The Smith Dilemma and Its Resolution

The Smith dilemma refers to the inconsistency (‘strictly an error’) between the Smith theory on the efficiency of the market based on the absence of increasing returns and the Smith theorem on the facilitation of the economies of specialization (which gives rise to increasing returns) by the extent of the market. This chapter argues that, despite the prevalence of increasing returns, Adam Smith was largely right on the efficiency of the invisible hand and hence the Smith dilemma does not really exist. Ignoring separate issues such as environmental disruption, the market is very efficient in coordinating the allocation of resources even in the presence of increasing returns. The efficiency due to the automatic and incentive-compatible adjustments, free trade, and enterprise (entry/exit) largely prevails. The Dixit–Stiglitz model shows that the free-entry market equilibrium coincides with the (non-negative profit) constrained optimum when the elasticity of substitution between products is constant. For non-constant elasticities, the divergences between the market equilibrium and the constrained optimum in output levels, in the numbers of firms, and in utility levels are shown to be small.