What are the consequences of the invisible hand?

Question

I am currently reading The Wealth of Nations, and it is noticeable that the concept of the "invisible hand" appears only once in the whole book, and where it does appear, there is little in the way of details.

I would like to know what the consequences of the invisible hand are. I've sort of narrowed down on at least one possible consequence: The invisible hand of the market system gives us access to a wide variety of goods and services at lower prices than alternative economic systems. I'm stating it comparatively because I believe that it is the only way such a non-quantifiable notion can be elucidated, at least in a way that makes sense to me.

The reason I feel confident making the statement in italics is because of the connection of the invisible hand to self-interest, which encourages a business owner to improve efficiency. It all goes back to the first chapter of The Wealth of Nations, where Smith talks about how each one produces far more than they can consume, and therefore end up trading their surplus produce for other things that they might need.

I would like to know if the consequence I have derived is valid, and also if there are other consequences of this metaphor at work in a market economy. I'm looking mostly for informal insights.

Answer 1

Smith’s invisible hand concept is not related to the idea of comparing an economic system, as capitalism for instance, to other possible economic systems.

But it is an image that has become famous as it synthetizes the idea that the economic system has, in itself, the capability of self-adjustment and spontaneous coordination of economic activities, toward a ‘desirable’ state, traditionally identified as full employment of resources.

As if there were a ‘hand,’ a hidden agent, underlying the economic system and coordinating individual actions.

This was a core question of economic analysis, beginning with nineteenth century classical economists, and Smith was the most important classical economist who tried to explain this self-adjusting feature of the economic system, whereas other classical economists as Malthus and Marx hadn’t this belief.

Smith’s invisible hand is, in a sense, a continuation of a philosophical tradition, exemplified in Mandeville’s Fable of the Bees, that states that ‘private vices’ as egoism and the pursuit of individual interest, can become ‘public virtues’ in the overall functioning of human activities.

For Smith (he wrote about it in his The Theory of Moral Sentiments) egoism was not a vice also from a private point of view, provided that it is applied to the appropriate sphere of activity, that is production and exchange:

The centrale aspect of that thesis is therefore that egoism is not a disrupting factor of the society, but it can become an element of order and development. […] The Wealth of Nations represents the attempt to explain in which way the free realization of individual forces on the economic ground gives rise to the establishment and development of economic society.$^1$

In this sense, Smith confirms liberalism, and sees economic activity as the foundation of society, assigning to the State the function of ensuring the orderly functioning of economic activity.

In contemporary term, the issue about Smith’s invisible hand could be formulated in terms of the capability of self-adjustment of the economic system and, on the contrary, the existence coordination failures.

The contemporary literature about coordination failures considers Keynes as its most famous exponent, and there are other well-known economists who dealt with this approach, as Clower and Leijonhfvud, or economists who dealth with non-walrasian equilibria.

Many economists therefore think of depression as being a state of coordination failure; a state in which market forces have failed to coordinate the millions of transactors that interact daily through a web of interconnected markets. What Smith called the ‘invisible hand,’ or Mummery and Hobson (disparagingly) called the ‘automatic machinery of commerce,’ has not guided them to a state in which markets clear. Instead, people are somehow led to act at cross purposes, failing collectively to take full advantage of potential gains from trade. As Keynes put it, the system is not ‘self-adjusting'.$^2$

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$^1$ Napoleoni C., Smith, Ricardo, Marx, Boringhieri, (1973), p. 46 ( my translation).

$^2$ Howitt P., Coordination failures, (2001), p. 1,

https://www.brown.edu/Departments/Economics/Faculty/Peter_Howitt/publication/Coordination.pdf

Answer 2

Q: I would like to know if the consequence I have derived is valid, and also if there are other consequences of this metaphor at work in a market economy. I'm looking mostly for informal insights.

The consequence is valid in wide range of situations but it is not valid generally.

Invisible hand is an anthropomorphic metaphor for self organizing economic system. As Smith argues in Wealth of Nation Book IV Ch2, output/income of a nation is simply a sum of individual output. Or in Smith words;

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry

Smith had the great insight to realize that as a consequence when every individual endeavours to maximize their output/income they jointly also maximize the output of a society. Or in Smith words;

As every individual, therefore, endeavours as much as he can, both to employ his capital in the support of domestic industry, and so to direct that industry that its produce maybe of the greatest value; every individual necessarily labours 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 no part of it.

Additional insight was that this sort of spontaneous self organization is often more efficient than more top down centralized organization as bureaucrats have neither information nor the same incentives as individuals and centralized bureaucracies are prone to abuse of power. Or in Smith words;

By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. ... What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can in his local situation judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

However, it is not an insight that is always valid. The same invisible hand (i.e. mechanism of spontaneous self-organizing system) can lead to worse outcomes in various situations. Outcomes from self-organizing systems (as well as any system for that matter) depend on what incentives people face.

For example, in small market dominated by few firms that can enter into binding collusion contracts with each other the same invisible hand that delivers low prices in competitive markets might lead to higher prices and lower quantity or quality. This is because firms have incentive to bind together to maximize their profit by restricting quantity on the market for example.

However, introduce anti-trust legislation that forbids creation of 'trusts' by binding contracts and suddenly incentives change and you get back to situation where pursuit of self interest of individual firm will lead to lower prices and more quantity and quality again. This is because without enforcement mechanism even if firms would verbally agree on collusion, members of the trust can outcompete their competitors if they violate the verbal agreement and charge lower prices and supply higher quantity of products to the market (e.g. see models of collusion in some IO textbook such as Belleflamme & Peitz Industrial Organization).

Hence, the consequences of the 'invisible hand' always depend on what sort of incentives people have depending on background institutional setting (or lack of there-off). In real life spontaneously organized market economies typically significantly outperform non-spontaneous centrally planed economies because they create better incentives but this in no small amount thanks to institutions they adopt such as property rights or anti-trust legislation for example. Nonetheless, they certainly do not always deliver lower prices and larger variety of services. Especially not when there are bad institutions or lack of good ones that creates some perverse incentives (e.g. lack of property rights creates incentive for theft, short-term thinking etc).