The Invisible Hand by Adam Smith and Decoding

Free Market Economies

Report by Krittika Kumar
Economics - 11 commerce
The Invisible Hand - Adam Smith

Who was Adam Smith?

Adam Smith was an 18th-century Scottish economist,

philosopher, and author who is considered the father of
modern economics. Adam Smith was a Scottish
economist and philosopher who was a pioneer in the
thinking of political economy and key figure during the
Scottish Enlightenment.He was seen by some as "The
Father of Economics" or "The Father of Capitalism", he
wrote two classic works, The Theory of Moral Sentiments
(1759) and An Inquiry into the Nature and Causes of the
Wealth of Nations (1776). The latter, often abbreviated as
The Wealth of Nations, is considered his magnum opus
and the first modern work that treats economics as a
comprehensive system and an academic discipline. Smith refuses to explain the
distribution of wealth and power in terms of God's will and instead appeals to natural,
political, social, economic, legal, environmental and technological factors and the
interactions among them. The Wealth of Nations was a precursor to the modern
academic discipline of economics. In this and other works, he developed the concept of
division of labour and expounded upon how rational self-interest and competition can
lead to economic prosperity.

● Adam Smith was an 18th-century Scottish philosopher; he is considered the father

of modern economics.
● Smith is most famous for his 1776 book, "The Wealth of Nations."
● Smith's ideas—the importance of free markets, assembly-line production
methods, and gross domestic product (GDP)—formed the basis for theories of
classical economics.
The Concept of the "Invisible Hand" by Adam Smith

The invisible hand is a metaphor inspired by the Scottish economist and moral
philosopher Adam Smith that describes the incentives which free markets sometimes
create for self-interested people to accidentally act in the public interest, even when this
is not something they intended. Smith originally mentioned the term in two specific, but
different, economic examples.
In simple words, The invisible hand is a metaphor for the unseen forces that move the
free market economy. Through individual self-interest and freedom of production and
consumption, the best interests of society, as a whole, are fulfilled. The constant interplay
of individual pressures on market supply and demand causes the natural movement of
prices and the flow of trade.

● The invisible hand is a metaphor for how, in a free market economy,

self-interested individuals operate through a system of mutual interdependence.
● This interdependence motivates producers to make what is socially necessary,
even though they may care only about their own well-being.
● Adam Smith introduced the concept in his 1759 book "The Theory of Moral
Sentiments" and later in his 1776 book "An Inquiry Into the Nature and Causes of
the Wealth of Nations."
● Each free exchange signals which goods and services are valuable and how
difficult they are to bring to market.
● Critics argue that the invisible hand does not always produce socially beneficial
outcomes, and can encourage greed, negative externalities, inequalities, and
other harms.
How does this concept work?

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 those of a regulated, planned economy.
Each free exchange signals 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.
For example, a baker wanting to earn money makes bread that others need, creating
jobs and providing food. Competition ensures better quality and fair prices, and supply
and demand balance things out naturally. This process helps the economy organise
itself, even without anyone planning it directly.
Why is the Invisible Hand important?

The above graph shows,

the invisible hand that allows the market to reach equilibrium without government or other
interventions forcing it into unnatural patterns. When supply and demand find equilibrium
naturally, surplus and shortages are avoided.
Eventually, the best interest of society is achieved via self-interest and freedom of
production and consumption.

Relevance of the Invisible Hand in Modern Economics

The invisible hand remains a foundational idea in economics, influencing policies that
prioritise free markets and minimal government intervention. It also provides a framework
for understanding how decentralised decisions can lead to order. However, modern
economic theories, such as Keynesianism and behavioural economics, have expanded
on or challenged Smith’s ideas, emphasising the importance of government action to
correct market imperfections and address social concerns.

Smith famously stated:

"By pursuing his own interest, [an individual] frequently promotes that of the
society more effectively than when he really intends to promote it."
Criticism on the concept of ‘the Invisible Hand’
Economists criticise the "invisible hand" for several reasons. They argue that it overlooks
market failures, such as monopolies, pollution, and public goods, where self-interest
doesn't lead to optimal outcomes. It also fails to address inequality, as markets often
concentrate wealth in a few hands. Additionally, information imbalances and short-term
thinking can distort decision-making.
Economists like Keynes and Stiglitz argue that government intervention is necessary to
correct these issues, promote fairness, and ensure long-term stability, as the invisible
hand cannot manage these challenges on its own.

Economists take on this concept :-

Lester Thurow : Lester Thurow critiqued Adam Smith’s

"invisible hand," arguing that it falls short in addressing
modern economic challenges. He highlighted issues like
market failures, where self-interest doesn’t account for
problems like pollution or public goods, and economic
inequality, which markets often exacerbate. Thurow also
noted that the invisible hand struggles to manage global
challenges, such as trade imbalances and financial crises,
requiring coordinated policies. He believed governments
and institutions must play a stronger role to achieve societal
goals like fairness, sustainability, and long-term stability, as
markets alone cannot handle these complexities.

Emma Rothschild : Emma Rothschild argued that

Adam Smith’s "invisible hand" is often oversimplified and
misunderstood. She noted that Smith used the term
sparingly and as a metaphor for unintended consequences,
not as a justification for laissez-faire economics. Rothschild
emphasised that Smith recognized market limitations and
supported government roles in areas like education and
poverty relief. Her interpretation reframes the "invisible
hand" as part of Smith’s broader, more complex vision,
which includes ethical and institutional considerations
alongside market forces.
 John Keynes : John Maynard Keynes was critical of
Adam Smith's "invisible hand," arguing that it often fails to
ensure economic stability or full employment. Keynes
believed that markets do not always self-correct in times
of crisis, such as during recessions or depressions, when
demand drops and unemployment rises. He challenged
the idea that individual self-interest naturally benefits
society, emphasising that short-term decisions by
businesses and consumers can lead to economic
imbalances.
Keynes advocated for active government intervention to
stabilise economies, such as through fiscal and monetary
policies. He saw the invisible hand as insufficient for
addressing large-scale economic challenges, believing that deliberate public action was
necessary to manage demand, promote growth, and prevent prolonged economic
downturns.
The Invisible Hand and Market Economies

Business productivity and profitability are improved when profits and losses accurately
reflect what investors and consumers want. This concept is well-demonstrated through a
famous example in Richard Cantillon’s "An Essay on Economic Theory (1755)," the book
from which Smith developed his invisible hand concept.
Smith's "The Wealth of Nations" was published during the first Industrial Revolution and
the same year as the American Declaration of Independence. His invisible hand became
one of the primary justifications for an economic system of free-market capitalism.
As a result, the business climate of the U.S. developed with a general understanding that
voluntary private markets are more productive than government-run economies. Even
government rules sometimes try to incorporate the invisible hand.
What is a Free Market Economy?

A free market economy is one based on competition rather than government control.
Supply and demand regulate production and labour. Companies sell goods and services
at the highest price consumers are willing to pay while workers earn the highest wages
companies are willing to pay for their services.
A capitalist economy is a type of free market economy; the profit motive drives all
commerce and forces businesses to operate as efficiently as possible to avoid losing
market share to competitors. In capitalism, businesses are owned by private individuals,
and these business owners hire workers in return for wages or salary. In such an
economy, the government serves no role in regulating or supporting markets or firms.
In reality, no country is purely capitalist and no country has a purely free market.

(the above graph shows the interaction of forces of demand and supply with respect to
the price)
 Index of Economic Freedom - heritage.org

(top 10 highest ranked countries with economic freedom)

Economic Freedom and Human Development - heritage.org

(In countries around the world, economic freedom has been shown to increase the
capacity for environmentally friendly innovation. The positive link between economic
freedom and higher levels of innovation ensures greater capacity to cope with
environmental challenges)
 India : according to the Index of Economic Freedom
India’s economic freedom score is 52.9, making its economy the
126th freest in the 2024 Index of Economic Freedom. Its rating is
unchanged from last year, and India is ranked 26th out of 39
countries in the Asia-Pacific region. The country’s economic freedom
score is lower than the world and regional averages. India’s
economy is considered “mostly unfree” according to the 2024 Index.
India’s overall progress with market-oriented reforms has been uneven. The foundations
for long-term economic development remain fragile in the absence of an efficiently
functioning legal framework. State-owned enterprises have an extensive presence in many
sectors, and the legacy of decades of failed socialist policies includes a substantial tolerance
for government meddling in economic activity. Entrepreneurs continue to face serious
challenges. The regulatory framework is burdensome. The labour regulatory framework is still
evolving, and the informal economy remains an important source of employment. Monetary
stability has weakened.
The economy of India is a developing mixed economy with a notable public sector in
strategic sectors. It is the world's fifth-largest economy by nominal GDP and the third-largest
by purchasing power parity (PPP); on a per capita income basis, India ranked 141th by GDP
(nominal) and 125th by GDP (PPP).
Singapore : ranked 1st in terms of Economic Freedom
Singapore is a prime example of a successful free-market
economy, characterised by low taxes, minimal government
interference in most sectors, and a competitive, open market. The
government plays a strategic role by investing in infrastructure and
providing regulatory oversight, particularly in finance and essential
industries, while maintaining a pro-business environment. With
policies that foster ease of doing business, protect property rights, and encourage
innovation, Singapore has attracted significant foreign investment. Its highly skilled
workforce, flexible labour market, and strong global trade links further contribute to its
economic success. At the same time, social policies like public housing and healthcare
ensure a stable society, balancing free-market principles with social welfare.

Singapore's economy has been consistently ranked as the most open/free in the world,
the joint 4th-least corrupt, and the most pro-business. Singapore has low tax-rates and
the third highest per-capita GDP in the world in terms of purchasing power parity (PPP).
 United States : World's Largest Economy
The United States’ economic freedom score is 70.1, making its
economy the 25th freest in the 2024 Index of Economic Freedom. Its
rating has decreased by 0.5 point from last year, and the U.S. is
ranked 3rd out of 32 countries in the Americas region. The country’s
economic freedom score is higher than the world and regional
averages. The United States’ economy continues to be considered “mostly free” according to
the 2024 Index. Enormous policy challenges undermine long-term U.S. economic
competitiveness. Big-government policies have eroded limits on government, public spending
continues to rise, and the regulatory burden on business has increased. Restoring the U.S.
economy to “free” status will require significant changes to reduce the size and scope of
government. The United States is an example of a free-market economy, where market forces
determine the production, distribution, and pricing of goods and services with minimal
government interference. The private sector drives most economic activity, fostering competition
and innovation across industries like technology, finance, and healthcare. Capitalism
encourages entrepreneurship, and the U.S. is a global leader in trade and investment. While the
government enforces laws and provides limited social safety nets, such as Social Security and
healthcare programs, the economy remains largely driven by private enterprise and market
competition. The United States is a highly developed mixed economy. It is the world's largest
economy by nominal GDP; it is also the second largest by purchasing power parity (PPP),
behind China. It has the world's sixth highest per capita GDP (nominal) and the eighth highest
per capita GDP (PPP) as of 2024.
Advantages of a Free Market Economy :

● Efficiency: Since resources are allocated based on demand and supply, free markets
tend to be more efficient in distributing goods and services. Producers respond to
consumer preferences, ensuring that the most desired goods are produced in the
quantities needed.
● Innovation and Entrepreneurship: Free markets foster innovation because
businesses are incentivized to develop new products and services to compete
with others. Entrepreneurs can create businesses with less red tape, leading to
new ideas and technologies.
● Consumer Choice: Consumers have the freedom to choose from a variety of
goods and services. In a competitive market, companies cater to consumer needs,
offering diverse products to meet different preferences.

Disadvantages of a Free Market Economy :

● Monopolies and Oligopolies: Without regulation, large firms or corporations can

dominate markets, potentially leading to monopolies or oligopolies. This stifles
competition and can lead to higher prices, reduced product quality, and less
choice for consumers.
● Market Failures: Free markets are not perfect, and certain goods (like public
goods or externalities) may not be efficiently provided. For example, if a firm
pollutes the environment while producing goods, the broader societal cost (e.g.,
health care, environmental damage) may not be accounted for in the price of the
product, leading to market failure.
● Short-term Focus: Firms in a free market often focus on short-term profits, which
can be detrimental to long-term sustainability, such as environmental degradation
or neglect of workers' rights.

Challenges and Modern Considerations

While free market economies can drive prosperity, modern challenges have forced
governments to take a more active role in addressing the negative side effects of pure
free-market capitalism.

● Globalisation: In today’s globalised economy, free market principles often collide

with national interests and social objectives, as businesses expand beyond
borders and the competition intensifies.
● Regulation vs. Freedom: The debate continues over the balance between
regulation and freedom. Supporters of a free market argue that government
intervention stifles innovation and reduces efficiency, while critics argue that
regulation is necessary to protect consumers, workers, and the environment.
Conclusion
Key takeaways from the ‘invisible hand’ concept :
★ The "invisible hand" concept helps me understand how people, by pursuing their own
self-interest, can unintentionally benefit society. It shows how markets work through
supply, demand, and competition, which can improve quality and lower prices.
★ For example, businesses may seek profit but also create jobs and provide products
people need. It shows how markets work through supply and demand, where
competition can improve quality and lower prices.
★ However, it also teaches me that markets don’t always solve problems like inequality or
pollution, and sometimes the government needs to step in. Overall, it helps me see how
personal actions are connected to broader economic outcomes and the balance
between personal gain and social responsibility.
★ Another example, a shoemaker needs others to produce their house, while a
homebuilder relies on a shoemaker for shoes. On a larger scale, market forces and
competition motivate producers to make what is most profitable at the lowest cost,
encouraging technological progress and innovation, for the benefit of all.

Key takeaways from the Free Market Economy :

★ From studying the concept of a free market economy, I've learned that it’s based
on private ownership, voluntary exchanges, and competition, with minimal
government intervention. Resources are allocated efficiently through supply and
demand, leading to innovation and consumer choice.
★ However, it also has downsides, like income inequality, monopolies, and market
failures, where certain goods or societal costs aren't properly accounted for. I’ve
seen that while countries like the U.S. and Singapore operate with free market
principles, most economies are mixed, balancing market freedom with some
regulation to prevent negative outcomes.
★ Overall, I now understand the strengths and weaknesses of a free market system
and how it impacts both individual businesses and society as a whole.
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