THE INVISIBLE

HAND OF
THE MARKET BRINGS

ORDER
FREE MARKET ECONOMICS
56 FREE MARKET ECONOMICS

A
ccording to the Scottish
IN CONTEXT thinker Adam Smith, the
West had embarked on
FOCUS
a great revolution before the 18th
Markets and firms
century, with nations changing
KEY THINKER from agrarian, or agricultural,
Adam Smith (1723–90) societies to commercial ones.
During the Middle Ages towns had
BEFORE developed, and they were slowly
1714 Dutch writer Bernard joined up by roads. People brought
Mandeville illustrates the goods and fresh produce to the
unintended consequences that towns, and the markets—with
can arise from self-interest. their buying and selling—became
1755–56 Irish banker Richard a part of life. Scientific innovation
produced reliable, agreed-upon
Cantillon describes a version of
units of measurement, along with
“spontaneous order.”
new ways of doing things, and
AFTER centralized nation-states formed
1874 Léon Walras shows how from the mix of principalities that Mandeville’s Fable of the Bees
supply and demand lead to a had dotted Europe. People enjoyed explored the idea that when people
a new freedom and had begun to act out of self-interest, they benefit the
general equilibrium. whole of society, like the self-interested
exchange goods for their own
1945 Austrian economist behavior of bees benefits the hive.
personal gain, not merely for that of
Friedrich Hayek argues that their overlord.
market economies produce Smith asked how the actions answer. Man, in his freedom, rivalry,
an efficient order. of free individuals could result in and desire for gain, is “led by an
1950s Kenneth Arrow and an ordered, stable market—where invisible hand to promote an end,
Gérard Debreu identify people could make, buy, and sell which was no part of his intention”
conditions under which free what they wanted without enormous —he inadvertently acts on behalf of
waste or want. How was this possible the wider interest of society.
markets lead to socially
without some kind of guiding hand?
optimal outcomes.
In his great work of 1776, The Laissez-faire economics
Wealth of Nations, he provided the The idea of “spontaneous order”
was not new. It was proposed in
1714 by the Dutch writer Bernard
Mandeville in his poem The Fable
of the Bees. This told the story
of a beehive that was thriving
on the “vices” (self-interested
behavior) of its bees. When the
bees became virtuous (no longer
acting in their own self-interest
but trying to act for the good of
the hive), the beehive collapsed.
Smith’s notion of self-interest was

Covent Garden Market in London

is pictured here in 1774. Smith thought
markets were key to making society fair.
With the freedom to buy and sell, people
could enjoy “natural liberty.”
 THE AGE OF REASON 57
See also: Economic man 52–53 ■ The division of labor 66–67 ■ Economic equilibrium 118–23 ■ The competitive market
126–29 ■ Creative destruction 148–49 ■ Economic liberalism 172–77 ■ Markets and social outcomes 210–13

not a vicious one. He saw humans

as having an inclination to “truck This might lead to a
and barter” (bargain and exchange) Every individual acts out
of self-interest. chaotic mix of products
and to better themselves. Humans, and prices, but…
in his view, were social creatures
who act with moral restraint, using
“fair play” in competition.
Smith believed that
governments should not interfere … other self-interested people provide competition—
with commerce, a view that was they take advantage of each other’s greed.
also held by other Scottish thinkers
around him, including the
philosopher David Hume (p.47).
An earlier French writer, Pierre de
Boisguilbert, used the phrase laisse If one seller charges If one employer pays wages
faire la nature (“leave nature alone”), too much… that are too low…
by which he meant “leave business
alone.” The term “laissez-faire” is
used in economics to advocate
minimal government. In Smith’s
view government did have an … another will undercut … another will
important role, supplying defense, his price, and the first seller’s take his employees,
justice, and certain “public goods” products will fail to sell. and his firm will fail.
(pp.46–47) that private markets
were unlikely to provide, such
as roads.
Smith’s vision was essentially Businesses fail unless they pay market
optimistic. The English philosopher wages and make products the market demands
Thomas Hobbes had earlier argued at the price people are willing to pay.
that without strong authority,
human life would be “nasty,
brutish, and short.” British
economist Thomas Malthus (p.69)
looked at the market and predicted
The invisible hand of the
mass starvation as a direct result of market brings order.
increased wealth. After Smith,
Karl Marx (p.105) would predict
that the market leads to revolution.
Smith, however, saw society as goods that people want. If demand Society, the Austrian economist
perfectly functional, and the entire for a product exceeds its supply, Friedrich Hayek (p.177) showed
economy as a successful system, consumers compete with each how prices respond to individuals’
an imaginary machine that worked. other to drive the price up. This localized knowledge and desires,
He mentioned the “invisible hand” creates a profit opportunity for leading to changes in the amounts
only once in his five volume work, producers, who compete with each demanded and supplied in the
but its presence is often felt. Smith other to supply more of the product. market. A central planner, Hayek
described how his system of This argument has stood the said, could not hope to gather up
“perfect liberty” could have positive test of time. In an essay in 1945, so much dispersed information. It is
outcomes. First, it provides the titled The Use of Knowledge in widely believed that communism ❯❯
58 FREE MARKET ECONOMICS
collapsed in Eastern Europe because In that case, opportunities for gain
central planning failed to deliver the will arise, and prices will increase,
goods that people wanted. Some but only until competition brings
criticisms of Smith’s first point have new firms into the market and
been raised, such as the fact that prices fall back to their natural
the market might only provide the level. If one industry begins to
goods that are wanted by the rich; suffer a slump in demand, prices
Consumption is the
it ignores the desires of the poor. It will drop and wages will fall, but
sole end and purpose
also responds to harmful desires— as a different industry rises, it will of all production.
the market can feed drug addiction offer higher wages to attract Adam Smith
and promote obesity. workers. In the long run, Smith
says, “market” and “natural” rates
Fair prices will be the same: modern
Second, Smith said that the market economists call this equilibrium.
system generates prices that are Competition is essential if
“fair.” He believed that all goods prices are to be fair. Smith attacked
have a natural price that reflects the monopolies occurring under the about competition, although
only the efforts that went into mercantilist system, which dissenters, such as Austrian-
making them. The land used in demanded that governments American economist Joseph
making a product should earn its should control foreign trade. When Schumpeter (p.149), would later
natural rent. The capital used in its there is only one supplier of a say that innovation can also lower
manufacture should earn its natural good, the firm that supplies it can prices, even where there appears to
profit. The labor used should earn permanently hold the price above be little competition. As inventors
its natural wage. Market prices and its natural level. Smith said that come forward to provide higher
rates of return can differ from their if there are 20 grocers selling a quality products at lower prices,
natural levels for periods of time, as product, the market is more they blow away existing firms in
might happen in times of scarcity. competitive than if there are just a storm of creative destruction.
two. With effective competition
and low barriers to entry into a Fair incomes
Smith described the ways in which
labor, landowners, and capital (here
market—which Smith also said Smith also argued that market
invested in the horses and plow) work was essential—prices tend to be economies provide incomes that
together to keep the economic system lower. Much of this underlies are fair and can be spent on goods
moving and growing. mainstream economists’ views in a sustainable “circular flow,”
 THE AGE OF REASON 59
in which money paid in wages Demand in a market can change for many reasons. As it does so,
circulates back into the economy the market responds by altering supply. This happens spontaneously—
when the worker pays for goods, there is no need for a guiding hand or plan in a market that encourages
competition among self-interested people.
only to be paid back out in wages
to repeat the process. Capital
invested in production facilities helps During a rainy summer…
to increase labor productivity,
which means that employers can
afford to pay higher wages. And if
employers can afford to pay more,
they will because they have to
compete with each other for workers.
Turning to capital, Smith … demand … demand for
for umbrellas sunglasses
said that the amount of profit that soars. drops.
capital can expect to earn through
investments is roughly equal to
the rate of interest. This is because
employers compete with each other
As prices As prices
to borrow funds to invest in profitable rise, so do drop, so do
opportunities. Over time the rate profits. profits.
of profit in any particular field
falls as capital accumulates and
opportunities for profit are exhausted.
Rents gradually rise as incomes
rise and more land is used. Umbrella firms
Smith’s realization of the employ more
interdependence of land, labor, and people and Self-interested
capital was a real breakthrough. He enjoy profits employers let
until other go of staff.
noted that workers and landowners firms enter the
tend to consume their incomes, market, forcing Staff go to work
while employers are more frugal, prices back to a in the booming
investing their savings in capital “natural level.” umbrella business.
stock. He saw that wage rates vary,
depending on different levels of
“skill, dexterity, and judgment,” labor (pp.66–67). Economists
and that there are two forms of call this “Smithian growth.” As
labor: productive (engaged in more products are produced and
agriculture or manufacturing) and consumed, the economy grows,
what he called “unproductive” and markets also grow. As markets
(supplying services needed to back grow, there are more opportunities It is not from the
up the main work). The highly for specialization of work. benevolence of the butcher,
unequal outcomes of today’s The second engine of growth is the brewer, or the baker
market system are a long way the accumulation of capital, driven that we expect our dinner,
from what Smith envisioned. by saving and the opportunity for but from their regard
profit. Smith said that growth can to their self-interest.
Economic growth be reduced by commercial failures, Adam Smith
Smith claimed that the invisible a lack of resources required to
hand itself stimulates economic maintain the fixed capital stock,
growth. The source of growth is an inadequate money system
twofold. One is the efficiencies (there is more growth with paper
gained through the division of money than with gold), and a ❯❯
60 FREE MARKET ECONOMICS
high proportion of unproductive invisible hand would be socially
workers. He claimed that capital is beneficial. Kenneth Arrow and
more productive in agriculture than Gérard Debreu (pp.208–11) showed
in manufacturing, which is higher how free markets do this, but they
than in trade or transport. also showed that the conditions
Ultimately, the economy will grow There is no art which needed were stringent and did not
until it reaches a wealthy, stationary bear much relation to reality.
one government sooner
state. In this, Smith underestimated This was not the end of the
the role of technology and
learns of another than story. After World War II the idea
innovation—the Schumpeterian
that of draining money of laissez-faire was in hibernation.
growth described earlier (p.58). from the pockets However, from the 1970s, Keynesian
of the people. policies, which advocated state
Classical legacy Adam Smith intervention in economies, seemed
Smith’s system was comprehensive. to break down, and laissez-faire
It considered small (microeconomic) enjoyed a strong resurgence. The
details and the large (macroeconomic) seeds of this flowering can be
picture. It looked at situations in found in works on the market
both the short and long run, and its economy by Milton Friedman
analysis was both static (the state (p.199) and the Austrian School,
of trade) and dynamic (the economy their returns. Later, free market notably Friedrich Hayek (p.177),
in motion). It looked in detail at the theory took a different, who were skeptical about the good
class known as workers, “neoclassical” form with general that interfering governments can
distinguishing entrepreneurs such equilibrium theory, which sought do and argued that social progress
as farmers and factory owners from to show how a whole economy’s would be attained through
suppliers of labor. In essence it prices could reach a state of stable unfettered markets. Keynesians,
established the parameters for equilibrium. Using mathematics, too, recognized the power of
“classical” economics, which economists such as Léon Walras markets—but for them markets
focuses on the factors of production (p.120) and Vilfredo Pareto (p.133) needed to be nudged to work best.
—capital, labor, and land—and reframed Smith’s claim that the The free market approach
enjoyed an important boost from
theories in the 1960s and 70s based
on the role of rationality and rational
expectations (pp.244–47). Public
choice theory, for example, depicts
government as a group of self-
seeking individuals who maximize
their own interests and extract
money without regard to the social
good (“rent-seeking”). New classical
macroeconomics uses Smith’s
assumption that markets always
sort themselves out and adds the
point that people can see the future
implications of any government
actions and understand the

Localized markets such as this

one in Kerala, India, exhibit all the
hallmarks of Smith’s free market and
demonstrate the natural way in which
supply and price adjust to demand.
 THE AGE OF REASON 61

Adam Smith
The founder of modern
economics, Adam Smith was
born in Kirkcaldy, Scotland,
in 1723, six months after his
father’s death. A reclusive,
absentminded scholar, he
went to Glasgow University at
the age of 14, then studied at
workings of the economic system, Smith didn’t foresee the kinds of Oxford University for six years
so state intervention will not work. inequalities that can arise from free before returning to Scotland
Even so, most economists today markets in their present form. In stock to take up a professorship in
exchanges and money markets notions
believe that the market can fail. logic at Glasgow University.
of “fairness” become almost irrelevant.
They focus on disparities in In 1750, he met and became
information, held by various close friends with the
participants in a market. George rationality (pp.266–69), and see philosopher David Hume.
Akerlof referred to this in his The the non-rationality of humans as In 1764, Smith resigned
Market for Lemons (pp.274–75). a reason for markets to fail. his post at Glasgow to travel
to France as tutor to the Duke
Behavioral economists have The issue of laissez-faire
of Buccleuch, a Scottish
questioned the whole notion of economics divides economists
aristocrat. In France, he
along political lines. Those on the met the physiocrat group of
political Right embrace laissez- economists (pp.40–45) and the
faire; those from the Left align philosopher Voltaire, and he
themselves with Keynesian began writing The Wealth of
intervention. This remains a Nations. He devoted 10 years
central debate in economics today. to the book before accepting a
Human society, when The financial crisis of 2007–08 position as Commissioner of
we contemplate it in a has added fuel to this dispute. The Customs. He died in 1790.
certain abstract and free marketeers felt vindicated in
philosophical light, their theories about the business Key works
appears like a great, cycle, while Keynesians pointed
an immense machine. to market failure. US economist 1759 The Theory of Moral
Adam Smith Nouriel Roubini (1959– ), who Sentiments
1762 Lectures on
predicted the crash, was speaking
Jurisprudence
of those who had distorted Smith’s 1776 An Inquiry into
ideas when he said that “decades the Nature and Causes
of free market fundamentalism laid of the Wealth of Nations
the foundation for the meltdown.” ■