The Invisible Hand

Question 1

Explain the concept of the invisible hand

Answer 1

The idea that, without observable intervention, free markets determine an equilibrium in the supply and demand of goods. States that by following self interest, consumers and firms can create an efficient allocation of resources for the whole of society

Question 2

Explain how the invisible hand deals with shortages

Answer 2

If a good is in short supply, there is an excess of supply, which will allow firms to increase their prices. These higher prices will provide an incentive for either existing firms to invest in production to increase supply or for new firms to enter the market. The net effect is that proves will rise until equilibrium is reached and the shortage is overcome

Question 3

How does Adam Smith describe the invisible hand?

Answer 3

Through individuals considering selfish aims, a more efficient economy is created and there is an equilibrium in the market for goods and services. He also suggests that the invisible hand can have a redistributive, trickle-down effect

Question 4

State the implications of the invisible hand

Answer 4

• there is no need for government regulations and price controls as the invisible hand will ensure optimal price and output
• pursuing self interest can benefit society
• an increase in the wealth of the owner class can trickle down and benefit society
• private businesses can follow the profit motive to identify the most efficient allocation of resources
• free trade is beneficial as it allows firms to specialise in goods where they have a competitive advantage

Question 5

What does Joseph stiglitz say about the limitations of the invisible hand

Answer 5

‘The reason the invisible hand seems invisible is that it is often not there.

Question 6

State and describe the limitations of the invisible hand

Answer 6

• firms with monopoly power can push prices above the equilibrium. Without competitive pressure, firms could become stagnant, inefficient and exploit customers
• it could lead to the overproduction of goods with external costs, such as those that cause pollution
• the tragedy of the commons describes how acting out of self interest can lead to the depletion of natural resources
• the invisible hand assumes that economic agents will act rationally. Industries like finance see individuals get carried away by irrational exuberance. This can lead to booms in prices that are distorted from economic realities
• time lags and immobilities. If a firm closes, the invisible hand may push the unemployed to get a job in another industry. There are occupational and geographic immobilities that mean labour and capital can remain unemployed for a long period of time
• the invisible hand also justifies selfish behaviour