Invisible hand

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In economics, the invisible hand is the term economists use to describe the self-regulating nature of the marketplace.[1] The invisible hand is a metaphor coined by the economist Adam Smith. Once in The Wealth of Nations and other writings, Smith tried to show that, in a free market, an individual pursuing his own self-interest tends to also promote the good of his community as a whole through a principle that he called “the invisible hand.” He argued that each individual maximizing revenue for himself maximizes the total revenue of society as a whole, as this is identical with the sum total of individual revenues.

Smith used the term 'invisible hand' only three times, but the metaphor later gained widespread use.

Contents

[edit] The Wealth of Nations

Adam Smith mentions the metaphor in Book IV of The Wealth of Nations, arguing that people in any society will certainly employ their capital in foreign trading only if the profits available by that method far exceed those available locally, and that in such a case it is better for society as a whole if they so did.

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavors as much he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. 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.

(IV.ii.6-9, page 456 of the 1776 Glasgow Edition of Smith’s works; vol. IV, ch. 2, p. 477 of 1776 U. of Chicago Edition.) (Book IV, Ch. II, page 484-485 Modern Library Edition, New York)

[edit] Economists' interpretation of the "invisible hand" quote

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."[2]

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 greed will drive actors to beneficial behavior. Efficient methods of production will be adopted in order to maximize profits. Low prices will be charged in order to undercut competitors. Investors will invest in those industries that are most urgently needed to maximize returns, and withdraw capital from those that are less efficient in creating value. Students will be guided to prepare for the most needed (and therefore most remunerative) careers. And all these effects will 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. Entrepreneurs can make great profits by building factories in poor countries. But because they increase the demand for labor, they will increase its price. And because the new producers will also become consumers, local businesses will have to hire more people in order to provide for them the things that they want to consume. As this process continues, the labor prices will eventually rise to the point at which there is no advantage for the foreign countries doing business in the formerly poor country. Overall, this mechanism will cause the local economy to function on its own.

In The Wealth of Nations Smith provides an example that illustrates the simplicity of 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.[3] ”

[edit] 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 which arise from actions not orchestrated by a central command and which 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 will produce socially beneficial results. An underlying unifying force that Shaftesbury called the “Will of Nature” maintains equilibrium, congruency, and harmony. This force, if it is 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.[citation needed]

[edit] 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 which 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 has argued in Darwin’s Dangerous Idea that this represents a “universal acid” which may be applied to a number of seemingly disparate areas of philosophical enquiry (consciousness and free will in particular). See also Social Darwinism.

[edit] 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 which 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.)
 ”

[edit] 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."[4]

The other is in his published work, Theory of Moral Sentiments. Here, 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."

So unequal distribution does not matter because it filters to the poor.[5] More importantly, unequal distribution of the necessaries of life is the only possible outcome given the realities of human life. Therefore, Smith argues that a society governed by an "invisible hand" or market transactions is the most just society in that it minimizes, more than any other political economy, the marginalization of the poor. 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 do not become input in the next circle is "unproductive labour" produced by a "classe stérile" (Économistes). So the beneficial results of the "invisible hand" in Smith's "Moral Sentiments" are contradicted by Smith's argument against "unproductive labour" in the "Wealth of Nations." The demand for unproductive labour is often a demand for luxuries and therefore an obstacle for deepening the division of labour (i.e. economic progress in general) and increasing the "Wealth of Nations."

[edit] Criticism

[edit] Joseph E. Stiglitz

The Nobel Prize winning economist (2001) Joseph E. Stiglitz says: "the reason that the invisible hand often seems invisible is that it is often not there." (Making Globalization Work, 2006).[6] 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 been long understood—environmental externalities. Markets, by themselves, will produce too much pollution. Markets, by themselves, will also produce too little basic research. (Remember, the government was responsible for financing most of the important scientific breakthroughs, including the internet and the first telegraph line, and most of the advances in bio-tech.)
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 will differ from time to time and place to place.[6]

[edit] Noam Chomsky

Noam Chomsky, although acknowledging the intelligence of the thesis of Adam Smith, criticizes how the term of the "invisible hand" has been misused and abused. 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, will destroy 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 will destroy 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. (...)[7]

[edit] See also

Books
Articles

[edit] References

  1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 32. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 
  2. ^ Friedman's Introduction to I, Pencil
  3. ^ Smith, Adam. "2". Wealth of Nations. http://www.econlib.org/LIBRARY/Smith/smWN1.html#B.I%2C%20Ch.2%2C%20Of%20the%20Principle%20which%20gives%20Occasion%20to%20the%20Division%20of%20Labour%2C%20benevolence. Retrieved on 2007-12-08. 
  4. ^ Minowitz, Peter. "Adam Smith's Invisible Hands" (December 2004). [1]
  5. ^ Minowitz, Peter. "Adam Smith's Invisible Hands" (December 2004). [2]
  6. ^ a b ALTMAN, Daniel. Managing Globalization. In: Q & Answers with Joseph E. Stiglitz, Columbia University and The International Herald Tribune, October 11, 2006 05:03AM.
  7. ^ http://www.chomsky.info/articles/199303--.htm

[edit] External links

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