Father Knows Best: Using Adam Smith to Teach Transactions Costs

Abstract

Adam Smith's moral philosophy can be used to introduce economics students to the important idea of transactions costs. The author provides a brief background in this article to Smith's moral philosophy and connects it to the costs of transacting in a way that fits easily into the standard principles of microeconomics classroom. By doing so, instructors can also demonstrate to students that there are connections between ethical behavior and market outcomes.

Keywords:

• Adam Smith
• ethics
• impartial spectator
• transactions costs

JEL codes:

• A22
• B12
• B15

Notes

¹See also Wight (2007) for an excellent discussion of Smith's invisible hand, the institutional structure in which it operates, and common misperceptions about it.

²We do have a published version of notes from lectures Smith delivered on this topic, Lectures on Jurisprudence.

³The connection of ethical foundations to market exchange is, of course, not new; for example, Frank Knight argued that there were ethical limitations to the theory of perfect competition in his 1935 The Ethics of Competition and Other Essays.

⁴I am grateful to an anonymous referee for suggesting this way of explaining Smith's approach.

⁵Students might get this material in a history of economic thought class before graduating with a degree in economics, but that is unfortunately rare. What I present here could then be viewed as a low-cost way of incorporating at least some history of economics into the curriculum.

⁶Ashraf, Camerer, and Loewenstein (2005) interpreted Smith's work from the perspective of modern behavioral economics. The article in full is nice background reading for students, but if time is too limited to devote to the entire article, instructors can still get to the essence of the article and to Smith's theory of behavior.

⁷One might think of “market failures” from informational asymmetries, for example, as a subset of what is here referred to as a “market barrier.” I use the word barrier rather than failure because these really are informational barriers just as geographical barriers might prevent long-distance trading. I am grateful to an anonymous reviewer for the suggestion on terminology.

⁸This is a good opportunity for those instructors who would also like to introduce the concept of transactions costs (itself an important but often neglected concept in the introductory classroom) to do that. For those who do not wish to spend time on transactions costs, a simple definition is sufficient. For those who want more details, a good overview can be found in Allen (2000).

⁹The neoclassical approach to transactions costs began with Hicks (1935) and Coase (1937). There is a competing “property rights” approach to transactions costs, but the neoclassical framework works well in the undergraduate classroom because this is the approach taught in nearly all undergraduate courses.

¹⁰See Constantinides (1979) and Allen (2000) for a discussion of how transactions functions can be used to model transaction costs in a neoclassical framework.

¹¹Book IV, Chapter 2, 454: “Upon equal or nearly equal profits, every wholesale merchant naturally prefers the home-trade to the foreign trade of consumption, and the foreign trade of consumption to the carrying trade. In the home-trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.”

¹²There are other unobservable transactions costs, such as the costs of searching for a home, which are not included in the North and Weingast (1986) estimates.

¹³Smith and Wilson (2012, 4–5, footnote 5) discuss an interesting way to formalize the idea. They formally model an action as a function of its propriety given the circumstances, using indicator variables for whether an action deserves social praise or not. Such an approach could be useful for more advanced students.

¹⁴Perhaps there is either selection into the profession by people who behave less cooperatively, or perhaps the discipline tends to reinforce it. This could be why Frank, Gilovich, and Regan (1993, 167) found that “economists appear to behave less cooperatively than noneconomists along a variety of dimensions.”