A theory introduced by the Scottish economist Adam Smith in his book “The Wealth Of Nations”.
This theory was based on the idea that people who are seeking for their individual interests could actually benefit other people too, even if unintentionally .
Smith suggested to leave self-interested traders compete with one another without the intervention of the government. This competition, and by a pure profit motive, pushes businesses to do their best to improve their quality/price ratio to increase their turnover, and by doing this they are contributing to the general wellbeing of the country.
The “invisible” hand refers to the unseen forces that move the economy. The interplay of individual pressures on market supply and demand causes the natural movement of prices and the flow of trade.
This let-go approach leads to market equilibrium without the intervention of external forces.
Every individual… neither intends to promote the public interest, nor knows how much he is promoting it… 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 Wealth Of Nations, Book IV, Chapter II, p. 456, para. 9.
Adopting this invisible hand theory has considerable advantages for the market and the society as a whole:
. Ensures the optimal and efficient production: when the supply is high compared to the demand businesses are ready to reduce the production to protect their profits, if the demand is higher than the supply businesses will increase the production to meet their customers’ needs. This process is beneficial for businesses as well as the consumers because it leads to price levels stabilization and market equilibrium.
. Free trade and the non-intervention of the government allow businesses to specialize in productions where they have comparative advantage .
. This theory also enables each person (and business) to make free choices.
Despite its advantages for the economy and the society, invisible hand theory faces many limitations as well :
. Smith’s theory is based on the assumption that people are rational and have the relevant information to make decisions but there are cases where people can be emotionally charged and irrational.
. Without the intervention of government markets may take a lot of time to achieve the equilibrium .
. People following their own interests can result in some un-wanted external costs like pollution and overproduction .
A debate about a given theory does not reach an absolute conclusion, as there are always positive and negative aspects that are taken into consideration. Smith’s theory is subject to the same logic, although it may seem the closest to the application under the current economic system prevailing in the world.