Adam Smith's Theory of Market Efficiency
Adam Smith's Theory of Invisible Hand
One of the founding pillars of Economics was laid in the form of the theory of invisible hand proposed by Adam Smith which states that markets achieve efficiency by balancing production and demand of goods in a way that everyone ends up making the best of what is possible. Smith concluded that if left alone, markets can work in a way that serves to create wealth and optimize social welfare.
His theory has continued to guide later philosophers and remains a cornerstone of most modern economic planning even after all these years.
The Invisible Hand
In late eighteenth century, Adam Smith came out with a book titled, "An Inquiry into the Nature and Causes of the Wealth of Nations" First published in 1766, it detailed Smith's observations of real life markets and his theory that proposed that in a free and unregulated market, where anyone can freely become a producer or a consumer, the demand of people for different goods equals their production, and resources for production are so allocated allocation that achieve this state where production and consumption of different goods will be optimal for the welfare of the society. In other words, Smith suggested that the invisible hand consisting of market forces of demand and supply will achieve the most efficient level of production, consumption and distribution of goods in the society, through the markets.
Smith's theory of market being capable of achieving the best social outcome created a very strong reason in favor of free markets, and has been the standard argument against government interventions or control.
ADAM SMITH - The person who proposed the market forces of demand and supply from observations in real life
An Argument for Economic Freedom
Free Markets bring Efficiency in Production & Consumption
The invisible hand theory is the economic counterpart of democratic theory.
Just like people are supposed to be capable of choosing the best leaders for themselves in a democracy, the invisible hand theory proposes when allowed to do so in a free market, people will demand and supply goods in a manner that society's needs are best met within the given resources available with it. There are, of course, many preconditions for an efficient market that have subsequently been pointed out, like 'adequate information', which is an essential ingredient for its success, as it is in politics too - if the people were to elect the best option. Similarly, like in any democratic setup, there must be adequate competition, otherwise a monopoly or a cartel will capture the market and defeat its very purpose.
In real life, markets may often end up being less than efficient. When that happens, it is not because the invisible hand theory of free markets is inaccurate, but due to different factors. Still, more often than not, they provide us the best option for achieving an efficient system of human economic activity.
Adam Smith's theory continues to be held and accepted unanimously, even in the age of people's protests against the markets.
Markets bring buyers and sellers together, and by doing so, bring the transaction cost of exchange to minimal, making it possible for people to exchange their surplus production. This creates incentives for producing more, which leads to economic growth of society,
The Demand and Supply
Forces that balance each other
The two basic factors that ensure efficiency in market are those of demand and supply, and their interaction leads to so called 'invisible hand' proposed by Adam Smith.
'Demand' refers to the willingness of people to pay a price for a particular unit of a good. When 100 people are willing to pay $ 10 or more for that object, the demand for that object is hundred units at a price of $ 10. Out of these, if only 50 are willing to pay $ 20 or more for the same object, then the demand of that object at a price of $20 would be 50. At a price of $30, the corresponding demand may be even lesser, say only 20.
Now, if cost of production of this object is $ 8, and the market price of that object is $30, then the profit margin of $22 will attract more producers to the market. When they also start production, the supply will be more, and the competition among the producers will bring the market price down, so as to bring it to $ 20, at which level, there will be more demand and so all that is produced will be consumed. If new producers continue to enter the market, the price may fall to $ 10, when there would be 100 buyers and all the 100 units of the object produced will be consumed.
Thus, when the demand is more than its supply, the market price of an object rises, thereby attracting more producers to setup production of that object. The entry of new producers increases the supply, which in turn reduces the prices. This continuous adjustment of market prices by addition or exit of new producers that happens all the time, is the very basic mechanism by which the invisible hand of the free market operates.
Smith's theory also tells us that when prices rise, it is not just because producers are trying to cheat people with excessive margins. That will not happen in a free market, because other producers will enter the market in quest of extra profits and lead to more competition and fall of prices. However, this is possible when market is not free.
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