The Invisible Hand that Guides the Market

Adam Smith (5 June 1723 – 17 July 1790)

Foundation of modern economic philosophy

The modern economic theory is largely based on the observations made by Adam Smith in the late eighteenth century. While analyzing the behaviour of producers and sellers in an unregulated market, he came up with the theory that the markets have an inherent potential of being efficient, if just left alone. He referred to this inherent property of the markets as the 'invisible hand'. Even after more than two centuries, his theory has remained the cornerstone of our understanding of market behaviour.

Adam Smith & the theory of Invisible Hand

In late eighteenth century, Adam Smith who undertook an analysis of the markets came up with a conclusion that if the market is left free and unregulated, with no restrictions on production or consumption, then the demand of people for different goods and their production by the market will be equal, leading to a general welfare of the society. To put in different words, Mr. Smith suggested that the invisible hand of market, consisting of forces of demand and supply will achieve an efficient level of production, consumption and distribution of goods in the society.

This idea of unregulated markets achieving efficiency on its own, as if guided by an invisible hand, has created a very strong argument in favour of free markets, and against governments controlling production or consumption in any form that interferes with the free market.

Advocating Economic Freedom

In many ways, Adam Smith's Invisible Hand theory is the economic counterpart of democratic theory. His concept of Free markets is based largely on the condition that there should be no restrictions on economic activity, with everyone left alone to exercise her choice of production, consumption and exchange, as per her best judgement.

Just as people are supposed to be capable of choosing the best leaders for themselves, in a democracy, the Invisible Hand theory of Adam Smith presumes that people will be able to produce and consume in a manner that is most efficient if they are given a free hand. Adequate information is as essential for the free markets as it is for the success of a democracy. Lack of information or Information Asymmetry can result in an inefficient market. Similarly,as in a democracy, restriction on competition, as happens in case of monopolies, can defeat the whole process and prevent the markets from achieving efficiency.

In real life, markets may not be perfectly efficient, but that does not negate the importance of Adam Smith's Invisible Hand theory. Markets can often fail because of many different factors, but in spite of them, they still provide the best option we have for achieving an efficient system of human economic activity.

Introducing the principles of demand and supply

The real contribution of Adam Smith was to introduce the concepts of Demand and Supply and identify them as the prime movers in the free market. Demand refers to what the people are willing to pay for a particular good. As the price rises, demand of the product falls, giving rise to a down-sloping curve. On the other hand, Supply refers to what the producer or supplier would be willing to produce at a given price. The interplay of demand and supply leads to pricing of a good in the market.When the demand of a good is more, the market price of a good rises, thereby attracting more producers to the market, which increases the supply, and in turn reduces the prices, thereby maintaining a stable equilibrium. This continuous adjustment of market prices by addition or exit of new producers is the basic mechanism by which the invisible hand of the free market operates.

Though Adam Smith did not go in to graphical representation or the mathematical derivation of the Demand as a relationship between price and quantity, he discussed the concept with great clarity in his book, An Inquiry into the Nature and Causes of the Wealth of Nations, first published in 1776. He summarised the concept of Invisible Hand in the following words,

"As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and 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 eases, led by an invisible hand to promote an end which was no part of his intention . Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good."

Adam Smith's theory is the basic pillar of modern economics. during the last two centuries, the markets have been observed to fail, as happens in case of monopolies, public goods or information asymmetries between the consumers and the producers. However, we also know that in spite of their limitations, markets do deliver. Most importantly, this knowledge ensures that we have a sound and logical argument against authorities who might be mistaken into excessive regulation and restriction of economic freedom in the garb of political idealism or some other excuse. The fact that a Communist China adopts the principles of market efficiency to become a global economic superpower may  be the greatest tribute to Adam Smith and his Invisible Hand theory.

Demand and Supply in Modern Economics

ECONOMICS QUIZ

What do you think about markets ?

Do you agree with the Efficiency of the Free Markets ?

  • Yes. Free Markets are the best thing for the Economy.
  • No, Markets need to be closely regulated by the Governments.
See results without voting

© 2011 V Kumar

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Comments 3 comments

VirtuousCycle profile image

VirtuousCycle 5 years ago from London, England

The invisible hand that guides the market? Are you talking about God? Do you think God (if s/he exists) is a free-market capitalist? Or is he infinitely more wise than that?

Adam Smith wrote what was for the most part true in his century, now his insight is obsolete. We live in a fast changing universe where the knowledge of yesterday is today's superstition. Where yesterday's cellphone is today's prehistoric tool.

I would highly recommend you to watch a video called Zeitgeist: Moving Forward

http://www.youtube.com/watch?v=4Z9WVZddH9w&feature...

It will give you perspective on what's been happening all over the world, namely Egypt and the Middle East.

Also, this free-market is about to come to an end (not necessarily tomorrow or even the next 2 years, but soon):

http://www.eutimes.net/2010/07/global-economic-col...

Collapse happens when a system has become so inefficient that it can no longer recover.


dmop profile image

dmop 4 years ago from Cambridge City, IN

I believe that in a perfect world a free market system would work perfectly. However in this world we have those who use their power and influence to sway the market and the consumer to a point that renders the free market ineffective. Too much power in the hands of too few individuals is the recipe for disaster and that is exactly what we are seeing all over the world today. If one studies history it can be observed over and over again in every society in recorded history.


V Kumar profile image

V Kumar 3 years ago Author

Economic theory of markets is still applicable, but there are complexities that are often not well understood. The theory of demand and supply works very well with consumable goods, it is not applicable to assets - this simple basic phenomenon is overlooked by modern economists, who cannot look beyond multiple regression. That is the real misfortune. Then aspects like transaction costs, market friction, time lags and expectations are not taken into account by economists who are always in a hurry to produce figures. Unfortunately, human beings are not mechanical instruments, and life is not an equation.

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