Invisible Hand (supply and demand) and Adam Smith

Invisible Hand (supply and demand) and Adam Smith

Invisible Hand

I realized as I was writing on some of these articles that some of the readers might not understand or know about many of the economic theories and principles that I’ve been mentioning. In that endeavor, to make the public and my friends, more educated about economics I’m planning to write a summary about economic theories. Each one will be a post and there’s TONS of theories out there. I hope this will all turn into a big data base of theories so that people can come and read up on what economists generally think about a certain idea. Then after they read about they can make their own conclusions.

I’m planning to begin with the past and work my way towards the current era. So obviously I’ll start off with my first post of the series that being supply and demand or as Adam Smith called it the “invisible hand”.

Disclosure: The links for the books will link to amazon.com and the author will recieve a small compensation for the product purchased. 

The Invisible hand and Adam Smith.

 Let’s first define what the “invisible hand” is: It is a term used by Adam Smith to describe the unintended social benefits or consequences of individual’s actions. Adam Smith used the term first in “The Theory of Moral Sentiments”(1759) and then later in his better known book “The Wealth of Nations”(1776).

The invisible hand describes the phenomena as Adam Smith saw it which was this: each individual pursuing his own selfish desires was lead to achieve the best good for all. So that any interference from government was almost always to be a bad thing.

Or in other words; as a consumer is allowed to freely buy what they want and each producer is allowed to freely sell what is profitable and produce what the consumers want, the market will settle on a product distribution and a price. This will benefit the individuals who are consuming and producing the products as well as the whole community. Each person wants a fair price and each producer wants to cut costs and maximize profits. If the price gets too high consumers will stop buying. If the price gets too low producers will stop making the product.

Supply and Demand

As you can probably infer that is where the theory of supply and demand comes from. The market will eventually reach an allocative efficiency due to numerous individual interactions that is called the equilibrium price and quantity.

Let’s take a quick example. If a clothing store over produces a t-shirt they will continue to cut the price for that t-shirt until people start buying the product. A surplus creates downward pressure on the price.

A shortage has the opposite effect on the market. Consumers who really want the t-shirt will bid the price up or the producers will continue to raise the price until no-one buys it. Then they lower it back down until people buy it again. At some point they will reach an equilibrium in price and quantity where both consumers and producers feel they are getting a decent deal.

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Shifts/movement in demand/supply

 Finally we have shifts in demand or supply. There are different things that can cause demand and supply to shift. Here’s a quick run-down.

Demand shifts:

  1. Income
  2. price of related goods
  3. preferences and expectations
  4. population
  5. expectations about the future

Supply Shifts:

  1. input prices
  2. Technology/productivity
  3. price of a substitute/complement good
  4. number of firms
  5. expected future price of the product

 

Demand Shifts Right

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Supply Shifts Right

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Supply shifts cause the equilibrium to change. As you can see from the above graphs. Shocks or shifters to the supply and demand functions are studied a lot by economists.

Movement:

The shifts have been covered briefly but it’s possible to move along the supply or demand curve. This is fairly simple. It’s a change in price or it’s a change in quantity supplied or demanded. A shift is generally an outside thing that impacts the curve.

Conclusion:

The observations of Adam Smith have created the basis for modern economic theory and political economy. His theory on invisible hand, markets, and supply and demand started an entire field of study. Adam Smith saw a beautiful thing…

The beauty Adam Smith saw in markets is that there is no central planning required. These markets arise without outside intervention and they come into equilibrium without planning. And in fact, most people are completely unaware that this happens.

This isn’t to say that markets can’t be imperfect or have inefficiencies in them or create pain and agony for both producers and consumers. However, what this does show us is that markets will reach allocative efficiency due to the “invisible hand” given long enough periods.

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