What’s it: Invisible hand refers to the forces that move the market toward equilibrium when there is no intervention. These forces are entirely based on interactions among economic actors in the market. Allowing the supply and demand forces to operate will ultimately result in the most efficient resource allocation and maximum social benefit.
However, some economists criticize. They argue that the invisible hand is not a panacea. Letting the market work without intervention will not solve problems such as externalities, monopolies, and public goods.
The originator and the basic idea of the invisible hand
Adam Smith introduced the term invisible hand for the first time in 1759 through his work “Theory of Moral Sentiments.” Then, in 1776, he used the same term in his book entitled “An Inquiry into the Nature and Causes of the Wealth of Nations.“
He views, in the free market, individuals and businesses will pursue their own interests. The company will rationally maximize profits in producing goods and services. Meanwhile, individuals will maximize utility or satisfaction in consuming goods and services.
This pursuit of its own interests will ultimately maximize social benefits. Consumers strive to find the best in the market to satisfy their needs and wants. Likewise, businesses are looking for the best in the market for maximum profit. Consumers and businesses interact and produce the best price and quantity for both.
From this viewpoint, he argued that these benefits would outweigh if the market is regulated or intervened.
The basic concept of the invisible hand
In a free market, there is no external intervention whatsoever. Each economic actor rationally maximizes its own profit. Consumers form the market demand forces while the producers form the market supply force. Two forces interact in the market to determine the price and quantity of a product.
In the absence of intervention, market prices reflect market supply and demand. Because they want to maximize benefits (utility and profit), each economic actor will efficiently allocate their own resources.
Consumers will use their money and resources efficiently to maximize the utility from the consumption of goods and services. They will buy from sellers and look for the most affordable price.
Meanwhile, producers will use the most efficient production factors. They must choose the most appropriate production method to cut costs and charge high prices to maximize profits.
Since each looks for the best, the output and the equilibrium price are the best. When looking for the lowest price, consumers realize that producers are unwilling to supply them. Likewise, when charging a high price, producers see that no consumer is willing to buy it. Therefore, both parties will adjust the decision according to supply and demand conditions.
The invisible hand and market mechanism
The invisible hand basically tries to convey that without external intervention (e.g., the government), the market will automatically be in each party’s best economic interests. When the market is in a disequilibrium condition, the market mechanism will move the market toward equilibrium.
For example, when prices are lower than market prices, demand is higher than supply. The market experiences shortage (or excess demand). The market mechanism will drive changes in demand and supply to a new equilibrium. Prices will tend to rise.
Due to the low supply, some consumers are willing to pay more. At the same time, as prices rise, producers are willing to supply more. This condition will continue until the new equilibrium is reached, i.e., when the quantity demanded equals the quantity supplied.
The market mechanism also works when the market is in excess supply. Because prices are above equilibrium, the market sees more of the goods being supplied than demanded. It becomes a signal for consumers and producers to adjust demand and supply. In the end, an equilibrium is reached at a lower price than before.
The invisible hand in macroeconomic concepts
The invisible hand concept is closely related to the concept of a free market, especially laissez-faire. This concept emphasizes “letting things go on their own, without any interruption or intervention.” In the laissez-faire concept, the role of government is absent or at least minimized. That is what underlies classical economist thinking.
The economy will run on its own to find a new equilibrium, even during a recession or depression. The economy doesn’t require interventions such as fiscal or monetary policies.
For example, during a recession, wages will fall because the labor market is oversupplied with high unemployment rates. A decrease in wages reduces the production costs of firms, encouraging them to increase production. They recruit more workers and thus create more jobs and income. As a result, the economy is slowly moving out of recession.
Criticism of the invisible hand
Critics argue the invisible hand won’t always produce the best social benefits. Selfish motives will ultimately encourage economic actors to do “evil” by benefiting themselves and harming others.
Negative externalities. For example, the goal of maximizing profits will encourage producers to behave exploitatively. They will exploit natural resources regardless of their impact on the environment. They won’t treat the waste because it burdens the company’s operating costs. And, if there is no government intervention, they are free to do so. Such practices may benefit producers but harm others.
Monopoly. The competition will lead to one winner. The dominant company will try to remove competitors from the market. That way, the company can maximize profits and don’t have to share the market profit pie with other players. When it has become a monopolist, the company is free to increase prices or reduce costs by reducing quality to maximize profits. Of course, it hurts consumers.
Public goods. You cannot exclude other people from using public goods, even when they are not paying. And what you consume, it doesn’t reduce the benefits received by other people. Examples of public goods are roads and city parks. Because of the profit motive, businesses would naturally not be willing to supply such goods.
In macroeconomics, Keynesians refute classical economists about the invisible hand. Keynesians question the validity of the invisible hand in the short term, especially during times of recession. They argue government intervention matters to equilibrate the economy.
Keynesians believe that the only way out of recession is government intervention. Such intervention is necessary because the private sector is incapable enough to move the economy out of recession.
The Great Depression proved that the concept of the invisible hand and the free market economy were incapable of explaining the causes and providing solutions to escape such conditions.
Then, John Maynard Keynes, the father of Keynesian economics, came up with his new theory and 180 degrees opposite the invisible hand concept. Keynes argued that stimulating aggregate demand is a way to grow the economy.
To go out of recession and boost aggregate demand, governments should intervene in the economy. In this case, the government must increase its spending or reduce the tax rate. It will increase aggregate demand and move the economy out of the depression.
The private sector will unable to drive market demand. The rationality and profit motives discourage businesses and households from increasing their consumption and investment.
Households are unwilling to increase their consumption because, during the depression, they lose their income and most of their wealth.
Likewise, businesses won’t be willing to invest. When they invest, the market supply increases. It will only produce a growing excess supply, pushing prices and profits further down.