Microeconomics Monday-The Invisible Hand

People often refer to the invisible hand.  However, many markets that are over regulated make it impossible for the invisible hand to do it’s dirty work.  For example, the government policy for banks, “too big to fail”, is a clear violation of the invisible hand.  It’s one reason among others that we should have allowed banks to go broke.

People and politicians ignore the invisible hand at their peril.  Instead of trying to force markets, they ought to use economic jujitsu and utilize the power behind the invisible hand to increase economic output.  Instead, time and time again they try to put round pegs in square holes through law, regulation, subsidy or tax.

The invisible hand is a positive economic force, not normative. It doesn’t care a whit about outcomes for individual entities-but only enforces maximum efficiency on the marketplace. The invisible hand sweeps through markets and allocates resources far more efficiently than any central planner could.

A well functioning competitive industry has important properties, especially related to efficiency.  Four important points to remember when you are analyzing and industry, or thinking of starting a business:

  1. markets tend to arise spontaneously, especially if there are gains from trade
  2. markets tend to be self correcting, especially if there are no government regulations, subsidies, taxes or other artificial constraints
  3. all gains from trade are realized; maximizes total consumer and producer surplus
  4. firms produce at their most efficient scale, minimizing average costs
  5. Pareto Efficient

Of course, we might say it more simply.  Competitive markets bring powerful intrinsic incentives to innovate and be creative.  The most creative class in the world are the businesspeople that populate it.  Owners of companies have an even more powerful incentive to innovate since they benefit directly through higher profitability that comes with greater market share.

Adam Smith first postulated the invisible hand of markets.  Over time, it has been proven to work academically and in reality.  The Invisible Hand is something that actually works in theory-and practice.

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