What Is the Invisible Hand?
The invisible hand is a metaphor for the unseen forces that move the free market economy. Through individual self-interest and freedom of production and consumption, the best interest of society, as a whole, are fulfilled. The constant interplay of individual pressures on market supply and demand causes the natural movement of prices and the flow of trade.
The term "invisible hand" first appeared in Adam Smith's famous work, The Wealth of Nations, to describe how free markets can incentivize individuals, acting in their own self-interest, to produce what is societally necessary.
- The invisible hand is a metaphor for how, in a free market economy, self-interested individuals operate through a system of mutual interdependence.
- This interdependence incentivizes producers to make what is socially necessary, even though they may care only about their own well-being.
- Adam Smith introduced the concept in his 1759 book The Theory of Moral Sentiments and later in his 1776 book An Inquiry Into the Nature and Causes of the Wealth of Nations.
- Each free exchange creates signals about which goods and services are valuable and how difficult they are to bring to market.
- Critics argue that the invisible hand does not always produce socially beneficial outcomes, and can encourage greed, negative externalities, inequalities, and other harms.
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How the Invisible Hand Works
The invisible hand is part of laissez-faire, meaning the "let do/let go," approach to the market. In other words, the approach holds that the market will find equilibrium without government or other interventions forcing it into unnatural patterns.
Scottish Enlightenment thinker Adam Smith introduced the concept in several of his writings, such as the economic interpretation in his book An Inquiry Into the Nature and Causes of the Wealth of Nations (often shortened to just The Wealth of Nations) published in 1776 and in The Theory of Moral Sentiments published in 1759. The term found use in an economic sense during the 1900s.
The invisible hand metaphor distills two critical ideas. First, voluntary trades in a free market produce unintentional and widespread benefits. Second, these benefits are greater than those of a regulated, planned economy.
Each free exchange creates signals about which goods and services are valuable and how difficult they are to bring to market. These signals, captured in the price system, spontaneously direct competing consumers, producers, distributors, and intermediaries—each pursuing their plans—to fulfill the needs and desires of others.
The term "invisible hand" only appears twice in The Wealth of Nations, a volume of around 1,000 pages.
The Invisible Hand and Market Economies
Business productivity and profitability are improved when profits and losses accurately reflect what investors and consumers want. This concept is well-demonstrated through a famous example in Richard Cantillon’s An Essay on Economic Theory (1755), the book from which Smith developed his invisible hand concept.
Smith's An Inquiry Into the Nature and Causes of the Wealth of Nations was published during the first Industrial Revolution and the same year as the American Declaration of Independence. Smith’s invisible hand became one of the primary justifications for an economic system of free-market capitalism.
As a result, the business climate of the U.S. developed with a general understanding that voluntary private markets are more productive than government-run economies. Even government rules sometimes try to incorporate the invisible hand.
Former Fed Chair Ben Bernanke explained the "market-based approach is regulation by the invisible hand" which "aims to align the incentives of market participants with the objectives of the regulator."
Example of the Invisible Hand
Consider an example of a small business facing stiff competition. To best position itself in the market, the small business decides it will invest in higher quality materials for its manufacturing process as well as reduce its prices. though the small business may be doing so out of the best interest of its company (i.e. to drive sales and steal market share), the invisible hand is at work as the market now has access to more affordable yet higher quality goods.
Another example of the invisible hand is the ripple effect a retail company can have when attempting to meet consumer demand. Consider a hardware store that anticipates demand for yard maintenance tools. The hardware store will coordinate with a manufacturer to secure the appropriate goods. Meanwhile, the manufacturer will communicate with a raw materials distributor to ensure it has the items it needs.
In this second example, each entity is acting in its own best interest. However, each entity is also creating economic activity for other parties. In addition, the entities are stringing together a process that results in a consumer receiving a product it needs. Though each individual action taken by itself may not amount to much, the invisible hand helps move resources along a process to deliver a final product.
Why Is the Invisible Hand Important?
The invisible hand allows the market to reach equilibrium without government or other interventions forcing it into unnatural patterns. When supply and demand find equilibrium naturally, oversupply and shortages are avoided. The best interest of society is achieved via self-interest and freedom of production and consumption.
How Is the Invisible Hand Used Today?
As former Fed Chair Ben Bernanke explained, the "market-based approach is regulation by the invisible hand" which "aims to align the incentives of market participants with the objectives of the regulator."
What Did Adam Smith Say About the Invisible Hand?
Adam Smith wrote about an invisible hand in his writings during the 1700s, noting that the mechanism of an invisible hand benefits the economy and society thanks to self-interested individuals. Smith mentions "an" invisible hand, which is the automatic pricing and distribution mechanisms in the economy that interact directly and indirectly with centralized, top-down planning authorities.
Why Is the Invisible Hand Controversial?
Critics argue that the idea that self-interested, profit-driven actors will converge on some social optimum is clearly false, and that instead it naturally leads to negative externalities, economic and social inequalities, greed, and exploitation. Moreover, competition driven by the invisible hand can ultimately result in monopolies and the concentration of economic power, both of which are undesirable for society.
Other critiques hone in on the fact that the concept relies on the assumption that producers can easily switch from producing one type of good to any other, depending on its relative profitability at a given moment. This does not account for the sometimes enormous costs of switching and the idea that people may engage in a business that they enjoy doing, or which has been passed down in a family, regardless of profitability.
The Bottom Line
The invisible hand is the idea that specialization in production can lead self-interested individuals to produce what is socially necessary and for the good of all. This is because increased specialization naturally leads to a web of mutual interdependencies, such that a shoemaker will need others to produce their house, food, clothing, etc.; while a homebuilder will rely on the shoemaker for shoes and others for their own clothing, food, and so on. Market forces and competition will incentivize producers to make what is most profitable at the lowest cost, also encouraging technological progress and innovation, for the benefit of all.