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Invisible Hand in Economics: Definition & Theory

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Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn what the invisible hand is and where it came from. Find out how self-interest plays a key role in guiding the economy and how it can result in better prices for you.

Definition of the Invisible Hand Theory

Have you ever wondered how the United States economy came to be? Why do people open certain businesses? Why do they sell certain products? How do we come up with the prices for these products? These are pretty big questions! Adam Smith, an influential economist of the 1700s, is responsible for at least some of the answers to these questions. He inspired much of our country's current economic policies when he wrote the book The Wealth of Nations in 1776.

Adam Smith used the metaphor of the invisible hand to refer to the guidance and benefit society receives when individuals act in their own self-interest when trying to make money. According to Smith, when consumers are left to freely choose what they want to buy, and businesses are left to freely decide what they want to sell, the self-interest of both will lead to decisions that result in good prices and the right products in the economy and marketplace. As a result, Smith argued that no government intervention is needed. We simply have the invisible hand of economic self-interest to guide us. Let's explore the theory more to help it all make sense.

Example of the Invisible Hand Theory

Adam Smith argued that an economy works best when the government leaves people alone to buy and sell freely among themselves. If businesses are allowed to pick their products, and price and trade them as they wish, self-interested owners who are trying to maximize profit will compete with each other, leading to lower prices and better product offerings.

For example, if Business B charges less than other stores for a gallon of milk, the customer will then buy milk from Business B. As a competing business owner, you will have to then lower your price of milk or offer something better than Business B if you want to keep making money and selling products. Your own self-interest in staying in business will make you work to come up with better prices, services or products.

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