By Aidan Hackett. Edited by Arjun Chandrasekar.
Overview
“It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own self-interest.” This famous Adam Smith quote from The Wealth of Nations truly sums up the whole of Smith’s philosophy on the way markets and humans interact with one another.
Investopedia puts it as, “The invisible hand is part of laissez-faire, meaning “let do/let go,” approach to the market. In other words, the approach holds that the market will find its equilibrium without government or other interventions forcing it into unnatural patterns.”
What is the Invisible Hand?
The system of buying, and necessarily not buying, items, is a form of voting, where buying a product is a vote in favour, saying “this is a good product”, and a product not selling says the opposite. Considering the case where the product sells well, this signals a heightened demand in the market for this product. This will, in turn, make more producers get into that market so that they can start making profits from this product. This transitions back to the quote mentioned in the overview – a businessman does not do this for the public good, they do it to line their own pockets. But, the end result is positive for the transactors in a society – businesses get more profits which translates into more products, higher wages, etc., and the consumers get the product they demand at a reasonable price that is driven down due to competition. This push and pull between different goods and services that is created by the interactions buyers and sellers have with each other is the invisible hand Adam Smith wrote about.
How does this Affect Business Owners?
When the invisible hand leads buyers to new and different products, they naturally divert this money away from something else. This may mean for a business such as Apple, they can profit off of this by releasing a new phone every year by diverting resources away from producing older phones. On a more macroeconomics scale, this means that companies who do not adapt, die off.
A great example of this is with Polaroid, which has been through many different phases. Starting in 1937 as a research firm for polarization, they saw an opportunity in the 1970’s in the market of photography, specifically instant film cameras. This was something that the market demanded, and for years they had a dominant share. Then Kodak set up shop seeing how profitable it was, and started making similar cameras, forcing both firms into competition for a better product at the best price. Polaroid failed to properly adapt to consumer needs, and ended up slowly falling behind the competition, eventually going bankrupt in 2001. Recently, they have noticed a new trend in retro items, so the reborn company has been capitalizing off that.
How does this Affect General People?
Buyers will always naturally want the best items for the lowest cost – that is what is best for them, and that is what the invisible hand leads them to do. The majority of businesses compete for consumers’ money, not out of a moral desire to fulfil the client’s need (regardless of what they say in ads), but out of a desire to make money for the business owners. This competition necessarily leads to lower prices and better products and it is very hard for monopolies or corporate-price-fixing-coalitions to form in an absolutely free market.
Going back to the Polaroid example, if consumers thought Polaroid had a better product, then they would have bought that product. They didn’t buy the product, however, so Polaroid went bankrupt, and a better company serviced the consumers. In this situation, consumers got exactly what they wanted – good cameras at prices they were willing to pay.
Implications with Government Regulation
An integral part of the invisible hand theory is that the market will by nature reach an equilibrium state, that is the price will be exactly as much as buyers are willing to pay, and as little sellers are willing to sell, at rates that meet the effective market demand fully. The role of government is more or less to make sure that no one is cheated out of something owed to them. The invisible hand theory in its purest form makes government seem unnecessary, oftentimes seeming to be the cause of a lot of grief in markets.
Consider a business that frequently cheats its customers, breaks contracts, and charges high prices. The role of the government would be to 1) protect consumers, 2) enforce contracts, and 3) make sure prices are not exploitative. But the invisible hand theory contends that this business would not exist as buyers would not buy from it, and armed with this knowledge, the owner (assuming they wanted to make money) would not commit any of the aforementioned acts.
Now, obviously not everyone in a market is rational (see our introductory article on behavioural economics here), so the government does have jobs to do. Smith says these are to build roads, bridges, etc. as well as enforce contracts, but nothing more. Milton Friedman, who was an admirer of Smith, agreed with this assertion, and added they should control inflation too. If Adam Smith were alive today, he would probably think that many government programs were unnecessary, and the state they have society in would be the same, or better, if things were left up to the invisible hand that guides us.
Conclusion
The invisible hand theory, on inspection, seems like an incredibly simple and self-evident idea, because it is something natural – looking out for yourself. Whether it is you trying to sell sweets at school, or buying a car, you will always act in your own self-interest, squeezing every last cent out of the people buying your sweets, and bargaining to get the best deal on your car. You will always need to compromise with someone if you, and by extension society, are going to advance anywhere. That, Smith claimed, was the beauty of the free market. By letting people act as they would without a society, society can flourish.
Ending Quote
“Every individual necessarily labors to render the annual revenue of the society as great as he can … He intends only his own security, 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 … By pursuing his own interests, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”
For more information, we highly recommend checking out this video.
