Invisible hand
The invisible hand describes the unintended social benefits of an individual's self-interested actions, a concept that was first introduced by Adam Smith in The Theory of Moral Sentiments, written in 1759, invoking it in reference to 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 IV, Chapter II, "Of Restraints upon the Importation from foreign Countries of such Goods as can be produced at Home." The exact phrase is used just [|three times in Smith's writings].
Smith may have come up with the two meanings of the phrase from Richard Cantillon who developed both economic applications in his model of the isolated estate.
The idea of trade and market exchange automatically channeling self-interest toward socially desirable ends is a central justification for the laissez-faire economic philosophy, which lies behind neoclassical economics. In this sense, the central disagreement between economic ideologies can be viewed as a disagreement about how powerful the "invisible hand" is. In alternative models, forces which were nascent during Smith's lifetime, such as large-scale industry, finance, and advertising, reduce its effectiveness.
Interpretations of the term have been generalized beyond the usage by Smith.
Adam Smith
''The Theory of Moral Sentiments''
The first appearance of the invisible hand in Smith occurs in The Theory of Moral Sentiments in Part IV, Chapter 1, 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 they are honorable beings.
''The Wealth of Nations''
Adam Smith uses the metaphor in Book IV, Chapter II, paragraph IX of The Wealth of Nations.Using the invisible hand metaphor, Smith was trying to present how an individual exchanging money in their own self-interest unintentionally impacts the economy as a whole. In other words, there is something that binds self-interest, along with public interest, so that individuals who pursue their own interests will inevitably benefit society as a whole.
Other uses of the phrase by Smith
Only in The History of Astronomy Smith speaks of the invisible hand, to which ignorants refer to explain natural phenomena otherwise unexplainable:In The Theory of Moral Sentiments and in The Wealth of Nations Adam Smith speaks of an invisible hand, never of the invisible hand. In The Theory of Moral Sentiments Smith uses the concept to sustain a "trickling down" theory, a concept also used in neoclassical development theory: The gluttony of the rich serves to feed the poor.
Smith's visit to France and his acquaintance to the French Économistes changed his views from micro-economic optimisation to macro-economic growth as the end of Political Economy. So the landlord's gluttony in The Theory of Moral Sentiments is denounced in the Wealth of Nations as unproductive labour. Walker, the first president of the American Economic Association, concurred:
Smith's theoretical U-turn from a micro-economical to a macro-economical view is not reflected in The Wealth of Nations. Large parts of this book are retaken from Smith's lectures before his visit to France. So one must distinguish in The Wealth of Nations a micro-economical and a macro-economical Adam Smith. Whether Smith's quotation of an invisible hand in the middle of his work is a micro-economical statement or a macro-economical statement condemning monopolies and government interferences as in the case of tariffs and patents is debatable.
Economist's interpretation
The concept of the "invisible hand" is nearly always generalized beyond Smith's original uses. The phrase was not popular among economists before the twentieth century; Alfred Marshall never used it in his Principles of Economics textbook and neither does William Stanley Jevons in his Theory of Political Economy. Paul Samuelson cites it in his Economics textbook in 1948:In this interpretation, the theory is that the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. The reason for this is that self-interest drives actors to beneficial behavior in a case of serendipity. Efficient methods of production are adopted to maximize profits. Low prices are charged to maximize revenue through gain in market share by undercutting competitors. Investors invest in those industries most urgently needed to maximize returns, and withdraw capital from those less efficient in creating value. All these effects take place dynamically and automatically.
Since Smith's time, this concept has been further incorporated into economic theory. Léon Walras developed a four-equation 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 Edgeworth box contact line to illustrate a similar social optimality. Ludwig von Mises, in Human Action uses the expression "the invisible hand of Providence", referring to Marx's period, to mean evolutionary meliorism. He did not mean this as a criticism, since he held that secular reasoning leads to similar conclusions. Milton Friedman, a Nobel Memorial Prize winner in economics, called Smith's Invisible Hand "the possibility of cooperation without coercion." Kaushik Basu has called the First Welfare Theorem the Invisible Hand Theorem.
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 economic 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 Klein argues that reconciliation is legitimate. Moreover, even if Smith did not intend the term "invisible hand" to be used in the current manner, its serviceability as such should not be rendered ineffective. In conclusion of their exchange, Kennedy insists that Smith's intentions are of utmost importance to the current debate, which is one of Smith's association with the term "invisible hand". If the term is to be used as a symbol of liberty and economic coordination as it has been in the modern era, Kennedy argues that it should exist as a construct completely separate from Adam Smith since there is little evidence that Smith imputed any significance onto the term, much less the meanings given it at present.
The former Drummond Professor of Political Economy at Oxford, D. H. MacGregor, argued that:
Harvard economist Stephen Marglin argues that while the "invisible hand" is the "most enduring phrase in Smith's entire work", it is "also the most misunderstood."
According to Emma Rothschild, Smith was actually being ironic in his use of the term. Warren Samuels described it as "a means of relating modern high theory to Adam Smith and, as such, an interesting example in the development of language."
Understood as a metaphor
Smith uses the metaphor in the context of an argument against protectionism and government regulation of markets, but it is based on very broad principles developed by Bernard Mandeville, Bishop Butler, Lord Shaftesbury, and Francis Hutcheson. In general, the term "invisible hand" can apply to any individual action that has unplanned, unintended consequences, particularly those that arise from actions not orchestrated by a central command, and that have an observable, patterned effect on the community.Bernard Mandeville argued that private vices are actually public benefits. In The Fable of the Bees, he laments that the "bees of social virtue are buzzing in Man's bonnet": that civilized man has stigmatized his private appetites and the result is the retardation of the common good.
Bishop Butler argued that pursuing the public good was the best way of advancing one's own good since the two were necessarily identical.
Lord Shaftesbury turned the convergence of public and private good around, claiming that acting in accordance with one's self-interest produces socially beneficial results. An underlying unifying force that Shaftesbury called the "Will of Nature" maintains equilibrium, congruency, and harmony. This force, to operate freely, requires the individual pursuit of rational self-interest, and the preservation and advancement of the self.
Francis Hutcheson also accepted this convergence between public and private interest, but he attributed the mechanism, not to rational self-interest, but to personal intuition, which he called a "moral sense". Smith developed his own version of this general principle in which six psychological motives combine in each individual to produce the common good. In The Theory of Moral Sentiments, vol. II, page 316, he says, "By acting according to the dictates of our moral faculties, we necessarily pursue the most effective means for promoting the happiness of mankind."
Contrary to common misconceptions, Smith did not assert that all self-interested labour necessarily benefits society, or that all public goods are produced through self-interested labour. His proposal is merely that in a free market, people usually tend to produce goods desired by their neighbours. The tragedy of the commons is an example where self-interest tends to bring an unwanted result.
The invisible hand is traditionally understood as a concept in economics, but Robert Nozick argues in Anarchy, State and Utopia that substantively the same concept exists in a number of other areas of academic discourse under different names, notably Darwinian natural selection. In turn, Daniel Dennett argues in Darwin's Dangerous Idea that this represents a "universal acid" that may be applied to a number of seemingly disparate areas of philosophical inquiry, a hypothesis known as Universal Darwinism. However, positing an economy guided by this principle as ideal may amount to Social Darwinism, which is also associated with champions of laissez-faire capitalism.
Tawney's interpretation
saw Smith as putting a name on an older idea:Criticisms
Joseph E. Stiglitz
The Nobel Prize-winning economist Joseph E. Stiglitz, says: "the reason that the invisible hand often seems invisible is that it is often not there." Stiglitz explains his position:The preceding claim is based on Stiglitz's 1986 paper, "Externalities in Economies with Imperfect Information and Incomplete Markets", which describes a general methodology to deal with externalities and for calculating optimal corrective taxes in a general equilibrium context. In it he considers a model with households, firms and a government.
Households maximize a utility function, where is the consumption vector and are other variables affecting the utility of the household. The budget constraint is given by, where q is a vector of prices, ahf the fractional holding of household h in firm f, πf the profit of firm f, Ih a lump sum government transfer to the household. The consumption vector can be split as.
Firms maximize a profit, where yf is a production vector and p is vector of producer prices, subject to, Gf a production function and zf are other variables affecting the firm. The production vector can be split as.
The government receives a net income, where is a tax on the goods sold to households.
It can be shown that in general the resulting equilibrium is not efficient.
Let's use as a simplifying notation, where is the expenditure function that allows the minimization of household expenditure for a certain level of utility. If there is a set of taxes, subsidies, and lump sum transfers that leaves household utilities unchanged and increase government revenues, then the above equilibrium is not Pareto optimal. On the other hand, if the above non taxed equilibrium is Pareto optimal, then the following maximization problem has a solution for t=0:
This is a necessary condition for Pareto optimality. Taking the derivative of the constraint with respect to t yields:
Where and is the firm's maximum profit function. But since q=t+p, we have that dq/dt=IN-1+dp/dt. Therefore, substituting dq/dt in the equation above and rearranging terms gives:
Summing over all households and keeping in mind that yields:
By the envelope theorem we have:
;∀k
This allows the constraint to be rewritten as:
Since :
Differentiating the objective function of the maximization problem gives:
Substituting from the former equation in to latter equation results in:
Recall that for the maximization problem to have a solution a t=0:
In conclusion, for the equilibrium to be Pareto optimal dR/dt must be zero. Except for the special case where ∏ and B are equal, in general the equilibrium will not be Pareto optimal, therefore inefficient.