Invisible hand

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The invisible hand is a metaphor coined by Adam Smith to illustrate how those who seek wealth by following their individual self-interest, inadvertently stimulate the economy and assist society as a whole. In the general opinion, in The Wealth of Nations and other writings, Smith claims that, in capitalism, an individual pursuing his own good tends also to promote the good of his community, through a principle that he called “the invisible hand” of the market, which ensures that those activities most beneficial and efficient will naturally be those that are most profitable. The specific mechanism for this, Smith saw as being the free price system.[1]

Contents

[edit] The Wealth of Nations

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

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 as 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 1976 Glasgow Edition of Smith’s works; vol. IV, ch. 2, p. 477 of 1976 U. of Chicago Edition.)

[edit] Economists' Interpretation of The Wealth of Nations 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.

Notice that the invisible hand is here considered a natural inclination, not yet a social mechanism as it will be classified after Leon Walras and Vilfredo Pareto.

Many economists claim that 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 the entire community. 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. Capitalists can make great profits by building factories in poor countries. But since they increase the demand for labor, they will increase its price. And since 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 a metaphor 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 interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of their fellow-citizens.

[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 claimed 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 claimed 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.”

A contemporary example of such an effect could be the far-reaching social benefit realized via the proliferation of computers and commercial software; goods which have been produced almost entirely by people trying to maximize their own economic gain. Presumably those producers didn’t manufacture the computers and develop the software out of a love for humanity or an altruistic desire to promote society’s collective fortune. Any social benefits that have accrued therefore, according to Smith’s doctrine, are simply a by-product of their striving for selfish reward.

Contrary to common misconceptions, Smith did not assert that all self-interested labor necessarily benefits society, or that all public goods are produced through self-interested labor. 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, capitalism 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.

[edit] Examples and arguments

A very simple real world example of how the invisible hand is supposed to work is the queue for a shop checkout. Each customer getting in line selfishly chooses to maximize his own interest, that is to checkout in the shortest time, regardless of the other customers. Their utility maximizing choice is to get in queue in the shortest line, this means that eventually customers queue up in lines all of the same length. Therefore even without the slightest direction and by following only their selfishness, the lines are all of the same length, which is clearly the most efficient disposition.

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 in so far 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 Usages of the Phrase

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.

The other is in his published work, Theory of Moral Sentiments (1759). Here, Smith uses the invisible hand to explain the distribution of wealth. The invisible hand is active in economics because the landlord can not consume all of the products himself and is thus forced to distribute them in exchange for work and for other goods.

[edit] Criticism

The American philosopher Noam Chomsky points out that Smith's metaphor from this book is wildly taken out of context by many of today's mainstream economists:

Let's... keep to Adam Smith, a very important figure. He was pre-capitalist in his conceptions, and often quite interesting. For example, his basic argument for his rather nuanced views about markets: that under conditions of liberty they would lead to equality, an obvious desideratum. Or his one use of the term "invisible hand" in "Wealth of Nations," in an argument for what economic historians call "home bias," in effect an argument against what is now called "neoliberalism" or "neoclassical economics." Smith argued that the English economy, what he cared about, would be wrecked if British capitalists were to invest abroad and import from abroad, but it would not be a problem, because "home bias" would lead them to invest at home and use domestically-produced goods, and therefore, by an "invisible hand," Britain would be saved from the ravages of international markets. Or his argument against division of labor, and insistence that in any civilized society, governments would intervene to constrain it, because it would turn working people into creatures as stupid and ignorant as a human creature can be -- essentially on von Humboldt's assumptions. Yes, Smith is very much worth reading, whether one agrees with his interesting work or not. Reading, not worshipping on the basis of concocted mythology. [1]

Further, Adam Smith himself frequently warned in Wealth of Nations about how the invisible hand can lead to disastrous outcomes (as Chomsky pointed out [2]). For instance:

In the progress of the division of labour, the employment of the far greater part of those who live by labour, that is, of the great body of the people, comes to be confined to a few very simple operations, frequently to one or two. But the understandings of the greater part of men are necessarily formed by their ordinary employments. The man whose whole life is spent in performing a few simple operations, of which the effects are perhaps always the same, or very nearly the same, has no occasion to exert his understanding or to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become. The torpor of his mind renders him not only incapable of relishing or bearing a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment, and consequently of forming any just judgment concerning many even of the ordinary duties of private life. Of the great and extensive interests of his country he is altogether incapable of judging, and unless very particular pains have been taken to render him otherwise, he is equally incapable of defending his country in war. The uniformity of his stationary life naturally corrupts the courage of his mind, and makes him regard with abhorrence the irregular, uncertain, and adventurous life of a soldier. It corrupts even the activity of his body, and renders him incapable of exerting his strength with vigour and perseverance in any other employment than that to which he has been bred. His dexterity at his own particular trade seems, in this manner, to be acquired at the expence of his intellectual, social, and martial virtues. But in every improved and civilized society this is the state into which the labouring poor, that is, the great body of the people, must necessarily fall, unless government takes some pains to prevent it. [3]

Another critique could be that the actual grounds for the invisible hand "Every individual naturally inclines to employ his capital in the manner in which it is likely to afford the greatest support to domestic industry, and to give revenue and employment to the greatest number of people of his own country." is in public reduced to "Every individual naturally inclines to employ his capital in the manner in which it is likely to afford the greatest profit" and has most individuals acting accordingly, which does not include employing the greatest number of people in his own country with shortsighted profit-maximising strategies.

[edit] See also

[edit] External links

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