The Economy is such a tricky thing to maintain in the right roads. Sometimes governments just get overwhelmed by the pressure and the speed with wich problems, e.g. rising unemployment and a decrease in incomes…etc, come. Governments are always trying to take the right decisions, that will maximise the benefits and the happiness of the people. But it rarely happens that way. Most of the times governments end up taking the wrong, or not the best, action to improve the situation.
In 1776, the Scotish economist Adam Smith released his work for what he is famous nowadays and known as the father of Economics: The Wealth Of Nations.
According to Adam Smith, in these kinds of situations governments should simply let the people act only by themselves. They will be guided by the hand of god, which will lead them to make the best choice to their own happiness and also brings profits to the whole society.
In order to understand it better. Let’s see it in depth.
What does the Invisible Hand really means in Economics?
Adam Smith
As said earlier, when times are tough, no government knows how to deal with the situation at the best way. Adam Smith came with the solution and it is so simple and easy that it is shocking! Governments should just leave the market alone. People should be free to buy and exchange goods and services as freely as they want.
In his book, The Wealth Of Nations, he says:
“Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it […] 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 society that it was no part of his intention. 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.”
So, even if people are seeking their own interest and satisfaction, they will be –somehow without even figuring out that they are- helping the whole economy to improve and gets better.
People are normally and instinctively always looking to be as happiest as possible, and one of the ways that help to achieve it is by becoming wealthiest. Getting wealthier than what you actually are, helps not because only you will have more money than what you have now, but mostly because you will start improving yourself, succeeding in a challenge, achieving a new level in your life…etc. And that usually leads to more chances of happiness than staying in the same level for your whole life.
In order to do it, people will either start saving more or investing more. By saving more, people will search more actively for the right object that will both maximise their happiness and reduce the expenses as much as possible. From the other side, the entrepreneurs are going to be forced to innovate to please the customers and be efficient to keep realising some benefices.
So that’s the Invisible Hand. It’s what lead us to pursue the greatest solution for us to maximise our own well-being. In some places, it is called also the Hand of God because it is the God who is responsible for the superior influences that lead us to take most of the decisions. But Adam Smith, called it simply the Invisible Hand because it could be controlled by any kind of Divinity. Any kind of superior powers that are a way beyond us. That’s why the name Invisible Hand is more suitable for it.
Not all people have the same beliefs, but they are all under the same influences.
So, we are all led by an Invisible Hand to maximise our happiness and the general interest, which profit to everyone inside the economy according to Adam Smith. That solution is so simple, but yet something is missing. It looks too good to be real.
There are 3 points that are essential to know and respect when it comes to the Invisible Hand in Economics:
- It dictates the rules not anyone else: It’s an Invisible Hand, a power which is superior and beyond us. There can’t be any government or economy that can put for it some ground rules to respect; e.g: to try to direct the people to consume more local products than the imported ones even if both the local and imported products have the same price but the imported ones have a better quality and satisfy the consumers more. Governments can only encourage to consume more locally, they can’t dictate what to do. Never forget the satisfaction of everyone is the goal that will lead to a better economy, the prohibition measures are not advised at all.
- It works with the rhythm it wants: As said earlier, since it’s superior to anyone else and it makes the rules. There is no authority that can dictate to it the rhythm that it should have. How fast does it should be active? How Slow? Etc. If such a thing was possible, all economies would be able to reach very high levels of economic prosperity without any struggle and faster than we can just wink. Sadly, it can be very slow to take action most of the times, and governments are unable to do anything to accelerate it. That’s why, they all end by taking the situation in hand, and they dictate themselves all the prerogative of the evolution of the economy, letting the Invisible Hand remain invisible and giving more trust to the visible hands that they have.
- To work efficiently it needs a totally free market: And that’s the hardest one. When governments fix some ground rules in any economy, they directly affect the work of the Invisible Hand, which can either make it unuseful or make it pushes people to pursue unreachable levels of satisfaction.
If you miss these 3 crucial points you are missing the Invisible Hand.
Example of The Invisible Hand in Action:
Just in order to understand it more, let me give you a little theorical example of it:
I have $1 and I want to buy an ice cream. There is a seller that sells it for $1. Another seller says he sells the same product for half of the price ($0.5). Of course, I will be automatically led to the second seller, if the first one wants to have any chance he will have to reduce the price and/or bring a better quality ice cream.
The two sellers will always keep improving their offers and the invisible hand will always keep leading me to the best choice that would maximise my satisfaction and improve the Economy.
And that’s how a simple personal choice like just buying ice cream, can lead to improving the health of the whole Economy!
Now imagine all of that in Million and Billion of Dollars.
Real-Life Example of The Invisible Hand in Action:
Unfortunately, nowadays there is no free market at all where the Invisible Hand can really take action. The Invisible Hand is always here, but it’s usually the visible hands of governments that we see more in action these days. Everybody is pressed these days….
But, there is a place where the power of governments is very reduced. A market that it is a way more free than all the others. There is no central authority, and anyone can become a part of it. It’s the Bitcoin market.
Of course in the Bitcoin market as we saw when we talked about it, it isn’t just a free market, but also a risky one -people can steal your bitcoins and you can’t even dream about getting them backs. That’s so unfortunate, the only free market where we could see the Invisible Hand make big actions is also an unsecured market.
But in general, all the evolution that the Bitcoin has known these last years was in a big part cause of the Invisible Hand. Every Bitcoin holder was always looking for the best choice to improve how much value he has, the Bitcoin went from a value less than $1 at it first days to a value of more than $250 these days.
A Weak spot of the Invisible Hand:
John Nash
The Invisible Hand leads us all to pursue the thing that would maximise our satisfaction and happiness. Sometimes by pursuing this we end up with exactly nothing and we will just be unsatisfied, sad and in a non-wanted situation.
John Nash, a great mathematician who suffered from schizophrenia and died just some weeks ago, has showed to the world that this could be a weak spot in what Adam Smith showed to the world. (note: there is a movie about him, it’s “A Beautiful Mind” and here is the trailer)
He showed many cases in his Game Theory, where looking for the best choice can lead to a loss more to a win.
Imagine that there is two products A & B.The product A is the best choice for you but it is hard to get since it exists only in one copy, unlike the product B which exist in enough copies to be owned by everyone. You have four competitors who all wants the same product A. You will enter in a competition with them and there are more chances that this competition will be more harmful than beneficial for all of you. Sometimes taking the second option can have best results than taking the best option which will lead to harmful ones.
For example, let’s mention one of the most famous dilemmas of the Game Theory developed by John Nash: “The prisoners dilemma”
The prisoners dilemma describes two people in a simple situation, both attempting to maximise their own satisfaction and yet they make choices that will lead both of them to a bad outcome.
Two people are suspected to be accomplices in a crime. They have been captured by the police and each one of them has been placed in a separate, non-communicating cells.
Since the police don’t have enough evidences to convict them, they need a confession, and to incite them to do so they are going to play a game.
They will go to the cell of each one and make to each one of them the following offer:
- If neither of you confesses, you will be both sentenced for 2 years.
- If one of you confess implicating the other, the one who confess will go free and the other one will receive a punitive sentence of 5 years.
- If both of you confess implicating each other, both of you will be sentenced for 3 years.
Simple, right?
According to the Invisible Hand of Adam Smith, each one of the prisoners will try to maximise his own satisfaction and wellbeing. So, each one will automatically choose to confess implicating the other to go free. But since both of them confessed implicating the other they will be both sentenced for 3 years, which is one year more than what they would have got if both of them remained silent (only 2 years).
In the end, following the Invisible Hand would have been a big mistake in that case.
This simple dilemma situation doesn’t only concerns prisoners. It happens a lot in the economic world too.
Let’s say for example we have only two glasses company in a town of 100 people that all need glasses.
The companies have the 3 following scenarios:
- To both don’t advertise.
- To one advertise and one not.
- To both advertise.
Let’s say none of them advertised. They will both rationally get 50% of the market. So each company will sell 50 glasses.
Let’s assume that each glasses is sold at $100. In the first scenario each company will make 50 x $100 = $ 5,000
Now, let’s say that only one of the two companies will advertise. We consider that the cost of advertising is $1,000 and that advertising brings 25% additional parts of the market.
So in that case, the company which will advertise will get 75 customers, so it will sell 75 glasses. The other company, which hasn’t made any advertisement will sell 25 glasses.
The first one will get: 75 x $100 -$1,000 = $ 6,500
The second one: 25 x $100 = $2,500
Now, the third scenario: The both advertise.
Since each one will get and added 25% parts of the market, the additional effects will just cancel each other. Consequently, they will both end with 50% of the market and both will sell 50 glasses.
They will both earn: 50 x $100 – $1,000 = $4,000
Then, in the last scenario they will both sell the same amount as if they didn’t advertise but their earnings will be less cause of the advertising fees.
Contrary to the prisoners, the companies are free and they can talk to each other. The best thing they should do is to cooperate and make a deal so they will both earn as much as possible. Even if both are going to be attracted to advertise when the other company isn’t doing it to make more profits, but at the end doing it will just lead to a worse scenario (the 3rd one).
That’s it! That’s all that the Invisible Hand is about, and as we showed it can be very powerful and lead to great results, but it doesn’t take in consideration “the others” as we explained it through the prisoners dilemma of the Game Theory of John Nash.
If there is anything that you think I missed or you want to talk about don’t hesitate to say it in the comments below.