In The Theory of Moral Sentiments, Adam Smith theorized that as every individual intends to seek out his own gains, he is “led by an invisible hand to promote an end which was no part of his intention.”
What does the invisible hand of the marketplace do? Does it suggest that at all times, there is a higher influence that guides how free markets run?
The idea of an invisible hand has nothing to do with conspiracy theories or hidden entities, but rather the natural order of the laissez-faire market. Here’s everything you need to know about how the invisible hand works through the marketplace.
What Is the Invisible Hand?
The definition of the invisible hand comes from the writings of economist and philosopher Adam Smith. In The Theory of Moral Sentiments, Smith discussed an unseen force that naturally guided the flow of a free and open market. These ideas were later expounded upon in Smith’s most important book, The Wealth of Nations.
Adam Smith and ‘The Wealth of Nations’
Published in 1776, The Wealth of Nations is considered one of the greatest treatises on economics, The book was the culmination of Smith’s research on French Physiocrats during the 18th century.
The Physiocrats believed that the true wealth of any given nation was in the value of its land and how it was developed. Because agriculture provided food and energy, this group of philosophers believed the resulting commodities should be the highest-priced items in the marketplace.
Although Smith did not necessarily agree with the idea of physiocracy, the concept would ultimately drive his economic philosophy. Instead, Smith believed that open markets with little government interference were effectively self-sufficient and would create a natural balance. Instead of centering an economy around a commodity, an economy diversified through the natural exchange of goods and services will self-regulate and create gains for everyone – as if the invisible hand directs the free market.
What Are the Main Themes of ‘The Wealth of Nations’?
Smith’s economic theories revolved around five different themes: how nations built true wealth, the division of labor, potential wealth through productivity, the invisible hand guiding the government, and the constant threat of monopolies and government interference.
1. Wealth Through Gross National Product
The first important concept from The Wealth of Nations is how nations accumulate wealth. While physiocrat theory argued that wealth was from land, Smith argued that wealth was built through healthy supply chains that were constantly exchanging goods and services. This introduced the idea of wealth from gross national product: the sum of all domestic and foreign output created by those in a nation.
2. Production and Exchange via Labor Markets
In order for a nation to have a strong gross national product, labor must be divided appropriately throughout the supply chain. Instead of having a few people working on production of goods or services, Smith posited that the invisible hand pushed a healthy labor scalability among specialized workers.
More specialized hands could produce more efficiently, putting more inventory on the market and creating a natural cash flow which could then be reinvested in labor or in machinery to create even more efficient workflows.
3. National Wealth Through Productivity
According to Smith, this labor market flexibility ultimately decided how much potential wealth a nation could create. As companies invested in their employees to drive efficiency, the invisible hand would ultimately create more national wealth.
The converse of this theory is also true: If labor is not appropriately divided – and production systems remain inefficient – a nation’s ability to grow wealth is limited.
4. An Economy Is an Automatic System
Because the invisible hand drives natural flows of labor and production, an economy can run automatically and self-adjust based on the law of supply. When demand is high and production is low, companies naturally adjust their labor to provide goods at a higher price. On the opposite side, if there’s too much supply and too little demand, companies will naturally shift towards production that is more profitable.
5. Monopolies and Tax Breaks are Counterproductive
In order for the invisible hand to automatically guide economies, the market has to run with as little interference as possible. Monopolies, favorable tax breaks, and other government interference can create complications which can throw off economic balance. Smith argued that the government should be in charge of national defense, public safety, public education, and infrastructure systems. Outside of these roles, the government should not interfere in – or attempt to guide – a balanced economy.
Adam Smith & the Invisible Hand
The five themes from The Wealth of Nations ultimately created a model for what Smith believed to be an ideal marketplace. Many of America’s current economic theories are based on Smith’s influence.
Invisible Hand and Self-Interest
One of the key ideas Adam Smith’s invisible hand refers to is self-interest driving supply chains and creating a cash flow cycle. As people seek out the goods and services they need to live, it puts in motion a continual chain of events that financially rewards activities that sustain life (and drives innovations for a better future). Thus, acting in self-interest equally benefits the community.
Invisible Hand vs. Laissez-Faire
The laissez-faire market theory suggests an ideal economy works when it is allowed to self-regulate without government interference. Adam Smith’s invisible hand complements this idea because it suggests self-interested consumer activities will naturally reward activities that move the economy forward. Alternatively, the invisible hand will naturally move “bad actors” out of the marketplace through non-participation. Active market participants will identify those looking to exploit negative actions and ultimately force them out of business.
Invisible Hand and Equilibrium
Like other economic theories (including Walras’s Law), Smith argued that an invisible hand could regulate the free market towards equilibrium. Even though individuals seek to protect their own interests, their survival requires regular trades within a community. Therefore, an uninterrupted economy automatically creates equilibrium through mutual gain.
Invisible Hand and Government Intervention
Equal parts philosophy and economic theory, Adam Smith’s invisible hand suggests that collective human behavior is self-regulating. Therefore, government intervention is not required and should be limited to its areas of regulation.
When Does the Invisible Hand Guide Economic Activity?
In theory, the invisible hand directs the free market by directing market participants and cash towards activities that drive communal success. But in practice, the idea of an invisible hand is dependent on the actions of the society.
If a society works together driven by its natural survival instincts, then the invisible hand correctly guides economic activity. When irrational behavior (like external costs of production and macroeconomic factors) affect a market, Smith’s concept can get lost quickly.
Are the Invisible Hand and Capitalism Related?
Although the ideas of the invisible hand and capitalism are related, they are not necessarily complementary to one another. The invisible hand theory suggests that both consumers’ and private business’ self interest benefit the public good. As a result, community wealth builds through mutual benefit.
In a perfect market, the invisible hand in capitalism guides economic activity where the need is greatest. Instead of artificially driving up prices on commodities to create gains, the invisible hand will drive capitalism to create equilibrium through competition and innovation.
Invisible Hand Examples
An invisible hand example can be found in the retail world. Customers expect a hardware store to have hand tools. Understanding customer demand, the hardware store orders enough hand tools from the distributor to keep shelves stocked. The distributor in turn orders the tools from suppliers, who in turn order the raw materials to create those tools.
In this situation, the invisible hand guides both the consumer and the flow of the marketplace. By looking out for themselves, the end customers enact a chain of labor and cash flow. As the individual buys items, cash flow goes up the chain from the retailer, to the distributor, to the manufacturer, to the material suppliers. These products and services flow back down the chain where the process continually repeats.
Why Is the Invisible Hand Theory Important?
The invisible hand theory is an important economic model because it creates balance through promoting the best practices to improve community wealth. If the theory is applied perfectly, market players create balance between supply and demand. As a result, resources are preserved, gross national product grows naturally, and the welfare of society is improved.
Furthermore, the idea of an invisible hand guiding economic growth thrives on being in a free market. Because of this, economists and scholars have continually focused on how it can help create self-regulation throughout the market.