Definition of invisible hand
What is the invisible hand?
The invisible hand is a metaphor for the invisible forces that drive the free market economy. Through individual self-interest and freedom of production as well as consumption, the best interest of society as a whole is satisfied. The constant interplay of individual pressures on market supply and demand results in the natural movement of prices and the flow of trade.
The invisible hand is part of laissez-faire, meaning “let go / let go”, market approach. In other words, the approach argues that the market will find its balance without government or other interventions forcing it to adopt unnatural patterns.
Scottish Enlightenment thinker Adam Smith introduced the concept in several of his writings, but he found this economic interpretation in his book. An inquiry into the nature and causes of the wealth of nations published in 1776 and in The theory of moral feelings published in 1759. The term was used in an economic sense during the 1900s.
The metaphor of the invisible hand distils two critical ideas. First, voluntary trade in a free market produces unintended and pervasive benefits. Second, these advantages are greater than those of a regulated and planned economy.
Invisible hand explained
Every free trade creates signals about valuable goods and services and how difficult it is to bring them to market. These signals, picked up in the price system, spontaneously direct competing consumers, producers, distributors and middlemen – each pursuing their individual plans – to meet the needs and wants of the others.
Key points to remember
- A metaphor for how, in a free market economy, interested individuals operate through a system of mutual interdependence.
- Adam Smith introduced the concept in his book An Inquiry into the Nature and Causes of the Wealth of Nations published in 1776.
- Every free trade creates signals about valuable goods and services and how difficult it is to bring them to market.
Each individual necessarily strives to make the annual income of the company as large as he can … He aims only for his own security, and he is in this, as in many other cases, led by one hand. invisible to promote an end that was not part of his intention … By pursuing his own interests, he often promotes that of society more effectively than when he really intends to promote it. I have never known much good done by those who traded for the public good.
Real world example of invisible hand
Business productivity and profitability are improved when profits and losses reflect exactly what investors and consumers want. This concept is well demonstrated through a famous example of Richard Cantillon An essay on economic theory (1755), the book from which Smith developed his concept of the invisible hand.
Cantillon described an isolated estate divided into competing leased farms. Independent contractors managed each farm to maximize their production and yields. Successful farmers introduced better equipment and techniques and only brought to market products that consumers were willing to pay for. He showed that the returns were much higher when competing personal interests ran the estate rather than the previous owner’s run economy.
An inquiry into the nature and causes of the wealth of nations was released during the First Industrial Revolution and the same year as the American Declaration of Independence. Smith’s invisible hand has become one of the main justifications for an economic system of free market capitalism.
As a result, the business climate in the United States has developed with a general understanding that voluntary private markets are more productive than government-run economies. Even government rules sometimes try to incorporate the invisible hand. Former Fed Chairman Ben Bernanke explained that “the market-based approach is regulation by the invisible hand” which “aims to align the incentives of market players with the objectives of the regulator”.