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The Invisible Hand

230 Year Old Microeconomic Theory Still Relevant Today

May 31, 2009 Miranda Miller

In 1776, Adam Smith introduced the invisible hand theory in The Wealth of the Nations. It applies today as an equalizing force in capitalist markets.

In his book An Inquiry into the Nature and Causes of the Wealth of the Nations, Smith wrote, "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 Invisible Hand in the Free Market

Smith's theory asserts that, in a competitive market, firms and the suppliers of factors of production will promote public or social interest simply by trying to further their own self-interests, as though they are guided by an invisible hand. Government regulation or protectionism interferes with the balancing effect.

In a capitalist market, it is in a business's best interests to use the least-costly methods and factors of production to create their product. The market requires that their product is competitively priced, and they must not lose money on an ongoing basis. At the same time, it is in society's best interest that resources are used efficiently. Firms are led to produce goods and services most desired by society. They will produce at the lowest possible cost, and consumers will buy at the lowest possible price.

Factors of Demand and the Invisible Hand

The invisible hand also works to balance factors of demand, such as the labor market. For example, a company moves to a new area, one with a high rate of unemployment, because labor is relatively cheaper there. As the demand for labor increases, so too does its price. This effect is compounded by the fact that the laborers are also local consumers; as their incomes rise, so does their spending. Stores in the local area demand more labor as their sales increase.

The invisible hand eventually brings the market to balance, so that labor is not unusually cheap and the firm is not making unrealistic profits. In seeking out cheap labor, the firm actually did society in the area a service by boosting the local economy and reducing unemployment.

More Information on the Invisible Hand

Adam Smith's An Inquiry into the Nature and Causes of the Wealth of the Nations is available here to read online in its entirety.

The copyright of the article The Invisible Hand in Investment is owned by Miranda Miller. Permission to republish The Invisible Hand in print or online must be granted by the author in writing.

The Invisible Hand Microeconomic Theory