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What is the Invisible Hand of the market?

Level:
AS, A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 14 Jul 2023

The invisible hand of the market refers to the idea that the market, through the self-interest of individuals and firms, can coordinate economic activity and allocate resources efficiently.

This concept was first articulated by Adam Smith, the father of modern economics, in his work "The Wealth of Nations."

According to Smith, individuals and firms, acting in their own self-interest and guided by the invisible hand of the market, will produce and consume goods and services in the most economically efficient way possible, leading to the optimal allocation of scarce resources and the greatest overall prosperity.

The invisible hand of the market is based on the assumption that the free market is a self-regulating system in which the forces of supply and demand interact to determine prices and quantities. It is believed that the market, through the process of competition, can allocate resources efficiently and produce the best outcomes for society as a whole. This is known as the price mechanism.

Examples

Here are some examples of the invisible hand of the market at work:

  1. The determination of prices: The invisible hand of the market coordinates the production and consumption of goods and services through the process of supply and demand. When there is a high demand for a particular good or service, the price will tend to rise, which will encourage producers to increase their output in order to take advantage of the higher price. Conversely, when demand is low, the price will tend to fall, which will discourage producers from producing as much of the good or service.
  2. The allocation of resources: The invisible hand of the market guides the allocation of resources to the most efficient uses. For example, if there is a high demand for smartphones, producers will allocate resources to the production of smartphones in order to take advantage of the higher profits. This will lead to an increase in the supply of smartphones and a decrease in the supply of other goods and services.
  3. The development of new technologies: The invisible hand of the market can also encourage the development of new technologies by providing incentives for firms to invest in research and development. For example, if a firm develops a new and innovative product, it will be able to charge a higher price and earn higher profits, which will provide an incentive for other firms to invest in similar technologies.

Existence of market failure

However, it is important to note that the invisible hand of the market is a theoretical construct and that real-world markets may not always function perfectly. There may be externalities, missing markets in the form of pure public goods and other factors including immobility of labour that can prevent the market from achieving optimal outcomes.

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