Business & Economics

The Five Fingers of the Invisible Hand

Markets don’t work because of a magical force. They work in accordance with time-tested economic theories

Image Credit: Sommai Larkjit/EyeEm/Getty Images

Earlier this fall, Declan Leary wrote an essay in the American Conservative upbraiding the late Leonard Read, author of the famed essay, “I, Pencil.” According to Leary, Read displays a quasi-religious, unquestioning faith in the invisible hand of the market:

“I, Pencil” treats supply chains in the language of religion. They are miracles in which we must have faith. They are the product of some inscrutable but benevolent superhuman intelligence. The precision alone of the Invisible Hand demands from us reverence and wonder.

But there is a difference between awed wonder and unquestioning religious faith. Consider Richard Dawkins’s paean to science in “Unweaving the Rainbow”:

The feeling of awed wonder that science can give us is one of the highest experiences of which the human psyche is capable. It is a deep aesthetic passion to rank with the finest that music and poetry can deliver. It is truly one of the things that makes life worth living.

There can be no doubt that Dawkins has reverence and wonder for the natural world. But no one could rightly accuse the famous atheist of having inscrutable faith in the benevolence of natural processes, no matter how wonderous he finds them.

Why, then, do so many mistake the economist’s awed wonder at the invisible hand of the market for unquestioning faith? Perhaps it is because we economists do not talk enough about the causal mechanisms at play. We know the human hand can catch a fly ball, perform coronary revascularization and play Vivaldi. But to appreciate how the hand works these wonders, one must think through the mechanisms at work: At the direction of 200,000 neurons, 34 muscles (each supplied with oxygen by a vast network of blood vessels) power the movement of 29 bones and—ultimately—five fingers.

The invisible hand of the market also works wonders. It powers cities. It keeps airplanes aloft. It fills our bellies. It cures our ailments. Over the past 25 years, the invisible hand of the market lifted 110,000 people out of poverty every day. And just as with the actions of a physical hand, there are many mechanisms that work to make markets function. We can appreciate these achievements without attributing them to a “benevolent superhuman intelligence.” Economists have not spent 245 years unthinkingly genuflecting to the invisible hand. Instead, they’ve built and then tested theories that explain how the invisible hand achieves its wonders.

So, in an effort to move from blind faith to informed understanding, let’s consider five mechanisms that explain how the invisible hand of the market works.

1. ‘Price Gravitates Toward Marginal Cost’

In the textbooks, there is one dominant explanation of how the invisible hand works: In a competitive market, price gravitates toward marginal cost, and this maximizes social welfare. The textbooks offer a technical—and, for many, inscrutable—explanation: A competitive firm has no choice but to charge the price that is set by the market. From its perspective, the demand curve looks perfectly flat. Each unit sold generates the same amount of revenue. Thus, the marginal revenue curve is also flat and is identical to the demand curve. Firms maximize their profits when the cost of the marginal unit just equals the revenue it generates. So, the profit-maximizing competitive firm sets its price equal to marginal cost. When marginal costs equal marginal benefits, then society’s welfare is maximized. Whew!

For many economists, this explanation is elegant and interesting, especially when translated into the language of mathematics. But it’s also not realistic in a lot of markets. And it’s a straw man. It gives the impression that this is the one and only reason to believe the invisible hand of the market can channel individual self-interest into greater social good. If the conditions for a perfectly competitive market cannot be obtained, this explanation for the invisible hand can feel like a raised middle finger.

But invisible hands have more than one digit. Here are four more.

2. We Gain From Exchange

The simplest and most powerful mechanism powering the invisible hand is the mutual gain that people expect when they trade with one another. The butcher will fill my belly, in exchange for money. And we will both say “thank you” when the deal is struck. This is evidence that we both gain from the transaction, even though the exchange itself does not create any new food or any new cash; it just changes the ownership titles. Let people trade on their own terms, and they will gain. The proof is in what the late Steve Horwitz called the double thank you.

And it’s important that these transactions be on the participants’ own terms. The vocabulary of macroeconomics—“the economy,” “the trade sector,” “the fiscal and monetary policy levers”—makes it seem as if the economy were a large machine with dials that can be turned just so to maximize the interests of society at large. Indeed, countless writers and pundits from Jean-Jacques Rousseau to Tucker Carlson have thought of it this way. These “men of system,” as Adam Smith called them, imagine that they can arrange the members of society “with as much ease as the hand arranges the different pieces upon a chess-board.” But the man of system makes the mistake of assuming that “the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them.”

Note, also, that exchange arises from disagreement. The butcher is happy to trade the roast for the cash because he believes the money is more valuable. I, on the other hand, want the roast and not the money because I think the meat is more valuable. The greater our disagreement about the relative value and opportunity cost of goods and services, the greater our potential gains from exchange. But because value is subjective—it is in the eye of the beholder—only an individual trader is able to say whether any particular deal is worthwhile.

But we don’t just gain from exchange; we gain from exchanging. As Smith put it, humans have a natural “propensity to truck, barter, and exchange.” Markets are often found at the physical centers of our communities. The social space of the market, as Virgil Storr put it, is “where people form friendships, meet their husbands and wives, and connect with their parents, children, and siblings.” From Seattle’s Pike’s Place to the Turkish Bazaar to the great trading festivals regularly constituted by the Puebloans of the American Southwest: Where there is trade, there is bustling excitement, there is usually peace and there is always a uniquely human experience.

3. We Are More Productive When We Specialize

Adam Smith’s preferred explanation for the invisible hand was specialization. Trade allows us to buy and consume far more than we could possibly make for ourselves. For most of human history the typical person (or family unit) had to do it all: My great-great-grandfather was his own butcher. But he was also his own home builder and his own farmer. My great-great-grandmother was her own tailor, the family’s bookkeeper and the children’s teacher.

Because they had to be jacks-of-all-trades, they were masters of none. They weren’t especially productive at any one of these activities. Nor did it make sense for them to acquire expensive specialized capital or tools to better perform these tasks. (And in a world without specialization, who would make these tools anyway?) Therefore, their incomes, like those of nearly everyone in their generation, were low by today’s standards.

While it is tempting to look on their self-reliance through sepia-colored glasses, the truth of the matter is that life was grindingly hard for these people. Compared with us and our contemporaries, they worked harder and longer, were more likely to suffer from disease or disfigurement, were less likely to read or read widely and didn’t have time or leisure for fine art (or not-so-fine art, for that matter). And on the whole, they died younger.

But as the extent of the market grows, specialization grows, people can create more value for others and incomes rise. When we have more people to sell to, we don’t have to do it all. We can do one thing and do it well. Because our ancestors were generalists in production, they had to settle for limited consumption opportunities. Because we are specialists in production, we can generalize in consumption, tasting the fruits of fellow specialists the world over.

4. Markets Communicate Dispersed Knowledge

So, we can do more if we trade and rely on the specialized expertise of others. But how do we make sure we specialize in the most valuable activities and that we produce the right amounts? My great-great-grandfather didn’t need to know how much meat to butcher. Since his family members were the only ones eating it, he had to butcher just enough to keep them fed. Things get vastly more complicated when we specialize and trade. The butcher needs to know how much meat to produce for his community. And the cutler needs to know how many butcher knives to make for the butchers, and the distributor needs to know how many refrigeration trucks to buy, and so on.

How can each of us make our own plans while ensuring that our plans complement those of others? One of the subtle and strange things about specialization and trade is the quiet role that prices play in allowing millions of people to coordinate their activities. Prices allow an individual, usually unknowingly, to harness the knowledge of others—as if led by an invisible hand (incidentally, this is the story that Read was telling, for those who bothered to listen to it).

COVID, and the changes in behavior and policy that came in its wake, obviously caught the world off guard. But notice that when the price mechanism has been allowed to work, it has eased these disruptions. Consider lumber. As fear of COVID and the policy response to it spread in the spring of 2020, sawmills across North America assumed they were in for a housing bust. They cut production and unloaded inventory. But they were wrong (no system, market or otherwise, can make us clairvoyant). As it turned out, high-income consumers found themselves with access to cheap credit, flush with stimulus cash and unable to spend their money on services that were restricted by state and local policymakers (construction was deemed essential and allowed to continue). So, they started home improvement projects, greatly increasing the demand for lumber.

With demand outstripping supply, a benevolent planner would want to figure out some way to get consumers to curtail their purchases and producers to ramp up production. The price mechanism did just that: Lumber prices jumped nearly 300%, encouraging consumers to hold off on those projects and causing producers to increase their production. Shortages disappeared, and now prices are headed back to pre-pandemic levels.

If you mess with the price system, you mess with these signals. And indeed, as others have documented, many of our current supply network woes can be traced back to policy errors that have disrupted market processes.

But as messed up as things are compared with the pre-COVID era, we shouldn’t overlook the good. Despite a global pandemic, despite policies that disrupted supply networks, cities around the world continue to be fed. Think of that logistical feat for a second. Napoleon’s Grande Armée of 700,000 men starved to death marching back from Russia because his centrally planned supply chain failed. Yet communities many times the size of the Grande Armée wake up every morning and are fed, even in a pandemic.

The price system, by quietly signaling relative scarcity and allowing each of us to coordinate our plans with those of others, is why.

 5. Dynamic Competition Solves Problems

 The middle-finger model of perfect competition gives the impression that competition is a noun. Perfection is achieved when a market is perfectly competitive, and price equals marginal cost. This gives the impression that no one decides anything. People just react, “taking” the price the market sets and producing a product that is identical to that of every other producer.

But in the real world, “to compete” is a verb. Every day, entrepreneurs decide what to do, how to do it, where to do it, how much to do it and how much to charge. The important thing about entrepreneurial dynamism is that people can profit by finding new and better ways to create value for their fellow humans.

If they see an imperfection in the market, they can profit by correcting it. Think about Uber and Lyft, which corrected an information problem inherent in the taxi industry: When someone hails a taxi, neither the passenger nor the driver knows anything about the other. This can lead to problems of varying seriousness—an unpleasant or awkward ride, incompetent drivers, passengers who decide not to pay. By providing more information, such as user ratings based on previous interactions, ridesharing apps enable drivers and passengers to make better decisions about how and with whom to travel.

Or think of emigrant agents, entrepreneurs who made a living by helping freed Blacks find better employment in new locales after the Civil War. The most famous of these entrepreneurs, Robert “Peg Leg” Williams, is said to have helped some 100,000 freedmen find better jobs and better homes after the war. Williams lost his leg fighting for the Confederate cavalry, so it’s doubtful that this “Moses of the Carolina exodus,” as one newspaper called him, did it for purely humanitarian reasons. He saw people suffering and saw a way to profit by alleviating their anguish, as if guided by an invisible hand.

Grasping the Invisible Hand

Human hands sometimes fail. People develop painful and debilitating arthritis, suffer from poor circulation or endure paralyzing neurological damage. And so it is with the invisible hand of the market. People make mistakes, misjudging their own abilities or the plans and the actions of others. And these misjudgments can lead to shoddy products, shortages, surpluses, losses and—if they are clustered—even recessions. But as imperfect as it may be, the invisible hand encourages each of us to correct for these mistakes. It does so by driving price toward marginal cost, by encouraging us to think of others whom we can benefit with trade, by allowing us to be more productive through specialization, by communicating dispersed knowledge so that our individual plans fit together and by allowing people to profit when they solve problems.

Like biologists who appreciate the intricate mechanisms that power the human hand, economists can take stock of the mechanisms of the invisible hand without assuming that they work by faith or magic. Nor should they assume that these mechanisms will always work. While theories can guide us, the ultimate test is found in the empirical record. From my perspective, the empirical case for the invisible hand is quite strong, while the case for effective government intervention is frustratingly weak.

So wonder at the invisible. But don’t assume it is guided by magic.


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