The Power of Economic Analysis: The Theory of Rational Self-interest and the Theory of moral Sentiments

Guest Blogger: William Kwame Dadson

Through out my years of teaching economics, I have developed what I consider to be the most effective way of preparing students and developing their economic and business leadership skills through the theory of rational self-interest and the theory of moral sentiments. Incorporating these two theories in my economic lectures, has improved the students’ understanding of “the power of economic analysis.” The power of economic analysis is a framework that enables a person to understand and seek solutions to economic problems. (Miller, 2010). It helps students to decide whether to study or not study; to buy a book for a class or spend the money on something else. In all these decisions, the student must accept the consequences of their decisions in terms of their impact on their grades, and graduation. The power of economic analysis teaches the students the economic way of thinking. It enables an individual to make informed decisions or judgments and prepares them for the dynamic global economy. You may ask: "What is the theory of rational self-interest?" or "What is the theory of moral sentiments?" Here, below, is an explanation of the two theories.

The Theory of Self-Interest or Self-Love

In the minds of economists, an individual’s actions are motivated by self-interest. In other words, an individual is a rational economic person whose actions are driven by incentives or rewards which should not leave them worse off in the end. This idea was developed by Adam Smith in his 1776 book, "An Inquiry into the Nature and Causes of the Wealth of Nations” Through his observations of human nature and individual self-interest, Adam smith concluded “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regards to their own interests” (Becker,1976i). In other words, individuals are rational beings driven by monetary gains, power and other incentives that help to realize their self-actualization. This is the driving force behind capitalism and the success of western economies. Under capitalism, individuals pursue their own entrepreneurial interests, which eventually become public interest. Examples are Graham Bell, Madam J C Walker, Bill Gates, and Steve Job. To follow the footsteps of these great entrepreneurs the student must master the “The Power of Economic Analysis." Even if the student wants to be an intrapreneur or work for somebody else, it is important that he master the concept of the power of economic analysis. I want to make it clear that whether you become an entrepreneur or an intrapreneur, you must be able to make use of available information in making sound judgments or decisions. Either way there is no free lunch. There is a price for every action we take.

The power of economic analysis helps us to understand that every action results in two consequences, positive and negative externalities. The positive externalities can be the monetary rewards received from a business transaction and the negative externalities may be a defective product or service, causing an injury to the consumer or the society in general. There is nothing wrong with becoming wealthy through an entrepreneurship venture. However, it is important to understand that in pursuing a self-interest endeavor, you and your activities become public interest. You must become familiar with the rules and regulations governing the modus operandi of the industry. What role does ‘The Theory of Moral Sentiments’ play in the ‘Power of Economic Analysis?

Theory of Moral Sentiment

The other issue I have been driving home to my students is that "the power of economic analysis" is incomplete without the understanding the “theory of moral sentiments.” This theory was also developed by Adam Smith in 1759. For Adam Smith, the market system is beneficial to the society as a whole; the individual self-love that drives the market system is instrumentally valuable to the society as a whole. In the modern translation, the pursuit of self-interest or individual self-love cannot ignore the moral responsibility in the process. Society’s interest must be given due consideration at all times. When self-interest eventually becomes public interest, a social contract has been established between the individual and the society. For example, AT&T was broken up in 1980, because it was deemed a monopoly and a threat to competition. Martha Steward went to jail for insider trading. Enron went out of business , its executives were tried and some jailed for financial fraud. It is important that every student any aspiring entrepreneur , individuals and companies learn from these mistakes.

The theory of moral sentiment is an important part of the power of economic analysis. It reminds us of our moral responsibility towards the society. Adam Smith believed that self-interest or self-love is a necessary condition for unleashing humankind’s productive energy and creativity. He stressed that this was not sufficient and warned that an unfettered freedom to pursue self-interest could undermine constructive liberal society. In other words, if laws and regulations are not put in place or enforced to curb excessive market abusive practices, there will be dire consequences for the society. Detrimental consequences such as individual or national economic disaster can lead to a degrading society or "a rent seeking society” may result. (Krueger, 1974; Evensky, 2005i).

Is it possible to apply the theories of rational self-interest and moral sentiments to the role the banking industry played in the current economic conditions in the United States? The answer is yes.

In "The Theory of Moral Sentiments," Adam Smith stressed the need for law and order in the free society. He Wrote:

The sine qua non for successful liberal

system, of free people and free markets

are security. For all participants. Society

cannot subsist among those who are at

all times ready to hurt and injure one

another. (Becker, 1976ii).

He believed that the source of this security must be a system of justice that establishes and enforces the principles of interpersonal behavior that insure individuals’ security. (Evensky, 2005ii)

There is nothing wrong with making money. I am a capitalist to the core. I assure the students that there is nothing wrong with being a capitalist and pursuing self-interest ventures to become wealthy. If citizens of a nation become wealthy, the nation prospers. However, the interest and the security of the society cannot be ignored in the pursuit of self-interest. The legal systems must be in place to protect individual liberty and the society as a whole. I believe that teachers of economic can benefit from this approach and equip their students with knowledge required for successful self-interest venture pursuits. It should be emphasized that teachers who adopt this approach must live by examples.

References:

Becker, Gary, 1976i.The Economic Approach to Human Behavior. University of Chicago Press. Page 27

Becker, Gary, 1976ii.The Economic Approach to Human Behavior. University of Chicago Press. Page 86

Evensky, Jerry. 2005i and 2005ii. "Adam Smith’s Theory of Moral Sentiments: On Morals and why they matter to a Liberal Society of Free People and Free Markets." Page 111

Krueger, Ann O. 1974. "The Political Economy of the Rent seeking Society” American Economic Review. 64:3, pages 291-303.

Miller, Roger LeRoy.2010. Economics Today, the Macro View, and the Micro View. Page 2