The Invisible Hand Theory Analysis - Essay Example

Invisible Hand Introduction Adam Smith, in his book The Wealth of Nations, introduced the term Invisible hand, for the first time, to establish the principle that an individual aiming at his own welfare tends to promote the overall welfare of the community to which the individual belongs. Precisely, it is a metaphor used by economists to express the possible inclination of individuals to cooperate towards the betterment of the society. According to Nobel Prize winner Milton Friedman, it is "the possibility of cooperation without coercion." (Friedman's Introduction to I, Pencil) The above theory is further explained as a condition by which an individual in a society will toil enough to put his capital in the domestic industry so as to encourage its produce for getting a better value, and by doing this, the individual is trying to put in his labor, unknowingly or indirectly, towards bringing in a larger revenue to the society as a whole. In this sort of constructive endeavors the individual actually does not intend to promote the public interest at all, and also does not know to what extent he is promoting it. This unintended promotion bestowed on the society will naturally be more than the actual worth if the individual has really intended it. The theory of the Invisible Hand affirms that if a consumer is given the chance to select freely, that is, at his own will without any external coercion or persuasion, from the several options or products before him, then each producer responsible for the options or products will get the total freedom to choose what to sell or what to produce and how to produce it. This will allow the intended market to settle upon a very convenient product distribution and pricing system so that it will benefit all the members of the society. The reason for deriving such an outcome is vested in the truth that the greed and self interest of an individual will force the attributes to transform into a state of collective and gainful qualities benefiting the society. In economics related to industrial organizations, this theory is applied in the viable and effective production methods in order to maximize the profits. Pricing of products will be fixed to the minimum to compete with the rivals. For getting the required profits the investors will put more money in industries which are considered to be the neediest to people or the target group instead of investing in less profitable industries. According to Adam Smith, "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." (Smith, Adam. 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 25th April, 2009) Thus, the Invisible Hand theory acts as a balancing mechanism in its entirety in the field of customer oriented production and its strategic marketing and in the matter of building customer relationships so as to increase the gains of the entrepreneurs. In this respect it cannot be construed that these entrepreneur's actions are fully motivated to benefit the interests of the society, but it is focused on himself and his kith and kin, and in reality, the net result of its application is nothing but the exploitation of the common people who are in dire wants of necessities and amenities in their struggle to survive in this world. Explanations of "Invisible Hand" in Society by different authors: Every individual...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 (The Wealth of Nations, Book IV Chapter II). "Wherever we see a well ordered arrangement of things or men we instinctively assume that someone has intentionally placed them in that way" (Michael Polanyi, 1951). Intellectuals with unstable degrees of achievement, tried to describe the nature and meaning of society right from the dawn of history. They also suggested ways and means of improving society. Till the Scottish Enlightenment in the 18th century, such suggestions and the driving force of these probes was intentionalist. Social order was conceived to be the outcome of some being's conscious design either man's or God's. According to Friedrich Hayek, (1973), "Neither the Greeks of the fifth century B.C. nor their successors for the next two thousand years developed a systematic social theory which explicitly dealt with these unintended consequences of human action or accounted for the manner in which an order or regularity could form itself among those actions which none of the acting persons had intended." Thomas Sowell, (1980) explained as "The effectiveness with which knowledge is transmitted and coordinated through social processes depends upon the actual characteristics of those specific processes. ... Emphasis on the characteristics of social processes implies a systemic analysis of social causation, in contrast to individual or intentional analysis of why things happen as they do.... the (systemic) outcome does not depend on the individual agent's subjectively pursuing the end result of the system." The modern social theory took birth during the Age of Enlightenment. This universal theory prospered primarily among the Scottish intellectuals like Adam Ferguson, David Hume, Josiah Tucker, and of course Adam Smith. It was for the first time that a thorough study of the accidental effects of human action was conducted and the study proved that these effects were not only gentle but also a must to achieve any resemblance of civilized social order. "By pursuing his own interest he frequently promotes that of 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" (Adam Smith, 1776). Theory of the Invisible Hand When each consumer is permitted to select freely what to purchase and in the same way each producer is permitted to select freely what to sell and how to produce then the market will resolve on a product allocation and costs that are valuable to all the individual members of a society, and therefore to the society as a whole. This is because ravenousness will force doers to beneficial behavior. This will lead to a situation whereby efficient modes of production will be followed so that profit can be maximized. Low prices will be charged in order to undercut competitors. Capitalists will commit in those industries which are most immediately required to capitalize on returns, and remove capital from the industries which are less efficient in making value. This principle also works as a balancing mechanism. For instance the people in a poor country will be ready to work cheaply. This would lead to amassing huge profits by the entrepreneurs when they construct factories in poor countries. But since this policy will increase the demand for labor, the price may also increase for hiring people. Apart from this the new producers automatically become consumers which would ultimately lead to hiring of labor by the local businesses to provide the producers with the products they require. Since this course goes forward, the labor costs will ultimately rise to such heights from where foreign countries doing business in previously poor country will have no advantage. In totality this mechanism leads to the local economy to operate on its own. At present Adam Smith's status depends on his enlightenment of how lucid self-interest in a free-market economy contributes to economic well-being. Actually Smith when he was an advocate, his first important work concentrated on ethics and charity. Adam Smith composed, "How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it." Concurrently, Adam Smith had a benevolent view of self-interest, refusing that self-love "was a principle which could never be virtuous in any degree." Adam Smith indicated that life would be hard if our "affections, which, by the very nature of our being, ought frequently to influence our conduct, could upon no occasion appear virtuous, or deserve esteem and commendation from anybody." Adam Smith said that sympathy and self-interest were not negating factors; they were corresponding. "Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only," (Adam Smith, 1776). Charity is no doubt an honorable act but that alone will not supply the necessities for living. According to Adam Smith self-interest is the means which can cure this defect. "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest" (Adam Smith, 1776). When a person earns by using his own labor then he benefits himself. But without his knowledge he benefits the society also. Since to earn money on labor in a competitive market, it is inevitable that he produces something else which others value. According to Adam Smith (1776) "By directing that industry in such a manner as its produce may be of 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." Even more far-reaching was Smith's conviction that a society collected of individuals performing in search of their own concerns would ensue in a static, free and more affluent society than one restricted and designed by the state. Smith took Isaac Newton's visualization of a creation running by itself according to natural laws and enforced it to society as a whole and to economic action in detail. When the recorded history of humanity is interpreted it cannot be found that any disagreement has rendered more argument than this effortless idea established on trust in the curiosities people can accomplish when permitted to trade and live in liberty. As a matter of fact, the bulk of what today is called politics is some projected practical diligence of state power that is annealed by this continuing debate between Smith's generally laissez- faire approach and the advancement of planning advocators who arrogate they can produce higher-ranking effects through compulsion. Economic development for Smith is good and is accomplished by the ever-extending diligence of the partitioning of labor, which is coordinated within markets and motored by intellectual self-interest. The nations which permit market forces to bring forth such development will become more affluent, in Smith's view, than those that adopt the commercial model of handled trade Robbins (1998, 128-29). In his writings on strategy issues in Wealth of Nations, Smith places out the right role for state action. He preserves that there are 3 arenas for lawful governmental action in society; defense against international and inner protection menaces, the establishment of laws that preclude individuals from suppressing one another and the proviso of public goods that the market would not supply. Finally, he stated that this ensues in the most effective manufacturing procedures and the lowest prices. But Adam Smith was not able to foresee the development of mighty governments, and their control on this entire process. "In the midst of all the exactions of government, capital has been silently and gradually accumulated by the private frugality and good conduct of individuals, by their universal, continual, and uninterrupted effort to better their own condition. It is this effort, protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement in almost all former times" (The Wealth of Nations, Book II, Chapter III). Normally government does not manufacture or sell to generate money. Instead it just devours money. Even if the government looks as if it is generating money, it is a sine qua non consumer. In fact government employees are paid salaries from the taxes which are collected from the citizens. Needless to say that money which is an input to the economy as wages is always lesser than output by way of taxes. The equilibrium eventually ceases back in the economy as it is being used to pay for overhead and infrastructure, because finally the money is utilized to pay off something, somewhere. But this happens only after a considerable delay. For example if there are 5 individuals earning $4,000 each and they pay a tax of $1,000 each. The money collected by the government is $5,000 which is then used to pay $4,000 to a government employee and the remaining for infrastructure. But had there been no tax then the 5 individuals would have spent $20,000 and the money would have instantly been available to the rest of the economy. Here it would permeate through the economic system. But since tax is paid only $15,000 immediately finds its way into the economy where as the remaining $5,000 is put on hold. The reason is that it takes a little time for the collecting process, the accounting process and the allocating process for the payroll after which it finally is being paid to the government employee and from there on to the economy. The remaining $1,000 also reaches the economy. Of course there is a considerable time lag between the original 5 individuals receiving their money and spending it and the time the rest of the money at last gets into the economy. Within the time gap the money is idle and so similar to friction this idle money also takes in energy from the economy without producing anything and adding an inevitable amount of inefficiency. Thus jointly, production (mining, farming, etc.), manufacturing (cars, computers, etc.), and services (accounting, legal, etc.) shape a synergism which helps in keeping the whole economy buoyant and working resourcefully. Adam Smith used the phrase invisible hand in an example about a common point he was making. He stated that the market could be trusted on to govern the economy and that government involvement was not needed or preferred. In extending up to the invisible hand Smith (1976 [1776], p. 453) made his general point that: "Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society." Smith then offered his illustration of the invisible hand where he said that "people prefer to keep their capital at home, when profits are equal, and that the more capital at home means more production and a larger population". No one gets into an exchange to create a price, but yet a swap ratio or a price comes forth from the transaction. Actually price is not the outcome of anyone's purpose but a price can be meaningful only with an invisible hand explanation. Prices are both unintentional and benignant. They lead to the instant growth of money which promotes a further division of labor. This division of labor is like price both unintended and undesigned social institutions. The appearance of money and a free banking system, such as subsisted in Scotland, comprise one of the most unclouded object lessons in impulsive order theory. Criticism of the Invisible Hand hypothesis: Even though the present rational reputation of free market doctrines and the increased disbelief cast on the proposal that the political control of the state can perk up the unprompted workings of a deconcentrated, private property trade system in the construction of advantageous social results, disapproval of the Invisible Hand hypothesis continues to grow. These criticisms do not originate exclusively from the socialist members who are concerned to conserve a rationally expended economic empire but from some of the creative and complicated economic and social theoreticians. The critiques of Invisible Hand procedures wrap a broad range of economic and social effects. A question to be answered at the range of pure theory is that whether lucid economic brokers, determined only by self-centeredness, will create an economic "equilibrium". Further is "equilibrium" a useful explanation of economic realism With reference to welfare economics, the professionals debate that the goodnesses depicted by the propositions of market equilibrium have no essential link with economic justice. As the optima are steady with any known dispersions of property holdings then challenges are posed with reference to the utility of the market in relation to service and wellbeing policy in developed countries (Cato Journal, Vol. 5, No. 1 Spring/Summer 1985). Popularity as a Major Problem At a time when history of economic thought had been banned to the particular journals on the subject, Smith's invisible hand has received a renaissance with economists looking deeper into its significance and scholars from other fields employing the conception. On the other hand, this renaissance of interest has formed problems, most remarkably the problem of manifold, equally exclusive meanings and the more conventional problem of vagueness. A genuine cottage industry has formed in modern years to describe the factual meaning of Smith's phrase and to take advantage of its extensive acknowledgment and use. For instance, Syed Ahmad (1990) puts forward four different invisible hands while William Grampp (2000) propounded ten different possibilities. Spenser Pack (1996) renders an elucidation where the invisible hand heads to modified poverty among the poor while profiting the wealthy. Emma Rothchild (1994) construes the invisible hand as a joke Smith played on his readers because the significance of the term is not coherent in its three uses. Joseph Persky (1989) discovers that the invisible hand is linked to the production of public goods because it slows the export of capital and thus raises the national defense, combining the odd tastes of both commerce and public goods theory to Smith's invisible hand. Similarly, Grampp (2000) claims that the invisible hand is self-interest heading individuals to keep their capital at home, rather than exporting it, and this pushes the national defense. In Grampp's words, the "invisible hand then is self-interest operating in this circumstance, the circumstance in which a private transaction yields a positive externality that augments a public good." Grampp says that this is Adam Smith's own version of the invisible hand even though it is founded exclusively on a somewhat tormented view of Smith's third use of the invisible hand. Assimilators have understood some kind of religious constituent for the invisible hand since Hirschman (1977) says that there was a requirement for a normative understanding of the market to make it suitable. Hill (2001), Waterman (2002) and Denis (2005) supply us with latest versions of the invisible hand with a religious glove; while Evensky (1993) states that it has some sort of ethical dimensions. In fact all these interpretations collectively add confusion to the meaning of the invisible hand by lending it multiple-concept confusion. These modern interpretations are very different and reciprocally restricted. These versions are not linked from the conventional interpretations of the invisible hand which are mostly unconnected to each other. It is reasonable to say that these current versions have not elucidated the idea of the invisible hand, but have together periled the Scientific utility of Smith's most outstanding and permanent share. The other chief trouble for the invisible hand is what Grampp (2000) marks the "Neo-Austrian" view by which the invisible hand is the metaphor for the amount of valuable social orders comes forth from the unintentional consequences of individual actions. Grampp cites the entrance on the invisible hand in the New Palgraves by Karen Vaughn as the basis of this version. Here the idea is said to be compiled of three "logical" steps: (1) human action contributes to accidental consequences, (2) The law of big numbers is raised and aggregated with evolutionary time to bring forth intelligent design, (3) The final outcome is helpful and wanted even though it not intended. The Invisible Hand as a Competitive Market Process The protection of the Invisible Hand procedure has to start from the theoretical level with a precise and logical account of what is being claimed in the economic doctrines of those who use it. It can also be argued, with sufficient consideration, that much of the preliminary plausibleness of the unfavorable judgment of the Invisible Hand theorem deduces from a taxonomical deception of the impulsive market order that it explains. As a matter of fact, the explanation of a viable market arrangement given in the orthodox texts of neoclassic economics has no or very little similitude to the theory of competition propounded by Adam Smith and his heirs. The differences are centered on the concepts of human activity which underlines rival models of economic concepts. The significance of invisible hand theorem is difficult to understand because it is inextricably bonded to the conception of equilibrium. The exploration for the existence of an Invisible Hand procedure has been corrupted towards the search for the creation of equilibrium in a deconcentrated market economy. To expect what is to follow, the evaluators of the market system maintain that the lack of a steady balance in real economies means the defense of the Invisible Hand theorem. Modern views on the invisible hand "It is the highest impertinence and presumption, therefore, in kings and ministers, to pretend to watch over the economy of private people, and to restrain their expense... They are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look well after their own expense, and they may safely trust private people with theirs. If their own extravagance does not ruin the state, that of their subjects never will" (The Wealth of Nations, Book II, Chapter III). The heart of current welfare economics can be summed up by its 2 main theorems: (1) A aggressive equilibrium is a Pareto optimum, (2) Any Pareto optimum can be continued as a competitive equilibrium. The second theorem suggests that any Pareto optimum apportionment can be brought forth through suitable relocation of income between individuals. The profit-maximizing conduct of butchers, brewers and bakers guides them to encourage the pursuits of consumers in the controlled sense of the Pareto optimality standard. If there has to be a search for a broader feeling of the public interest, we have to act outside Pareto optimality so that fair assessment on the allocation of income and resources between individuals and households can be derived at. This opinion was elucidated in the growth of welfare economics that took place in the 1940s and '50s. This was mainly done with the beginning of the Bergson-Samuelson social welfare utility (Samuelson 1947, chapter VIII). Conversely, the recognition of Smith's public concern with social welfare in the Bergson-Samuelson sense, signals the fact that, in common, dictums about increments or reductions in social welfare have to be established on honorable judgments that consider together alterations in the criterion of living between individuals. Total national income is a faulty pointer of social welfare as it does not consider allocation of income. In reality Smith's recognition of the public interest with the "the annual revenue of society" has to be construed with care in the light of advanced perceptivities. Public interest based on the modern view is assisted by competitive markets along with a public sector that renders public goods and takes on income distribution. This is a view which even Adam Smith would agree to. But he may have been concussed by the impractical degree of flawlessness accepted in the explanation of competitive markets, particularly in the validated theory of universal equilibrium. Alternatively, he would possibly have detected that many modern economists in their more practical work incline to take an outlook of competition nearer to his own. Competition may work out for the public interest although it is not ideal in the firm hypothetical sense. Adam Smith may also agree with the outlook that strategy testimonials should be founded on a mixture of exact theory, institutionalized perceptivities and usual sense. Today, the invisible hand theory is often demonstrated in conditions of a raw process that leads free markets and entrepreneurship in the route of effectiveness, through supply and demand and competition for limited resources, rather than as something that ensues in the welfare of individuals. "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 many who had folly and presumption enough to fancy himself fit to exercise it" (The Wealth of Nations, Book IV, Chapter II). Conclusion "Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue, is in most countries employed in maintaining unproductive hands... Such people, as they them-selves produce nothing, are all maintained by the produce of other men's labor... Those unproductive hands, who should be maintained by a part only of the spare revenue of the people, may consume so great a share of their whole revenue, and thereby oblige so great a number to encroach upon their capitals, upon the funds destined for the maintenance of productive labor, that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment"(The Wealth of Nations, Book II, Chapter III). Even these concise thoughtfulnesses propose that economists should be more worried with viewing how institutional arrangements might aid in the working of the Invisible Hand rather than establishing joyfully how far some on hand market distribution goes away from a so-called optimum. If there is no Invisible Hand procedure then there are no economic regularities, and if there is no such regularity then it only means that there is no economic science. In the nonexistence of the Invisible Hand, the economic world would become the toy of, first (and very briefly), the fragile and stylish but headily impossible abstract theorist, and then the naked target of the clinched fist of the political commissar. Scholars have also recommended that the key to unlock the anonymity of the invisible hand is in making logic of Smith's three different functions of the phrase. This judgment backs up the following conclusions: 1. The modern versions are not correct and normally symbolize nothing more than current economists attempting to write their own interpretation into Smith. 2. The conventional versions involving self interest and the market system were mostly accurate. 3. There is nothing mysterious about the invisible hand. 4. The invisible hand comprises of real world procedures that are basically strong in logic and experience. Particularly, the proof proposes that we can find the mechanism of Smith's invisible hand with property ownership. Property privileges are the anchor of economic breakdown. Production determinations are made which results in a natural allocation of income established on reciprocated interdependence of interests between property owners, labor, and entrepreneurs or the circular-flow economy. Natural self interest determines and accords this transmission with the market mechanisms of costs and profits. Costs control the allocation of goods among consumers, while profits and losses allocate the use of labor and resources for the production of goods. The system comes to a full circle because the buildup of profits and insolvency influences the future of property distribution. A the same time self interest, entrepreneurship, and consumer sovereignty are surely significant, the "hand" may have been invisible for Smith as it denotes both nothing and everything. It is "nothing" as there is no direction, no director, in the economy. It is "everything" because everyone is concerned, or could be concerned, in shaping the economic results. When encountered with such difficulty, Smith may have simply fell back to the metaphors of the invisible hand as a shorthand way of catching the multifaceted workings of the market economy in an easy, but highly useful phrase to communicate his meaning. Reference: 1. Atkinson, Anthony B. (2001), "The strange disappearance of welfare economics," Kyklos 54, 193-206. 2. Friedrich Hayek's trilogy Law, Legislation and Liberty (London: Routledge & Kegan Pau, 1973-79), vol. I, Rules and Order, 1973; vol. II, The Mirage of Social Justice, 1976; vol. III, The Political Order of a Free People, 1979. 3. Michael Polanyi, The Logic of Liberty: Reflections and Rejoinders (1951) (Indianapolis: Liberty Fund, 1998). Available from Liberty Fund's Online Book catalog. 4. Smith, Adam, 1776, The Wealth of Nations. New York, Random House. 5. Samuelson, Paul A. (1947), Foundations of Economic Analysis. Cambridge, Massachusetts: Harvard University Press. 6. Smith, Adam (1776), An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan and Cadell. Glasgow Bicentenary Edition, ed. by 7. R. H. Campbell and A. S. Skinner. Oxford: Oxford University Press, 1976. 8. Thomas Sowell, Knowledge and Decisions, New York: Basic Books, 1980. 9. Pareto, Vilfredo (1909), Manuel d'conomie politique. Paris: Giard & Brire,1909, English edition as Manual of Political Economy, translated by Ann S. Schwier. London: Macmillan, 1971. 10. Grampp, William D., (2000) "What Did Adam Smith Mean by the Invisible Hand," The Journal of Political Economy, Vol. 108, No. 3 (June) pp. 441-465. Read More

 

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