Invisible hand

For other uses, see Invisible hand (disambiguation).

In economics, the invisible hand, also known as the invisible hand of the market, is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith in The Theory of Moral Sentiments. For Smith, the invisible hand was created by the conjunction of the forces of self-interest, competition, and supply and demand, which he noted as being capable of allocating resources in society. This is the founding justification for the laissez-faire economic philosophy.

The Wealth of Nations

Adam Smith uses the metaphor in Book IV, chapter II, paragraph IX of The Wealth of Nations, arguing that people in any society will employ their capital in foreign trading only if the profits available by that method far exceed those available locally. In such a case, Smith argues, it is better for society as a whole if they so do.

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. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest 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. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

jkjhkhkhkhmhjkkmmj,,jk

Economists' interpretation of the "invisible hand" quotation

The concept of the "invisible hand" is nearly always generalized beyond Smith's original discussion of domestic versus foreign trade. Smith himself participated in such generalization, as is already evident in his allusion to "many other cases" quoted above.

Milton Friedman, a Nobel Prize winner in economics, called Smith's Invisible Hand "the possibility of cooperation without coercion."

Notice that the Invisible Hand is here considered a "natural inclination", not yet a social mechanism as it was later classified by Leon Walras and Vilfredo Pareto.

The theory of the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. The reason for this is that self-interest drives actors to beneficial behavior. Efficient methods of production are adopted to maximize profits. Low prices are charged to maximize revenue through gain in market share by undercutting competitors. Investors invest in those industries most urgently needed to maximize returns, and withdraw capital from those less efficient in creating value. Students prepare for the most needed (and therefore most remunerative) careers. All these effects take place dynamically and automatically.

It also works as a balancing mechanism. For example, the inhabitants of a poor country will be willing to work very cheaply, so entrepreneurs can make great profits by building factories in poor countries. Because they increase the demand for labor, they will increase its price; further, because the new producers also become consumers, local businesses must hire more people to provide the things they want to consume. As this process continues, the labor prices eventually rise to the point where there is no advantage for the foreign countries doing business in the formerly poor country. Overall, this mechanism causes the local economy to function on its own.

In The Wealth of Nations, Smith provides an example that illustrates the principle:

It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

Some economists question the integrity of how the term "invisible hand" is currently used. Gavin Kennedy, Professor Emeritus at Heriot-Watt University in Edinburgh, Scotland, argues that its current use in modern economic thinking as a symbol of free market capitalism is not reconcilable with the rather modest and indeterminate manner in which it was employed by Smith. In response to Kennedy, Professor Daniel Klein argues that reconciliation is legitimate. Moreover, even if Smith did not intend the term "invisible hand" to be used in the current manner, it's serviceability as such should not be rendered ineffective. In conclusion of their exchange, Kennedy insists that Smith's intentions are of utmost importance to the current debate, which is one of Smith's association with the term "invisible hand". If the term is to be used as a symbol of liberty and economic coordination as it has been in the modern era, Kennedy argues that it should exist as a construct completely separate from Adam Smith since there is little evidence that Smith imputed any significance onto the term, much less the meanings given it at present.

Understood as a metaphor

Smith uses the metaphor in the context of an argument against protectionism and government regulation of markets, but it is based on very broad principles developed by Bernard Mandeville, Bishop Butler, Lord Shaftesbury, and Francis Hutcheson. In general, the term “invisible hand” can apply to any individual action that has unplanned, unintended consequences, particularly those that arise from actions not orchestrated by a central command, and that have an observable, patterned effect on the community.

Bernard Mandeville argued that private vices are actually public benefits. In The Fable of the Bees (1714), he laments that the “bees of social virtue are buzzing in Man’s bonnet”: that civilized man has stigmatized his private appetites and the result is the retardation of the common good.

Bishop Butler argued that pursuing the public good was the best way of advancing one’s own good since the two were necessarily identical.

Lord Shaftesbury turned the convergence of public and private good around, claiming that acting in accordance with one’s self-interest produces socially beneficial results. An underlying unifying force that Shaftesbury called the “Will of Nature” maintains equilibrium, congruency, and harmony. This force, to operate freely, requires the individual pursuit of rational self-interest, and the preservation and advancement of the self.

Francis Hutcheson also accepted this convergence between public and private interest, but he attributed the mechanism, not to rational self-interest, but to personal intuition, which he called a “moral sense.” Smith developed his own version of this general principle in which six psychological motives combine in each individual to produce the common good. In The Theory of Moral Sentiments, vol. II, page 316, he says, “By acting according to the dictates of our moral faculties, we necessarily pursue the most effective means for promoting the happiness of mankind.”

Contrary to common misconceptions, Smith did not assert that all self-interested labour necessarily benefits society, or that all public goods are produced through self-interested labour. His proposal is merely that in a free market, people usually tend to produce goods desired by their neighbours. The tragedy of the commons is an example where self-interest tends to bring an unwanted result.

Moreover, a free market arguably provides numerous opportunities for maximizing one’s own profit at the expense (rather than for the benefit) of others. The tobacco industry is often cited as an example of this: the sale of cigarettes and other tobacco products certainly brings a very good revenue, but the industry’s critics deny that the social benefits (the pleasures associated with smoking, the camaraderie, the feeling of doing something “cool”) can possibly outbalance the social costs.

Examples and arguments

Since Smith’s time, the principle of the invisible hand has been further incorporated into economic theory. Leon Walras developed a four-equation general equilibrium model that concludes that individual self-interest operating in a competitive market place produces the unique conditions under which a society’s total utility is maximized. Vilfredo Pareto used an edgeworth box contact line to illustrate a similar social optimality.

Ludwig von Mises, in Human Action (see note 3 at the bottom), claims that Smith believed that the invisible hand was that of God. He did not mean this as a criticism, since he held that secular reasoning leads to similar conclusions.

The invisible hand is traditionally understood as a concept in economics, but Robert Nozick argues in Anarchy, State and Utopia that substantively the same concept exists in a number of other areas of academic discourse under different names, notably Darwinian natural selection. In turn, Daniel Dennett argues in Darwin’s Dangerous Idea that this represents a “universal acid” that may be applied to a number of seemingly disparate areas of philosophical inquiry (consciousness and free will in particular). See also Social Darwinism.

Tawney's interpretation

Christian socialist R. H. Tawney saw Smith as putting a name on an older idea:

If preachers have not yet overtly identified themselves with the view of the natural man, expressed by an eighteenth-century writer in the words, trade is one thing and religion is another, they imply a not very different conclusion by their silence as to the possibility of collisions between them. The characteristic doctrine was one, in fact, which left little room for religious teaching as to economic morality, because it anticipated the theory, later epitomized by Adam Smith in his famous reference to the invisible hand, which saw in economic self-interest the operation of a providential plan... The existing order, except insofar as the short-sighted enactments of Governments interfered with it, was the natural order, and the order established by nature was the order established by God. Most educated men, in the middle of the [eighteenth] century, would have found their philosophy expressed in the lines of Pope:

Thus God and Nature formed the general frame,

And bade self-love and social be the same.

Naturally, again, such an attitude precluded a critical examination of institutions, and left as the sphere of Christian charity only those parts of life that could be reserved for philanthropy, precisely because they fell outside that larger area of normal human relations, in which the promptings of self-interest provided an all-sufficient motive and rule of conduct. (Religion and the Rise of Capitalism, page 195.)

Other uses of the phrase by Smith

Adam Smith used the phrase two other times in his writings, once published and once unpublished. The unpublished reference simply says that practitioners of Polytheistic religions did not attribute gravity or fire to the invisible hand of Jupiter, and the idea clearly has no relation to the invisible hand of the market. However, this particular reference should be observed for a complete picture of what Smith intends to portray by the term "Invisible Hand."

In Theory of Moral Sentiments, Smith uses the invisible hand to explain the distribution of wealth (1759, p. 350):

The rich ... consume little more than the poor, and in spite of their natural selfishness ... They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and ... advance the interest of the society, and afford means to the multiplication of the species.

This was written before Smith visited France and the "Économistes" (Physiocrats) who gave him and classical economics the "circular flow" vision of the economy. See the emphasis of "annually" in Smith's Introduction. In a "circular flow" output that does not become input in the next circle is "unproductive labour" produced by a "classe stérile" (Économistes).

Criticism

Joseph E. Stiglitz

The Nobel Prize-winning economist Joseph E. Stiglitz, says: "the reason that the invisible hand often seems invisible is that it is often not there." Stiglitz explains his position:

Adam Smith, the father of modern economics, is often cited as arguing for the "invisible hand" and free markets: firms, in the pursuit of profits, are led, as if by an invisible hand, to do what is best for the world. But unlike his followers, Adam Smith was aware of some of the limitations of free markets, and research since then has further clarified why free markets, by themselves, often do not lead to what is best. As I put it in my new book, Making Globalization Work, the reason that the invisible hand often seems invisible is that it is often not there.

Whenever there are "externalities"—where the actions of an individual have impacts on others for which they do not pay, or for which they are not compensated—markets will not work well. Some of the important instances have long understood environmental externalities. Markets, by themselves, produce too much pollution. Markets, by themselves, also produce too little basic research. (The government was responsible for financing most of the important scientific breakthroughs, including the internet and the first telegraph line, and many bio-tech advances.)

But recent research has shown that these externalities are pervasive, whenever there is imperfect information or imperfect risk markets—that is always.

Government plays an important role in banking and securities regulation, and a host of other areas: some regulation is required to make markets work. Government is needed, almost all would agree, at a minimum to enforce contracts and property rights.

The real debate today is about finding the right balance between the market and government (and the third "sector"—non-governmental non-profit organizations.) Both are needed. They can each complement each other. This balance differs from time to time and place to place.

Noam Chomsky

Noam Chomsky, while acknowledging the intelligence of Smith's thesis, criticizes how the term of the "invisible hand" has been used. He also explains:

Throughout history, Adam Smith observed, we find the workings of "the vile maxim of the masters of mankind": "All for ourselves, and nothing for other People." He had few illusions about the consequences. The invisible hand, he wrote, destroys the possibility of a decent human existence "unless government takes pains to prevent" this outcome, as must be assured in "every improved and civilized society." It destroys community, the environment, and human values generally—and even the masters themselves, which is why the business classes have regularly called for state intervention to protect them from market forces. (...)

E. K. Hunt

The political economist E. K. Hunt criticized markets and the externalities emerging from market exchanges as being a route for self-advancement at the expense of social good. Hunt helped contribute to the literature on heterodox economics, helping to coin the term "invisible foot" in contrast to a presumably beneficent "invisible hand":

If we assume the maximizing economic man of bourgeois economics, and if we assume the government establishes property rights and markets for these rights whenever an external diseconomy is discovered [the preferred "solution" of the conservative and increasingly dominant trend within the field of public finance], then each man will soon discover that through contrivance he can impose external diseconomies on other men, knowing that the bargaining within the new market that will be established will surely make him better off. The more significant the social cost imposed upon his neighbor, the greater will be his reward in the bargaining process. It follows from the orthodox assumption of maximizing man that each man will create a maximum of social costs which he can impose on others. D'Arge and I have labeled this process "the invisible foot" of the laissez faire ... market place. The "invisible foot" ensures us that in a free-market ... economy each person pursuing only his own good will automatically, and most efficiently, do his part in maximizing the general public misery. "

See also

Books

• Essays on Philosophical Subjects by Adam Smith
• I, Pencil by Leonard Read
• The National Gain by Anders Chydenius
• The Theory of Moral Sentiments by Adam Smith
• The Visible Hand by Alfred Chandler
• The Wealth of Nations by Adam Smith
• Capitalism: The Unknown Ideal by Ayn Rand

Articles

• Enlightened self-interest
• Free price system
• Laissez-faire
• Market fundamentalism
• Philosophy of social science
• Rational egoism
• Rational selfishness
• Spontaneous order
• Emergence
• Objectivism

External links

• The Theory of Moral Sentiments (full text)
• The Wealth of Nations (full text) or
• The History of Astronomy, in Essays on Philosophical Subjects (full text)
• I, Pencil (full text)
• The National Gain (full text)
• Template:PDFlink
• "Adam Smith and the Invisible Hand" From Metaphor to Myth" article by Gavin Kennedy, May 2009