The Invisible Hand – Definition

Definition of the invisible hand:
The observation by economist Adam Smith that a free market formed of independent actors acting in their own self interest will appear to automatically settle at the correct price to provide the maximum benefit. Almost as those the process was guided by an invisible hand.

What is the invisible hand?

The invisible hand is an expression coined by Adam Smith to support the idea of free markets in his economics book ‘The Wealth of Nations’. He used the expression to point out that free markets manage themselves very effectively – almost as if a god-like or magical force was directing the action.

The invisible hand isn’t a specific economics concept in itself, but rather it draws up topics such as free markets, supply & demand, and the market equilibrium.

As explained in free market definition, a free market is a marketplace in which:

  • There are many buyers and sellers
  • Each side has perfect information
  • There are no taxes or costs

In such a free market, Adam Smith theorised that the price will always settle at the price which would match the maximum number of buyers and sellers.

This is known as market equilibrium, and is the holy grail of micro economics because at this price point, a market will serve the interests of as many people as possible by maximising the amount consumed.

The Invisible Hand - Definition
The definition of the invisible hand is an economics definition

How is the phrase invisible hand used in a sentence?

“Prices naturally revert to the market equilibrium thanks to the invisible hand.”

What else you should know about the invisible hand

What made Adam Smith’s comment in ‘The Wealth of Nations” about the invisible hand very memorable was the apparent conflict between:

  • Everyone acting purely in their own self interest
  • The market outcome being the best result for everyone

It feels quite counterintuitive that selfish acts could result in a good overall outcome, indeed the ‘perfect outcome’.

That’s because the perfect outcome in a strict, micro economics sense is not the same as the best outcome per utilitarian philosophy or deontological schools of thought.

In basic microeconomics, the optimal result is when the most value is created or the most goods & services consumed. But all within the constraints of the personal preferences of the market participants.

In other words, if most food shoppers are only prepared to pay £3 or less, and a food shop will make no profit on food sold for less than £2, then the optimal result has to fall somewhere within the two prices.

The limitations of the phrase

But this doesn’t necessarily create an ideal result for the whole of society. In microeconomics, the pursuit of self interest naturally means that a firm will not be expected to perform an action if it doesn’t generate profit.

Therefore if a group of poor people could only afford £1.50 for food – the ‘optimal result’ would price them out of the market.

By abandoning assumptions of self-interest, a firm could choose to sell certain foods below cost to feed this group, but this would break outside of Adam Smith’s model of economics.

In summary, the ‘invisible hand’ term appears benign, but it should not be interpreted to mean that if left alone, free markets would act in a paternalistic fashion to achieve a perfect outcome for society as a whole.

It should do a reasonable job at maximising the output created, and serving each market participant with value. But adjustments and corrections in the shape of a welfare system will be necessary to ensure that the poorest are protected from being ‘priced out’ of the market. Although this needn’t be as heavy handed as becoming a command economy!

How does the definition of the invisible hand relate to investing?

The invisible hand is very similar to the efficient market hypothesis – the preposition that prices automatically factor in all available information to predict the future. You can find out more about the efficient market hypothesis in investing books or investing courses.

Adam Smith was referring directly to financial markets when he coined the phrase, however it applies very neatly to the almost magical way in which the financial markets absorb the self-interested actions of beginner day traders, experienced fund managers, pension providers and investors. This results in a price which should ensure a fair expected return in the long term for anyone who decides to buy shares or invest in any of the major asset classes.

Leave a Reply

Your email address will not be published. Required fields are marked *