by Jack Roviere

Created on: March 09, 2007   Last Updated: August 21, 2009

Economically speaking, nations can be roughly classified based on the economic systems they have. Regardless of political preferences, prices in an economy may be set by the government (which would denote a planned economy) or perhaps by custom (which would denote a traditional economy). However, in a third system, prices may not be set at all, but may "float" based on the wills of supply and demand. This economic system, the market economy is that espoused (roughly) by America (but, these days, it's espoused - to some extent - by nearly all nations). Invisible Hand Theory, proposed by Adam Smith in the 18th century, helps to explain how the market economy that we all know and love works, even with its chaotic nature.

Mr. Smith reasoned that a market economy's resources were guided metaphorically by an "Invisible Hand." This wasn't the hand of God or some other deity, but simply represented pricing through competition. So, for example, a person might look at the competitive environment, see that he had an advantage in selling clothes, and therefore would enter some kind of industry related to clothes. Instead of the government (for example, a mandated quota) or custom (for example, a hereditary trade) dictating the best use of his resources, the individual would direct his resources based on competitive sense of supply and demand.

As with any economic system, Smith's Invisible Hand Theory and market economy attempts to answer three basic questions: what should be produced? For whom should things be produced? and how will things be produced? The Invisible Hand of competition proposed that these questions could best be answered by looking at the 'advantages' that different people and different resources have. The first kind of advantage that Smith formulated was the "absolute advantage" - simply, the person who can produce an item with the least cost has the absolute advantage, and therefore should produce in the industry and drive other less efficient people out of the market. So, if one person could make a pair of shoes for $3.00, and another person could make it for $.50 cents, then obviously, the person who could make the shoes for less would have a dramatic advantage, could make more shoes or reap greater profits.

According to Smith, nations or individuals would have few absolute advantages, and the market would always balance it. So, the shoemaker (who was good at making shoes) would make shoes for the benefit of the breadmaker (who was good at making

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