth of Nations, which many consider the genesis of modern economic and financial thinking. In my experience, current economic thinking is the foundation of actuarial science and public policy, so it is crucial to understand the roots.

Let’s first define complex adaptive systems, which are “systems in which large networks of components with no central control and simple rules of operation give rise to complex collective behavior, sophisticated information processing and adaptation via learning or evolution.¹ For example, insect communes like beehives can achieve astonishing outcomes without central control. By sending signals through pheromones, they can efficiently attack predators and find food. These insects possess knowledge and know-how well beyond what seems possible.

Even though The Wealth of Nations predates complex adaptive system theory by about 200 years, I believe Adam Smith was doing his best to describe the economy in these terms. I hope this reframing, which differs from actuarial approaches, is enlightening.

Adam Smith’s simple statement about the invisible hand inspired the invisible hand theorem (IHT) in microeconomics. Price Theory and Its Applications simplifies IHT by stating: “In essence, people who selfishly pursue their interests achieve a socially desirable outcome.”²

In episode 124 of the podcast People I (Mostly) Admire, economist Daron Acemoglu explains that economics’ models assume that corporations are run in a cold, calculated manner with the sole intent of maximizing shareholder profit. But this is an oversimplification of the problem and not a measure of reality. In episode 108 of People I (Mostly) Admire, titled “Ninety-Eight Years of Economic Wisdom,” Robert Solow states that current economic models are designed to be mathematical exercises rather than explain how the economy works because of their reliance on dynamic stochastic general equilibrium (DSGE) models. Robert Solow does not believe that DGSE can be taken seriously. Joseph Stiglitz, in his speech “Smith’s ‘Invisible Hand’ a Myth?” claims that no one today would defend that bankers’ pursuit of self-interest has led to society’s well-being.

All of these criticisms are rooted in IHT’s unrealistic assumptions. These unrealistic assumptions require homogenous people either to be inanimate objects like atoms or possess God-like omniscience and efficiency, dramatically simplifying mathematics.³ Efficiency dictates that human labor, services and manufactured items are fungible.⁴ We do not live in those two extremes, but between them, where complex adaptive systems thrive.

I believe Adam Smith would have agreed with these criticisms because he would see modern economics as distorting his words by reaching opposite conclusions about what his invisible hand comment was trying to convey. I want to show you the true nature of his comments and how they tie back to complex adaptative systems, which are the foundation of evolutionary economics. I believe evolutionary economics is far better suited to actuarial science than the current mainstream economics that underlies our work. I want to challenge you to think in a completely new way.

Adam Smith and Control

Before diving into the statements concerning the invisible hand, let’s examine how Adam Smith considers control and knowledge. In The Wealth of Nations, he stated: “The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. To give the monopoly of the home-market to the produce of domestic industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must, in almost all cases, be either a useless or a hurtful regulation.”⁵

Now think of what Adam Smith stated here, but reframe it as questions about a beehive and the role of the queen bee.

1. Should the queen bee tell all the worker bees where the food is and how much to bring back to the hive? Should the worker bees coordinate all decisions with the queen bee?
2. Should the queen bee allow all the worker bees to forage by themselves with no instructions in a parallel fashion, coordinating through the strength of signaling pheromones?

Adam Smith is stating that the first option is impossible. The queen bee would be overwhelmed and not have the knowledge or skills to direct the entire operation. The hive would starve as the bees wait for instruction.

It does not matter whether the controlling body is a government, a single corporation, a CEO or a queen bee. According to Adam Smith, a highly centralized control structure would not work because it would waste resources and could not adapt to changing environments. Ironically, general equilibrium theory relies on a benevolent dictator to redistribute wealth and income before commerce takes place.⁶ Option two is addressed with the invisible hand because it is how complex adaptative systems work.

Knowledge and Know-how

Adam Smith explained his framework this way in The Wealth of Nations: “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The [tailor] does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a [tailor]. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for. It is an acquired advantage only, which one artificer has over his neighbor, who exercises another trade; and yet they both find it more advantageous to buy from one another, than to make what does not belong to their particular trades.”⁷

This quote addresses three major topics:

1. Competitive advantage
2. Opportunity costs
3. Knowledge and know-how

Competitive Advantage

The skills of the tailor and shoemaker allow each to do what they are good at. The more they can focus on and refine their craft, the better off they will be. The more society branches out into more novel, diverse and specialized skills, the better off the economy because everyone can do what they are best at.

Embedded in the notion of competitive advantage is trust—to purchase shoes from the shoemaker, you must trust the shoemaker and their skills. I believe Adam Smith is saying that trust ruins the ability for human labor and services to be completely fungible and self-involved because it requires strong network connections.⁸ Relationships out of self-interest are volatile and unreliable.

Opportunity Costs

The tailor may be tempted to make shoes—and the shoemaker may be tempted to make clothes—because they may think it is cheaper to do it themselves. When trust exists in the economy, Adam Smith theorizes that this makes no sense because it costs them in multiple ways. It costs them money, time and, likely, quality because they do not excel at the other’s tasks. Hence, the economy is better off when the tailor buys the shoes and the shoemaker buys the clothes.

Origins of Knowledge and Know-how

According to cognitive science, why do opportunity costs and competitive advantage exist in the first place? Because they are both, among other things, a derivative of a person’s knowledge and know-how. Therefore, markets ultimately trade expertise because the traded goods solidify human knowledge in novel combinations.⁹ Our ability to do massively parallel computations, heterogenous—not homogenous—collaborations, and use our environment are the sources of our explosive computational power. We do this so naturally that it leads us to our illusion of personal knowledge.¹⁰

Human computation, which César Hildago calls the person-byte,¹¹ is limited, so knowledge and know-how are terraced. Each level of human systems also has limitations, such as team byte, department byte, organization byte, city byte and country byte.¹² Humans overcome these computation limits by creating cultures at each level and making ever-larger parallel computational systems, which significantly increases humanity’s knowledge and know-how.¹³ For example, it takes a certain level of cooperation to knit a sweater, a higher level to offer insurance and the highest level to create microprocessors.

Invisible Hand

Adam Smith wrote this about individuals in The Wealth of Nations: “He generally neither intends to promote the public interest nor knows how much he is promoting it. By preferring the support of domestic to that of the foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and is in this, as in many other cases, led by an invisible hand to promote an end which has no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of society more effectually than when he really intends to promote it.”¹⁴

Now let’s consider Adam Smith’s framework compared to Melanie Mitchell’s, who writes in a section titled “Information Processing in Living Systems” in her book Complexity: A Guided Tour:

• “Space and knowledge. It appears that such intrinsic random and probabilistic elements are needed for a comparatively small population of similar components (ants, [bees]) to explore an enormously larger space of possibilities, particularly when … there is little a prior knowledge about what will be encountered. However, randomness must be balanced with determinism: self-regulation in complex adaptive systems continually adjusts probabilities of where the components should move, what actions they should take and, as a result, how deeply to explore particular pathways in these large spaces.
• Emergence of efficiency. Many, if not all, complex systems … have a fine-grained architecture in that they consist of large numbers of relatively simple elements that work together in a highly parallel fashion. Several possible advantages are conferred by this type of architecture, including robustness, efficiency and evolvability.
• Exploration. One additional significant advantage is that a fine-grained parallel system can explore many possibilities or pathways in which the resources given to each exploration at a given time depend on the perceived success of that exploration at that time. The search is parallel in that many different possibilities are explored simultaneously. The search is terraced in that not all possibilities are explored at the same speeds or depth. Information is used as it is gained to continually reassess what is important to explore, [which provides feedback to the system].”¹⁵

Let’s tie Adam Smith’s passages to Melanie Mitchell’s description of information processing in living systems.

Space and Knowledge

Market participants are a small population of similar components like bees and ants. The market for products and services is an enormous search space of possibilities with little prior knowledge of what will be encountered.

The enormous search space of possibilities derives from the information previously shared in the “Knowledge and Know-how” section earlier in this article. The opportunity costs and competitive advantage make all the possibilities. Each market participant can mix and match their knowledge and know-how in new and novel ways to create a massive space of prospects.

All the possibilities and innovations mean little prior knowledge of all future outcomes that market participants will encounter. As I stated in “Real Options in Radical Uncertainty: Part 2—The Limits of Financial Option Theory,” the world is uncertain, and due to universal innovation, all future outcomes cannot be known with certainty, which is contrary to the definition of risk. At every moment, the world creates path-dependent outcomes from previous states. Innovation and uncertain outcomes will require market participants to continually adapt and modify probabilities regarding particular pathways.

Exploration

When market participants organize without central control, they can quickly modify their skills to search many market possibilities and pathways to find opportunities within their resource constraints. Because knowledge and know-how are terraced, the resulting search for opportunities is terraced, too. Furthermore, having terraced knowledge allows market participants to search at different speeds and depths, ensuring no stone goes unturned. Just as ants use pheromones to signal and coordinate with each other to find food, market participants can continually provide feedback based on the current market environment to reassess what is important to explore.

Emergence of Efficiency

A centralized control structure would take too long to compute the combinations needed for a well-functioning market. The parallel search of market participants allows people to quickly adapt and create new relationships to find ever more economic opportunities. Quickly adapting and changing to the environment creates stability and robustness, which is Adam Smith’s perception of the invisible hand. IHT assumes market equilibrium exists, which is taking it for granted.

However, Adam Smith explained—and complex adaptive systems show—that the cooperation and collaboration of heterogeneous skills at many levels in a parallel fashion achieves market stability and efficiency. Adam Smith did not promote a self-interested, hedonistic point of view. He believed market participants could be self-sufficient, self-regulated and largely ignore what other participants are doing so the market can search in a parallel fashion. To put it simply: The market swarms for gains like ant colonies swarm for food.

The Bottom Line: Evolutionary Economics Is Relevant

The point of this article was to take you on my journey to understanding mainstream economics. But the more I dig and try to understand, the more I question it. This questioning led me to its beginnings. Adam Smith’s framework resonated with me because it aligns with modern complexity theory.

Adam Smith’s framework contributes to open thought, individuality and the ability to make independent, informed decisions. Under his framework, each economic agent uses networked communication and collaboration to achieve a competitive advantage.

Adam Smith never promoted a self-interested, winner-take-all mentality to create a more socially desirable economy as some microeconomic theories describe. He never stated that the economy was always at equilibrium or any modern economics concept specified in the IHT. They may be similar in name, but they are contrary in economic knowledge and practicality. Buyers’ and sellers’ prices are not counterforces, which are typically stable. They are delicately balanced, entangled feedback loops fighting for dominance through massive collaboration of independent, heterogeneous, informed market participants searching for gains.

A well-functioning market does not work efficiently if its participants are homogenous, self-interested and only out for themselves—because they will have the same skills, search for the same resources and have no reason to cooperate and communicate. Understanding the deficiency of IHT is vital for actuaries because IHT is the foundation of our models. To be blunt, not including systems science in economic thinking ignores the social dynamics that economics is supposed to study.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

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