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A short understanding of the Invisible Hand theory of Adam Smith

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Adam Smith
Philosopher, 1723 – 1790

Adam Smith was born in Kirkcaldy, Fife, Scotland. The exact date of his birth is unknown; however, he was baptized on June 5, 1723. Smith was the Scottish philosopher who became famous for his book, “The Wealth of Nations” written in 1776, which had a profound influence on modern economics and concepts of individual freedom.

In 1751, Smith was appointed professor of logic at Glasgow University, transferring in 1752 to the chair of moral philosophy. His lectures covered the field of ethics, rhetoric, jurisprudence and political economy, or “police and revenue.” In 1759 he published his Theory of Moral Sentiments, embodying some of his Glasgow lectures. This work was about those standards of ethical conduct that hold society together, with emphasis on the general harmony of human motives and activities under a beneficent Providence.

Smith moved to London in 1776, where he published An Inquiry into the Nature and Causes of the Wealth of Nations, which examined in detail the consequences of economic freedom. It covered such concepts as the role of self-interest, the division of labor, the function of markets, and the international implications of a laissez-faire economy. “Wealth of Nations” established economics as an autonomous subject and launched the economic doctrine of free enterprise.

Smith laid the intellectual framework that explained the free market and still holds true today. He is most often recognized for the expression “the invisible hand,” which he used to demonstrate how self-interest guides the most efficient use of resources in a nation’s economy, with public welfare coming as a by-product. To underscore his laissez-faire convictions, Smith argued that state and personal efforts, to promote social good are ineffectual compared to unbridled market forces.

In 1778, he was appointed to a post of commissioner of customs in Edinburgh, Scotland. He died there on July 17, 1790, after an illness. At the end it was discovered that Smith had devoted a considerable part of his income to numerous secret acts of charity.

Invisible hand theory of Adam Smith

One of the greatest contributions of Adam Smith was the invisible hand theory. He said that if the government doesn’t do anything, there’s a controlling factor of people themselves who can guide markets. I believe that the government should be responsible in defining the property rights, to set up honest courts, to impose minor taxes and to compensate for well defined “market failures” If I sell candies for 1 peso each and Christian sells them for 2 pesos for 3 pieces, he will get all the business making me lose mine so in order to compensate for my loss I should be forced to lower my price as to stay alive in the business. I am guided by an invisible hand which is my self interest to gain profit or as Adam Smith would say everyman for himself.

The theory of 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. 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. Students prepare for the most needed (and therefore most remunerative) careers. All these effects take place dynamically and automatically.

The way I understand the said theory is by giving my own example;

Joan and Joanne are fresh graduates and are trying to open up a business to help them understand and be aware about the invisible hand. About a month they have realized that people from their hometown had to go the mountains to purchase fruits and vegetables. They conducted a survey to find the most fruits and vegetables in demand of the community. After careful consideration and months of planning they decided to open up a fruit and vegetables business naming it Twin’s fruit and vegetables where they would be the one to purchase wholesale goods and sell it to the people. The people were quite glad about it because it would save them the time and effort to go up the mountains to buy rather just go to Twin’s fruit and vegetable. Things were running smoothly for their business and they were happy about it. They offered free delivery within a certain area and maintain their low prices to satisfy their customers for they have realized that only with the continuous support of the people will they be able stay in business and also discourage other businessmen from entering the market.

It is understood that the invisible hand in this situation is the idea of being the only producer of a certain good by being considerate as to lower the price for the people to be able to afford thus making a good reputation to the said company. If the community is already satisfied with the way things are then they will continue to support the said business making it hard for other businessmen to open market

This was taken from the famous wealth of nations

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. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

This is as how Adam Smith explained it that being led by an invisible hand is actually profitable in the sense that it uses the will of a person’s self interest which drives him to create more and better ideas to overcome the other competitors as long as he would be doing it in a legal way.

http://www.lucidcafe.com/library/96jun/smith.html

http://en.wikipedia.org/wiki/Invisible_hand

http://plus.maths.org/issue14/features/smith/

http://answers.yahoo.com/question/index?qid=20100225123447AA1ooUA

Written by jongart

May 25, 2010 at 11:04 PM

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