The Invisible Hand Theorem 101
“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest.” Adam Smith’s idea about a free market is perhaps the most fundamental idea which forms the basis of economics; a sort of truism which governs an economy’s affairs. If we have a competitive economy where all individuals try to serve their own rational, self-centred interests, then the resultant equilibrium that will arise will be the most optimal. This is famously known as the Invisible Hand theorem.
When it was first promulgated, the most important moral conundrum of the orthodox society vanished; that of the choice between the interests of the individual and the society. When each individual serves his own self-interest, the interests of the society are automatically taken care of. So to speak, to the outsider, it would seem as if an invisible hand is at play, puppeteering the entire society.
I used the word ‘competitive’ in my explanation. Without going into the complexities of technical definitions, as defined by economists for their mathematical purposes, a competitive economy is one in which no individual can alter the prices prevailing in the market; every individual is a price taker. Of course this does not mean that when a group of individuals will demand less of a particular commodity that its price will not fall; it only means that a single individual treats the prevailing market prices as unchangeable. In that context, every individual in the economy is a rational, self-interested individual who looks at the prevailing prices in the market and then decides how much to buy or sell so as to maximise his own utility, well-being, happiness, or preference (used synonymously for the sake of simplicity).
Let’s consider the problem faced by the consumer. He has some income, which would be typically determined by the prevailing price of labour (salary) along with any other non-labour income or wealth that he may have. He now faces the prevailing market prices at which he can buy different goods for his consumption, which will in turn give him utility. Given his income, he can choose a bundle of different goods (like a car and food, or a refrigerator, a fan and food, but not both these bundles) based on his preference. Given that the individual is a rational person, he will select a bundle which will give him the highest satisfaction given his limited income.
To generalise it a little more, consumers and producers are not different from each other. Each person in an economy is assumed to own some initial bundle of goods, and, on seeing the prevailing market price for each good, they decide how much of which ones they would like to buy more of and how much of which ones they would like to sell off.
Now, there is an arbitrary set of prices prevailing in the market, one for each good. Each individual, based on these prices, will decide how much of each they want to own. Accordingly, they enter in transactions with each other. If, say for a particular good, the total quantity demanded is more than the total quantity supplied, the sellers, on seeing the high demand, will increase the price of that good. Some individuals wanting that good will no longer be able to buy it given that it has now become expensive. Finally, an equilibrium will be reached for that good, where the quantity supplied will become equal to the quantity demanded at some new price (in this case, higher) level. This will happen for all the goods in the market and we will have a ‘general’ equilibrium.
This equilibrium is inherently optimal because every individual has served his self-interest and decided how much of which goods he wants to consume. The distribution of goods in the society is the best there is possible.
Tan (2008) provides a decent mathematical formulation of the Invisible Hand theorem, which in academic literature, is known as the First Fundamental Theorem of Welfare Economics.
