The Invisible Hand term is used as a metaphor for invisible forces moving the free market economy. British philosopher Adam Smith used this metaphor for the first time. This metaphor describes how self-interested individuals work through a system of mutual interdependence.
The interdependence ensures producers keep making what society demands. Product manufacturers may solely focus on their benefit, but they keep the wheel moving. Free exchanges in a free market produce signals regarding valuable goods and services. Those signals reveal how tough it is to source valuable goods and why they are more valuable than others.
Many experts believe the invisible hand does not always lead to socially beneficial results. According to them, it may promote negative externalities, greed, inequalities, and other problems. How the invisible hand affects people and why economics students must learn about it? Find out more interesting information in this post.
What is a free market economy?
You have to understand the free market economy if you wish to understand how the invisible hand affects it. Some countries have complete control over their economies. The government has complete control over production facilities, wealth distribution, goods prices, and cost of services. Those governments control wages, work time, and other things related to labour.
The free-market economy follows the law of supply and demand. There is no central authority controlling or regulating goods production, service cost, and labour. Producers pick the highest rate customers may pay for their products and services. Customers have free choice to buy goods and services from any company. Labours get much higher wages in a free market economy than they get in a dictator regime.
The capitalist economy is the best example of the free market economy. All the involved parties are focused on making money and earning profit. Therefore, free market economies attract more businesses, consumers, and labours than controlled economies.
How does the invisible hand influence the free market economy?
The Invisible Hand supports the laissez-faire approach. It is also known as the “let do/let go” approach. This approach suggests that the market does not require government or other interferences to find the equilibrium. If interventions are carried out, they may force the market into unusual patterns.
Adam Smith was a Scottish enlightenment thinker, who wrote many books on economic topics. He brought the concept of the invisible hand and proposed theories related to this hidden force. Other economists started believing in that term during the 1900s and thus it became a mysterious term.
The Invisible Hand metaphor came with two essential ideas:
- Voluntary trades benefit everyone
Nobody forces a company to produce sufficient goods to meet the needs of potential customers. There is nobody forcing customers to buy products from the best manufacturers. Voluntary trades occur because producers, suppliers, and buyers look for their own interests. It produces unintentional benefits.
- A planned economy may not match the benefits of involved parties in a free market
The invisible hand metaphor indicates that benefits in the free market economy are much greater than those of a planned or regulated economy. The free market benefits everyone. Therefore, countries with free market economies have much wealthier and happier people.
What is the connection between capitalism and the free market?
There is no completely uninhibited free market in the world. However, free markets can be found in countries that support individual rights, private ownership, and capitalism. Political systems in capitalist countries do not interfere too much with voluntary economic transactions. Capitalist nations offer well-protected property rights and they gain incentives by pursuing profits.
The free market and capitalism may look pretty similar, but both are distinct economic systems. They usually go hand-in-hand but that does not mean both systems are identical. Capitalism focuses on producing wealth and owning the production, distribution, and capital. The free market economic system focuses mainly on exchanging wealth and services. People sometimes confuse those two economic systems because free markets are often found in capitalist societies.
Why is the Invisible Hand important?
Adam Smith believed that wealth does not reside in a vacuum. People, who work hard for their own interest, benefit the entire society. Their interests are aligned with the interests of society in a free market.
The Invisible Hand ensures there is equilibrium in the market. That equilibrium is gained without any intervention from central authorities. Shortages and oversupply of goods never occur when there is an equilibrium between supply and demand. That equilibrium benefits suppliers, buyers, and society. Since every person is working for his own interest, losses do not occur frequently. It eventually keeps everyone happy.
Ben Bernanke is a renowned economist and he was the 14th chairman of the Federal Reserve. He emphasized a market-based approach. That approach is regulated by the concept of the invisible hand. According to him, the primary goal is to align the regulator’s objectives with market participants’ incentives.
Some considerable advantages of the Invisible Hand include the following:
- Freedom of making decisions
The invisible hand metaphor states that all the parties focus on their interest. Each person gets a free choice and he/she can make the best decisions for the business. Suppose you are a baker, you will produce top-quality bread, pastries, cakes, and other items to make a profit. You won’t focus on quality because you are concerned about customers. Your ultimate goal is profit and customers choose your product because you got the quality.
Producers charge more for better quality and they find customers because clients seek better quality. No regulations require producers to maintain a certain level of quality in a free market. Nobody forces buyers to pay more for quality service or products. The invisible hand states that every person got the freedom to make decisions that benefit him and his organization.
All producers aim to produce a better profit. They do not gain any incentive for maintaining quality. They feel the pressure to meet the market’s demands because it benefits the business. Some producers may cut corners to gain more profit. They may not survive in a free market much longer because customers will eventually switch to a better-quality product.
The invisible hand “the hidden force” prevents manufacturers from reducing product quality. They know that demand may reduce if they decrease product quality for short-term profit. It can lead to huge losses and those losses may collapse the business. Therefore, producers try to operate as efficiently as possible.
Why do critiques find the Invisible Hand controversial?
Does everyone agree that self-interested actors will benefit the entire society? No, they do not believe in such an idealistic world. According to critiques, profit-driven entities and individuals may never converge on some social optimum.
Critiques believe that the invisible hand concept may cause social and economic inequalities and negative externalities. If there is nobody regulating companies, greed will force them to think less about society. The Invisible Hand may cause monopolies and snub small businesses.
People, who believe in the Invisible Hand, presume that producers will easily switch to products that deliver maximum profit. They will always supply products that deliver maximum profit. That does not happen because companies have operated for many decades and provided the same type of goods and services.
Some experts criticize the Invisible Hand due to the following drawbacks and limitations:
As mentioned earlier, certain businesses may exert monopoly power. They may emerge as natural monopolies and destroy competitors. Monopoly is the best threat to the supply and demand equilibrium. Therefore, it does not validate the concept of the invisible hand.
- Negative externalities
Since businesses will pursue only what is best for them, they may cause negative externalities. It is a major drawback of the invisible hand and it may occur. Suppose a company supplies packed seafood, it may encourage over-fishing. That will affect marine life around the world and the monopoly of certain firms will destroy local businesses. People may enjoy cheap products and completely avoid pollution and other problems created by self-interested business organizations.
Does the Invisible Hand work in the real world?
We have discussed both the good and bad aspects of the invisible hand. It works flawlessly in theory and maybe in many markets. However, this concept can also lead to many issues. Supposed demands go down, production will reduce and people will lose their jobs.
The theory states that people move to a new location where jobs are available, but that does not happen in reality. Labour forces prefer to reside in the local vicinity. Liquid labours do not exist in the real world and therefore businesses need to stay where labours are.
Why should business students be familiar with the concept of the Invisible hand?
Business & Economics students may get questions related to the Invisible Hand in economics tests. Therefore, they should be familiar with this metaphor and how accurately it describes the movement of the free market economy.
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