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Adam Smith's Theory of Market Efficiency

Updated on September 14, 2014
MARKETS
MARKETS
Market efficiency through demand & supply
Market efficiency through demand & supply

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 Cover of Wealth of Nations by Adam Smith
The Cover of Wealth of Nations by Adam Smith

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

Adam Smith
Adam Smith

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.

© 2011 vkumar05

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    • Normyo Yonormyo profile image

      Normyo Yonormyo 4 years ago

      @CampingmanNW: I think you mistake markets, software is a service market, all you need is a good computer, the necessary software and knowledge to start a business, ten thousand dollars should be enough. Try to do the same thing with computers and you will need a lot more money. And off course it is possible to find examples of people who found a way into a market, but if you look closer you will see that most of those persons created a new market. Dell for example created the first successful postorder computer seller. Cuban if I may take your example created one of the first internet radio stations. Both were new markets. But most important they all created a new market in an economy that was regulated by law.

      So what is important if you want to succeed and make it big, create a new market. But you will need to do it in a economy that is directed by law and not the free market. Because if it is a free market expect to be blown out of the water by the first competitor who thinks your new business is a danger to its current position.

    • CampingmanNW profile image

      CampingmanNW 4 years ago

      In response to normyo-yonormyo I guess if entering the private service sector were the only way to go? How does one explain, Bill Gates and Microsoft, or Mark Cuban and his single owner business model success? To name just two, but a success that in both cases, are now worldwide phenoms. If one were to believe that only service sector business could survive in today's marketplace, I suppose they should talk to Mrs. Field's Cookies. Anyway V Kumar, you lens was excellent and a good read. Thanks for your effort

    • Normyo Yonormyo profile image

      Normyo Yonormyo 5 years ago

      It is a pity that everybody stresses Adam Smith's theory of the invisible hand. Where he in the same book addresses the fact that his model only works in a market that is protected by law. Adam Smith noticed in his time that a lawless market existed. Because merchants and producers had access to politicians and were able to get the politicians to create laws that were to the advantage of the merchants. That of course is not a democratic nor a free market model.

      A second flaw in the model is the idea that producers can enter at will a market. That might be true in a market where production costs are low. But if I want to start a tablet or mobile phone company, I will need to find billions of dollars, just to be able to compete with the current producers.

      So the globalisation of the market has made it almost impossible for individuals to enter a global market. Which probably explains the growth of so many one person businesses in the service sector of the economy. Service is the last sector in which you can enter with a small budget and build a company.

    • Brandi Bush profile image

      Brandi 5 years ago from Maryland

      Great lens...very well done! :)

    • profile image

      anonymous 5 years ago

      Thanks for sharing such a wonderful lens.

    • profile image

      anonymous 5 years ago

      Very nice chronicle on Adam Smith's theory. Thank you for sharing this here!

    • bhavesh lm profile image

      bhavesh lm 6 years ago

      Never before this foundational theory in economics more relevant than now. You have outlined an objective and balanced view of Adam Smith's Invisible Hand theory. I also admire Mr. Stiglitz's work whose book you have spotlighted. A nice resource.

    • profile image

      anonymous 6 years ago

      Trying to understand the guidelines and Adam Smiths theory, I think free market is always a good thing to thrive upon.