The Invisible Hand
Adam Smith’s Invisible Hand’s Theory
Smith’s novel theory was that the free market system Opens in new window is like an invisible hand that can unobtrusively coordinate the behavior (behaviour) of a multitude of individuals, interested only in maximizing their own selfish utility, so as to bring about efficiency and a socially optimal outcome.
For Adam Smith, the pursuit of self-interest and the division of labor Opens in new window (labour) do create a spontaneous order of coordinated activities of supply and demand, regulated by the price system Opens in new window, and an optimal allocation of resources. Therefore, they also most forcefully promote the public interest and the common good.
Smith did not put it in those words, but he discussed this basic idea in several places in his classic book.
For instance, he pointed out how in making economic decisions, each person “intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention” (1776; 1937, 423).
A visible hand of politicians and bureaucrats neither exists nor is needed.
There is no system of central planning or any super-intelligent human mind that could possibly fulfill this task of coordination, because such coordination can be achieved only as the outcome of the whole system of, on the level of individual intentionality, uncoordinated and thus “spontaneous” economic transactions.
Now, the point of all this is that in a free market economy Opens in new window, as conceived by Adam Smith, there is actually no such thing as an invisible hand at all.
To those who do not understand the mechanism of markets, the division of labor (labour), and free competition, an invisible hand seems to be there (they seek a “hand” that explains the otherwise seemingly miraculous outcome, according to the logic of conspiracy theories, which always look for the invisible hand: one single cause explaining complex patterns).Yet, in the free market economy, there is no “one hand” that explains the result.
In reality, the invisible hand is the feedback system of the “many hands,” that is, of the market that, through the price system, spontaneously coordinates private interests in such a way as to concur with an optimal allocation of resources.
The hand, thus, is “invisible” because this indicates the market Opens in new window as a kind of black box: we know the result, but, despite knowing the basic mechanism, we are unable to comprehend all the steps having brought it about, precisely because in none of these steps did somebody actually intend to bring it about.
Adam Smith was not an extremist; but he knew that an individual engaged in business does not, and cannot, intend to promote the public interest.
Yet, when Smith writes, “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it,” he not only simply describes what obviously happens, but also moderately and wisely says that this is the case only “frequently.”
In fact, nothing in the idea of the invisible hand denies that laissez-faire is only a necessary but not a sufficient condition for coordinating private interests, attaining thereby the common good. Further, there is not any denial that there are many circumstances and cases in which the invisible hand would not work because some condition for its proper functioning fails.
Unfortunately, there persists a confusing and detrimental attitude of those who, beginning from the insight into the insufficiency of laissez-faire and its unsatisfactory outcome if the market is left to itself, conclude that a free market is intrinsically harmful.
Thus, entrepreneurial decisions and the regulatory force of the price system Opens in new window should on principle be checked by government intervention or even by directly converting the state into a competitor of private business to overcome its alleged egoism and agreed of profit—of course by unjustly subsidizing economic state activity with taxpayers’ contributions (also with those of citizens engaged in private business who thus are unjustly constrained to subsidize their often even less efficient state-run competitors).
Such people think that capitalist laissez-faire, instead of being as it actually is, though very imperfectly, a cause of prosperity Opens in new window, is in reality a problem and a cause of misery. This is the great confusion to which Keynes Opens in new window, among economists—Marx, after all, was only a philosopher—has contributed certainly in the most influential way.
This is not to deny that the capitalist or free market economy Opens in new window avoids causing problems or undesirable side effects. Yet, these should be resolved not by abolishing or fettering capitalism and the dynamics proper to it, but by making it work better and more efficiently, according to truly just rules, so that it can develop its true potential.
Now, we need to put into perspective the concept of a competitive economy and its equilibrium Opens in new window.
Basically, a competitive economy is one in which no individual can alter the prices prevailing in the market Opens in new window by the individual’s own behavior (behaviour).
Each single person or agent is considered to be too small for that. Hence, my decision to buy or sell more bread cannot alter the market price of bread. This is not to deny that if a whole bunch of people decide to buy more bread, then the price of bread will rise, and if a group of sellers decide to sell more, the price will fall.It is simply that each single agent treats the prevailing market prices as unchangeable.
This is described, in brief, by saying that every individual in a competitive economy is a “price taker.”
- A rational Opens in new window, self-interested individual or agent is basically someone who looks at the prevailing prices, and then decides how much to buy or sell so as to maximize the person’s own utility, well-being, happiness, or preference.
Consider the problem faced a by a consumer. The consumer has some income, which would typically be determined by the prevailing price of labor [labour] (meaning salary) along with any other nonlabor income or wealth that he or she may have, and the consumer faces the prevailing market prices.
Given these prices, consider all the bundles of goods that cost less than or equal to the consumer’s income. Clearly these are the bundles that are feasible for the consumer. Thus, the consumer may be able to buy a car and food, or a television, refrigerator and food, but cannot buy both these bundles.The collection of all such bundles that can be afforded within the budget is called the consumer’s budget set.
A rational consumer is a person who chooses a bundle from which the budget set so as to attain the highest possible utility.
In a fuller description of a competitive exchange economy, we do not distinguish between a consumer and a supplier. Each person is assumed to own some initial bundle of goods, and, on seeing what the prices are, they decide how much of which ones they would like to buy more of and how much of which ones they would like to sell off.
Now consider an arbitrary list of prices for all goods available on the market.
Let individuals choose how much each person would like to buy or sell each good on the basis of these prices.
- Check if for each good the total demand (that is, the demand from all individuals) is equal to the total supply of that good. If not, then we do not have an equilibrium.
- We would then expect the price to rise or fall depending on whether there is an excess demand or supply.
Once we find a price vector such that the total demand equals the total supply for each good, so that there is no pressure for prices to change, we have found a competitive equilibrium or simply an equilibrium.
More specifically, a list of prices – one for each good – that results in the total demand for each good being equal to the total supply, is referred to as an equilibrium. Once such prices are achieved there is no pressure for the prices to change; hence the use of the term equilibrium.
With this in mind, the invisible hand theory can be described as follows:
If we have a competitive economy, where all individuals choose freely according to their respective rational self-interest, then (given a few technical conditions) the equilibrium that will arise will be Pareto optimal Opens in new window.