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One of the penalties for refusing to participate in politics is that you end up being governed by your inferiors. -- Plato (429-347 BC)

Thursday, December 22, 2016

What Is the "Invisible Hand"?

by Art Carden:
“As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He 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.”Adam Smith, Wealth of NationsWhich better guides the use of a society’s decentralized knowledge: the invisible hand of the market or the visible fist of the state? Adam Smith began An Inquiry into the Nature and Causes of the Wealth of Nations by explaining that people have become more productive because they have been able to specialize and divide labor. He identified and explained something really marvelous. The invisible hand of the marketplace helps us make use of others’ knowledge and encourages us to help ourselves by helping others. The invisible hand of market exchange—and voluntary action more generally—generates the ordered use of social knowledge according to the visions, plans, and expectations of the many members of that society, rather than according to the visions, plans, and expectations of state functionaries.

The "Invisible Hand" Describes the Communal Benefits of Personal Actions
In the passage above, Smith makes one of his most bracing, important, and often misunderstood claims. The invisible hand of the marketplace converts our self-interest into the public interest. We intend to make the world a better place according to our preferences, with the result being an unintended increase in others’ capacity to make the world a better place according to their preferences. By working to maximize our own well-being, “every individual necessarily labours to render the annual revenue of the society as great as we can.”

Smith observes a pattern and an outcome. An investor, entrepreneur, or manager directs his time, talent, and treasure toward the industries that will yield the largest revenue. To the extent that he supports “domestic industry,” it is not because he wishes to do so per se but because this is most conducive to “his own security” as measured by his desire for profit and his tolerance for risk.

He encounters four problems, though.

First, his wants are unlimited. No matter how much he has, he can almost certainly think of ways he could use even more. This needn’t be selfishness or greed. I enjoy traveling, for example, and I plan to do more of it as my income increases. I can also think of spiritual, humanitarian, and intellectual causes I would support more generously if I had more money.

Second problem: Resources are scarce. If Adam takes a bite of an apple, that is a bite Eve cannot take. The baker cannot knead bread dough and chop firewood in the same instant. That blob of plastic can become a coffee stirrer or a guitar pick, but not both at the same time. Material resources are scarce.

Third problem: He doesn’t share others’ talents, tastes, and values. Should the land be used to grow apples in the first place, or should it be used to grow oranges? Should the baker knead dough or chop firewood? Guitar players and coffee drinkers might have very different views about how specific bits of plastic should be used. That is not to say there should be only guitar picks to the exclusion of coffee stirrers or only coffee stirrers to the exclusion of guitar picks. Rather, a given unit of plastic of a given type, composition, and quality can only be used for one or the other.

Fourth problem: The investor, entrepreneur, or manager doesn’t share others’ knowledge. In thinking about examples for the previous paragraph, I reflected on how little I know about chemical engineering and plastics. If I wanted to make coffee stirrers or guitar picks, I wouldn’t know where to begin. Maybe “buy some plastic,” but I don’t know what kind of plastic is most appropriate for coffee stirrers and what kind is most appropriate for guitar picks. There are people in the world who do know—and some of them are probably reading this article—but I’m almost totally in the dark.

Free Markets Allow Us to Trade Freely and to Divide Labor Based on Our Wants and Talents
This is where the invisible hand of the market comes in. Voluntary market exchange reveals the patterns of specialization, division of labor, and production most consistent with consumers’ preferences. Others’ talents, tastes, values, and knowledge constitute the invisible hand. I convey information about my own talents, tastes, values, and knowledge with offers to buy or sell. Others convey their knowledge by their willingness to accept my bids and offers. I am being led by the invisible hand of others’ knowledge toward patterns of specialization and production that leave us most satisfied, given that we are all free to accept or reject any offer.

As the economist Paul Heyne put it in his book Are Economists Basically Immoral?, market exchange means “everyone wins, or at least everyone with the right to be consulted.” The parties to the transaction are the ones who have skin in the game, and they are the only ones who have the right to be consulted.

Observers who disapprove of others’ actions and exchanges too often want to substitute the visible fist of the state for the invisible hand of the market and prohibit the buying and selling of goods and services of which they do not approve. In doing so they destroy potentially valuable knowledge about, for example, the risks I am prepared to take. Furthermore, the state allows observers to substitute their own reasoning without paying a meaningful price beyond simply having an opinion about something. It’s easy to conjure up a vivid nightmare scenario in which I am breathing my last in a hospital room, the air heavy with my regret at having eaten genetically modified almonds, for example. Just because we can imagine it happening doesn’t mean it is probable enough for us to worry about. When we substitute the visible fist of the state for the invisible hand of the market, we essentially say that some knowledge as expressed by some voices has no place in the social conversation—and more important, we divert resources away from the patterns of specialization and production that yield maximal social output, or an increase in well-being for all.

Art Carden is grateful to James Otteson for an e-mail exchange that clarified his thinking on some of these points.
Art Carden is Associate Professor of Economics at Samford University’s Brock School of Business. H/T Intercollegiate Review (IR) who shared this article with the editor. IR is published by the Intercollegiate Studies Institute (ISI) and is dedicated to advancing the principles that make America free, virtuous, and prosperous.

Tags: Art Carden, the Invisible Hand, Adam Smith, Intercollegiate Review, Intercollegiate, Studies Institute, To share or post to your site, click on "Post Link". Please mention / link to the ARRA News Service. and "Like" Facebook Page - Thanks!
Posted by Bill Smith at 4:29 PM - Post Link


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