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Working Papers m 2011:04

Rediscovering Adam SmithHow The Theory of Moral Sentiments can explain emerging evidence in experimental economics

Douglas E. Stevens

Adam Smith Research Foundation Working Papers Series 2011:04

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Working Papers m 2011:04

Rediscovering Adam SmithHow The Theory of Moral Sentiments can explain emerging evidence in experimental economics

Douglas E. Stevens

July 2011

Adam Smith Research Foundation . Working Papers Series

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About the authorDouglas E. Stevens is Associate Professor of Accounting at Florida State University (http://www.cob.fsu.edu/) and was a Visiting Fellow at the Adam Smith Research Foundation between February and April 2011.

Professor Stevens has published research on organizational control and financial markets in such journals as The Accounting Review; Contemporary Accounting Research; and Accounting, Organizations and Society. His primary research interest is in experimental economics, which uses experimental methods to test economic theory and behavioral extensions.

Address for correspondenceProf. Douglas E. Stevens, Department of Accounting, College of Business, Florida State University, 821 Academic Way, PO Box 3061110, Tallahassee, FL, 32306-1110.

Email: [email protected]

AcknowledgementsThis paper is a product of my 2011 spring semester at the University of Glasgow as a Visiting Fellow at the Adam Smith Research Foundation. First, I would like to thank Christopher Berry for sponsoring my fellowship at ASRF and for many helpful comments and conversations. I would also like to thank the research and administrative staff at the University of Glasgow, including Julie Gardham, Jon Lewin, Kerr Ross, Moira Sinclair, and Louise Virdee. This paper has benefitted from helpful conversations and correspondence with David Cooper, Dino Falaschetti, Jim Gwartney, Randy Holcombe, Mark Isaac, Don Moser, Doug Norton, Maria Paganelli, Tim Salmon, Peter Schweizer, and Paul Zak. I would also like to thank the research groups at FSU who have given me the opportunity to present my research, including the Accounting Department, the Experimental Science Group (xs/fs), the Economics and Moral Sentiments Group, and the Financial Math Proseminar. Jeremy Douthit and Casey Gunther provided valuable research assistance on this study.

Abstract: Emerging evidence in experimental economics has been difficult to explain using traditional economic theory. In particular, experimental tests of economic theory have provided

evidence consistent with the existence of internalized social norms such as reciprocity, fairness,

and honesty. Even in single period settings where traditional economic predictions are most

likely to hold, participants frequently exhibit “repeated play behavior” and achieve cooperative

solutions that surpass game theoretic predictions based on narrow self-interest. I discuss

how the moral theory in Adam Smith’s first book, The Theory of Moral Sentiments, can explain

this evidence. I begin by reviewing the historical context behind Adam Smith and the Scottish

Enlightenment. Next, I present the moral theory in The Theory of Moral Sentiments within this

historical context. Next, I present the emerging evidence in experimental economics that has

been difficult to explain using traditional economic theory. Finally, I discuss how The Theory of

Moral Sentiments can be used to explain this emerging evidence.

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In this study, I take an experimental economics approach. Rather than introduce behavioral theories to help explain the emerging evidence, I discuss how the moral theory in Adam Smith’s The Theory of Moral Sentiments can be used to explain this evidence. Thus, I remain within the domain of traditional economic theory, and use arguments and theory that would be amenable to traditional economists. For example, I maintain the assumption of economic rationality in decision-making. This is an area where behavioral economists frequently depart from traditional economic theory. I also maintain the assumption of utility maximization and the full set of tools and results in the current economic literature. The only innovation I introduce to the traditional economic paradigm, therefore, is to incorporate insights from Adam Smith’s first major work. I view Smith’s moral theory as complementary and foundational to his economic theory. This unified approach resembles that of Vernon Smith (1998, 2003, 2010) and Paul Zak (2008). This unified approach is also consistent with recent scholarship on Adam Smith and the Scottish Enlightenment (Griswold, 1999; Berry, 2003; Skinner, 2003; Alvey, 2007).2

History supports the usefulness of incorporating insights from Adam Smith’s moral theory to advance economic theory. A study of Adam Smith’s influence over time and across national boundaries shows that some nations initially focused on his second book before discovering the importance of his first book. Nations that translated The Wealth of Nations into their native language before The Theory of Moral Sentiments include Spain, Russia, and Japan. Lai

(2000) conjectures that this occurred because at the time they translated The Wealth of Nations (Spain in 1792, Russia in 1802, and Japan in 1870), these three countries were developing nations that were primarily interested in learning something useful of “the nature and causes of the wealth of nations.” Lai also conjectures that Spain, Russia, and Japan later translated The Theory of Moral Sentiments into their native language (Spain in 1941, Russia in 1868, and Japan in 1948) because they realized that Smith’s first book was the philosophical foundation for his second book and thereby an important source for a fuller understanding of The Wealth of Nations.3

I identify at least three motivations for economists to rediscover Adam Smith’s moral theory: 1) to help explain emerging results in experimental tests of economic theory, 2) to help expand the descriptive power of traditional economic theory, and 3) to help generate a fuller understanding of The Wealth of

1. Introduction

E merging evidence in experimental economics has been difficult to explain using traditional economic theory.1 While experimental market studies generally support the power of “the invisible hand” to yield efficient outcomes over repeated trading periods, experimental studies of personal exchange commonly yield results

that violate axioms of traditional economic theory. In particular, participants in personal exchange experiments behave as if they are governed in part by internalized social norms such as reciprocity, fairness, and honesty. Even in single period settings where traditional economic predictions are most likely to hold, participants frequently exhibit “repeated play behavior” and achieve cooperative solutions that surpass game theoretic predictions based on narrow self-interest. Some researchers have taken a behavioral economics approach and have introduced theories from psychology to help explain this emerging evidence. (See Camerer & Loewenstein, 2004, for a review.) Other researchers, however, have taken an experimental economics approach and have attempted to explain the evidence by expanding the boundaries of traditional economic theory. (See V. Smith, 2010, for a review.)


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Nations. In this paper, I focus on the first motivation. The second motivation is discussed in fuller detail in Stevens & Thevaranjan (2010), where we introduce a morally sensitive agent into the traditional principal-agent model and demonstrate how it increases the descriptive validity of the model. The third motivation is discussed at length by others (see Griswold, 1999 for an example). In this study, I focus on the ability of Adam Smith’s first book, The Theory of Moral Sentiments, to explain emerging evidence in experimental tests of economic theory. Because some of this emerging evidence exists in the accounting literature, I include experimental evidence from studies in both economics and accounting.

This paper is structured in the following manner. In the following section, I review the historical context behind Adam Smith and the Scottish Enlightenment. In Section 3, I present The Theory of Moral Sentiments within this historical context. In Section 4, I present emerging evidence in experimental economics that has been difficult to explain using traditional economic theory. In Section 5, I discuss how Adam Smith’s moral theory in The Theory of Moral Sentiments can be used to explain this evidence. I conclude in Section 6 by arguing that Adam Smith’s moral theory is general and powerful enough to explain the emerging evidence in experimental economics.

2. Adam Smith and The Scottish Enlightenment: Some Historical Context

To understand Adam Smith’s moral theory, one must understand something of the religious-political-economic forces that gave birth to 18th century Great Britain and the Scottish Enlightenment. When King James I of England (King James VI of Scotland) died in 1625, the crowns of England and Scotland had been united in an uneasy alliance for almost 20 years. His son Charles I inherited the throne with a deeply divided English Parliament that was committed to the established Protestant religion. Charles I alienated the English by claiming divinely granted powers and aligning himself increasingly with French and Catholic interests, and he alienated the Scots by attempting to impose the Anglican form of worship on Presbyterian Scotland. The latter led to the National Covenant of 1638, a document limiting the powers of the king that was drawn up by Presbyterian dissenters and circulated throughout all of Scotland. This document led to the Covenanting Wars in Scotland (1644-1665).

In 1649 Charles I was tried for treason by the English Parliament, found guilty, and executed at Whitehall.

England threw off its monarchy and declared itself a republic, but the Scots accepted Charles’ son as king of Scotland and England, and crowned him Charles II at Scone Palace in 1651. Oliver Cromwell, the future Lord Protector of the newly formed republic, responded by invading Scotland, thereby forcing Charles II into exile in mainland Europe.4 After the death of Cromwell in 1658, England restored its monarchy and Charles II returned to London in 1660 to rule over England and Scotland. In 1670, however, Charles II entered into a secret treaty with his first cousin King Louis XIV of France to convert to the Catholic faith for support against the Dutch in the Third Anglo-Dutch War and a pension. As his father before him often did, Charles II dissolved the English Parliament in 1681 and ruled alone until his death in 1685. He was received into the Roman Catholic Church on his deathbed.

Because Charles II had no legitimate heir, the succession for the crown was to pass to his brother, James. The newly established Whig party was in favor of excluding James from the throne because he was a devout Catholic, and the Tory party was in favor of granting him the throne because of his Stuart blood line. When King James II of England (King James VII of Scotland) took the throne in 1685, he attempted to reverse Protestant rule in England and Scotland by directly promoting the Catholic faith. According to Pincus (2009), the reign of King James II/VII caused such a schism in England and Scotland that the people were faced with one of two choices. They could either invite King Louis XIV to invade from France to establish an absolute Catholic monarchy, or they could invite Prince William of Orange to invade from the Netherlands to establish a limited Protestant monarchy. The Tories, who initially supported King James II/VII, eventually joined the Whigs and a coalition of other Protestant and Catholic dissenters to invite Prince William of Orange to invade from the Netherlands in 1688.

Pincus (2009) attributes the Glorious Revolution of 1688 to the increasingly dictatorial rule of James II/VII and the civil liberty that the people of England and Scotland had tasted during the periods of Civil War (1642-1649) and the English Commonwealth (1649-1658). During this time, principles of liberty and free trade were advanced in coffeehouses, taverns, and churches throughout the empire. Yet, French-style absolutism was a real possibility for the people of England and Scotland up until the Glorious Revolution.5 The old religious-political-economic conflicts, however, persisted well into the 18th century.

Rediscovering Adam Smith . Stevens

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In Scotland in particular, where Stuart monarchs had ruled for over 300 years, loyalty to the deposed Catholic King James II/VII remained strong. Distrust of the loyalty of Jacobite Scottish clans led to the massacre of members of the MacDonald clan in Glencoe in 1692. Major Jacobite uprisings occurred in Scotland in 1715 and 1745, and the threat of religious and political upheaval only ended at the devastating defeat of Bonnie Prince Charles and his Jacobite army at Culloden in April of 1746.

When William of Orange died in 1702, the throne passed to Protestant Queen Anne, the daughter of James II/VII. The English Act of Settlement in 1701 required all future monarchs to be Protestant in religion. When Queen Anne died without an heir in 1714, therefore, the throne passed to Anne’s Protestant second cousin, the Elector of Hanover King George I. George I aligned himself with the Whigs, who now formed the government and dominated British politics from 1714 to 1760. The Act of Union of 1707 formally joined England and Scotland into one parliament, one sovereign, one coinage, one system of taxation, and one trading regime. Lowland towns and cities in Scotland, such as Edinburgh and Glasgow, largely prospered from the Act. Much of the Highlands, however, suffered greater economic hardship. This hardship led to high levels of emigration and fired the flame of Jacobite rebellion in the northern regions of Scotland.

This brief history reveals the violent religious-political-economic forces that gave birth to 18th century Great Britain and the Scottish Enlightenment. This historical context had the following influence on Adam Smith and the other Scottish Enlightenment writers. First, the religious and political upheaval led to a search for universal truth that spanned religion and national politics. The university professors, ministers, and lawyers who formed the Scottish Enlightenment were “enlightened” precisely because they put earlier truth claims based on religious authority and national politics to the test of reason (Broadie, 1997). Second, the victory of Dutch influence over the French influence in 1688 solidified the movement towards liberty and free trade across the empire (Pincus, 2009). Third, radical idealism gave way to pragmatism and economic realities. The Darien Scheme, which was designed to establish a Scottish colony in Central America and open up new trade routes for Scottish goods, had failed and bankrupted the nation by the close of the 17th century. At that time, Scottish intellectuals, entrepreneurs, and politicians concluded that what Scotland needed most was more investment

and larger markets. The Union with England in 1707 was to be the solution to Scotland’s economic and political woes. Shamed at times by their apparent backwardness to their neighbors in the south, these same Scottish intellectuals, entrepreneurs, and politicians used the new stability to create unprecedented advancements in social, political, and economic theory (Emerson, 2003).

Adam Smith is considered one of the most influential thinkers of the Scottish Enlightenment (Broadie, 2003). He was born in 1723 in the port town of Kirkcaldy, Scotland. Situated on the northern bank of the Firth of Forth across the river from Edinburgh, Kirkcaldy had a long history as an international port of trade. Towards the end of the 11th century, the Scottish King Malcolm II purchased the shire of Kirkaladunt from the crown lords of the Kingdom of Fife to be given to the monks of Dunfermline Abbey as a means of funding their newly built church. Between 1315 and 1328, the town was given the right to trade with the Low Countries, the Baltic states, England and Northern France by King Robert I. By the middle of the 15th century, Kirkcaldy gained independence from the Abbey and increased its trade with the Baltics. King Charles I granted Kirkcaldy royal burgh status in 1644, further increasing its status as an influential port of trade.

The importance of Kirkcaldy as a center of influence in the 17th and 18th century can be seen in its prominent role in the Covenanting War, the English Civil Wars, and the Jacobite rebellions of the 18th century. Local support for the Covenanting War (1644-1665) led to the death of over 250 town men, many at the battle of Kilsyth in 1645. Oliver Cromwell’s troops came to Kirkcaldy to seek Scottish riches in 1651 and nearly destroyed the town. Kirkcaldy was invaded by the Highland Jacobite forces in both the rebellions of 1715 and 1745 (the latter while Smith was still at Oxford). By the end of the 18th century, the port town had become a home for leather making, a brick and tile works, a


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spinning cotton mill and linen factories. The town also had a small shipbuilding industry which by the end of the century had built 26 square riggers, one sloop and two ferries.6

Adam Smith’s father, who passed away just before his famous son’s birth, was a Presbyterian Whig who served in the Scottish customs office in Kirkcaldy. Thus, Adam Smith was born to a family and community that was Presbyterian in religion, Whig in politics, and free market in economics. This family and community background helps explain why Smith was sent to the Presbyterian University of Glasgow for his initial higher education in 1737, and why he found himself an outcast at Anglican and Tory Oxford during his six years of schooling there from 1740 to 1746. This background also helps explain why the church leaders of the Glasgow Presbytery supported Smith’s appointment as a professor at the University of Glasgow, first as Professor of Logic in 1751 and then as Professor of Moral Philosophy from 1752 to 1764, and why Smith was comfortable signing an oath of fidelity to the Westminster Confession of Faith upon his appointment.7 This background also explains why Smith met regularly with the Glasgow city merchants who were turning Glasgow into a thriving metropolis due to the tobacco trade with the American colonies.

Adam Smith published The Theory of Moral Sentiments in 1759, which contained his moral theory dealing with the source and role of moral judgment in everyday life. He left the University of Glasgow and tutored the future Duke of Buccleuch in Europe from 1764 to 1766, including extended periods in Toulouse, Paris, and Geneva. After a brief stay in London, he returned to Kirkcaldy to work on his second book from 1767 to 1773. Smith published the first edition of The Wealth of Nations in 1776, which contained his economic theory dealing with the division of labor, commerce, and political economy. Due to his political connections and his association with the Duke of Buccleuch, in 1778 he was appointed to a seat on the Board of Customs in Scotland and moved to Edinburgh where he lived until his death in 1790.

3. The Theory of Moral Sentiments

The Theory of Moral Sentiments was based on Adam Smith’s lectures at the University of Glasgow. Although commonly overlooked by economists, it was his first book that gained Smith widespread recognition as a philosopher of the highest order. The Theory of Moral Sentiments appeared in no fewer than twenty-six editions in English between 1759 and 1825, together

with six editions of three separate translations into French and two editions of two separate translations into German in the same period (Reeder, 1997). It is important to recall that political economy was not an important discipline in the 18th century. In contrast to today, moral philosophy was the central discipline in most universities and economic matters were an integral part of that discipline (Raphael & Macfie, 1982; Griswold, 1999).8 Lia (2000) speculates that the translation of The Theory of Moral Sentiments into French and German paved the way for the rapid translation and acceptance of The Wealth of Nations in those two countries, and that France and Germany translated The Wealth of Nations just as they did The Theory of Moral Sentiments, from an intellectual, philosophical perspective.

Much has been made of the fact that Smith spent more time during his lifetime working on and revising The Theory of Moral Sentiments than he did The Wealth of Nations. In the latest comprehensive biography of Smith’s life, Phillipson (2010) asserts that Smith always considered The Theory of Moral Sentiments a superior work to The Wealth of Nations, and this belief was reflected in both his behavior and his words. Other researchers claim that Smith became alarmed by the fall of moral capital in commercial life, and this may have driven his emphasis on his moral theory toward the end of his life (Alvey, 2007). What is clearly known is that the first edition of The Theory of Moral Sentiments was an immediate literary success that allowed its author to launch his reputation as a man of letters. This reputation brought students from around the world to Glasgow to study under Smith’s tutelage.

The Theory of Moral Sentiments was well received by leading philosophers in Scotland, England, and throughout Continental Europe (Reeder, 1997). There is evidence that the book was read and critiqued by Scottish Enlightenment writers such as David Hume, Edmund Burke, Lord Kames, Thomas Reid, Adam Ferguson and Dugald Stewart. The book was also read and critiqued by French philosophers such as D’Holbach and the Condorcets, Antoine and Sophie, as well as German philosophers such as Herder and Kant. In France, The Theory of Moral Sentiments was still being discussed from the period of the Restoration up until the end of the 1830s. According to Reeder (1997), the lengthy analysis by French philosopher Theodore-Simon Jouffroy in 1830 marks the end of the book’s life as a work of relevant contemporary philosophy. In the 1870s, the discussion of what came to be known as “Das Adam Smith Problem” in the German speaking world reduced the significance of


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Smith’s moral theory in the eyes of many economists. In particular, his first major work came to be seen “as of interest only insofar as it revealed supposed ambiguities in the mind of the author of the later work of economics” (Reeder, 1997, p. viii).

The last two editions of The Wealth of Nations which appeared during Smith’s lifetime (the fourth and fifth editions) contained only minor changes, whereas the sixth edition of The Theory of Moral Sentiments which appeared just prior to his death in 1790 contained important new sections and elaborations on his original moral theory.9 The fact that neither book directly refers to the other would suggest that Smith viewed his moral theory as separate from his economic theory. In his lifetime, however, Smith gave no indication that he thought the two works were at odds with one another or that he had changed his mind about the fundamental tenets of his two theories. Griswold (1999, p.30) insists that the “change of mind” view held by some philosophers and economists would imply that Smith “was more than a little unhinged, since he alternately revised his two books right up to the year of his death but gave no sign of recanting his views” (as other philosophers such as Kant and Heidegger did in their lifetimes). More directly, Raphael and Macfie (1982, p.20) state that the so-called “Adam Smith problem” was a pseudo-problem based on ignorance and misunderstanding.

Each edition of The Theory of Moral Sentiments begins with the following sentence:

How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.

(Smith, 1790/1982, I.i.I.1)

Thus, Smith begins his book on moral theory by confronting the “selfishness” theory advocated by Hobbes, Pufendorf, and Mandeville. He does not deny that selfishness exists, for that would ignore human nature and personal experience. The selfishness theory that Smith confronts, however, attributes all human motives to selfishness. Smith stakes out his position early and succinctly. There are some “principles” in man’s nature that cause him to be interested in the fortune and happiness of others, even when he derives nothing from it himself. One of the main purposes of The Theory of Moral Sentiments, therefore, is to provide convincing evidence of this “unselfish” part of human nature and articulate a theory capable of explaining it.

Why did Smith take up the issue of selfishness at the outset of his book on moral theory? Why did the problem of selfishness appear so pressing to the author? Given Smith’s understanding of human history, especially the history of his own country, he was naturally concerned with the potential for religious-political-economic conflict and the need for peace and stability within a society. The view that we are ruled solely by selfishness, understood to Smith as a vice of character, and the view that we are selfish in the sense that we are unable to understand the situation of other human beings, therefore needed to be taken up at the outset by the author (Griswold, 1999). This was especially important to Smith because he built his moral theory on the ability of humans to understand the situation of others and sympathize with their emotions and motives.

Smith’s moral theory reflects three major influences in his life: Stoicism, his mentor Francis Hutcheson, and his good friend David Hume. The influence of stoic philosophy can be seen in Smith’s emphasis on virtue and duty and in his frequent references to ancient stoic philosophers (Epictetus, Marcus Aurelius, and Cicero). Smith follows the Stoics in holding that self-preservation is the first task committed to us by nature, and self-interested behavior is a virtue so long as it does not injure others (Raphael & Macfie, 1982). Hutcheson introduced Smith to the moral philosophy of the ancients as the chair of Moral Philosophy at Glasgow from 1729-1746. Hutcheson merged elements of Stoic thought with Christianity to promote a more moderate and rational religion than existed in the Scottish Presbyterian Church of his day (Clarke, 2007). Hume’s influence upon Smith’s moral theory, although no less dramatic, was more complex. Smith rejected or transformed Hume’s ideas far more often than he followed them (Raphael & Macfie, 1982). Although Hume never formally declared himself an atheist, his skepticism and criticism of religious “superstition” was well known and kept him from


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receiving faculty positions at the Presbyterian Scottish universities in Glasgow and Edinburgh.10

Hutcheson asserted that moral action and moral judgment are both disinterested, and that both depend on natural feelings or sentiments. In particular, moral action is motivated by the disinterested feeling of benevolence and moral judgment is motivated by the disinterested feeling of approval or disapproval attributable to the “moral sense” endowed by the Creator (Raphael & Macfie, 1982). Hutcheson envisioned a society whose behavior was regulated by the moral sense and the love of the Creator and the public good (Phillipson, 2010). In contrast to Hutcheson, Hume built his moral philosophy upon human nature and the scientific method. In his first published work, A Treatise of Human Nature, Hume proposed a “science of man” that, similar to the physical sciences, relied heavily upon observation and experimental methods. First, he led an assault on the authority of all known forms of Christian theology and philosophical systems of thought by asserting that, “Reason is, and ought to be the slave of the passions”.11 Then he established a new foundation for morality based upon social experience and the principle of sympathy. Thus, Hume replaced Hutcheson’s divinely-imputed “moral sense” with a socially-derived “moral sensibility.”

Smith borrowed from both Hutcheson and Hume in forming his own moral theory. First, he joined Hutcheson and Hume in rejecting the selfishness theory that attributed only selfish motives to human beings. Second, he joined his two mentors in granting a significant role to the passions in moral judgment. Third, consistent with the ancient philosophers, he retained from Hutcheson and Hume the importance of virtue and the role of the spectator in moral judgment. Like Hume, however, Smith rejected Hutcheson’s concept of a moral sense endowed by the Creator. He also joined Hume in giving social experience and sympathy a major role in moral judgment. But Smith’s moral theory contains a more developed and active form of sympathy. For Hume, sympathy is simply a sharing of pleasure or pain and is important in judging the utility of an action. For Smith, sympathy can be the sharing of any feeling or emotion, and its role in moral judgment concerns the motive behind the action rather than the utility of the action (Raphael & Macfie, 1982).

In The Theory of Moral Sentiments, Smith focuses on the relation between the “agent” and the “spectator”. As the spectator, we do not have access to the agent’s mind but we have access to the agent’s observable

circumstances and his or her action. Thus, moral judgment involves putting one’s self in the agent’s circumstances and then evaluating the motives behind the action. If we are able to sympathize with or share in the agent’s motives, we approve of the action. If we cannot sympathize with the agent’s motives, we disapprove of the action. Similar to Hume, therefore, sympathy is an emotion of fellow-feeling that is an act of the imagination. In contrast to Hume, however, the role of sympathy is to determine the appropriateness of the motives behind the action rather than the utility of the action. Smith strongly rejected Hume’s assertion that the appropriateness of an action depended upon its utility (Griswold, 1999). The role of the spectator is also more developed in Smith’s moral theory. Smith’s “impartial spectator” not only judges the agent’s actions and motives, but it becomes internalized and judges one’s own actions and motives. Thus, the originality of Smith’s impartial spectator is its ability to explain the source and nature of the conscience (Raphael & Macfie, 1982).

The use of an impartial spectator for moral education can be seen in the writings of the ancient Stoics, including Epictetus’ Enchiridion, which Smith would have been exposed to as a young student in Kirkcaldy and Glasgow (Phillipson, 2010). But Smith uses the conception of the impartial spectator to explain how agents become moral beings. Consistent with other writers of the Scottish Enlightenment, he held that humans are social creatures who require extended nurture and are thereby highly susceptible to habits or social norms (Berry, 2003). Thus, Smith’s impartial spectator is developed over time from ordinary life and is the personification of society’s standards or social norms. Humans learn by observing others what constitutes praiseworthy or blameworthy behavior, and eventually internalize these moral standards to the point where they feel guilt and remorse when they know themselves to be blameworthy. This internalization of the impartial spectator is what makes humans moral beings (Griswold, 1999). This internalization of the impartial spectator also helps explain why Smith avoided Hume’s religious skepticism, Mandeville’s cynicism, and Rousseau’s despair (Phillipson, 2010). He understood the importance of religion, family, and other social institutions in providing moral education for the impartial spectator.

In addition to granting a central role to sympathy and the impartial spectator, Smith maintained an important role for virtues and rules in his moral theory. The morality of virtues emphasizes character, judgment,


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and perception whereas the morality of rules emphasizes duty, obligation, and conformity of action to principal (Griswold, 1999). Similar to the ancient moral philosophers, Smith emphasized the four virtues of courage, temperance, justice, and prudence. Similar to Hutcheson, he also emphasized the virtue of benevolence.12 Smith also distinguished between the “negative” virtue of justice (the virtue of abstaining from injurious behavior) and the “positive” virtues of courage, temperance, prudence, and benevolence (Haakonssen, 2006). Finally, similar to Kant, Smith emphasized the importance of duty or a solemn regard for the general rules of conduct (Fleischacker, 1991; Firth, 2007). According to Smith, the impartial spectator is not immune to self-deceit, and is therefore not sufficient to ensure moral behavior in all occasions. To remedy this deficiency in the impartial spectator, human beings are endowed with a natural respect for general rules of conduct. For example, Smith emphasized the moral rule of honesty.

In all the middling and inferior professions, real and solid professional abilities, joined to prudent, just, firm, and temperate conduct, can seldom fail of success…The good old proverb, therefore, That honesty is the best policy, holds, in such situations, almost always perfectly true. In such situations, therefore, we may generally expect a considerable degree of virtue; and, fortunately for the good morals of society, these are the situations of by far the greater part of mankind.

(Smith, 1790/1982, I.iii.3.5)

Some commentators see in Smith’s scientific approach to morals the beginnings of sociology and social psychology (Campbell, 1971; Barbalet, 2005). The natural respect for societal standards, for example, can be seen in the notion of social norms in social psychology (Bicchieri, 2006). The influence of social norms has been documented in many experimental studies in economics and psychology. In support of Smith’s role of sympathy in moral judgment, the biological sciences have documented the overreaching influence of empathy on the behavior of humans. Brain research has found two regions of the brain related to moral judgments; the frontal lobes are engaged in moral decision-making that is purely calculative in nature, whereas the ventromedial prefrontal cortex is engaged in moral decision-making that is empathetic in nature. This brain research suggests that empathy is normal and morally powerful, and it often takes special training or a brain injury to disengage it (Lakoff, 2009).

Smith’s approach to moral theory was heavily

influenced by the Scottish Enlightenment emphasis on science (Berry, 2006). As with other Enlightenment writers, he believed that there was an underlying order in the natural, social, and moral worlds, and that moral and social systems needed good design and constant management if good ends were to be achieved (Thorpe, 2007). Based on his schooling at Glasgow (1737-1740) and Oxford (1740-1746), Smith was well versed in the classics, mathematics, and natural philosophy (science). Smith also appeared to have a love of the principles of physics, and was a studier of systems and machines. Because of this, Smith explained his moral theory in less abstract language than was common in contemporary works of moral philosophy. In particular, Smith used the language of science and art, and included examples from everyday life, history, drama, and travelers’ tales to reach a wider audience (Barbalet, 2007).

As Smith expressed in a footnote, his moral theory concerns itself primarily with matters of “fact” rather than matters of “right” (Smith, 1790/1982, II.i.5.10). In other words, his theory attempts to explain what “is” rather than what “should be.” Thus, the moral theory contained in The Theory of Moral Sentiments is a positive theory in the sense of Keynes (1891) and Friedman (1953).13 In fact, Smith rarely breaks from the positivism of his approach except to occasionally extol the virtue of prudence or disdain the vice of greed (Thorpe, 2007). As I argue in Section 5, this feature of Smith’s moral theory makes it particularly useful for economists. I also discuss other aspects of Smith’s moral theory that make it useful to explain emerging evidence in experimental economics that has been difficult to explain with traditional economic theory. First, I present this emerging evidence.


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4. Emerging Evidence in Experimental Economics

The notion that norms of behavior enter our individual and social consciousness has been described by F.A. Hayek as “ecological rationality”. Hayek (1988) argued that rather than exhibiting constructivist rationality, or the deductive process of human reason, human behavior and institutions reflect homegrown norms and traditions that frequently lie beneath our conscious awareness. Hayek identified a “fatal conceit” within the constructivist mind. Binding itself to reason, the constructivist mind supposes that “reason is in the higher critical position and that only those moral rules are valid that reason endorses” (Hayek, 1988, p.21). Instead, according to Hayek, home-grown principles of action, norms, traditions, and “morality” emerge out of cultural and biological processes. This ecological approach resembles Adam Smith’s approach to moral theory, which is based on the natural forces of socialization and nature rather than philosophical reasoning (Cockfield, Firth & Laurent, 2007).

In his Nobel lecture, “Constructivist and Ecological Rationality in Economics,” Vernon Smith (2003) identified ecological rationality as a likely explanation for much of the behavior emerging in experimental economic settings. While constructivist reasoning has been strongly supported in impersonal market exchange settings – market efficiency has been documented in hundreds of market experiments under much less restrictive conditions than theory would suggest – constructivist reasoning has not fared as well in personal exchange settings. In ultimatum, dictator, public goods, and trust games, for example, behavior frequently arises that is difficult to explain with traditional economic theory based on constructivist rationality. This emerging evidence suggests the presence of preferences for reciprocity, fairness, trust, or even altruism, often with superior results for the parties involved (Smith, 2010).

One insight that appears to emerge from these experiments is that, inconsistent with traditional economic theory, morality matters. That is, participants in these experiments frequently follow social norms and standards of behavior rather than constructivist notions of narrow self-interest. Thus, these experimental results support what the philosophers of the Scottish Enlightenment believed about morality – it is a naturally occurring part of human nature that is discoverable. This growing body of experimental evidence has led Vernon Smith (2010, p.40) and others within the experimental tradition of economics to ask the following

question: “What is the subject’s perception of the problem that he or she is trying to solve?” This evidence has also led experimental researchers to conclude that cues within the experimental settings engage mental frames or “scripts” within subjects (Samuelson, 2005; Bicchieri, 2006).

Experimental economics studies in accounting have provided direct evidence that experimental settings can generate mental scripts that engage moral reasoning. Evans et al. (2001) found that participants sacrifice wealth to provide honest or partially honest cost reports and do not lie more as the payoff to lying increases. Similarly, Stevens (2002) found that participants sacrifice wealth to reduce the amount of slack in their production budget. Stevens also found that budgetary slack was negatively related to participants’ moral judgments regarding budgetary slack. Rankin et al. (2008) found that requiring a factual assertion about cost reduced slack in the manager’s cost budget, consistent with a preference for honesty. But this effect went away when a superior could reject the budget. Schatzberg and Stevens (2008), however, found no evidence that moral judgments reduced budgetary slack in a setting in which budgetary slack and low effort gave the subordinate a larger share of the available surplus, and superiors allowed subordinates to set relatively high budgetary slack to induce high effort from the subordinates.

On the surface, these experimental studies appear to provide conflicting results. While results in Evans et al. (2001) and Stevens (2002) suggest that moral judgments control self-interested behavior in participative budgeting settings, results in Rankin et al. (2008) and Schatzberg & Stevens (2008) downplay the potential effect of such moral judgments in budgeting settings. The experimental settings in Rankin et al. (2008) and Schatzberg & Stevens (2008), however, appear to have minimized the potential for a moral dilemma to arise that activates moral reasoning. First, no expectation of a truthful budget was conveyed to participants in the instructions. Second, participants formed anonymous superior/subordinate pairs and communication was limited to budget information over computer terminals. Third, the budget determined the split of a surplus amount and the relative share of the surplus was publicly disclosed to both parties. These features likely caused participants to view the participative budgeting setting in a strategic frame rather than in a moral frame (Salterio & Webb, 2006).

A recent study by Hobson, Mellon, and Stevens (2011) investigates this variability in moral judgment. The


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authors argue that budgetary slack may pose a moral dilemma because it allows a subordinate to extract excess resources through deceptive means, and such behavior violates common social norms and basic standards of professional conduct. They also argue, however, that moral dilemmas are characterized by variability in moral judgment. Thus, they design a study aimed at explaining the variability in moral judgment displayed in the literature. In particular, they use the experimental setting in Stevens (2002) to examine the effect of pay scheme and personal values on moral judgments regarding budgetary slack.

Hobson et al. find the experimental setting in Stevens (2002) to be ideal for addressing the variability in moral judgment in the literature because, 1) the instructions contained mundane realism and communicated an expectation for a truthful budget, 2) a measure of moral judgment was gathered from an exit questionnaire, and this moral judgment was negatively associated with budgetary slack created under a slack-inducing pay scheme, 3) a personality test was given to participants prior to the experiment to gather measures of personal values, 4) student producers interacted with an experimenter manager, so distributional fairness concerns were minimized, and 5) the experimental design incorporated an unambiguous prediction from agency theory and a competing prediction from social norm theory, which increases the potential for economic theory-building (Brown et al., 2009).

Hobson et al. find that participants who set budgets under a slack-inducing pay scheme judged significant budgetary slack to be unethical on average whereas participants who set budgets under a truth-inducing pay scheme did not. This pay scheme effect is not driven by justification or hindsight bias, as participants given the slack-inducing pay scheme built significantly more budgetary slack during the experiment than participants given the truth-inducing pay scheme (41.1% versus 3.6% of expected production). In addition, this pay scheme effect is not driven by differences in perceived moral obligation, as both pay scheme groups agreed on average to a statement in the exit questionnaire that the firm desired a budget that reflected expected production. Hobson et al. conclude, therefore, that the slack-inducing pay scheme generated a moral frame by setting economic self-interest against common social norms such as honesty or responsibility.

Controlling for pay scheme, Hobson et al. find that participants who scored high on the Traditional Values

scale of the Jackson Personality Inventory-Revised (Jackson, 1994) were more likely to judge significant budgetary slack to be unethical on average. Since traditional values are inconsistent with a utilitarian or “relativist” value orientation, this result is consistent with prior empirical research finding a negative relation between moral judgment and relativism (O’Fallon & Butterfield, 2005). They also find that participants who scored high on the Empathy scale were more likely to judge significant budgetary slack to be unethical on average. This is the first direct empirical evidence I am aware of that empathy enhances moral judgment, consistent with Adam Smith’s moral theory. In an analysis of the slack-inducing pay scheme group alone, Hobson et al. find that the Traditional Values and Empathy variables explain the increase in moral judgment under the slack-inducing pay scheme. These results suggest that financial incentives play a role in determining the moral frame of the budgeting setting and that personal values play a role in determining how individuals respond to that moral frame.

The experimental evidence cited above has helped researchers better understand behavior in participative budgeting settings. As Salterio and Webb (2006) point out, researchers in accounting and finance have traditionally viewed budgetary slack as an organizational and behavioral issue, but this experimental evidence has led many researchers to view budgetary slack as a moral issue as well. Because these experimental studies examine what “is”, they help advance positive economic theory. Because they are based on good positive science, however, they also help advance normative economic theory. For example, the evidence suggests that budgetary slack does not raise moral concerns when participants observe high budgetary slack in others or view budgetary slack as a strategic game to extract resources from the firm. Thus, this experimental evidence explains why corporate budgeting can often degenerate into a game of deception (Jensen, 2001).


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This experimental evidence also suggests, however, that the usefulness of corporate budgeting can be preserved by emphasizing the importance of truthful budgeting and building a culture of honesty through recruiting and training. Completing the loop back to positive economic theory, this intuition helps explain why participative budgeting continues to function as a valuable part of organizational control.

Other experimental economics studies in accounting have documented the presence of social norms and morality using different economic settings. Douthit, Kearney, and Stevens (2011) use a principal-agent setting to examine the effect of a communication of intended effort on the traditional agency problem. Given traditional agency theory assumptions and unobservable effort in a single-period setting, the agent is expected to receive low pay from the principal in exchange for low effort. Traditional solutions to this agency problem involve paying the agent a financial incentive tied to some noisy measure of performance, but these incentive solutions are costly and become increasingly costly with increases in the noisiness of the performance measure. In many single-period agency settings in the firm, however, the agent can communicate an intended level of effort to the principal prior to contracting. Douthit et al. document that this pre-contract communication, which is non-enforceable and therefore considered “cheap talk” by traditional economic theory, can be highly effective in mitigating agency problems. In a repeating single-period experimental setting where production is a very noisy indicator of effort, communication of intended effort results in higher pay for the agent, higher effort, and higher profit for the principal than both the control group and a group where the principal and agent interact over multiple periods. Thus, they document a setting where cheap talk can be more effective at mitigating agency problems in the firm than reputation building.

Davidson and Stevens (2011) examine the role of social norms in the investment game developed by Berg, Dickhaut, and McCabe (1995). Davidson and Stevens predict that a code of ethics will improve manager return behavior and investor confidence to the extent that it activates social norms within the manager. Further, they predict that a certification choice will enhance the activation of social norms within the manager by making the manager’s commitment to the code more explicit, thereby increasing the disutility of behavior inconsistent with the code. They find that a code of ethics only improves manager return behavior and investor confidence when the code incorporates a public certification

choice by the manager. When the code is present but there is no certification choice, manager return behavior does not improve and investor confidence erodes over time because of increased expectations that are not met by managers. An analysis of individual return decisions and exit questionnaire responses suggest that the certification choice improves manager return behavior by narrowing the range of return behavior that managers find morally acceptable, consistent with the certification activating social norms within the manager.

In summary, emerging evidence from experimental economics has been difficult to explain using traditional economic theory focusing on “constructivist” rationality based on narrow self-interest. Rather than attribute such behavior to irrationality, leading economists such as Vernon Smith have attributed this behavior to “ecological” rationality and social norms that arise from social interaction (V. Smith, 2003, 2010). Despite the potential for these emerging results to be explained by The Theory of Moral Sentiments, Adam Smith’s moral theory has not been explicitly incorporated into the experimental economics literature (Paganelli, 2011). Below, I conclude by discussing the usefulness of Smith’s moral theory to explain the emerging evidence in experimental economics.

5. Conclusion: The Usefulness of Smith’s Moral Theory for Experimental Economics

Emerging results in experimental economics have caused researchers in economics and accounting to rediscover Adam Smith and his moral theory (V. Smith, 1998, 2003, 2010; Zak, 2008; Stevens & Thevaranjan, 2010). In the past, a common approach taken by economists has been to use Smith’s economic theory to attribute only narrow self-interest to the motives of economic decision makers. Another common approach has been to trivialize moral theory by asserting that the most moral outcome arises when individuals act in their own narrow self-interest, as followers of Ayn Rand seem to advocate. As the prior section reveals, however, emerging results in experimental economics suggest that moral and social norms arise that can control the opportunistic behavior of economic decision makers. Thus, any economic theory that ignores such norms may be empirically misspecified.

Theorists have recently attempted to incorporate morality into traditional economic theory. For example, Michael Jensen and his associates have developed


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a “positive” economic model that incorporates integrity. Erhard, Jensen, and Zaffron (2009, p.1-2) motivate their model by arguing that integrity is a factor of production as important as knowledge and technology, “yet its major role in productivity and performance has been largely hidden or unnoticed, or even ignored by economists and others”. The authors, however, are heavily influenced by the view that positive economic theory must be void of normative content. In their model, Erhard et al. strip integrity of all of its normative definitions. In particular, Erhard et al. identify two realms, a normative realm of virtues and a positive realm devoid of normative values, and place integrity exclusively into the positive realm for purposes of their economic theory. As Smith’s moral theory demonstrates, however, a moral theory itself may be a positive theory. Thus, there is no valid rationale for stripping moral constructs such as integrity of their moral content before incorporating them into traditional economic theory.

Other theorists have incorporated morality directly into the principal-agent model of the firm. As is well known, the principal-agent model describes the firm as a series of principal-agent relationships (Jensen & Meckling, 1976). The principal is risk neutral and seeks to hire a risk- and effort-averse agent to provide a productive effort for the firm.14 There is uncertainty in the production outcome, and the expected value of the agent’s effort is a multiple of the firm’s productivity and the agent’s effort. Given the risk neutrality of the principal, she would prefer to assume all of the risk and offer the risk-averse agent a fixed wage contract in exchange for his effort. The traditional principal-agent model, however, assumes complete moral failure on the part of the agent. Thus, the principal takes it as given that the agent will always renege on his commitment and attempt to shirk his effort obligation because he suffers no disutility in doing so. When the agent’s effort is unobservable, as is typically assumed, the moral failure of the agent becomes a “moral hazard” problem for the principal (Stevens & Thevaranjan, 2010).

Because of the assumption of complete moral failure on the part of the agent, the principal must overcome this moral hazard by paying the agent a financial incentive based on the production outcome. Because the agent is risk-averse, however, the principal must pay the agent a risk-premium and the incentive solution is always second-best. That is, the financial incentive solution is always more costly than the cooperative fixed wage solution. The descriptive validity of the traditional principal-agent model has

been criticized because the solution always relies on financial incentive solutions to solve the moral hazard problem. Employment contracts in real organizational settings, however, frequently pay fixed salaries and rely on social norms of reciprocity, honesty, and fairness. Further, the magnitude of the fixed salaries differs across industries and professions. The traditional principal-agent model, with its assumption of complete moral failure on the part of the agent (i.e., narrow self-interest), cannot explain this organizational behavior.

Koford and Penno (1992) argue that incorporating moral agents may increase the descriptive validity of the principal-agent model. Koford and Penno make three arguments for enhancing the theory by incorporating morality (p.128): 1) Detailed control systems that are cost-justified under the traditional model may not be justified when agents display some ethical behavior. 2) Informal social control mechanisms may be alternatives to formal accounting mechanism. 3) If agents have some underlying ethical standards, accounting control systems will be more effective if they reinforce and utilize those standards. Koford and Penno (1992, p.131) propose two different approaches to modeling morality in the traditional principal-agent model: 1) Assume that some people are ethical and others are not ethical. 2) Assume that a given individual’s behavior will appear to be ethical in some situations and unethical in other situations. Kofford and Penno conclude by providing some preliminary analytical results suggesting that such an approach may better reflect how individuals behave within the firm.

Stevens and Thevaranjan (2010) develop a principal-agent model that examines a moral solution to the moral hazard problem. In particular, Stevens and Thevaranjan maintain all of the standard assumptions of the traditional LEN form principal-agent model,15 and incorporate a preference for morality by assuming that the agent suffers a disutility if he chooses to violate a previously agreed upon standard for effort.


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The magnitude of the moral disutility depends upon the moral sensitivity of the agent and the level of violation, and is additively separable from the agent’s utility for the net wage (wage less the cost of effort). Thus, the agent trades off his preference for morality against his preference for the net wage, and each preference is capable of dominating the other. Thus, Stevens and Thevaranjan apply Koford and Penno’s (1992) second approach to incorporating morality in the traditional principal-agent model.

Stevens and Thevaranjan conclude that adding moral sensitivity increases the descriptive, prescriptive, and pedagogical usefulness of the principal-agent model. Their model is able to explain the common existence of fixed salary contracts and the differential magnitude of salary contracts across industries and professions. Their model also demonstrates the considerable benefits of the agent’s moral sensitivity to the principal, the agent, and the overall economy. This explains the emphasis that accounting practitioners, regulators, and educators place on professional ethics. Finally, their model increases the usefulness of the principal-agent model in the classroom by raising important organizational control issues and discussions of moral obligations, moral sensitivity, and the impact of economic incentives on moral judgment. Stevens and Thevaranjan (2010) state that their theory is consistent with Adam Smith’s moral theory in The Theory of Moral Sentiments. They do not directly discuss, however, the aspects of Adam Smith’s moral theory that makes it useful to economists.

The Theory of Moral Sentiments contains a coherent and comprehensive moral theory that can help experimental economists explain emerging results in the laboratory. In contrast to other great works of moral philosophy, from the Platonic dialogues to Kant’s Critique of Practical Reason, Smith’s moral theory focuses on everyday experience rather than philosophical debate. The two questions his moral theory is designed to address are the source of virtue and the mechanism that gives rise to moral judgment. These are largely positive questions of what “is” rather than normative questions of what “should be.” The first question involves virtue theory and the second question involves moral psychology. Because Smith views moral judgment as being grounded in sentiments rather than reason, he views moral philosophy as primarily a descriptive enterprise rather than a constructive enterprise (Griswold, 1999). Thus, the extensive use of examples and stories in The Theory of Moral Sentiments is essential to Smith’s moral theory.

In what sense is The Theory of Moral Sentiments a theory that is useful for explaining human behavior? In his Essays on Philosophical Subjects, published posthumously by his two colleagues Joseph Black and James Hutton, Smith characterizes powerful explanatory theories in terms of their comprehensiveness, unity of explanation, ability to account for detail, elegance and simplicity, and the corresponding wonder and admiration that they provoke (Raphael & Skinner, 1982). These qualities are consistent with “Newtonian” theorizing, which Smith viewed as considerably more satisfying that “Aristotelian” theorizing (Griswold, 1999). Smith also identifies three steps in theory development. First, we feel surprise when some phenomenon is drawn to our attention which does not fall into a recognized pattern. Second, we feel wonder or discomfort which gives rise to a pursuit for an explanation. Third, when we have succeeded in finding an acceptable explanation, we admire the phenomenon to a greater extent than before. Thus, surprise, wonder, and admiration are three sequential sentiments which give rise to theoretical development. According to Smith, a new theory may be preferred because it accommodates new empirical observations, because it is simpler, or because it can be connected more directly with the theory of a related branch of science (Raphael & Skinner, 1982). In all aspects, Smith’s moral theory appears to fit his own definition of a powerful explanatory theory.

In conclusion, I identify at least four characteristics of Smith’s moral theory that enhance its ability to explain emerging evidence in experimental economics. First, by incorporating sympathy and the impartial spectator of internalized social norms, Smith’s moral theory incorporates ecological rationality that arises from social interaction. This ecological rationality generates cooperative solutions that are impossible given traditional constructivist rationality based on narrow self-interest. These cooperative solutions are typically more efficient than solutions based on traditional axioms of economic theory, and reflect the wider social context in which economic decisions are made. This is what Vernon Smith (2010) refers to when he states that participants come to the experimental lab with a recording of previous social interactions, and display “repeated play behavior” even in single period games and settings.

Second, by exploring what “is” relative to the source of virtue and the mechanism that gives rise to moral judgment, Smith’s moral theory incorporates the emphasis within economics on descriptive or positive theory. The emerging evidence in experimental economics supports what Adam Smith and the other


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moral philosophers of the Scottish Enlightenment believed about morality – it reflects the “non-selfish” part of human nature that is observable. Given Adam Smith’s interest in empirical data as the basis for his moral theory, he would have been very interested in experimental economics and its potential to yield new insights regarding social norms and morality. Because Smith’s moral theory is a positive theory based on observable behavior in natural settings, it is useful for explaining behavior in the laboratory or in the field. As with any positive economic theory, however, Smith’s moral theory is also useful for forming normative policy statements.

Third, Smith’s moral theory is powerful and general. In particular, Smith’s moral theory in The Theory of Moral Sentiments is capable of explaining a wide variety of behavior in a wide variety of economic settings. The generality of Smith’s moral theory can be seen in its ability to absorb and incorporate other theories intended to explain moral behavior. For example, Smith’s use of internalized social norms resembles behavioral theory in social psychology related to social norms (Bicchieri, 2006), self-awareness (Duval & Wicklund, 1972), and self-concept maintanence (Mazar, Amir & Ariely, 2008). Smith’s moral theory is also general enough to incorporate recent economic theory in identity (Akerlof & Kranton, 2010).

Finally, the same economists who have turned to Smith’s Wealth of Nations as a foundation for modern economic theory should find the moral theory in The Theory of Moral Sentiments useful when expanding that economic theory to incorporate morality. This research agenda is made even more important by recent scholarship suggesting that Smith’s two books are meant to form a unified whole, and that a full understanding of his economic theory is impossible without an understanding of his moral theory. While this paper does not directly address this unified view of Adam Smith’s writings, and further research linking his two major works appears warranted, Vernon Smith and other prominent researchers in experimental economics have already begun the process of incorporating insights from Adam Smith’s moral theory into economic theory. Thus, it is the belief of this author that more economists should rediscover Adam Smith and his first book, The Theory of Moral Sentiments.

m1 Vernon Smith (2010, p.1) explains the potential usefulness of experimental studies for economic theory: “Experimental economics is good at measurement, testing, and discovery in studying the microeconomics of human behavior governed by the informal norms of social exchange and the more explicit rules of exchange in institutions. It has not been good

at integration and interpretation within the broader context of human social and economic development. The learning from a half-century of experimental discovery will be particularly significant if we can find a way to leverage that learning into a broader understanding of the human career; otherwise, the rewards from the range of our research will be too narrowly drawn, fragmented, and of passing interest, as scholars move on to the intricate details of whatever is next.”

2 The unified approach taken recently by scholars on Adam Smith is summarized well by Griswold (1999, pp.29-30), whose reading of Smith prompts him to assume “not only that The Theory of Moral Sentiments and The Wealth of Nations posses ‘organic unity’ but that together they form a coherent whole.” This unified view, while relatively new to American researchers in economics, is the position commonly held by Scottish researchers most familiar with Adam Smith’s life and work. (See Raphael & Macfie, 1982.) I thank Christopher Berry at the ASRF for making this point abundantly clear to me.

3 As I mention below, Adam Smith’s influence in France and Germany was quite different. In particular, France and Germany translated The Theory of Moral Sentiments into their native languages shortly after it first appeared in English in 1759 (France in 1764 and Germany in 1770). In fact, the popularity of Adam Smith’s moral theory in France and Germany increased the acceptance and popularity of his economic theory in those two countries.

4 During part of his time in exile, Charles II lived in the Hague where his sister Mary and brother-in-law William II, Prince of Orange, lived. While there, he fathered an illegitimate son through Lucy Walter. Her son, James Crofts, was later to become the Duke of Buccleuch. Adam Smith resigned his professorship at the University of Glasgow to tutor a future Duke of Buccleuch in Europe from 1764-1766.

5 Pincus (2009) and other historians have speculated that the British monarchy survived where other major European monarchies failed because the British kings and queens after King James II/VII were willing to give increasing liberty and freedom to the people.

6 The above information on historical Kirkcaldy was gathered from various sources including the Kirkcaldy Civic Society, VisitScotland, and the Wikipedia online Encyclopedia. Much of this information was gathered during several visits to Kirkcaldy and the region of Fife during my spring semester at the ASRF.

7 While his mother was a devout Presbyterian and regular church attender her whole life, Adam Smith was more likely a deist who maintained a belief in a creator God but held some skepticism concerning those truths of revealed religion that must be accepted through faith. His close relationship with key benefactors of the University at Glasgow (e.g., Henry Home and the Duke of Argyll) kept his faculty position safe against more hardened members of the Glasgow Presbytery who may have doubted his religious devotion. Upon his departure, however, the Chair of Moral Philosophy at Glasgow was filled by Thomas


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Reid, a committed Christian and Presbyterian minister (Broadie, 1997).

8 Based on Smith’s published and unpublished works, Griswold (1999) places The Theory of Moral Sentiments and The Wealth of Nations within a more general corpus or “system” that Adam Smith had in mind throughout his life. Within this system, moral philosophy consisted of both ethics (treated in The Theory of Moral Sentiments) and natural jurisprudence (treated in The Wealth of Nations). Griswold concludes that The Wealth of Nations must be understood in terms of a more extensive ethical project and conception.

9 There exists some debate as to whether or not the changes Smith made in subsequent editions of The Theory of Moral Sentiments represent substantive alterations to his moral theory. As Griswold (1999) points out, Smith was a systematic thinker who very early on had the fundamental outlines of his moral and economic theories sketched out in his lectures. This characteristic of Smith, plus a thorough and unbiased consideration of his changes, brings Griswold and many other philosophers to conclude that the changes do not represent substantive alterations to his original moral theory.

10 Knowing full well that it may cost him professionally and politically, Smith kept a close friendship with Hume throughout his life. While at Oxford, for example, tradition has it that Smith was severely reprimanded for having a copy of Hume’s recently published book, A Treatise on Human Nature. By the time of their meeting in 1749-1750, however, Smith already appeared to be using Hume’s theory of human nature to lay the foundation for his own philosophy (Phillipson, 2010). Yet, in the last weeks of Hume’s life Smith refused to grant Hume’s request that he publish Hume’s Dialogues Concerning Natural Religion posthumously because it was too skeptical of revealed religion and religious faith.

11 Phillipson (2010, p.67) asserts that it was the pattern of response to Hume’s challenge in A Treatise of Human Nature that gave the Scottish Enlightenment its distinctive philosophical character.

12 As McCloskey (2011) points out, Smith avoided the “Christian” or “theological” virtues of faith, hope, and love, and chose instead to add the virtue of benevolence—which is a part of the virtue of love.

13 The importance of distinguishing between positive and normative theory in economics was proposed by John Neville Keynes (1891) and elaborated by Milton Friedman (1953) in an influential essay. The concept of positive theory, however, can be found as far back as the writings of David Hume in 1739 and Machiavelli in 1515. It is important to emphasize that positive statements can be incorrect, but they must be testable. In contrast, normative statements are value judgments that are not testable. Both positive and normative statements must be combined, however, to make a policy statement. One must first make a judgment about what goals are desirable (the normative part), and then decide on a way of attaining those goals (the positive part). This is why few economists confine themselves to positive statements only.

14 The argument behind a risk neutral principal is that she is capable of effectively diversifying her investments.

15 The combined assumptions of linear incentive contracts, exponential utility functions, and normal distribution of noise terms in the principal-agent framework has been labeled the LEN model (Lambert, 2001).

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