Definition: The unobservable market force that helps the demand and supply of goods in a free

market to reach equilibrium automatically is the invisible hand.

Description: The phrase invisible hand was introduced by Adam Smith in his book 'The Wealth
of Nations'. He assumed that an economy can work well in a free market scenario where
everyone will work for his/her own interest.

He explained that an economy will comparatively work and function well if the government will
leave people alone to buy and sell freely among themselves. He suggested that if people were
allowed to trade freely, self interested traders present in the market would compete with each
other, leading markets towards the positive output with the help of an invisible hand.

In a free market scenario where there are no regulations or restrictions imposed by the
government, if someone charges less, the customer will buy from him. Therefore, you have to
lower your price or offer something better than your competitor. Whenever enough people
demand something, it will be supplied by the market and everyone will be happy. The seller end
up getting the price and the buyer will get better goods at the desired price.

The invisible hand is a concept that – even without any observable intervention – free
markets will determine an equilibrium in the supply and demand for goods.

The invisible hand means that by following their self-interest – consumers and firms can
create an efficient allocation of resources for the whole of society.

How does the invisible hand work?

Suppose, a firm was charging a very high price for bread – £4 a loaf. This creates an
incentive for another baker to sell at a lower price, say £2. Consumers will then switch
from the high-cost bread to the low cost bread. This competitive pressure means that
the price will fall – until there is an equilibrium between supply and demand. We don’t
need a government to set an equilibrium price – the market price will automatically
occur from all the actions of firms and supplies.

How does invisible hand deal with shortages?

Suppose, a good was in short supply. At the current price, demand was greater than
supply – leading to queues.

In this case, firms have an incentive to increase the price and/or firms have an incentive
to increase supply – invest in production. The net effect, is that prices will rise until
equilibrium is reached and the shortage is overcome.
Therefore, over time, prices and supply will adjust until the market returns to equilibrium.

Invisible hand – Adam Smith

In the Wealth of Nations (1783) Adam Smith mentioned the term ‘invisible hand’ on two
occasions. The book is an important explanation of how free markets can operate.

Every individual… neither intends to promote the public interest, nor knows how
much he is promoting it… 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.
The Wealth Of Nations, Book IV, Chapter II, p. 456, para. 9.

Smith is saying that individuals consider their selfish aims – businessman to make
profit, consumer to purchase cheap goods. However, by seeking to make profit, firms
end up helping to create a more efficient economy that leads to an equilibrium the
market for goods.
 Adam Smith also mentions the concept of ‘invisible hand’ in another work “The Theory
of Moral Sentiments.”

The rich…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 thus without intending it, without
knowing it, advance the interest of the society…
The Theory of Moral Sentiments (1776) Part IV, Chapter 1.

This is a different interpretation. It suggests that those with wealth, will be led by some
invisible force to redistribute their wealth – either through charity or paying workers
higher wages.

In the nineteenth century, Karl Mark argued capitalist inequality would lead to revolution,
but as capitalists become more wealthy – this started to trickle down to workers. In the
period 1850-1990, there was a rise in real wages for most workers in the western world.
Higher real wages also benefited capitalists as they could sell more goods.

Short video on the invisible hand

Implications of the invisible hand

 For most goods and services, there is no need for government regulation and price
controls. The ‘invisible hand’ of market forces will ensure the optimal price and output.
 Agents pursuing self-interest can contribute towards societies well-being – even if they
don’t mean to.
 If owners of capital increase in wealth -there can be a trickle-down effect to benefit
everyone in society.
 Private business will follow their profit motive to find the most efficient use of investment
funds.
 Free trade is beneficial. Free trade enables firms to specialise in goods where they have
a comparative advantage.

Limitations of the invisible hand

“The reason that the invisible hand often seems invisible is that it is often not
there.”
Joseph Stiglitz

Monopoly Power. Adam Smith himself was aware of how firms with monopoly power
could cause prices to be pushed above the equilibrium. Without sufficient competitive
pressure, firms could become stagnant, inefficient and exploit customers through higher
prices.
 Externalities. The invisible hand can lead to an efficient outcome – if there are no
external costs/benefits. But, if there are significant externalities – e.g. pollution costs,
then the free market can lead to over-production of goods with these external costs.

Tragedy of the commons. This is a situation where people pursuing self-interest can
lead to depletion of natural resources, e.g. over-fishing in the sea. Tragedy of the
commons

Irrational behaviour. The theory of the invisible hand and free-markets suggests
consumers and firms are rational. However, in industries, such as finance we can see
individuals can get carried away with irrational exuberance. This can lead to booms in
asset prices – and prices distorted from economic realities. See: Criticisms of efficient
market hypothesis

Time lags and immobilities. If an industry closes down, then the invisible hand may
push the unemployed to move and get a job in another industry. However, in reality,
there are occupational and geographical immobilities, therefore, resources (labour and
capital) can become unemployed for a long time)

Limitations of selfish actions. The invisible hand could be used to justify selfish
actions. But, to some, this is the wrong approach. You could argue the motivation is
important and individuals should be aware of the actions on the rest of society – rather
than gaining justification to be just selfish.

Role and Function of Price in

Economy
The price of goods plays a crucial role in determining an efficient distribution of
resources in a market system.

 Price acts as a signal for shortages and surpluses which help firms and consumers
respond to changing market conditions.
 If a good is in shortage – price will tend to rise. Rising prices discourage demand, and
encourage firms to try and increase supply.
 If a good is in surplus – price will tend to fall. Falling price encourage people to buy, and
cause firms to try and cut back on supply.
 Prices help to redistribute resources from goods with little demand to goods and
services which people value more.
 Adam Smith talked about ‘the invisible hand‘ of the market. This ‘invisible hand’ relies
on the fluctuation of prices to shift resources to where it is needed.

Example of how price influences a market

 1. Fall in supply causes higher price

 As the supply of oil falls, the price rises.

 In the short-term, demand is price inelastic and so there is only a small fall in demand.

2. Impact in long-term

However, markets do not stay static. If price rises, the profitability of producing oil
increases. Firms can now make super-normal profit because the marginal revenue is
greater than marginal cost.

Therefore, this higher price acts as an incentive for firms to try and increase supply. For
example, at a low price, it was not worth drilling for oil in the North Sea, but with the
higher price, it is an incentive.
 Therefore, in the long-term, the higher price causes more investment in the industry and
supply can increase back to S LR

How price affects consumer behaviour

In the short-term, demand is very price inelastic. However, the higher price of oil also
has an effect on consumer behaviour in the long-term.

 Consumers look for more fuel-efficient engines as people are keener to buy cars which
have a better fuel efficiency. Therefore, over time, demand falls.
 Over time, people may start cycling or getting the bus rather than driving.
 Responding to these changing consumer preferences, firms have incentives to develop
cars which don’t run on petrol. (hydrogen powered cars, solar cars e.t.c) – enabling
more alternatives leads to less demand in long-term.
Therefore, in theory, the rising price of oil will help move the economy away from oil
dependency to other means of transport and energy.

Some people think we will wake up one day and there will be no oil left and the
economy will collapse. But, that is unlikely to happen. Prices will create signals to firms
and consumers to look for alternatives.

The importance of price and profit in perfect competition

In this diagram, an increase in industry demand has led to an increase in price. This
higher price means that firms now make supernormal profits.

Supernormal profits encourage new firms to enter the market. Supply will increase until
prices fall back to P1.
 Price and allocative efficiency

Allocative efficiency is said to occur where the marginal benefit from a good equals the
marginal cost. This allocative efficiency will occur at an output where the price =
marginal cost.

Limitations of price in the economy

Although the price has an important role in the economy, it has some limitations.

 In presence of externalities, the price of goods does not reflect the true social
cost / social benefit. Therefore, a free market can cause under or over-consumption.
 Inequality. Price helps resources shift to areas of greatest demand, but it could lead to
an inequitable distribution of resources. For example in a draught, the market price of
water could rise so much, people don’t have enough to drink. In this scenario, it may be
 more appropriate to introduce a scheme of rationing – to ensure a fair distribution,
rather than efficient distribution.
 Monopoly. In a monopoly, high prices may not reflect shortages, but reflect monopoly
power and this leads to allocative inefficiency.