Resources moving from declining sectors to expanding ones and stopping in equilibrium demonstrate the way the market mechanism (price mechanism) operates.
This was first spotted by Adam Smith in the Wealth of Nations as early as 1776 although the diagrams did not come until later. Understanding how an economic system works in this fashion led to the phrase “the consumer is king” as the next sentence explains.
Resources (land, labour and capital) flow from where they are not in demand, or demand is falling, to where they are in demand, or demand is rising. So the price mechanism is well-regarded as a good (but by no means perfect) way of allocating resources to society’s demands.
The modern economic theory is largely based on the observations made by Adam Smith in the late eighteenth century. While analyzing the behaviour of producers and sellers in an unregulated market, he came up with the theory that the markets have an inherent potential of being efficient, if just left
alone. He referred to this inherent property of the markets as the 'invisible hand'. Even after more than two centuries, his theory has remained the cornerstone of our understanding of market behaviour.
In late eighteenth century, Adam Smith who undertook an analysis of the markets came up with a
conclusion that if the market is left free and unregulated, with no restrictions on production or consumption, then the demand of people for different goods and their production by the market will be equal, leading to a general welfare of the society. To put in different words, Mr. Smith suggested that the invisible hand of market, consisting of forces of demand and supply will achieve an efficient level of production, consumption and distribution of goods in the society.
This idea of unregulated markets achieving efficiency on its own, as if guided by an invisible hand, has created a very strong argument in favour of free markets, and against governments controlling production or consumption in any form that interferes with the free market.
In many ways, Adam Smith's Invisible Hand theory is the economic counterpart of democratic theory.
His concept of Free markets is based largely on the condition that there should perfect competition, that is, no restrictions on economic activity, with everyone left alone to exercise their choice of production, consumption and exchange, as per their best judgement (known as consumer sovereignty).
Just as people are supposed to be capable of choosing the best leaders for themselves, in a democracy, the Invisible Hand theory of Adam Smith presumes that people will be able to produce and consume in a manner that is most efficient if they are given a free hand. Adequate information is as essential for the free markets as it is for the success of a democracy. Lack of information or Information Asymmetry can result in an inefficient market.
Similarly, as in a democracy, restriction on competition, as happens in case of monopolies, can defeat the whole process and prevent the markets from achieving efficiency.
In real life, markets may not be perfectly efficient, but that does not negate the importance of Adam Smith's Invisible Hand theory. Markets can often fail because of many different factors, but in spite of them,
they still provide the best option we have for achieving an efficient system of human economic activity.
The real contribution of Adam Smith was to introduce the concepts of Demand and Supply and identify them as the prime movers in the free market. Demand refers to what the people are willing to pay for a particular good. As the price rises, demand of the product falls, giving rise to a down-sloping curve. On the other hand, Supply refers to what the producer or supplier would be willing to produce at a given price. The interplay of demand and supply leads to pricing of a good in the market. When the demand of a good is more, the market price of a good rises, thereby attracting more producers to the market, which increases the supply, and in turn reduces the prices, thereby maintaining a stable equilibrium. This continuous 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.
Though Adam Smith did not go in to graphical representation or the mathematical derivation of the
Demand as a relationship between price and quantity, he discussed the concept with great clarity in his book, An Inquiry into the Nature and Causes of the Wealth of Nations, first published in 1776. He summarised the concept of Invisible Hand in the following words,
"[The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity…they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species."
The Theory Of Moral Sentiments, Part IV, Chapter I, pp.184-5, para. 10.
"Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; and 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."
The Wealth Of Nations, Book IV, Chapter II, p. 456, para. 9.
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages."
The Wealth Of Nations, Book I, Chapter II, pp. 26-7, para 12.
alone. He referred to this inherent property of the markets as the 'invisible hand'. Even after more than two centuries, his theory has remained the cornerstone of our understanding of market behaviour.
In late eighteenth century, Adam Smith who undertook an analysis of the markets came up with a
conclusion that if the market is left free and unregulated, with no restrictions on production or consumption, then the demand of people for different goods and their production by the market will be equal, leading to a general welfare of the society. To put in different words, Mr. Smith suggested that the invisible hand of market, consisting of forces of demand and supply will achieve an efficient level of production, consumption and distribution of goods in the society.
This idea of unregulated markets achieving efficiency on its own, as if guided by an invisible hand, has created a very strong argument in favour of free markets, and against governments controlling production or consumption in any form that interferes with the free market.
In many ways, Adam Smith's Invisible Hand theory is the economic counterpart of democratic theory.
His concept of Free markets is based largely on the condition that there should perfect competition, that is, no restrictions on economic activity, with everyone left alone to exercise their choice of production, consumption and exchange, as per their best judgement (known as consumer sovereignty).
Just as people are supposed to be capable of choosing the best leaders for themselves, in a democracy, the Invisible Hand theory of Adam Smith presumes that people will be able to produce and consume in a manner that is most efficient if they are given a free hand. Adequate information is as essential for the free markets as it is for the success of a democracy. Lack of information or Information Asymmetry can result in an inefficient market.
Similarly, as in a democracy, restriction on competition, as happens in case of monopolies, can defeat the whole process and prevent the markets from achieving efficiency.
In real life, markets may not be perfectly efficient, but that does not negate the importance of Adam Smith's Invisible Hand theory. Markets can often fail because of many different factors, but in spite of them,
they still provide the best option we have for achieving an efficient system of human economic activity.
The real contribution of Adam Smith was to introduce the concepts of Demand and Supply and identify them as the prime movers in the free market. Demand refers to what the people are willing to pay for a particular good. As the price rises, demand of the product falls, giving rise to a down-sloping curve. On the other hand, Supply refers to what the producer or supplier would be willing to produce at a given price. The interplay of demand and supply leads to pricing of a good in the market. When the demand of a good is more, the market price of a good rises, thereby attracting more producers to the market, which increases the supply, and in turn reduces the prices, thereby maintaining a stable equilibrium. This continuous 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.
Though Adam Smith did not go in to graphical representation or the mathematical derivation of the
Demand as a relationship between price and quantity, he discussed the concept with great clarity in his book, An Inquiry into the Nature and Causes of the Wealth of Nations, first published in 1776. He summarised the concept of Invisible Hand in the following words,
"[The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity…they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species."
The Theory Of Moral Sentiments, Part IV, Chapter I, pp.184-5, para. 10.
"Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; and 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."
The Wealth Of Nations, Book IV, Chapter II, p. 456, para. 9.
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages."
The Wealth Of Nations, Book I, Chapter II, pp. 26-7, para 12.