The Invisible HandUpdated: Nov 8, 2016
The Invisible Hand
The invisible hand is a term attributed to the 18th-century economist Adam Smith and appears in his landmark 1776 book, The Wealth of Nations. The term developed from Smith’s study of another classical economist, Richard Cantillon, and was used metaphorically by Smith to describe the “natural forces” that drive free markets, a kind of product the human nature of people interacting in the market. The term only appears twice in Smith’s book (he had used it in an earlier work in 1759, The Theory of Moral Sentiments, but in a philosophical rather than economic context), but has grown to be cited, and often misinterpreted, as one of Smith’s most important concepts.
What is the Invisible Hand?
In a free, unregulated market, competition for scarce resources encourages market participants to act to maximize their self-interest. “Maximizing self-interest” is a typical economic textbook term that is often not clearly explained, probably because it sounds a little more dignified than “seeking to purchase resources at the lowest or most efficient costs, and seeking to sell goods, services, or assets for the highest obtainable profit.” Even though no one is acting for the benefit of anyone else, the self-interests balance each other, creating a mutually beneficial exchange for everyone. This “balancing force” is what Adam Smith metaphorically called the “invisible hand”.
In simple terms, if consumers and producers are both free to look out for the own interests, an equilibrium will be created. Consumers generate demand for goods, and producers respond by developing efficient production and distribution methods to meet the demand at the lowest possible cost; prices are regulated by competition, which is in turn created by the consumer demand. Society benefits as a whole, because as prices decrease due to competitive pressure and greater efficiency, volume increases; this obliges producers to pay more for labor to keep up with demand, which increases costs and prices, which are canceled out by the higher purchasing power of the now better-paid worker/consumers. Everyone gets what they want in increasing amounts, and no one has to worry about anything other than their own needs and desires.
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Misinterpretation and Controversy
The idea of the “invisible hand” is popular with Objectivists and adherents of the Ayn Rand philosophy of “every man for himself”, but interestingly, the term in modern usage is applied to a section of Smith’s Wealth of Nations where it does not even appear. The idea that self-interested competition leads to larger social benefits appears early in the book, in Book I, Chapter 7, but the actual phrase “invisible hand” does not appear until Book IV, Chapter 4 in the following passage:
“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 cases, led by an invisible hand to promote an end which was no part of his intention.”
The idea that Smith expresses – that individual ambition has greater benefits – is a common theme throughout The Wealth of Nations, but the way Smith uses the metaphor of the “invisible hand” specifically refers to domestic versus foreign industry. Because the metaphor is consistent with Smith’s philosophical theme, it has been used to underpin the entire philosophy of neoclassical economics; George Stigler, a key leader of the Chicago School of Economics and close friend of Milton Friedman, once famously greeted a symposium on Smith’s work by saying, “I bring you greetings from Chicago, where Adam Smith is alive and well.” Much of the confusion about what Smith actually said and intended in his own work and the apparent source of the neoclassical application of the metaphor is the 1948 book Economics by Paul Samuelson, in which he quotes Smith’s “invisible hand” passage in a way that combines a bit of Smith’s explanation of self-interest among market participants with the original quotation, thus linking the metaphor – perhaps inaccurately, perhaps not – to Smith’s entire economic philosophy.
Despite Dr. Stigler’s amusing greeting, Adam Smith is not, in fact, alive and well to add further insight to the argument over what he really meant, so the safest interpretation is an analysis of what he actually wrote. The market participant prefers domestic industry to foreign industry, and we can infer reasons why this might be so; costs of production and transportation are lower, the goods produced are more suitable to the local market because of more available and complete information, and as a consequence of all that, prices for the goods that are produced are lower. Because the domestic industries are preferred for those reasons alone, the domestic society benefits through the need for labor to produce goods and raw materials – a positive, unintended consequence of the market participants’ pure self-interest. Thus social benefit is created as if guided by an “invisible hand”.
Criticism of the “Invisible Hand”
The strongest argument against the validity of the metaphor, and its consequential idea that markets should be allowed to regulate themselves, comes from the Nobel Prize-winning economist Joseph Stiglitz, who wrote in his book The Roaring Nineties that, “the reason that the invisible hand often seems invisible is that it is often not there.” Free markets have certain limitations, according to Stiglitz, one of the most important being their inability to manage “externalities”. Stiglitz holds that the idea of unintended benefits being allowed to happen without some sort of accounting is irrational; if a person’s actions create a benefit for someone else for which he is not compensated, or if a person benefits from another’s actions without cost to himself, that person will adjust his activities accordingly – either reduce his activity to prevent “giving something away for free,” or reduce his activity to avoid paying for more than he needs, since he is receiving some of it at no cost.
Stiglitz argues that any time there is imperfect information and some degree of risk uncertainty in markets – which is always – these “externalities”, which we can understand as “forces other than the supposed invisible hand and conceptual equilibrium of an efficient market”, are always present and make the market less efficient because market participants “hold back” a little. That is why, he says, that some of the most important developments in modern civilization, such as the telegraph, genetic advances in food production, and the internet, did not develop in markets but were supported by governments. In other words, some degree, hopefully, a balanced degree, of government intervention in markets is necessary, first to “take up the slack” in progress towards efficiency that is not happening in markets, and second to reduce risk uncertainty in ways such as enforcing contracts and protecting property rights.