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In a free market, where people are free to produce, consume and exchange goods,the demand and supply of different goods will be equal. Even though no one in particular monitors that they are equal, the market forces ensure that they are same, as if directed by an invisible hand. This in summary, is the invisible hand theory.

This theory given by Adam Smith in eighteenth century also demonstrates that when the free markets operate, the allocation of resources for production and consumption of different goods will be in a way that is the best for the society. In other words, the invisible hand of market forces, in the form of demand and supply will achieve the most efficient level of production, consumption and distribution of goods.

One can say that the invisible hand theory is the economic counterpart of democratic theory. Just like in a democracy, people are supposed to choose the best leaders for themselves, the invisible hand theory presumes that the people will chose to produce and consume in the most efficient manner when given a free hand. Like politics, 'adequate information' is an essential ingredient for a free market as well; and like politics, inadequate information about prices, quality and suppliers can result in a less than efficient market. As is true of democracy, inadequate competition can defeat the process of market efficiency - as happens in case of monopolies.

So in practice, markets may still end up being less than efficient, but that is not because the invisible hand theory of free markets is inaccurate. Markets sometimes fail because of different factors, but more often than not they provide the best option for achieving an efficient system of human economic activity.

The DEMAND and SUPPLY

In the invisible hand theory of Adam Smith, the two crucial concepts are those of demand and supply. 'Demand' refers to the willingness of people to pay a price for a particular good. If 100 people are willing to pay $ 10 or more for an object, the demand for that object, at a price of $ 10, would be 100. Out of these, if only 50 are willing to pay $ 20 or more for the same object, then the demand of that object at a price of $20 would be 50. At a price of $30, the corresponding demand may be 20 only.

Now if the cost of production of this article is $ 8, and the market price of that article is $30, then their a profit margin of $22, which will attract more producers to the market. When they also start production, the supply will be more, and the competition among the producers will bring the market price down, so as to bring it to $ 20, at which level, there will be more demand and so all that is produced will be consumed. If new producers continue to enter the market, the price may fall to $ 10, when there would be 100 buyers and all the 100 units of the object produced will be consumed.

Thus when the demand is more, the market price of a good rises, thereby making it attractive for more producers to join. The entry of new producers or suppliers increases the supply, and in turn reduces the prices. This continues adjustment of market prices by addition or exit of new producers is the basic mechanism by which the invisible hand of the free market operates.

What was given by Adam Smith as a theory has now become the basic pillar of all economic decision making. It is true that the markets can also fail, as happens in the case of information asymmetries between the consumers and the producers, or in case of monopolies or public goods. However, it is still by far the most efficient system of allocation of resources, and hence deserves to be followed.

Learn more about this author, V. Kumar.
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