The Invisible Hand

The Invisible Hand

According to classical economic theory, the cumulative effect of buyers and sellers acting in their own self-interest will benefit society by creating the most efficient outcome of market price and quantity. The “invisible hand” is the idea that something as beneficial as maximum market efficiency can be the result of countless decisions being made in self-interest.

The concept is rather simple, in theory. In all markets, whether we are talking about product markets, labor markets, or something else, buyers want to receive the “most” or “best” but pay the least. That is the self-interest motive from the buyers’ side. Sellers, on the other hand, want to maximize profits. Profits are defined as revenue minus costs, so sellers want to conduct business in a manner that maximizes the amount that revenue exceeds costs. Sellers look towards getting the highest prices at the lowest cost. That is the self-interest motive from the sellers’ side.

The interests of the buyers and sellers are conflicting interests. The give and take of market forces creates equilibrium between these conflicting interests, and the maximum-efficiency economic outcome is the result of this give-and-take.

In this scenario, market efficiency is the result of the give-and-take of market forces unleashed by two sides of transactions acting in their own self-interest. There is an important lesson to learn here:

The self-interest of buyers does not create efficient markets.

The self-interest of sellers does not create efficient markets.

Only the give-and-take between the two opposing self-interests creates efficient markets.

Market efficiency can only result if both sides have equal market power. In this theory, there is no way to achieve market efficiency without each side being equal in market power.
Policies that give one side of this equation more market power than the other side do not promote market efficiency. These policies do the exact opposite; they promote inefficiency. The idea that somehow better results will occur if we have a set of policies that favors one side or the other is a fallacious idea.

The idea that better results will occur if we have no policies, or fewer policies, because doing so will “get the government out of the way and let the free market work its magic” is also fallacious, unless it can be shown that doing so would promote equal market power between buyers and sellers. Such a result would be very difficult to show. Except for the extreme situation of pure anarchy, the government by its very existence creates the conditions in which a market economy functions. Without anarchy, there is going to be government involvement. It isn’t government involvement per se that creates inefficient markets; it is unequal footing between buyers and sellers that does so. “No policy” is a policy.

The invisible hand is a theory from a simplified version of a more complex real world. Even so, this theory is used to justify policies designed to give more market power to sellers at the expense of buyers in the product markets, and more power to buyers at the expense of sellers in the labor markets. This is being done in the name of market efficiency.

Such policies do not follow rationally from the theory that is being used for their justification.

A version of this essay is included as a chapter in the book Sanity and Public Policy: Separating Truth from Truisms by Jerry Wyant. This book is available in both paperback and eBook formats.

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Jerry Wyant