Adam Smith in 1776 wrote the book called “An Inquiry into the Nature of Causes of the Wealth of Nations”ť (Gwartney & Stroup & Sobel & MacPherson, 2008). In this book he has formulated one of the core principles of economics, called the “invisible hand of the market”ť (Mankiw, 2008). The idea of this principle is the following: in a free economy, the actions of market participants ”“ self-interested individuals ”“ are coordinated by market prices so that their activities contribute to the general welfare. Adam Smith stated that “by pursuing his own interest, every individual promotes the welfare of the society more effectively than when he really intends to promote it”ť (Mankiw, 2008).
The mechanism of the invisible hand of the market can work only in the conditions of a truly free economy (also referred to as a “laissez-faire”ť economy). The invisible hand will work if four conditions are met (Bandelj, 2010):
”˘ competition : every market is purely competitive (there is vigorous competition everywhere);
”˘ absence of externalities: the transactions between the sellers and the buyers do not affect any third parties (no sale conditions or hidden agreements);
”˘ adequate information: consumers have all the required information for making purchase decisions, e.g. have access to information regarding prices, quality and availability of products and other issues which might affect consumer decision-making;
”˘ No public goods: there are no non-exclusive public goods (such as defense systems, judicial system etc.).
The mechanism of the invisible hand of the market is using the prices as a “communication means”ť (Gwartney & Stroup & Sobel & MacPherson, 2008). For example, buyers of a certain good analyze the price and available quantity of any given item when they want to purchase it, then choose the lowest price available, and adjust the quantity they want to purchase. At the same time, sellers are trying to maximize sale price, and also adjust their volumes of production to the market needs. Equilibrium market price reflects “both the value of a good to society, and the cost to society of making the good”ť (Mankiw, 2008). In this way the invisible hand of the market directs the participants of the market towards decisions optimal for the whole society.
Bandelj, N. & Sowers, E. (2010). Economy and State. Polity.
Gwartney, J.D. & Stroup, R.S. & Sobel, R.S. & MacPherson, D. (2008). Economics: Private and Public Choice. Cengage Learning.
Mankiw, G.N. (2008). Principles of economics. Cengage Learning.