It doesn’t seam complex but I’m just missing the point and I need to be able to explain it to someone else to show I understand it.
In: Economics
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The “invisible hand” is a way of describing how markets tend to produce the goods and services that are in demand without the need for someone to plan everything.
For example, if you live in a major city, there is probably a taco truck in your town. That taco truck couldn’t exist without a huge network of suppliers – tomato and corn farmers, factories that produce spices, iron mines, automobile companies, international oil shipments, and so on. But there is no government agency or master planner who decided that we need to create all these things so we can have a taco truck. The guy drilling for oil has no idea that he’s supporting a taco truck, nor does the person picking chili peppers, or the person manufacturing heating elements.
The taco truck exists because of millions of people making economic decisions in their own individual interests. Even the person who owns the taco truck doesn’t do it because you, in particular, want to enjoy a delicious taco. But all the myriad, incredibly complex choices that combine to put that delicious taco into your mouth can be described as an “invisible hand” that enables it to happen.
Economics is the study of decision making in a sense. Resources are scarce in this world. How do we allocate scarce resources? Some believe scarce resources are not always allocated optimally and a centralised planner should direct resource flow. The invisible hand observes that resources can be allocated optimally without the need of a centralised planner.
The way this is done in a decentralised manner is by the pricing mechanism. Prices co-ordinate the economy through its signal property and incentive property.
For example, when market prices for steel increases, it signals the real physical good has become more scarce and that the resource needs to be reallocated in the economy. Every single steel consumer down the supply chain will need to update their purchasing decision to the new economic condition. Steel mills being destroyed from some geopolitical disaster or high-value demand from an industrial boom could have been the cause, but no one needs to find out or care. They just have to update their decision-making based on the price signal.
How will the reallocation be socially optimal? The consumers themselves will determine if steel is valuable enough to warrant the price increase or a substitute can be used in place of steel. They are incentivised to monitor their consumption because they are risking their own resources. The end result is that steel usage will be maintained for high-value products and cut back for low-value products (steel chairs can be substituted for wood chairs easily, but structural beams are required to be steel).
If steel becomes more scarce, how do we know if we should produce more steel? On what margin? Through what methods? The higher price incentivises entrepreneurs to determine the condition of the steel market, and capital is allocated if it is the most profitable activity for the capital. Remember, capital (read as investment) is scarce too and should be allocated to what is most valuable.
So the invisible hand is about disparate actors making individual decisions on how to allocate their own resources, and how this can achieve socially beneficial outcomes. It also suggests markets are dynamic systems that reveal new information, and how markets aid in decision making through the price signal.
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