Adam Smith And The Invisible Hand

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Table of Contents

Introduction
Smith argument on the role of markets
Role of state
Duties of the government according to Smith
Theory of Invisible hand
Conclusion
Reference List

Introduction

Adam Smith, a Scottish philosopher and a moralist had a big impact on modern economics and concepts of individual freedom. He advanced various theories such as the moral sentiment theory which primarily entails the ethical conduct linking societies. In his book ‘An inquiry into the nature and causes of Wealth of Nations’ Adam Smith examines the impact of economic freedom. Smith argues that the well-being of individuals has been continuously progressing as a result of free exchange of products and services.

He also developed the concept of invisible hand. This concept describes natural forces which propel free market capitalism through competition for scarce resources. He further postulates that no regulation is required to enable exchange of goods and services. This paper seeks to provide the process through which social harmony is resolved in an era of individualistic chaos according to Adam Smith. It also analyzes the role played by the state.

Smith argument on the role of markets

Adam Smith’s formulated the law of profit motive. This law postulates that individuals engage in trade for monetary purposes. The law is crucial in explaining market roles. According to this law, individuals engage in various activities so long as they involve exchange of money. When an individual is pursuing self interests, the act can be perceived as being self serving. However, it may be for the benefit of the entire society. Smith argues that competition is vital in attainment of a productive society (Fusfeld, 2002, p.13).

In an unregulated economy which is characterized by capitalism, competition enables both the entrepreneur and capitalist to operate fairly. In unregulated markets, fair competition is very important in that it eliminates existence of monopolies. According to Adam Smith, development and prosperity of an economy can only be achieved via an environment where competition occurs freely and in accordance with the natural laws of the universe.

It is possible for one to view Smith’s idea as being anti-government. He believed that the government has a major role to play in an economy. According to Smith, the government should be responsible in ensuring that there is fair trade in the markets.

To encourage innovation among entrepreneurs, the government should grant patents and facilitate enforcement of contracts. In addition, it should act as a regulator in case of unfair competition. Smith’s view inclined towards an economy which is not regulated. In his opinion, supply and demand play significant role in markets within an unregulated economy.

Smith asserts that increase in demand leads to a proportional increase in supply, that is, if demand for a product is high, producers will be compelled to produce and supply more to satisfy consumers. This is the driving force of competition. Through market mechanism, society changes its allocation and distribution of production elements to fulfill its needs. With the market regulating prices and quantities of products, it ends up regulating income of people collaborating to create those goods.

Adam Smith had fair comments regarding importation market. He claimed that in some circumstances, it is probably unwise and foolish to spend much money on domestic goods which can be cheaply imported from other countries. Smith summarizes benefits of markets by saying that a market society leads to improved productivity through division of labor and specialization, it is affluent to all people and it leads to ultimate reduction of difference in class among the citizens of a country.

Function of capitalists

Capitalists are entrepreneurs who create goods and services so as to sell in the market thus increasing their wealth. Smith believed that capitalism gives workers freedom to choose their preferred trade. In his opinion, capitalists should accumulate wealth for the benefit of whole society.

Division of labor

This is where a given task is shared among a number of workers. Smith views division of labor to be the main reason for existence of wealth (Weizsacker, 1993, pp. 241). Growth, according to Adam smith is caused by division of labor. Jobs should be broken into smaller and manageable portions so that workers can execute tasks which they are conversant with. Division of labor promotes efficiency of workers because they can deliver quality results within a short time.

This is one of the reasons why some industries in the nineteen century were effective in their operation. However, there are a number of shortcomings associated with division of labor. For example, a worker undertaking the same task repeatedly becomes bored. This arises from the fact that the task becomes monotonous and hence there is no motivation to do the task. In addition, the worker becomes ignorant and dissatisfied.

Specialization

Specialization allows employees to do a particular task in which they are best at. Adam smith advanced specialization as a means of achieving high economic growth. He proposed a task be broken down into various tasks so that each worker can concentrate on one part.

Economies of scale

Production of goods in large quantities has the overall effect of reducing production cost. Economies of scale are aimed at attaining mass production using minimum input. Adam Smith reiterated that economic growth can be realized through incorporation of economies of scale in the production process.

He identified two main concepts via which this can be attained. These include division of labor and specialization. Using these techniques, workers can concentrate on a particular task thus enabling them to improve the skills required to execute tasks. This saves money and also increases output (Smith, 1904, p. 10).

Accumulation of capital

Every capitalist tries to maximize returns by employing accumulated capital in every possible ways. Adam Smith supports accumulation of capital using his law of population. According to Smith, more workers lead to increase in machines usage hence more production occurs.

Role of state

Adam smith was largely seen by many people as a person who does not see the importance of government in regulating an economy. This is evident in that he considers any form of government intervention as foolish and dangerous. He also believed that government should not advise capitalists on what to do regarding issues on wealth accumulation. Regulations imposed by the government via price controls and taxation has the impact of reducing wealth created by capitalists by reducing ability of people to create goods and services(Smith, 1904, p. 13).

Price controls involve price ceilings and price floors. Price ceiling prevents prices from exceeding the equilibrium price (the price where demand is equal to supply). This causes shortage of commodities. On the other hand, price floors cause surpluses by prohibiting prices from going below the equilibrium price.

Smith opposed social security programs because he did not trust the government in handling funds from the public. Smith explains that a nation that is most effective promotes its own wealth by implementing laws and regulations which enable businessmen and women to freely conduct their trade (Smith, 1904, p. 14).

Governments can promote monopoly of certain firms. This is made possible by putting up barriers of entry that can potentially block new competitors. Such barriers can be in form of high licensing fee, patent and trademarks.

Duties of the government according to Smith

National defense

The government should fund defense of a country. Military and police are paid from the public coffer thus ensuring that the country is safe from both internal and external aggressions. This arises from the fact that national defense cannot be sustained by private sector owing to enormous expenses attributed to this docket.

Administration of justice

The government is responsible for running a country’s justice system. It must ensure that citizens abide by the laws of the land. Government establishes corrective system aimed at rehabilitating wrong doers. In any democratic country, the independence of the judiciary is critical for the prevalence of justice.

Provision of essential services

The government can promote economic growth in a nation by building infrastructure such as roads, bridges, schools and hospitals. Capitalists cannot provide such vital amenities because it requires huge financial commitment which can only be provided by the government.

Theory of Invisible hand

There have been numerous interpretations of invisible hand provided by different scholars. It is evident that the concept has not been well understood. Gramp, interpreted invisible hand to mean people’s self interest leads to them keeping their capital at home instead of exporting them.

If any person is asked to interpret Adams smith Invisible hand theory, the possible answer to expect is that the invisible to benefit them. Such exchanges often lead to development of markets and enhance competition between buyers and sellers (Grampp, 2000, pp. 451).

Invisible hand leads to social goodness as a result of individuals pursuing their own interests. A good example is when a millionaire’s thirst for more money ends up satisfying societal needs. He can do so by inventing a unique product and selling it to the public.

Invisible hand is considered to be the most efficient and effective method of organizing an economy. This is because a free market consisting of self-interested people is better at creating overall prosperity as compared to the government monopolizing the production process. The government cannot manage to oversee every aspect of production of goods and services and hence it delegates the duty to experienced individuals such as entrepreneurs and companies.

However, this theory has a number of weaknesses. For example, people question the existence of the police and justice system. The reason for existence of such institutions is to prevent self seeking individuals from wrecking havoc in the process of individuals maximizing their wealth.

Various scholars perceive Adam Smith as a popular moralist and economist because of his famous “invisible hand” concept (Ahmad, 1990, pp.137). The theory of invisible hand as advanced by Adam Smith has been debated for decades. To highlight the different interpretation of invisible hand, Grampp’s view is provided here. He concurs that Self interest drives general interest but it only applies in competitive market.

Grampp rejected a common interpretation that invisible hand represents price mechanism. He also interpreted invisible hand to be the mutual advantage resulting from exchange. Other interpretations relate to the concept that the invisible hand represented God and that it promoted national defense through limiting capital export. Before any modern interpretation of invisible hand began to emerge, this theory suffered credibility issues because it was considered a mere apologetics for capitalists who concentrated on accumulating wealth.

Grampp asserted that there is a connection between the invisible hand and national defense. He claims that defense of a country is important than wealth, that is, governments should prioritize defense (Minowitz, 2004, pp. 381).

According to Minowitz (2009, pp.241) sub optimal outcomes resulted from certain behavior of people. This behavior makes the market to operate less competitively for instance when capitalists exhibit monopolistic tendencies.

Currently, the term invisible has a wider and broader meaning. It is assumed that invisible hand concept largely applies in a free market situation dictated by forces of demand and supply. This arises from the assumption that consumer’s prefer to choose the lowest priced items while producers choose high prices so as to maximize returns. The invisible hand provides positive aspect of a market based economy such that it compels producers to critically analyze what other people need and what should be done so as to fulfill these needs.

Conclusion

Numerous studies have been conducted regarding the theory of invisible hand. Richard Olsen, the President of Olsen and Associates in Switzerland challenged this theory in his paper “The fallacy of the invisible hand”. According to Oslen, there is statistical evidence which provides proof that invisible hand is significant in determining market prices.

His study was aimed at ensuring that individuals acknowledge that financial markets are predictable (Olsen, 1993, pp. 94). Olsen’s views regarding this theory highlights that more opinions will emerge in the future.

Reference List

Ahmad, S. 1990. Adam Smith’s four invisible hands. History of political Economy. Vol. 22, issue 1, pp .130-140.

Fusfeld, D. 2002. The Age of the Economist. London: Pearson.

Grampp, W. 2000. What did Adam Smith mean by invisible hand? Journal of Political Economy, Vol. 108, issue no.3, pp. 449-452.

Minowitz, P. 2004. Adam Smith invisible hand. Economic Journal Watch. Vol 1, no.3. pp. 230-269.

Olsen, R. 1993. Fallacy of invisible hand. Web.

Smith, A. 1904. An Inquiry into the Nature and Causes of the Wealth of Nations. London: Methuen and Co., Ltd.

Weizsacker, C. 1993. The division of labor and market structure. Netherlands. Kluwer Academic Publishers.

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