What is an Invisible Hand?

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Definition:

The invisible hand is the concept that buyers and sellers in a free market unknowingly act in a way benefitting the overall economy, as if guided by an invisible hand.

🤔 Understanding an invisible hand

The invisible hand was an expression used by the 18th-century philosopher Adam Smith to describe the way that free market economies tend to correct themselves without any deliberate influence from outside forces. Smith said that buyers and sellers act out of self-interest but inadvertently perform actions that result in the marketplace continuing to balance itself. He said it was as if buyers and sellers are guided by an invisible hand. Smith saw this market correction as a naturally occurring event. In contrast, he saw government intervention of the economy as unnatural, and he argued against it in most cases.

Example

Imagine Sally and Barb both launch new businesses. Sally makes house calls to repair broken televisions while Barb prepares meals for busy non-cooks. After three months, Sally is ready to close her business, but Barb is hiring extra help. What happened?

Both Sally and Barb offered specialized services, but only one was in demand. The marketplace ignored Sally’s television repair business because modern televisions seldom need adjustment. On the other hand, after a long day on the job, exhausted workers will always need something nutritious to eat.

No one told Sally or Barb which business to start. And no one directed potential customers to embrace Barb while rejecting Sally. Everything happened without outside interference.

It’s as if an invisible hand moved the customers and business owners to do what’s best for the economy. In the end, Barb was able to not only offer more service to the community but also create new jobs.

Takeaway

The invisible hand in human economies is like instinct in the animal kingdom...

Neither can be seen, but both are responsible for survival. No outsider tells animals when it’s time to fly south, hibernate, or swim upstream. The animals are guided by self-interest. That’s similar to free market economies. Generally, no one tells companies what they can sell, and generally no one tells customers what they can purchase. They, too, are guided by their own interest, which we call the invisible hand.

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What is the invisible hand?

The invisible hand is the concept that economies work best without direct governmental control or planning. Supporters of the invisible hand approach believe that if the economy is left alone, it will regulate itself in most cases.

Individual buyers and sellers will act according to what is in their own best interests. Their actions will result in correcting and improving the marketplace — As though an invisible hand directs the buyers and sellers to do exactly the right thing in the public interest and to boost the overall economy.

When an economy works under the concept of the invisible hand, shop owners choose which products they want to offer. Naturally, they’re going to choose items that they believe have the best chance of selling. They may want their customers to be happy, but they’re still primarily operating out of self-interest. The owners are selling those items because they want to make money. So, self-interest is the motivating factor.

Customers are likewise typically looking out for their self-interests. They don’t want to waste their money on products that aren’t right for them. They will purchase from a shop owner who stocks the items they like and offers them at reasonable prices. However, they will soon stop shopping at places that do not carry the merchandise that they want or that they feel are overcharging.

The self-interests of the buyer and seller determine the marketplace. When a savvy shop owner notices that certain items are no longer popular, they’ll replace them with merchandise that’s in demand. The buyer then rewards the shop owner by making purchases. The market becomes more efficient as buyers and sellers move in the same direction — as if directed by an invisible hand.

Why is the invisible hand important?

The concept of the invisible hand allows sellers the freedom to meet the demands of buyers. If a seller currently offers a product that is no longer popular, they have the option to switch to an item that customers are willing to purchase. They can also set their own prices for those products.

Conversely, buyers are free to bypass sellers who offer items in which they have no interest or that they feel are priced too high. They can choose to spend their hard-earned money only with sellers who are willing to offer them products that they want at a price they are willing to pay.

Both the supporters and critics of the invisible hand theory can influence the way that nations tackle economic downturns. Some believe that if you leave market forces alone, it will help everyone. Detractors argue that if you allow business owners great freedom, they’ll behave in a manner that will harm more vulnerable people.

Those who believe in the invisible hand are more likely to favor a hands-off or laissez-faire approach by the government regardless of the condition of the economy. Those less inclined to put faith in Smith’s invisible hand economic model tend to believe that government action can mitigate and even prevent national and local economic struggles such as recessions.

What is the history of the invisible hand?

The concept of the invisible hand dates back to 1776. It appeared in a famous book written by Scottish philosopher Adam Smith entitled An Inquiry into the Nature and Causes of The Wealth of Nations. Often the title is shortened to The Wealth of Nations.

Smith’s book appeared at a time when Europe and America were exploring the idea of giving a greater voice to the ordinary person. It was also a time when privileged people were using international trade and colonization to amass immense wealth.

Smith argued that free competition in the marketplace could serve as a defense against the rise of monopolies. Smith promoted the idea that would-be monopolies would fail so long as the public could buy products from whomever it pleased. In theory, if a company that sought to dominate an industry continued to offer inferior merchandise at exorbitant prices, the public would rebel. Customers would show their displeasure by fleeing to a competing business.

Smart businesses would react by offering quality products at reasonable prices. The market would punish the greedy business owner and reward the one who operated in a way that benefitted all concerned.

Smith said that the buyer and seller are instinctively looking out for their own gain, but by doing so are inadvertently improving the overall economy. He said that it was as if they are being guided in the right direction by an invisible hand.

Smith was not in favor of an economic system where the government steps in to correct a negative market fluctuation. Smith was convinced that a top-down approach from the government would not be as effective as a bottom-up strategy from the ordinary consumer.

Does the invisible hand still exist?

If you’ve ever noticed all the shops at the beach selling sunglasses, water, and sunscreen, then you’ve seen the invisible hand economic theory still at work. People need sunglasses, water, and sunscreen in a summer climate to protect their health. So, they’re likely to purchase those products for selfish reasons.

The people who sell those items aren’t selling them because they have a kindly interest in the health of the population. They’re selling those products because they’re concerned about their own self-interest. They want to make money.

Neither the buyer nor the seller is likely to consider the effects of their actions on the people around them. However, their transactions will boost the local economy and then the larger economy.

More sales mean the owner of the sunglass hut will have enough income to hire new staff. The new employee may then spend their money on lunch at a nearby sandwich shop. And the tips they give the waitstaff will allow those workers to buy used books at the store across the street. In other words, money flows throughout the community. It benefits many people, including those that the buyer and seller of the sunglasses don’t know personally.

But what happens if too many shops open that sell sunglasses? When there are too many sellers, market prices might fall as competitors fight for the remaining customers. The customers are fewer because many have already purchased sunglasses and aren’t shopping for more.

Eventually, the low prices are likely to push some of the sellers out of the market because they can’t earn enough revenue to survive. Once that happens, the prices tend to stabilize. The sellers who were best able to navigate the difficult times will still be in business.

All this happens without direct intervention by a government agency. The frenzied local competition among the sellers of sunglasses plays out until the economy achieves its balance.

What are examples of the invisible hand at work?

The modern world contains lots of examples of Smith’s invisible hand concept that says economies can function efficiently without outside interference.

The proliferation of coffee shops at the end of the 20th century into the 21st century is one example of the invisible hand at work. Consumers flocked to coffee bars, and entrepreneurs responded by building more and more coffee spots.

The customers’ tastes and preferences gave the shop owners the feedback they needed to be successful. If customers favored certain types of coffee made from particular types of beans, owners ordered more of those beans. In turn, coffee growers who planted those beans received more orders.

Greater demand for coffee beans means more workers were needed to operate the equipment used to plant, harvest, and process the beans. So a local community in Colombia or Kenya, where many of the citizens might work in the coffee industry, could experience a boost in its economy.

The same could be said to neighborhoods where coffee shops are located. They hire more baristas. Local behavior, whether in Seattle, Atlanta, or Toronto, can have a national, or in this case, international effect.

Smith would say that an invisible hand of the market guided the farmers, the coffee shop entrepreneurs, and the customers. They made the right decisions that led to increased income for their communities.

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