The Invisible Hand

The order contained in a market economy was first recognized by Adam Smith. I~ one of the. most. famous passages of all economics, quoted from the Wealth of National the opening of this chapter, Smith? saw the harmony between private profit and public interest. He argued that even though every individual “intends only his own security, only his own gain,… he ,is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.”

Pause for a moment to consider these paradoxical words, written in 1776. That same year was also marked by the American Declaration of Independence. It is no coincidence that both ideas appeared at the same time. Just as the American revolutionaries were proclaiming freedom from tyranny, Adam Smith ‘was preaching a revolutionary doctrine emancipating trade and industry from the shackles of a feudal aristocracy. Smith held that in this best. of all possible worlds, government interference with market competition is almost certain to he injurious.

Smith ‘s insight about the functioning of the market mechanism has inspired modern economists both the admirers and the critics of capitalism. Economic theorists have proved that under limited conditions a perfectly competitive economy is efficient (remember that an economy is producing efficiently when it cannot increase the economic welfare of anyone without making someone else worse off).

After two centuries of experience and thought, however, we recognize the limited scope of this doc- . trine. We know that there are “market failures,” that markets do not always lead to the most efficient outcome. ‘One set of market failures concerns monopolies and other forms or imperfect competition. A second failure of the “invisible hand”comes ‘when there are spillovers or externalities outside the marketplace-e-positive externalities such as scientific discoveries and negative spillovers such as pollution.

A final reservation comes when the income distribution is politically or ethically unacceptable. When any of these Elements occur, Adam Smith’s invisible-hand doctrine breaks down’ and government may want to step in to mend the flawed invisible
hand.

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