Chapter Four

The Invisible Hand

Adam Smith's Big Idea

The Invisible Hand

The Economic Problem forces us to decide what to produce, how to produce it, and who gets it. In his book The Wealth of Nations, Adam Smith argued that the best way to answer those questions is with markets. If you give someone the right to use their property as they see fit, 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 the society more effectually than when he really intends to promote it.”

Open Video Transcript

The Economic Problem forces us to choose how we will use our scarce resources. We need an economic system which helps us answer the questions: What will we produce? How will we produce it? And Who will get it? But we also want the economic system to answer those questions in a way that maximizes the value we get out of our resources. We want to produce things that people actually benefit from, things people actually need and want. We also don’t want to leave anything on the table, wasting our resources on inefficient production processes. We gain a lot of productive efficiency through specialization and trade. The division of labor allows us to minimize our use of resources and maximize our output. But when it comes to producing things people really need, and distributing them to the people that actually want them, human civilization struggled to find a good solution. For most of our history, a strict social hierarchy saw those with power make the decisions for the vast majority of people who lacked such power. --In 1776, however, the Scottish philosopher Adam Smith challenged the conventional wisdom on how economies should work. He published a book; whose full title is An Inquiry into the Nature and Causes of the Wealth of Nations. Rather than dictate to people what to produce and how to do it and who will get it, Smith recommended that governments just leave people to figure it out on their own. He argued that the best allocation of resources in society will be achieved if everyone does what they think is best. You may have heard the term “laissez-faire”, which is a French term which roughly translates to “allow to do”, but has come to represent an attitude of letting things take their own course, particularly in the economy. Many people today still find this idea questionable, but in Smith’s time and before it, it was downright unthinkable. Most thought that if the government wasn’t there managing the economy every step of the way, chaos would ensue. But they were wrong. --The key elements of Smith’s vision for a market economy are property rights and free markets. In order for the market system to work, the means of production must be owned privately by individuals. That ownership is enforced by law, and that enforcement is the main extent to which the government should be involved. Importantly, this means that the owner of some property is the one who reaps the rewards of that property. But they also must bear the burdens of it. A farmer who owns their land is the one who will profit from the successful production of food, and no one takes that profit away. But the farmer is also the one who must pay to plant the crops, tend them, and harvest the results. The other key element is free markets, meaning that participation in any economic activity is totally voluntary. If the farmer wants to walk away from their land and quit farming, they are perfectly within their rights to do so, an act that might have gotten you killed in the days of feudalism. Likewise, if someone else wants to buy some farmland and compete with you, you can’t stop them from doing so, another act that wouldn’t fly under feudalism. That freedom extends to consumers as well. The buyers of products choose what they want to buy and from whom. You are not required by laws to purchase exclusively from some state-sponsored seller, or barred from buying things due to your social class. All exchange has to be voluntary. --Smith argued that once property rights and free markets were in place, governments need not intervene any further. Through entrepreneurship and competition, resources would be directed to the uses most desired by society, and in the most efficient way possible. Since property owners reap the rewards of their production, this incentivizes them to use their resources in a profitable way. The profit motive is the desire for a financial gain, and while it is not by any means the only motivation we might have to start a business, it does help drive our decisions in ways that deliver the goods and services consumers actually want. If consumers really do want something, they will be willing to pay more for it, and this demand for something will incentivize producers to use their resources to deliver that outcome. Competition is what keeps things efficient. Unprofitable uses of resources are halted in favor of those that are profitable. When profit is found, more producers enter the market with their resources and compete, minimizing prices.As human beings, we have to admit that it is a little off-putting to think of things this way. We don’t like to admit things like profit motivates us or that when something is unprofitable it is a waste. And sometimes we want to bring inequality in wealth and income into it. Those are important subjects, but they aren’t as relevant to this as it may seem. Money is not what matters here, rather it is our ability to produce goods and services. Profits mean we have used our resources to produce goods and services people want. A lack of profits means we have ripped resources away from something people want in order to produce something less valuable. If we want to reach the edge of our production possibilities frontier, we want the profit motive to drive production. But where we are on the production possibilities frontier will be driven by the actual preferences of actual people, not by money. --The ultimate goal of an economic system is efficiency. Efficiency means we didn’t leave anything on the table. We used the least costly production techniques we could, and we produced the combination of goods and services most wanted by society. Allocative efficiency should mean that no one is getting short-changed, but it doesn’t mean everyone is starting from or ending with any kind of equality. A market system like the one proposed by Adam Smith doesn’t guarantee economic equality, but it also doesn’t rule it out. Before we talk about inequality though, I think it’s best to see why Smith’s answer works so well when it comes to efficiency. Efficiency is its own goal, and there is no reason not to achieve it. The key insight of Adam Smith is that – to just about everyone’s surprise – an economy which relied on free markets rather than a central government authority or any kind of central economic planning would be much better at achieving this efficiency.

Supply

Market Supply represents the cost of production to firms. When the price earned by selling a good is equal to or exceeds the cost of producing that good, firms have an incentive to actually produce it. Thus, the Supply Curve relates the market price of a good with the quantity supplied.

The supply curve will shift any time there is a change in the costs of production, such as:

A change in cost of raw materials or labor
A change in production technology
Natural events like a natural disaster or good weather
A change in expectations held by producers
A change in the opportunity cost of production
A change in the number of producers

Open Video Transcript

Firms – also known as businesses or companies or corporations or any other term for producers – take inputs and turn them into output. If you were running a lemonade stand, your inputs are the lemons, sugar, water, ice, and cups, as well as your time and effort. The output is the lemonade. Every day there are millions of firms around the world taking inputs – the resources and raw materials we have – and turning them in to the goods and services that satisfy people’s needs and wants.--In Adam Smith’s vision of a free market economy with property rights, people own these businesses and the means of production. It is the owners of these means of production that reap the reward of profits. Entrepreneurs who wish to maximize their profits have an incentive to minimize their costs. I’m not talking about cutting corners or exploiting resources here – that sort of thing doesn’t fly with Smith’s vision and should be run out of town by competition. Instead, I mean that entrepreneurs aren’t going to waste the resources they are using. They will try to maximize the output they can get out of every input. They can do this through strategies like the division of labor. Henry Ford was able to reduce the cost of making cars enormously by dividing the labor up across an assembly line. Many firms are able to find cost savings by outsourcing certain aspects of production. Coca-Cola doesn’t own any aluminum mines, even though they need a lot of aluminum cans. It is a lot cheaper to buy the aluminum from a company that specializes in that production, which is further division of labor. Entrepreneurs will also seek out the lowest priced inputs. They don’t want to overpay for the raw materials they need, or the labor they hire. As the buyers of these things, they will be as thrifty as we consumers are when we buy their products. Entrepreneurs will also streamline their inventory systems, taking advantage of efficiency gains where they can. Business owners have an incentive to keep their inventory rooms organized, to have a clear system for ordering the inputs they need, and to coordinate the production process to eliminate waste. Entrepreneurs will also try to reduce risks. Through the diversification of processes, the expansion of production, or even the simple buying of insurance, business owners have an incentive to make sure their operation will last into the future. This not only means an efficient use of our resources today, but also concern for the continued efficient use into the future. In other words, firms have an incentive not to sacrifice long-term growth for short-term profit. --If firms are minimizing their costs and maximizing their productive efficiency, we can consider how they will respond to market incentives. The market price is the amount a producer earns when they sell their product. It is the reward for production. Producers will supply a good when the price they earn covers the marginal cost of production. If a firm is able to earn $10 for the product they make, then they will continue to make more and more up until the point that producing one more unit will cost them more than $10. Due to the law of diminishing marginal returns, we expect the marginal cost for firms to increase, and so higher prices will incentivize more production. The market supply curve relates the price to the quantity supplied. It is a relationship that we can put on a graph, with price on the vertical axis, and quantity supplied on the horizontal axis. You can think of the market supply curve as the answer to a call for production. It is as if we put up a Wanted Poster declaring a need for the production of some good or service. If we offer a low reward, or a low price, then we will get a low response, a low quantity supplied. But as we increase the price we pay for this good or service, more firms show up and they start producing more of that thing. Each increase in price covers the higher costs associated with producing more of that good. When these are all connected, we have our supply curve. --To get a real-world sense of what this means, think about the production of oil. If the price of oil is low, it will only cover the costs of the easy-to-get oil, the stuff that is close to the surface and easy to dig up. But as the price of oil rises, that incentivizes the use of more expensive methods of getting oil out of the ground, like expensive drilling deep into the Earth. And as the price of oil goes up even further, it justifies the high costs of doing things like building huge oil rigs out in the ocean. Most supply curves are upward sloping for this reason. --The supply curve is like a list. It tells us how many units of a good or service all the producers in the market will make at every possible price. But sometimes things change. The prices of raw materials or labor could change, technology could change, we might experience a natural event like a hurricane or good weather that impacts production costs, or we might just have a change in expectations, or opportunity costs, or just the number of producers operating in the market. Any changes which impact the cost of production change the answer to how many units of a good or service all the producers in the market will make at every possible price. Those changes will shift the supply curve. If the costs of production are reduced, it means that firms will produce more than they did before at every price. In that case, supply will shift to the right. As a general rule of thumb for graphs, an increase means a shift to the right, and a decrease means a shift to the left. If we reduce costs, supply will increase and shift to the right. We can see that at any given price, the quantity supplied by the market has increased compared to the previous supply. Whether the price was low, or high, the quantity produced at every price has gone up when supply shifts to the right. --Likewise, if there is an increase in the costs of production, firms will reduce their quantity supplied at every price. A decrease in supply means a shift to the left like this. And now, at every price, the quantity supplied is lower than it was before. One tip is to think of these shifts as “to the left” or “to the right”. On the graph here, you may be tempted to say that supply is higher, because the new supply appears to be above the old one. But that would be misleading. Supply represents the costs of production. So, when supply decreases and shifts to the left, it represents an increase in costs. It is costs that are going up, not supply. Supply tells us what quantity can be profitably produced at the price paid for it.

Demand

Market Demand represents the benefit of consumption to the consumers. When the price paid for a good is less than or equal to the benefit of consuming that good, consumers have a desire to buy it. Thus, the Demand Curve relates the market price of a good with the quantity demanded.

The demand curve will shift any time there is a change in consumers' willingness to pay, such as:

A change in income
Changes in the price of related goods (e.g. complements and substitutes)
Changes in consumer preferences
Changes in expectations held by consumers
A change in the number of consumers

Open Video Transcript

Consumers are the buyers of a good or service. Whether or not a person wants to purchase a good or service depends on the subjective value they place on that good or service. I might think something is worth a lot of money, while you think it isn’t worth any money at all. These would be our preferences, and in economics we like to represent people’s preferences as utility. Utility is the ability of a good or service to satisfy a person’s needs or wants. We tend to think of this as a numerical value. We get utility whenever we eat some good food or visit a cool place, and all those values get added together or give us our total utility. Of course, we can’t have everything we want. Due to scarcity, we have to pick and choose, and we are limited by our budget constraint, or the amount of income we get from all our economic activity like labor, resource ownership, capital ownership, or entrepreneurship. Economists claim that consumers will be driven to maximize their utility subject to their budget constraint. We will pick and choose what we spend our money on in order to maximize our total utility from the consumption that money buys. We want to get the most out of our personal resources. --You can think of consumer behavior in the marketplace as a kind of reverse auction. The auctioneer announces the price of the product, and we consumers decide how many we want to buy at the going market price. Some people will find this price to be a great deal and they will buy many. For those consumers, this product gives them a lot of utility and it is worth sacrificing the ability to buy other things for. Other people will have bigger opportunity costs, with other options they simply value more than this one. They will buy few or none of this product at the market price. In Adam Smith’s market economy, these different preferences are a good thing, and when we express our preferences as a willingness-to-pay for the product, it is verification that the product is going to the person who values it more than the price paid. --If people know their own preferences, and are maximizing their utility subject to their budget constraint, we can consider how they will respond to market incentives. The market price is the amount a consumer pays to purchase a product. It is the cost of consumption. Consumers will buy a good if their marginal benefit – expressed by the amount they are willing to pay for something – is equal to or higher than the price paid. If someone is willing to pay $20 for a product, that means there is no other use for that $20 which gets the person more utility than this product. So long as the product costs $20 or less, the person will buy the product. Since people will set different amounts as their willingness-to-pay, we expect the quantity demanded to increase as the price falls. As the price goes down, more and more people agree to buy more and more of the product. The market demand relates the price to the quantity demanded. It is a relationship we can put on a graph, with price on the vertical axis, and quantity demanded on the horizontal axis. You can think of the market demand curve as the answer to the call for how many people wish to buy at a given price. If the price is high, then the quantity demanded will be low. And if we lower the price, more consumers will want to purchase this product, which means a higher quantity demanded. Each decrease in the price attracts more consumers to this product, leading to higher and higher quantities demanded. When these are all connected, we have our demand curve. --The demand curve is like a list. It tells us how many units of a good or service all the consumers in the market will buy at every possible price. But sometimes things change. Consumers might see an increase in their income, allowing them to afford more of everything they want. This would lead to an increase in demand, which would mean our old list is no good, because consumers will be buying more of this product at every price. To show this, we shift demand to the right, and you can see that whether the price was high or low, the quantity purchased is higher than it was before. Lots of other changes could lead to this same increase in demand. A change in the price of a related good is one that needs a little explaining though. --Related goods come in two forms: substitutes and complements. Two goods are substitutes when consumers tend to switch between them (think Pepsi vs. Coke or iPhone vs. Samsung). Two goods are complements when consumer tend to buy them together (think Peanut Butter & Jelly or Milk & Cereal). A change in the price of a substitute or complement good will shift the demand for our good. --If the price of Pepsi increases, that will increase the demand for Coke as people switch from buying Pepsi to buying more Coke than they otherwise would have. Or, if this is the demand for milk, and the price of cereal drops, we might see this same increase in demand for milk. That’s because cheaper cereal will mean people are willing to pay a bit more for milk than before, because the bundle of milk and cereal together is still cheaper. Continuing down our list, a change in consumer preferences – like a good advertisement that makes someone aware of a product, or a change in what people like or dislike, could lead them to be willing to pay more for a product, increasing demand. A change in expectations could also increase demand. For example, a new weather forecast might lead us to expect a severe storm, and so we are willing to pay a little more for batteries now to make sure we’re ok. And lastly, an increase in the overall number of consumers will also increase demand, since more people means more “yesses” at every price. --To decrease demand, we need to reduce how much people are willing to pay for the product. A reduction in consumer income, a decrease in the price of a substitute, an increase in the price of a complement, and shift in preferences or a change in expectations away from this product, or a reduction in the number of consumers will decrease demand, meaning a shift to the left. Remember, increases in demand are always shifts to the right, decreases are always shifts to the left. We can see that with a decrease, consumers will buy a lower quantity demanded whether the price was high or whether the price was low. Demand tells us what quantity will be voluntarily purchased by consumers at the price charged.

How Markets Work

Competition between sellers and between buyers will drive markets toward an equilibrium price where the quantity supplied is equal to quantity demanded. By way of the Invisible Hand, market forces bring about an efficient use of our resources which maximizes our collective welfare.

Open Video Transcript

A market consists of sellers who produce a product and buyers who consume the product. We represent sellers with supply. Supply represents the marginal cost of production. Each point along the supply curve tells us how much that unit cost to produce, and thus the minimum price needed to incentivize producers to make that quantity. Demand represents the marginal benefit of consumption. Each point along the demand curve tells us how much the consumers is willing to pay for that unit, and thus the maximum price at which consumers will still buy that quantity. Equilibrium is reached when the market price yields a quantity demanded equal to the quantity supplied. That is, of course, found where supply and demand cross. At equilibrium, the going market price incentivizes producers to make the same quantity as it incentivizes consumers to buy. Every producer is compensated for their efforts, and every consumer willing to do that compensating is able to buy the product. At equilibrium, resources are being used to make a product that consumers actually want, and the product is going to the consumers who are willing to pay the most for them. --Competition will always drive markets towards equilibrium. Imagine that we set a market price which was above where supply and demand cross. This high price discourages consumers. There are too few who want to buy it at this high price, because they would rather use their money on something else. The quantity demanded is low. But such a high price is a big incentive for producers, who are willing to produce a lot of this product if they can earn such a high reward. The quantity supplied is high. We have a surplus. A surplus occurs when the quantity supplied exceeds the quantity demanded. --This mismatch creates problems. There are not enough consumers willing to buy all this product that got produced. We have wasted resources in this market, and sellers are going to end up losing money on their efforts. They will reduce prices to move product, and many will shut down, driving the price lower and incentivizing consumers to buy more until we reach equilibrium, where there is no mismatch between the quantity supplied and the quantity demanded. --Suppose we go too far and set a market price which is too low. At this low price, consumers are eager to buy. The quantity demanded is high. But the producers aren’t going to produce very many, because the low price simply doesn’t cover the cost of production beyond this low quantity supplied. We have a shortage of this product. A shortage occurs when the quantity demanded exceeds the quantity supplied. So, what will happen? --Well, entrepreneurs will notice the long lines of consumers trying to get their hands on this product but leaving empty-handed, and they will try to offer more to consumers at a higher price. And consumers themselves will start to bid up this price as they compete with each other over the short supply. Think of how a product shortage – like the shortage of toilet paper during the Covid-19 pandemic – led many to put up what they had on eBay at exorbitant prices. That price is a signal to producers to ramp up production in order to earn that bounty themselves. --This drive towards equilibrium, fueled by competition and free markets, is why Adam Smith believed that the best allocation of resources would be achieved if we just let everyone do what they think is best. As soon as we stand in the way of that competition, and in the way of free enterprise, we lose the mechanism by which the economy drives out inefficiency and waste. But if we get out of the way of competition and free enterprise, each person will be driven “to promote an end which was no part of his intention... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”Under Adam Smith’s market economy, you are no longer able to get ahead through force and coercion. Instead, they only way to get ahead is to provide something of value to other people, something they will voluntarily purchase from you, and the rush to better ourselves and provide something of value drives us to make the best use of our resources, and provides to people the goods and services they genuinely need and want. --If the market forces us towards equilibrium without any intervention, we can use our supply and demand framework to understand how markets react to changes in the world. Here is an example. Consider the market for apricots. Heat waves have reduced yields on apricot farms. What will the impact be on the market?First, we want to think about whether it impacts supply or demand. These are two separate forces which respond to different things. So, did we impact producers and the cost of production, or consumers and their willingness-to-pay? Since the heat waves impact apricot farmers, we are certainly talking about supply, and the heat wave is going to make it costlier to produce apricots, since so many will be lost to the heat. Higher costs mean a decrease in supply, and a shift to the left. As we move from the old equilibrium to the new one, we can see that the market price rises, while the market quantity – the amount produced and purchased – decreases. We end up with fewer apricots and a higher price for them. If this seems intuitive to you that’s good! We all have lots of experience with markets in real life which can help us out. --Here is another one. Consider the market for cars made by Honda. A new Super Bowl ad for the cars has people talking. What will the impact be on the market? Does this advertisement impact supply or demand? The goal of most advertising is to inform consumers of a product and entice them to buy it. That means it impacts demand. If consumers respond favorably, demand will increase and shift to the right. The result of an increase in demand is a higher market price, and a higher market quantity. --Let’s do a tougher one. Consider the market for milk. The price of cereal, a complement for milk increases. What will the impact be on the market? Over in the market for cereal, a higher price has decreased the quantity demanded. Since people are buying less cereal, they won’t be willing to spend as much on milk. This will decrease the demand for milk, shifting it to the left, which lowers both the market price and the market quantity. As you might imagine, milk producers love it when cereal is cheap, and vice versa. --Now let’s consider the market for housing. The price of lumber falls. What will the impact be on the market? Since lumber is an important input for housing, a falling price means lower costs for home builders. Lower costs of production increase supply, which means a shift to the right. As we can see, the market price falls and the market quantity increases. The home builders pass on some of those cost savings to the consumers! --Shifts in the market can often be trickier than it seems. I can’t tell you how many times a friend or acquaintance has informed me at great length about why the price of this or that is going up or down with reasoning in direct defiance of how markets work. This handy chart can help discern how different market conditions impact supply or demand, and how that translates into a change in price and quantity. It is worth taking some time to get it down. But our key takeaway is that a market system is able to set prices across markets such that producers are incentivized to make what consumers want most. Adam Smith’s invisible hand organizes the whole economy, no intervention necessary, and it does so in a way that supports human flourishing.

Supply & Demand Flow Chart

If the price of X changes, that does not shift the supply or demand for X. Shifts lead to price changes, not the other way around.
In all other cases, this flow chart will help you identify how a change in the market will impact the equilibrium price and quantity.

Interactive Practice

Trust me, these are worth doing! Make sure you read through the explanations for each answer.

Demand vs. Quantity Demanded

Supply vs. Quantity Supplied

Finding Equilibrium

The Price System

The beauty of the market system is that it achieves both productive efficiency and allocative efficiency, and it does so without any plan or planner pulling the string. Instead, markets create a price system which drives resources to the production we want and incentivizes entrepreneurs to use those resources as efficiently as possible. To bring that message home, let me turn it over to the brilliant economists behind Marginal Revolution University.

Open Video Transcript

A modern economy depends on the cooperation of vast numbers of strangers, but how is this cooperation coordinated? Let's revisit the economics behind roses, but this time, let's go back to 1973. In the 1970s, the price of oil skyrocketed so it made sense to economize -- but oil has many uses. So which uses should we cut back and which should we maintain? In a market economy, no one person decides these questions or perhaps more accurately, everyone does. A price is a signal wrapped up in an incentive. So when the price of oil increased, it signaled that oil had become more scarce and it gave everyone an incentive to listen to that signal. It said, "Find ways to economize on oil or develop substitutes and you will profit."--When the price of oil first increased, most roses bought in the United States were grown in greenhouses in New Jersey, in Pennsylvania. The increased price of oil meant that it cost more to heat those greenhouses, which meant a shift upwards in the supply curve for flowers and an increase in the price. The result was that it encouraged people to turn to substitutes. Such as chocolate and Teddy bears to give to their loved ones at Valentine's Day -- but the story doesn't end there.--Seeing the higher price of oil, entrepreneurs began to think about other ways to produce flowers. Instead of heating a greenhouse, why not use the natural heat of the sun and transport the roses. Entrepreneurs encouraged farmers in Kenya and Ecuador to start growing roses. And they began to invest in a new global infrastructure to deliver roses around the world. Who could have predicted it? That one way of adjusting to a reduced supply of oil was greater consumption of chocolate? And another way, was by importing roses. In fact, no one could have predicted, let alone plan all the myriad ways in which people responded to the increased price of oil. That's because no one knows all the information that the market uses. Everything from the cost of growing greenhouses, to the demand for roses versus chocolate, to the value that a particular piece of land in Kenya has for growing flowers versus coffee. No single individual knows all of this information. It's dispersed.--So when oil becomes scarce, we want people all over the world to use this dispersed information, their information and their ingenuity to figure out how best to economize on oil. The price system does this in a remarkably efficient way. The Kenyan farmer doesn't have to know anything about oil to have an incentive to do the right thing. He just sees that the price paid for roses has increased and so following his self interest, he starts to produce more roses. Ultimately, that frees up more oil to be used in the production of jet fuel where there are fewer substitutes.--Millions of decisions like this made all over the world, rearrange and reallocate the world's production. Taking oil from where it has low value and moving it to where it has high value so that we produce the most value from our limited resources. That is the invisible hand in action. If it had been invented, the price system would be one of the most amazing creations of the human mind. But like language, it wasn't invented, and it worked long before anyone had any understanding of its principles. As Nobel Prize winning economist, Vernon Smith, has put it, "The pricing system is a scientific mystery as deep, fundamental, and inspiring as that of the expanding universe or the forces that bind matter."--We'll be exploring more about the mystery and the marvel of the price system in the next video.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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