Taken broadly, there is no single more crucial effect on the capitalist economic system than what Adam Smith called the "invisible hand." Capitalism relies on the private deployment of the means of production and a system of voluntary exchanges; it is entirely guided by a spontaneous, efficient allocation of resources.
In his famous 1776 book, "An Inquiry into the Nature and Causes of the Wealth of Nations," Smith introduced a doctrine of economic thought that eventually laid the theoretical foundation for free-market capitalism. The term "invisible hand" comes from a small passage in his book. Per Smith, “…Every individual...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…He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…He is… led by an invisible hand to promote an end which was no part of his intention… By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.”
Smith, often called the father of economics, introduced this concept of unguided economic order long before it was more fully understood. He argued for the private ownership of capital and for free trade uninhibited by government policy. These arguments laid the foundation for future proponents of laissez-faire capitalism.
Interpreted narrowly, Smith's invisible hand only suggests that self-interested, profit-seeking individuals are more broadly beneficial than those who use the political process to improve society. While accurate, this interpretation ignores the process that makes it possible for capitalism to produce wealth so efficiently.
How Does the Invisible Hand Work?
There could be several other names for the invisible hand: supply and demand, risk and reward, the price system or even human nature. To put it another way, the invisible hand is simply the sum of voluntary activities by economic actors. Proponents of the invisible hand model often believe that governments are incapable of replicating or improving upon the unintended consequences of capitalism.
Consider the following scenario: a blight destroys a huge crop of wheat in Ukraine. Since the supply of wheat is compromised, wheat prices rise across the globe. The first effect is for consumers to react to the higher prices by cutting back their wheat purchases, which helps to conserve the remaining supply for only those who value it most highly, ostensibly those who rely on wheat for survival and businesses that need it for other products.
There is also an important secondary effect. Wheat farmers in the United States, unaffected by the blight, can sell their wheat at a higher profit; after all, their inputs were unchanged. Wanting to capture more profits, existing farmers increase production. Wheat may be grown in areas where it was previously unprofitable to try to grow it. The supply of wheat increases again to meet global demand. Over time, the price falls back down.
The potential millions or billions of actors in this hypothetical situation need not speak to each other, like each other, be at peace with each other or even know each other exist. Together, though, their actions help move the invisible hand of the market to fix a global problem.