Invisible hand

The invisible hand is a metaphor inspired by the Scottish economist and moral philosopher Adam Smith that describes the incentives which free markets sometimes create for self-interested people to accidentally act in the public interest, even when this is not something they intended. Smith originally mentioned the term in two specific, but different, economic examples. It is used once in his '' Theory of Moral Sentiments'' when discussing a hypothetical example of wealth being concentrated in the hands of one person, who wastes his wealth, but thereby employs others. More famously, it is also used once in his '' Wealth of Nations'', when arguing that governments do not normally need to force international traders to invest in their own home country. In both cases, Adam Smith speaks of ''an'' invisible hand, never of ''the'' invisible hand.

Going far beyond the original intent of Smith's metaphor, twentieth-century economists, especially Paul Samuelson, popularized the use of the term to refer to a more general and abstract conclusion that truly free markets are self-regulating systems that always tend to create economically optimal outcomes, which in turn cannot be improved upon by government intervention. The idea of trade and market exchange perfectly channelling self-interest toward socially desirable ends is a central justification for newer versions of the '' laissez-faire'' economic philosophy which lie behind neoclassical economics.

Adam Smith was a proponent of less government intervention in his own time, and of the possible benefits of a future with more free trade both domestically and internationally. However, in a context of discussing science more generally, Smith himself once described "invisible hand" explanations as a style suitable for unscientific discussion, and he never used it to refer to any general principle of economics. His argumentation against government interventions into markets were based on specific cases, and were not absolute. Putting the invisible hand itself aside, while Smith's various ways of presenting the case against government management of the economy were very influential, they were also not new. Smith himself cites earlier enlightenment thinkers such as Bernard Mandeville. Smith's invisible hand argumentation may have also been influenced by Richard Cantillon and his model of the isolated estate.

Because the modern use of this term has become a shorthand way of referring to a key neoclassical assumption, disagreements between economic ideologies are now sometimes viewed as disagreement about how well the "invisible hand" is working. For example, it is argued that tendencies that were nascent during Smith's lifetime, such as large-scale industry, finance, and advertising, have reduced the effectiveness of the supposed invisible hand.Olsen, James Stewart. ''Encyclopedia of the Industrial Revolution''. Greenwood Publishing Group, 2002. pp. 153–154

History of the terms and concepts

The term "invisible hand" has classical roots, and it was relatively widely used in 18th-century English. Adam Smith's own usage of the term did not attract much attention until many generations after his death. In his early unpublished essay on ''The History of Astronomy'' (written before 1758) he specifically described this type of explanation as a common and unscientific way of thinking. Smith wrote that superstitious people, or people with no time to think philosophically about complex chains of cause and effect, tend to explain irregular, unexpected natural phenomena such as "thunder and lightning, storms and sunshine", as acts of favour or anger performed by "gods, daemons, witches, genii, fairies". For this reason the philosophical or scientific study of nature can only begin when there is social order and security, so that people are not living in fear, and can be attentive. Because of this background, a wide range of interpretations have been given to the fact that Smith himself used the metaphor twice when discussing economic topics. On one extreme it has been argued that Smith was literally suggesting that divine intervention is at play in the economy, and at the other extreme it has been suggested that Smith's use of this metaphor shows that he was being sarcastic.

The modern conception of a free market causing the best possible economic result, which is now commonly associated with the term "invisible hand", also developed further, going beyond Smith's conception. It has been influenced by arguments for free markets found not only in Smith's works, but also by earlier writers such as especially Bernard Mandeville, and later more mathematical approaches by economists such as Pareto and Marshall.

Adam Smith's use of the term in economics

''The Wealth of Nations''

The invisible hand is explicitly mentioned only once in the ''Wealth of Nations'', in a specialized chapter not about free trade but about capital investment, which discusses the concern that international merchants might choose to invest in foreign countries. Smith argues that a self-interested investor will have a natural tendency to employ his capital as near home as he can, as long as the home market does not give much lower returns than other alternatives. This in turn means...

As noted by William D. Grampp, this example involves "a particular condition that may or may not be present in a transaction on a competitive market". Essentially, the invisible hand refers to the unintended positive consequences self-interest has on the promotion of community welfare. Nevertheless, Smith draws a practical implication in this case is that legislators should not intervene too hastily in many (if not all) cases:

According to Grampp:

''The Theory of Moral Sentiments''

Smith's first use of the invisible hand metaphor occurs in ''The Theory of Moral Sentiments'' (1759) in Part IV, Chapter 1, where he describes a selfish landlord being led by an invisible hand to distribute his harvest to those who work for him. This passage concerns the distribution of wealth: the poor receive the "necessities of life" after the rich have gratified "their own vain and insatiable desires". It has been noted that in this passage Smith seems to equate the invisible hand to " Providence", implying a divine plan.

Although this passage concerns an economic topic in a broad sense, it does not concern "the invisible hand" of the free market as understood by twentieth century economists, but is instead about income distribution. There is no repeat of this argumentation in Smith's comprehensive work on economics in his later ''Wealth of Nations'', and income distribution is not a central concern of modern neoclassical market theory. As Blaug noted in the ''New Palgrave Dictionary of Economics'' this passage "dispels the belief that Smith meant one thing and one thing only by the metaphor of 'the invisible hand'." Grampp has claimed that if there is any connection between this passage and Smith's other one, "it has not been demonstrated with evidence from what Smith actually wrote".

The reinterpretation by modern economists

In contrast to Smith's own usage, the "invisible hand" today is often seen as being specifically about the benefits of voluntary transactions in a free market, and is treated as a generalizable rule. Paul Samuelson's comments in his ''Economics'' textbook in 1948 made the term popular and gave it a new meaning. The phrase was not originally commonly referred to among economists before the twentieth century. Alfred Marshall never used it in his '' Principles of Economics'' textbook and neither does William Stanley Jevons in his ''Theory of Political Economy''. Samuelson's remark was as follows:

In this interpretation, the theory is that 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 self-interest drives actors to beneficial behavior in a case of serendipity. Efficient methods of production are adopted to maximize profits. Low prices are charged to maximize revenue through gain in market share by undercutting competitors. Investors invest in those industries most urgently needed to maximize returns, and withdraw capital from those less efficient in creating value. All these effects take place dynamically and automatically.

Since Smith's time, this concept has been further incorporated into economic theory. Léon Walras developed a four-equation general equilibrium model that 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'' uses the expression "the invisible hand of Providence", referring to Marx's period, to mean evolutionary meliorism. He did not mean this as a criticism, since he held that secular reasoning leads to similar conclusions. Milton Friedman, a Nobel Memorial Prize winner in economics, called Smith's Invisible Hand "the possibility of cooperation without coercion." Kaushik Basu has called the First Welfare Theorem the Invisible Hand Theorem.

Some economists question the integrity of how the term "invisible hand" is currently used. Gavin Kennedy, Professor Emeritus at Heriot-Watt University in Edinburgh, Scotland, argues that its current use in modern economic thinking as a symbol of free market capitalism is not reconcilable with the rather modest and indeterminate manner in which it was employed by Smith. In response to Kennedy, Daniel Klein argues that reconciliation is legitimate. Moreover, even if Smith did not intend the term "invisible hand" to be used in the current manner, its serviceability as such should not be rendered ineffective. In conclusion of their exchange, Kennedy insists that Smith's intentions are of utmost importance to the current debate, which is one of Smith's association with the term "invisible hand". If the term is to be used as a symbol of liberty and economic coordination as it has been in the modern era, Kennedy argues that it should exist as a construct completely separate from Adam Smith since there is little evidence that Smith imputed any significance onto the term, much less the meanings given it at present.

The former Drummond Professor of Political Economy at Oxford, D. H. MacGregor, argued that:

Harvard economist Stephen Marglin argues that while the "invisible hand" is the "most enduring phrase in Smith's entire work", it is "also the most misunderstood."

According to Emma Rothschild, Smith was actually being ironic in his use of the term. Warren Samuels described it as "a means of relating modern high theory to Adam Smith and, as such, an interesting example in the development of language."

Proponents of liberal economics, for example Deepak Lal, regularly claim that the invisible hand allows for market efficiency through its mechanism of acting as an indicator of what the market considers important, or valuable.

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 that arise from actions not orchestrated by a central command, and that 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 produces socially beneficial results. An underlying unifying force that Shaftesbury called the "Will of Nature" maintains equilibrium, congruency, and harmony. This force, 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.

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 argues in '' Darwin's Dangerous Idea'' that this represents a "universal acid" that may be applied to a number of seemingly disparate areas of philosophical inquiry (consciousness and free will in particular), a hypothesis known as Universal Darwinism. Positing an economy guided by this principle as ideal may amount to Social Darwinism, which is also associated with champions of ''laissez-faire'' capitalism.

Tawney's interpretation

Christian socialist R. H. Tawney saw Smith as putting a name on an older idea:

Criticisms

Joseph E. Stiglitz

The Nobel Prize-winning economist Joseph E. Stiglitz, says: "the reason that the invisible hand often seems invisible is that it is often not there."ALTMAN, Daniel. ''Managing Globalization.'' In: ''Q & Answers'' with Joseph E. Stiglitz, Columbia University and ''The International Herald Tribune'', October 11, 2006
Stiglitz explains his position:

The preceding claim is based on Stiglitz's 1986 paper, "Externalities in Economies with Imperfect Information and Incomplete Markets", which describes a general methodology to deal with externalities and for calculating optimal corrective taxes in a general equilibrium context. In it he considers a model with households, firms and a government.

Households maximize a utility function $u^(x^, z^)$, where $x^$ is the consumption vector and $z^$ are other variables affecting the utility of the household (e.g. pollution). The budget constraint is given by $x^_+q \cdot \bar^\leq I^+\sum a^ \cdot \pi^$, where q is a vector of prices, a^hf the fractional holding of household h in firm f, π^f the profit of firm f, I^h a lump sum government transfer to the household. The consumption vector can be split as $x^=\left( x^_, \bar^ \right)$.

Firms maximize a profit $\pi^=y^_+p\cdot \bar_$, where y^f is a production vector and p is vector of producer prices, subject to $y^_-G^(\bar^, z^) \leq 0$, G_f a production function and z^f are other variables affecting the firm. The production vector can be split as $y^=\left( y^_, \bar^ \right)$.

The government receives a net income $R=t \cdot\bar-\sum I^$, where $t=(q-p)$ is a tax on the goods sold to households.

It can be shown that in general the resulting equilibrium is not efficient.

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!Proof
, -
, It is worth keeping in mind that an equilibrium for the model may not necessarily exist. If it exists and there are no taxes (I^h=0, ∀h), then demand equals supply, and the equilibrium is found by:

$\sum \bar{x} ^{h} (q,I,z) - \sum \bar{y}^{f}(p,z)=\bar{ x } (q,I,z) - \sum \bar{y}^{f}(p,z)=0$

Let us use $\frac{\partial E^{h{\partial q}=E^{h}_{q}$ as a simplifying notation, where $E^{h}\left( q, z^{h}, u^{h} \right)$ is the expenditure function that allows the minimization of household expenditure for a certain level of utility. If there is a set of taxes, subsidies, and lump sum transfers that leaves household utilities unchanged and increase government revenues, then the above equilibrium is not Pareto optimal. On the other hand, if the above non taxed equilibrium is Pareto optimal, then the following maximization problem has a solution for t=0:

: $\begin{align} &\underset{t,I}{\operatorname{maximize& & R = t \cdot \bar{ x } - \sum I^{h} \\ &\operatorname{subject\;to} & & I^{h}+\sum a^{hf} \pi ^{f} =E^{h} (q,z^{h}; \bar{u}^{h}) \\ \end{align}$

This is a necessary condition for Pareto optimality. Taking the derivative of the constraint with respect to t yields:

$\frac{dI^{h{dt}+\sum a^{hf}\left( \pi^{f}_{z} \frac{dz^{f{dt}+\pi^{f}_{P} \frac{dp}{dt} \right)=E^{h}_{q} \frac{dq}{dt}+E^{h}_{z} \frac{dz^{h{dt}$

Where $\pi^{f}_{z}=\frac{\partial \pi^{f}_{*{\partial z^{f$ and $\pi^{f}_{*}(p,z^{f})$ is the firm's maximum profit function. But since q=t+p, we have that dq/dt=I_N-1+dp/dt. Therefore, substituting dq/dt in the equation above and rearranging terms gives:

$E^{h}_{q}+\left( E^{h}_{q} - \sum a^{hf} \pi^{f}_{P} \right)\frac{dp}{dt}=\frac{dI^{h{dt}+\left\{ \sum a^{hf} \pi^{f}_{z} \frac{dz^{f{dt} -E^{h}_{z} \frac{dz^{h{dt} \right\}$

Summing over all households and keeping in mind that $\sum a^{hf}=1$ yields:

$\sum E^{h}_{q}+\left(\sum E^{h}_{q} - \sum \pi^{f}_{P} \right)\frac{dp}{dt}=\sum \frac{dI^{h{dt}+\left\{\sum \pi^{f}_{z} \frac{dz^{f{dt} -\sum E^{h}_{z} \frac{dz^{h{dt} \right\}$

By the envelope theorem we have:

$\widehat{ x }^{h}_{k}(q;z^{h},u^{h}) = \left. \frac{\partial E^{h{\partial q}\_{z^{h},u^{h$

$\left. \frac{\partial \pi^{f}_{*{\partial p_{k_{1}\_{z^{f=y^{f}_{k}$;∀k

This allows the constraint to be rewritten as:

$\bar{x} + \left( \bar{ x } - \bar{ y } \right)\frac{dp}{dt}=\sum\frac{dI^{h{dt}+\left( \sum\pi^{f}_{z}\frac{dz^{f{dt} - \sum E^{h}_{z} \frac{dz^{h{dt} \right)$

Since $\bar{x}=\bar{y}$:

$\sum \frac{dI^{h{dt}= \bar{ x } - \left( \sum \pi^{f}_{z} \frac{dz^{f{dt} - \sum E^{h}_{z} \frac{dz^{h{dt} \right)$

Differentiating the objective function of the maximization problem gives:

$\frac{dR}{dt}= \bar{ x } + \frac{d\bar{x{dt} \cdot t - \sum \frac{dI^{h{dt}$

Substituting $\sum \frac{dI^{h{dt}$ from the former equation in to latter equation results in:

$\frac{dR}{dt}= \frac{d\bar{x{dt} \cdot t +(\sum \pi ^{f}_{z} \frac{dz^{f{dt} - \sum E^{h}_{z} \frac{dz^{h{dt}) =\frac{d\bar{x{dt} \cdot t +(\Pi^{t} - B^{t})$

Recall that for the maximization problem to have a solution a t=0:

$\frac{dR}{dt} = \left( \Pi^{t} - B^{t} \right) = 0$

In conclusion, for the equilibrium to be Pareto optimal dR/dt must be zero. Except for the special case where Π and B are equal, in general the equilibrium will not be Pareto optimal, therefore inefficient.

Noam Chomsky

Noam Chomsky suggests that Smith (and more specifically David Ricardo) sometimes used the phrase to refer to a "home bias" for investing domestically in opposition to offshore outsourcing production and neoliberalism.American Decline: Causes and Consequences
Noam Chomsky

Stephen LeRoy

Stephen LeRoy, professor emeritus at the University of California, Santa Barbara, and a visiting scholar at the Federal Reserve Bank of San Francisco, offered a critique of the Invisible Hand, writing that "The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. (...) The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith...are accurate for modern economies.

John D. Bishop

John D. Bishop, a professor who worked at Trent University, Peterborough, indicates that the invisible hand might be applied differently to merchants and manufacturers from how it is applied with society. He wrote an article in 1995 titled "Adam Smith's Invisible Hand Argument", in which he suggests that Smith might be contradicting himself with the "Invisible Hand". He offers various critiques of the "Invisible Hand", and he writes that "the interest of business people are in fundamental conflict with the interest of society as a whole, and that business people pursue their personal goal at the expense of the public good". Thus, Bishop indicates that the "business people" are in conflict with society over the same interests and that Adam Smith might be contradicting himself. According to Bishop, he also gives the impression that in Smith's book 'The Wealth of Nations,' there's a close saying that "the interest of merchants and manufacturers were fundamentally opposed of society in general, and they had an inherent tendency to deceive and oppress society while pursuing their own interests." Bishop also states that the "invisible hand argument applies only to investing capital in one's own country for a maximum profit." In other words, he suggests that the invisible hand applies to only the merchants and manufacturers and that they're not the invisible force that moves the economy. He contends the argument "does not apply to the pursuit of self-interest (...) in any area outside of economic activities".

Thomas Piketty

French economist Thomas Piketty notes that although the Invisible Hand does exist and thus that economic imbalances correct themselves over time, those economic imbalances may lead to an extended unoptimal utility, which could be solved thanks to non-commercial processes. He takes for instance the cases of real estate of which imbalances may last decades, and of the Great Famine of Ireland, which could have been avoided by shipments of food from Great Britain to areas in crisis without waiting for new bread producers to come.

See also

* Emergence
* Enlightened self-interest
* Free price system
* Greed is good
* Laissez-faire
* Market fundamentalism
* Order of the Occult Hand
* Rational egoism
* Self-licensing
* Spontaneous order
* Trickle-down economics
* The Visible Hand: The Managerial Revolution in American Business
* Vanishing Hand

References

Bibliography

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Further reading

* Sen, Amartya. Introduction. The Theory of Moral Sentiments. By Adam Smith. 6th ed. 1790. New York: Penguin, 2009. vii–xxix.

''The Theory of Moral Sentiments'' (full text)



(full text)

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