What is the Invisible Hand? A Guide to Adam Smith's Economic Theory

Investors and economists are always looking to better understand how financial and consumer markets work, along with why we make the choices we do. After all, the answer to questions like why a shopper might choose one product over another is worth a lot of money.

One framework for understanding markets is the invisible hand theory, an idea proposed by economist Adam Smith that illustrates the hidden, self-interested forces behind people's economic choices. 

Definition of the invisible hand

The invisible hand is a concept stating that people act in their own best interests, yet despite their self-motivation, they end up benefiting markets and the economy as a whole. In other words, society is guided by an invisible hand toward optimal choices, as opposed to a more visible set of requirements leading to those choices. 

The theory is often used as a backbone to support the idea of a free market, though some have said that the idea is taken out of context. 

Origins of the invisible hand concept

The concept of the invisible hand is often credited to economist Adam Smith, as the term appeared in his 1759 work, "The Theory of Moral Sentiments," and again in "The Wealth of Nations" in 1776.

According to Michael Edesess, Ph.D. and managing partner and special advisor at M1K LLC, "The best example of how it works was given by Smith himself in [The Wealth of Nations]: 'It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.' He followed that up by saying, 'By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.' These are the two most famous quotes from Smith's long book."

Smith adds that people act with their own regard and their own interests in mind and not with an ulterior motive, but that can still have both positive and unexpected repercussions.

"In other words, Smith was saying that by solely pursuing their own self-interest — and not any conscious intention to be of help to others — and by trading with each other, the butcher, brewer, and baker all help each other to provide the goods they need for their dinners," explains Edesess.

However, Smith was not necessarily a proponent of fully unregulated, free-market capitalism or that businesses should be able to act immorally. Today, however, the concept of the invisible hand is often used in conjunction with letting the free market sort itself out, without intervention.

How the invisible hand works

The invisible hand concept is based on the idea of free markets and is said to benefit consumers by creating market equilibrium by people pursuing their own self-interest. 

In theory, people acting based on their own interests creates supply and demand and market efficiency, creating a positive outcome for the whole of the economy. Without government intervention, the markets supposedly work on their own based on consumer preferences and actions. 

Self-interest and market efficiency

When people act in their self-interest, that naturally leads to market efficiency, according to invisible hand proponents.

For example, if a car manufacturer produces more minivans than they can sell in a given year, their self-interest in making a profit means they'll adjust prices or produce fewer minivans going forward, and perhaps manufacture more sedans if that's what consumers want. The government doesn't necessarily have to tell the manufacturer how many models of different types of cars to make, as there's a natural force driving efficiency — the invisible hand. 

The invisible hand concept is closely related to laissez-faire economics, which proposes that government interference in the economy should be minimal and should run its own course. According to these ideas, as people act based on their own self-interest, it creates a need for supply and demand and can create a competitive and robust marketplace. 

"Smith's invisible hand theory shows that an optimal distribution of goods and services among a number of producers and consumers can be achieved without a 'visible hand' directing them to do so," says Edesess. "In fact, a visible hand that does things like dictating prices of goods can cause the end result to be suboptimal. This mistake was made crystal clear in the Communist-era Soviet Union."

However, one could argue that the invisible hand doesn't always lead to optimal efficiency. For example, monopolies can happen through events like luck or deceit. Then, the monopoly company can set prices at a non-competitive price — even if it's high and consumers don't want to pay that much, the barrier to entry could be so high that no other company tries to compete, leaving customers with the suboptimal choice to overpay or not buy at all.

Examples of how the invisible hand works 

In theory, the invisible hand inherently creates a free marketplace that supports competition among consumers and works best for everyone. 

"In contrast to the invisible hand, the heavy hand of government which seeks to direct what is best for others will do so in a far less efficient manner than the individual will for themselves," says Nicholas B. Creel, M.A, J.D., LL.M., Ph.D. and associate professor of accounting and business law at Georgia College and State University. 

"An example of this would be how a business owner, seeking only to make themselves better off, might sell an item of higher quality and at a lower price than their competitors," he explains. 

Keeping prices low may increase demand, and that could create competition among other suppliers offering similar products. 

"They don't do this for the consumer, they do so to win the business of the consumer to make themself better off. The end result is everyone is best off in this scenario. The consumer gets a better and cheaper product, the market maximizes efficiency, and the business owner stays afloat," explains Creel. 

A more specific example is how a food delivery company's self-interest in turning a profit could lead it to collaborate with restaurants to improve operational efficiency and make delivery more affordable for customers. Instead of cutting into restaurant margins to the point where they close, the food delivery company has an incentive to keep these businesses thriving, as a wide selection of restaurants at low prices makes the platform more appealing to customers. So, the invisible hand leads to a win-win-win situation between the food delivery company, restaurants, and consumers.

Criticisms and unintended consequences of the invisible hand

While many believe that the invisible hand concept is valid in many cases, some think that it doesn't always produce optimal results. 

For one, the invisible hand theory assumes that consumers are rational when making economic decisions, but that's not always the case. As humans, we don't always behave logically; we're often influenced by emotions or needs. Consider any time you have gone to the grocery store and overspent because you're hungry or sleep-deprived. These emotions or needs can change, so it can be hard for businesses to anticipate demand, which could lead to inefficiencies like over- or under-production. 

Additionally, some critics note the possibility of greed and exploitative practices that could be justified due to "self-interest" and the invisible hand. For example, effective advertising can lead to consumers buying more than they need. That might serve consumers' short-term self-interest, but it could lead to poor financial choices that ultimately lead to long-term economic instability. Or, consumers might buy products that harm the environment, not realizing that it threatens their long-term best interests. By the time the problem has been identified, e.g., buying certain products has led to extensive climate change, the problem could be too far gone for the market to course-correct. 

"The invisible hand promotes individual self-interest and competition. While this sounds nice, in practice, it's not actually a good thing, because economic theories also point out the 'irrational consumer' making choices say emotionally, impulsively, with incomplete information, and most importantly, generally not being mindful in the moment of what's best for the overall good of society," says Nick Thorsch, founder of environmental sustainability platform Share2Seed.

Invisible hand vs. government intervention

While Smith's invisible hand theory is still relevant today, it has also come under scrutiny during events like the financial crisis of 2008, the Covid-19 pandemic, and crypto boom, there is more debate about the role of government in the market. 

In other words, if left unchecked, do consumers really create the best results for the economy when there is no government interference? Or could it lead to greed or economic collapse? 

Free market economics vs. government regulation

Some people think that the free market should be left unchecked, while others think the government needs to regulate companies and consumers to avoid unintended consequences. For example, government regulation regarding environmental issues could potentially be considered necessary to prevent certain companies and individuals from damaging the shared resource that is the environment, while others say that the market will figure out environmental solutions if needed.

There's not necessarily one right answer. Part of it depends on your beliefs. Some, people think the free market should be left alone, while others think more regulation is needed.

It's also possible that there can be a mix of both. For example, balancing the invisible hand with regulation could involve issues like requiring banks to meet certain liquidity requirements, as has happened after the financial crisis of 2008. However, it's not as if the government does not allow privately owned banks to operate. Still, this arguably reduces the chances that ill-informed or overly risky decisions from some banks lead to broader economic collapse.

FAQs about the invisible hand

What does the "invisible hand" mean in economics?

The invisible hand in economics can be explained as naturally occurring market efficiency based on people and companies acting in their own self-interest. In doing so, they end up finding an equilibrium that works for the good of society, without the need for a more visible hand, like government regulation. However, not everyone agrees on the validity of the invisible hand.