ECONOMICS PROJECT

INVISIBLE HAND
(ADAM SMITH)

K N VARSHINI
XI B
 ACKNOWLEDGEMENT
I would like to express my special thanks of gratitude to my
teacher who gave me the golden opportunity to do this wonderful
project on the topic “ Invisible hand- Adam Smith” which also
helped me in doing a lot of research and I came to know about so
many newthings.
Secondly, I would like to thank my parents and friends who
helped me a lot in finishing theproject within thelimitedtime.
 CONTENT
• INVISIBLE HAND
• THE THEORY OF MORAL SENTIMENTS
• ECONOMISTINTERPRETATION
• HOW THE INVISIBLE HANDWORKS
• THE INVISIBLE HANDAND THE MARKET ECONOMIES
• EXAMPLE OF INVISIBLE HAND
• HOW DOES INVISIBLE HANDDEALSWITH SHORTAGE
• WHY ISTHE INVISIBLE HAND IMPORTANT
• WHATDID ADAMSMITH SAY ABOUT INVISIBLE HAND
• LIMITATIONS
• ADVANTAGES
• BENEFITS OF THE INVISIBLE HAND
• CONCEPTOF LAISSEZFAIRE
• IMPLICATIONSOF INVISIBLE HAND
• WHY ISTHE INVISIBLE HAND CONTROVERSIAL
• CONCLUSION
• BIBLIOGRAPHY

INVISIBLE HAND
 Theinvisiblehand describes theunintended social benefitsof
an individual’ s self-intended actions, a concept that was first
introduced by Adam Smith in The Theory of Moral Sentiments,
written in 1759, invoking it in referenceto income distribution.
By the time he wrote The Wealth of Nations in 1776, Smith had
studied the economic models of the French physiocrats for many
years, and in this work, the invisible hand is more directly linked, to
production, to the employment of capital in support of domestic
industry. The only use of “ Invisible Hand” found in the ‘ Wealth
of Nations’ is in book lV, chapter ll. “ of restraints upon the
importation from foreign countries of such goods as can be
produced at home” . The exact phrase is just used three times in
Smith’ s writings.
The idea of trade and market exchange automatically
channeling self-interest towards socially desirable ends is a central
justification for the laissez-fair economic philosophy which lies
behind neoclassical economics. In this sense, the central
disagreement between economic ideologies can be varied as a
disagreement abutshowpowerful is the “ InvisibleHand” .
THETHEORY OF MORALSENTIMENTS
 The first appearance of the invisible hands of smith occurs in
the theory of moral sentiments (1759), where he describes a selfish
landlord as being led by an invisible hand to distribute his harvest to
those who work for him. Elsewhere in the theory of moral
sentiments, smith has described the desire of men to be respected
by the members of the community in which they live and the desire
of men to feel that theyarehonorablebeings.

THE WEALTH OF NATIONS

Adam Smith uses the metaphor in the book 4, chapter 2 of the
wealth of nations. Using the invisible hand metaphor, Smith was
trying to present how an individual exchanging money in his own
self-interest unintentionally impacts the whole economy. In other
words, there is something that binds self-interest along with public
interest. So that individuals who pursue their own interests will
inevitablybenefit societyas a whole.

OTHER USESOF THE PHRASE

Only in the ‘ History of Astronomy’ (written before 1758)

smith speaks of the invisible hand, to which ignorant, refers to
explain natural phenomena otherwise unexplainable. In both the
theories, Adam Smith speaks of an invisible hand, never of the
invisible hand. In the theory of moral sentiment, Smith uses the
concept to sustain a ‘ buckling down’ theory a concept also used
in neoclassical development theory. The gluttony of the rich serves
to feed the poor.
 ECONOMIST INTERPRETATION

The concept of the “ invisible hand” is nearly always

generalized beyond Smith’ s original uses. The phrase was not
popularamong the economists before the twentieth century; Alfred
Marshall never used it in his principles of economics textbook and
neither does William Stanely Jevons in his theory of political
economy.
 Since Smith’ s time, this concept has been further
incorporated into economic theory. Leon Walras developed a four
equated 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 edge worth box contact line to
illustrate a similarsocial optimality.
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 economics 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 Clain argues that reconciliation is
legitimate. Moreover, even if Smith did not intend the term
‘ invisible hand’ to be used in the current manner, its
serviceabilityassuch shouldnot berenderedineffective.
HOWTHE INVISIBLE HANDWORKS?

The invisible hand is part of laissez-faire, meaning the "let

do/let go," approach to the market. In other words, the approach
holds that the market will find equilibrium without government or
other interventions forcing it into unnatural patterns.
Scottish Enlightenment thinker Adam Smith introduced the
concept in several of his writings, such as the economic
interpretation in his book
(often shortened to just
) published in 1776 and in
published in 1759. The term found use in an economic
sense during the 1900s.
The invisible hand metaphor distils two critical ideas. First,
voluntary trades in a free market produce unintentional and
widespread benefits. Second, these benefits are greater than
thoseof a regulated, planned economy.
 Each free exchange creates signals about which goods and
services are valuable and how difficult they are to bring to market.
These signals, captured in the price system, spontaneously direct
competing consumers, producers, distributors, and
intermediaries— each pursuing their plans— to fulfil the needs and
desires of others.
The Invisible Hand and MarketEconomies

Business productivityand profitabilityare improved when

profits and losses accuratelyreflect what investors and
consumers want. This concept is well-demonstrated through a
famous example in Richard Cantillon’ s
(1755),the book from which Smith developed his invisible
hand concept.
Smith's
was published during the first Industrial Revolution and
thesame yearas the American Declaration of Independence.
Smith’ s invisible hand became one of theprimaryjustifications
foran economic systemof free-market capitalism.
As a result,the business climateof the U.S. developed with a
general understandingthat voluntary private markets aremore
productive than government-run economies. Even government
rules sometimes try to incorporate theinvisible hand.
FormerFed Chair Ben Bernanke explained the "market-based
approach is regulation by the invisible hand" which "aims toalign
theincentives of market participants with the objectives of the
regulator."
Example of theInvisibleHand

Consideran exampleof a small business facing stiff

competition. To best position itself in the market,the small
businessdecides it will invest in higherqualitymaterials forits
manufacturing process as well as reduce its prices. though the
small business may bedoing so out of thebest interest of its
company (i.e., to drivesales and steal market share),the invisible
hand is at work as themarket now has access tomore affordable
yet higherquality goods.

Another exampleof the invisiblehand is theripple effect a

retail company can havewhen attempting to meet consumer
demand. Considera hardware storethat anticipates demand for
yardmaintenancetools. Thehardware storewill coordinate with a
manufacturerto secure theappropriate goods. Meanwhile, the
manufacturerwill communicate with a rawmaterials distributorto
ensure it has the items it needs.

In this second example, each entity is acting in its own best

interest. However,each entity is also creating economic activity for
other parties. In addition, theentities are stringing together a
process that results in a consumerreceiving a product it needs.
Though each individual action taken by itself may not amount to
much, theinvisible hand helps move resources alonga process to
delivera final product.
HOW DOES INVISIBLEHAND DEALS WITHSHORTAGE?

Supposea good was in short supply. At thecurrent price,

demandwas greaterthan supply leading to the queries. In this case
firms have an incentiveto increasethepriceand/orto increase the
supplyinvest in production. The next effect isthat prices will rise
until equilibriumis overcome.

Therefore, overtime prices and supplywill adjust until the

market return to equilibrium.

WhyIsthe Invisible HandImportant?

The invisiblehandallows the market to reach equilibrium

without government orotherinterventions forcing it into unnatural
patterns. When supply and demand find equilibrium naturally,
oversupply and shortages are avoided. Thebest interest of society
is achieved via self-interest and freedomof production and
consumption.
Theinvisiblehand is a metaphorforhow, in a free market
economy,self-interested individuals operatethrough a system of
mutual interdependence. This interdependence incentivizes
producers to make what is sociallynecessary,even though they
maycareonlyabout theirown well-being.

What DidAdamSmithSayAbout theInvisibleHand?

AdamSmith wroteabout an invisible hand in his writings

during the1700s, noting that the mechanismof an invisiblehand
benefits theeconomy and society thanks toself-interested
individuals. Smith mentions "an" invisiblehand, which is the
automatic pricing anddistribution mechanisms in the economy
that interact directly and indirectly with centralized, top-down
planning authorities.

LIMITATIONS

• MONOPOLY POWER
AdamSmith himself wasawareof how firms with
monopoly powercould cause prices to bepushed above
theequilibrium. Without sufficient competitive pressure,
firms couldbecome stagnant, inefficient andexploit
customers through high prices.
• EXTERNALITIES
Theinvisiblehand can lead to an efficient outcome, if
there are no external costs/benefits. But if theyare
significant externalities, ex-popularpollution costs, then
thefreemarket can leadtooverproduction of goods
with theseexternal costs.

• THE TRAGEDY OF THE COMMONS

Thisis a situation where peoplepursuing self-interest
can leadtodepletion of natural resources,ex-overjibing
in the sea.

• IRRATIONALBEHAVIOUR
Thetheoryof the invisible hand and the free markets
suggests consumers and firms are national. However, in
industries, such as financewecan see individuals can
get carried away with international exuberance. This can
leadtoboomin asset prices and the prices distorted
fromeconomic realities.

• TIME LAGSAND IMMABILITIES

If an industry closesdown, then theinvisible handmay
push theunemployed to move andget a job in another
industry. However, in realitythese are occupational and
geographical immabilities. Therefore, resources (labor
andcapital) can become unemployedfora long time.
 ADVANTAGES

✓ Theinvisible handcan lead to an efficient outcome if

there are no external costs/benefits. But ifthereare
significant externalities,ex-pollutions costs then the free
market can lead to overproduction ofgoods with these
external costs.

✓ Theinvisible handis a metaphorforthe unseen forces

that move the freemarket economy. Through individual
self-interest andfreedomof production as well as
consumption, thebest interest of society, as a whole, are
fulfilled. The invisiblehand metaphordistillstwo crucial
ideas.
✓ To put it anotherway, theinvisible handis simplythesum
ofvoluntaryactivitiesby economic factors. Proponents
oftheinvisiblehand model often believethat
governments are incapable ofreplicatingorimproving
upon these unintended consequences of capitalism.

✓ Supportersof a freemarket economy,claimthat the

system is having advantages. It contributes to political
and civil freedom. In theory, sinceeverybody has theright
to choose what toproduce orconsume. It contributesto
economic growth and transparency. It ensures
competitivemarket.
BENEFITSOFTHEINVISIBLEHANDTOTHESOCIETY

Theinvisiblehand benefits societyas it leads to the most

optimal production of a good. When there is a shortage ofa good,
prices rise,which allows the producers to increasethesupply of
that goodand meet demand. At the sametime, when thereis an
oversupply,prices decline to attract consumers and increase
demand.
CONCEPTOFLAISSEZFAIRE

Thetheoryof the invisible hand largelyrevolves around the

concept of laissezfaire. Thisconcept follows thepolicy ofletting
things taketheirown coursewithout any interference. Accordingto
laissezfaire, the less the government isinvolved in makingpolicy
decisions,thebettertheeconomy will be. Theunderlying
assumptions of this concept is that, “ natural older” ultimately
prevails. Social welfarewill bemaximized if the economyis let free
without regulations.
IMPLICATIONSOFTHEINVISIBLEHAND

• Formost goods and services there is no needforgovernment

regulations andpricecontrols. The invisiblehand of market
forces will ensure the optimal price and output.
• Agentspursuing self-interest can contributetowards
society’ s well beingeven if doesn’ t mean to.
• If owners ofcapital increasein wealth therecan be a buckle
down effect tobenefit everyone in the society.
• Privatebusiness will follow theirprofit motive to findthemost
efficient useof investment funds.
• Free trade is beneficial. Freetrade enables firmto specialize
in goods where theyhave a comparativeadvantage.
• Agentsthat pursueself-interest can contribute towards
society’ s well beingeven if theyarenot interested towards it.
Then also they can contribute.

WhyIsthe Invisible HandControversial?

 Critics arguethat the idea that self-interested,profit-driven
actors will convergeon some social optimumis clearlyfalse, and
that instead it naturallyleads to negativeexternalities, economic
and social inequalities,greed, and exploitation. Moreover,
competition driven by theinvisible hand can ultimatelyresult in
monopolies and theconcentration of economic power,both of
which areundesirable forsociety.

Other critiques hone in on the fact that the concept relies on

theassumption that producers can easily switch fromproducing
one type of good to anyother, depending on its relative profitability
at a given moment. This does not account for the
sometimes-enormous costs of switching and theidea that people
may engage in a business that they enjoy doing, orwhich has been
passed down in a family, regardless of profitability.

CONCLUSION

The invisiblehandis the idea that specialization in production

can lead self-interested individuals to produce what is socially
necessaryand forthegoodof all. This is becauseincreased
specialization naturally leads to a web of mutual
interdependencies, such that a shoemakerwill need others to
producetheir house, food, clothing, etc.; while a homebuilderwill
rely on theshoemaker forshoes and others for theirown clothing,
food, andsoon. Market forces and competition will incentivize
producers to make what is most profitableat thelowest cost, also
encouraging technological progress and innovation, forthe
benefit of all.

BIBLIOGRAPHY

• www.wikipedia.com
• www.youtube.com
• www.investopedia.com