The invisible hand: A concept that explains hidden economic forces in the market
- The invisible hand is a concept that was coined by economist Adam Smith to illustrate hidden economic forces.
- The invisible hand is a metaphor that describes the unseen forces that impact the free market through actions based on individual self-interest.
- In theory, consumers basing decisions on self-interest creates a positive outcome for the economy.
The invisible hand concept was an idea proposed by economist Adam Smith that illustrates the hidden forces behind people's economic choices. It is a foundational concept for rational choice theory, which states that people will make decisions based on their own personal self-interest and benefits.
Understanding the invisible hand and how it works
The metaphor of the invisible hand is used to describe the underlying forces that we don't see that have an impact on people's economic choices. As part of the concept, Smith said that people act in their own best interest, which ultimately benefits the economy as a whole. The theory is often used as a backbone to support the idea of a free market, though some have said in the past that the idea is taken out of context.
According to Michael Edesess, Ph.D. and managing partner and special advisor at M1K LLC, "The best example of how it works was given by Smith himself in that book: 'It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.' He followed that up by saying, 'By directing that industry in such a manner as its produce may be of the greatest value, he 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.' These are the two most famous quotes from Smith's long book."
Smith adds that people act with their own regard and interests in mind and not with an ulterior motive, but can have positive and unexpected repercussions.
"In other words, Smith was saying that by solely pursuing their own self-interest — and not any conscious intention to be of help to others — and by trading with each other, the butcher, brewer, and baker all help each other to provide the goods they need for their dinners," explains Edesess.
The invisible hand concept is closely related to laissez-faire economics, which proposes that government interference in the economy should be minimal and should run its own course. Based on these ideas, as people act based on their own self-interest, it creates a need for supply and demand and can create a competitive and robust marketplace.
"Smith's invisible hand theory shows that an optimal distribution of goods and services among a number of producers and consumers can be achieved without a 'visible hand' directing them to do so," says Edesess. "In fact, a visible hand that does things like dictating prices of goods can cause the end result to be suboptimal. This mistake was made crystal clear in the Communist-era Soviet Union."
Quick tip: As people make economic choices based on their own self-interest, there may be a "surplus" for the consumer or producer. Read more about this idea and economic surplus.
How the 'invisible hand' affects the economy
The invisible hand concept is based on the idea of free markets and is said to benefit consumers by creating market equilibrium by people pursuing their own self-interest.
In theory, people acting based on their own interests creates supply and demand and market efficiency, creating a positive outcome for the whole of the economy. Without government intervention, the markets work on their own based on consumer preferences and actions.
However, the invisible hand theory assumes that consumers are rational when making economic decisions. But that's not always the case. As humans, we don't always behave logically but based on emotions or need. Consider any time you have gone to the grocery store and overspent because you're hungry or sleep-deprived.
Additionally, some critics note the possibility of greed and exploitative practices that could be justified due to "self interest" and the invisible hand.
"The invisible hand promotes individual self-interest and competition. While this sounds nice, in practice, it's not actually a good thing, because economic theories also point out the 'irrational consumer' making choices say emotionally, impulsively, with incomplete information, and most importantly, generally not being mindful in the moment of what's best for the overall good of society," says Nick Thorsch, founder of environmental sustainability platform Share2Seed.
While Smith's invisible hand theory is still relevant today, it has also come under scrutiny during the Great Recession and financial crisis of 2008. Given the current pandemic, economic fluctuations and crypto boom, there is more debate about the role of government in the market.
In other words, if left unchecked, do consumers really create the best results for the economy when there is no government interference? Or could it lead to greed or economic collapse?
Quick tip: The economist Joseph Stiglitz countered this idea many years ago by stating there is no invisible hand.
Brief history of the 'invisible hand'
- Smith's invisible hand concept is said to be inspired by economist Richard Cantillon, who wrote "An Essay on Economic Theory" in 1755.
- In 1759, the term 'invisible hand' first appeared in "The Theory of Moral Sentiments" by economist Adam Smith.
- In 1776, the year of American Independence, the term again appears in "An Inquiry into the Nature and Causes of the Wealth of Nations" by Smith.
- The 1974 Nobel Prize winner in Economics, Friedrich A. Hayek used and expanded on the invisible hand concept.
Examples of how the invisible hand works
In theory, the invisible hand inherently creates a free marketplace that supports competition among consumers and works out for the best for everyone.
"In contrast to the invisible hand, the heavy hand of government which seeks to direct what is best for others will do so in a far less efficient manner than the individual will for themselves," says Nicholas B. Creel, M.A, J.D., LL.M., Ph.D. and assistant professor of accounting and business law at Georgia College and State University.
"An example of this would be how a business owner, seeking only to make themselves better off, might sell an item of higher quality and at a lower price than his competitors," he explains.
Keeping prices low may increase demand and create competition among other suppliers offering similar products.
"He doesn't do this for the consumer, he does so to win the business of the consumer to make himself better off. The end result is everyone is best off in this scenario. The consumer gets a better and cheaper product, the market maximizes efficiency, and the business owner stays afloat," explains Creel.
The financial takeaway
The invisible hand theory is an important economic concept that is still relevant today. It can offer an explanation into free markets and consumer behavior. While the concept is important, it's also often used out of context or in a way that's out of alignment with Smith's original text.
"Smith's theory has been misinterpreted by some modern lay economists and even some professional economists to mean that the unfettered pursuit of self-interest will always produce an optimal result, without any attention whatsoever to communal interests or to altruism, and that government intervention is always bad," says Edesess. "This aberrant strain of economics has been recently dubbed 'market fundamentalism.'"
So while the invisible hand plays an important role in the economy and economic history, it's important to look at the nuance and current economic conditions as well.
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