Invisible Hands In Economics

Article byAndrea Calcagno
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Invisible Hand In Economics?

The invisible hand in economics refers to the hidden market forces that lead individuals’ actions out of self-interest to benefit society. It was first coined by the economist Adam Smith. He used the concept in his two books, The Theory of Moral Sentiments and The Wealth of Nations. 

Invisible Hand

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The concept shows favoritism towards capitalismCapitalismCapitalism is an economic system consisting of businesses, resources, capital goods, and labour. Private entities own it, and the income is derived by the level of production of these factors. Because of the private hands, these entities can be operated efficiently and maximize their production activity also.read more. The various forces of capitalism pooled together, like personal interest and, in some ways, humanity greed, are what, in the end, will be needed for society’s evolution and progress. That is, the concept disfavors too much government intervention. The government should provide only essential public goods and leave resource allocation decisions to the private sectorPrivate SectorThe private sector is a section of the national economy that the government does not own. The business conducted under this sector is carried out by companies or entrepreneurs who focus on profit maximization and customer satisfaction.read more.

Key Takeaways

  • Invisible hand in economics refers to the unobservable market forces that lead individuals’ actions out of self-interest to benefit society.
  • The concept aligns with the capitalist economy. Therefore, it favors a free market without government intervention, and supply and demand determine the market equilibrium.
  • One of the famous examples is introduced by the economist Richard Cantillon. It explains how converting a single real estate into multiple lease units increased production.
  • The concept is important because it discloses the market’s self-regulatory capacity to attain equilibrium.

Invisible Hand In Economics Explained

The invisible hand concept in economics exemplifying an unobservable market force helps the supply and demand of goods in a free marketFree MarketA free market refers to an economic system free from government interventions and controlled by privately owned businesses.read more attain economic equilibriumEconomic EquilibriumEconomic equilibrium refers to a situation wherein specific market forces remain balanced, resulting in optimal market conditions in a market-based economy. The term is often used to describe the balance between supply and demand or, in other words, the perfect relationship between buyers and sellers.read more. A free market manifests a scenario without government intervention; hence the prices of goods and services are self-adjusted when buyers and sellers negotiate in an open market. The market forces of supply and demand stabilize the economic systemEconomic SystemThere are four prominent types of economic systems in the world based on their characteristics. It includes traditional economy, command economy, market economy and mixed economy. read more.

When private entities own a significant portion of resources, it is easy for them to gain control of production and resource allocation. A free market with minimal government intervention motivates people to produce or consume resources based on their interests. Producers can benefit from market opportunities by supplying the product in demand, and competition encourages them to innovate. These activities will ultimately revamp the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more.

The idea in invisible hand in market economy is that competition and self-interest will drive to offer the best products at the lowest prices to attract consumer demand, essential for securing profits. All this will contribute to raising social welfare. However, the reason behind this betterment of the human condition is ultimately selfish. Hence competition and self-interest will create a productive society contributing to the economy.

While it’s difficult to practically prove how such unseen forces may influence and shape the world economy, neo-classical economists have tried to do so for the past century and more. They believe that the old toolbox of government interference favoring protectionism and massive government spending will also harm the nation’s financial health along with its consequence on open market competition affecting international trade partners.

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Example

To better understand the concept of the invisible hand in the market economy by Adam Smith, let’s look into the famous example introduced by the economist Richard Cantillon in his book An Essay on Economic Theory. He described how a real estate property when divided into multiple lease Lease Leasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read moreunits, brought more revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more compared to the return obtained when a single owner controlled the entire real estate property. 

The desire for success and competition triggered the farmers of independent units to introduce new technology, better farming tools, and procedures to a circumscribed market. It led to growth in revenue for all parties involved since the products were better. The race to the top meant more satisfied customers, which led to better market practices and even more satisfied customers in a theoretically never-ending cycle of progress and innovation.

Importance

There are various reasons why the theory of the invisible hand concept in economics is so critical. Let us analyze the importance critically.

  • The most important of them has already been showcased in this article: It is not only a theory that affects the market. All aspects of life are directly tied to an ungrabbable hand since technological and societal progress means better conditions for humanity as a whole, and this theory drives the end goal of capitalism.
  • In economics, the result produced by this theory has aroused interest above all concerning its application to the market and, more precisely, to the possibility that individuals motivated solely by the objective of maximizing their material benefits (in particular, for producers, profits) may be led by the forces of the market to contribute to the well-being of society as a whole.
  • In fact, on the one hand, the invisible hand concept in economics is referred to as a system of decentralized decisions in which each agent pursues their interests by taking prices into account exclusively, and, on the other hand, social benefits are identified with the efficiency corresponding to the Pareto efficiencyPareto EfficiencyPareto Efficiency is a state of the economy in which economic resources are distributed or allocated in such a way that they are operating at their highest utility, and as a result, any additional effort made for reallocation will not provide a positive effect unless and until there is an equivalent negative effect.read more. The invisible hand theorem, also known as the first theorem of welfare economics, determines the conditions under which this result can occur and, therefore, allows us to state that in the market, in a sense specified above, an invisible hand operates for the progression of the world as a whole. 
  • The concept argues about the importance of limitation to government interference in the economy. Adam Smith believed that the market will give the kind of outcome need in a natural way if there is very limited interference of the government. It does not need heavy regulations. Government should only interfere for property related issues, contact enforcement or detection and prevention of fraud and resource misutilization.
  • It is believed that the concept of invisible hand principle economics leads to adoption of changes in the field of technological advancement, consumer choices and preferences. Market conditions are continuously changing. Therefore the businesses also need to change their production methods and types of goods and services that they offer to customers. The invisible hand concept allows the economy to adapt to these changes and accept challenges.
  • The invisible hand principle economics brings efficiency, quality improvement and cost reduction and benefits consumers. The businesses can pursue their interest in the economy and compete with each other to produce goods and services as per the demand but at the lowest cost possible.

Frequently Asked Questions (FAQs)

What is the concept of the invisible hand in economics?

It is an economic concept indicating the unplanned generation of economic benefit for the nation due to the individuals’ actions directed by self-interest. That is, the self-interested behavior of individuals creates a positive consequence for society.

What is an example of the invisible hand?

To increase market share, a manufacturer might provide a higher-quality product at a lower price than its competitors. Maintaining low pricing may generate demand and foster competition among companies selling comparable items. The producer’s actions are motivated by self-interest rather than concern for the customer’s well-being. However, in the end, everyone benefits from this arrangement. Consumers can select from various items with competitive pricing and quality.

Does the invisible hand exist?

It is a metaphorical usage explaining the underlying forces connecting the individual’s action out of self-interest to the nation’s economic growth.

This has been a guide to Invisible Hand Theory in Economics & its Meaning. Here we explain how it works along with examples and its importance. You may also have a look at the following articles to learn more –