Question

Adam Smith’s basic claim was : “The free market system is like an invisible hand that can obtrusively coordinate the behaviour of a multitude of individuals, interested only in maximizing their own selfish utility, so as to bring about efficiency and a socially optimal outcome.” Critically evaluating the concept of economic efficiency, discuss the above statement.

Answer 1

The concept of the "invisible hand" was explained by Adam Smith in his 1776 classic foundational work, "An Inquiry into the Nature and Causes of the Wealth of Nations." It referred to the indirect or unintended benefits for society that result from the operations of a free market economy.

Influence
Smith, considered to have founded modern economic theory in the late 18th century, was no fan of widespread government regulation of the economy. He even went so far as to defend smuggling as a natural, legitimate part of the economy.

His "laissez-faire," or free-market, theories are primarily embraced by the supply-side Milton Friedman school of economic thought. Those theories stand in contrast to the 19th century demand-side Keynesian economic theories that became increasingly predominant in shaping the economic policies of western governments since the 1930s and the Great Depression.

Basics
Smith's theory of the invisible hand constitutes the basis of his belief that large-scale government intervention and regulation of the economy is neither necessary nor beneficial. Smith put forth the notion of the invisible hand in arguing that free individuals operating in a free economy, making decisions that are primarily focused on their self-interest logically take actions that benefit society as a whole, even though such beneficial results were not the specific focus or intent of those actions.

Smith went on to argue that the intentional intervention of government regulation, although it is specifically intended to protect or benefit society as a whole, in practice is usually less effective for achieving that end than a freely operating market economy. In many cases, it is harmful to the people as a whole by denying them the benefits of an unencumbered marketplace.

Major Principles
According to Smith, the collective desires of all the individual buyers and sellers in a free economy operate naturally to accomplish:

Production of the most desired and beneficial goods in the most efficient manner possible, since the seller who most successfully does this gains the greatest market share and revenues.
Making goods and services available at the functionally lowest prices possible, since free competition between sellers does not allow for price gouging.
Automatically flowing the bulk of investment capital toward funding the production of the most necessary, most beneficial, and most wanted goods and services, since businesses producing goods or services for which there is the highest demand are able to command the highest prices and resulting profits.

Whether the invisible hand of free-market "goodwill" exists or is at all effective is hotly debated. It is, however, difficult to deny that Smith's market philosophy helped create the most successful economy in history.

Real World Example of Invisible Hand
Business productivity and profitability are improved when profits and losses accurately reflect what investors and consumers want. This concept is well-demonstrated through a famous example in Richard Cantillon’s An Essay on Economic Theory (1755), the book from which Smith developed his invisible hand concept.

Cantillon described an isolated estate that divided into competing leased farms. Independent entrepreneurs ran each farm to maximize their production and returns. The successful farmers introduced better equipment and techniques and brought to market only those goods for which consumers were willing to pay. He showed that returns were far higher when competing self-interests ran the estate rather than the previous landlord's command economy.

An Inquiry into the Nature and Causes of the Wealth of Nations was published during the first Industrial Revolution and the same year as the American Declaration of Independence. Smith’s invisible hand became one of the primary justifications for an economic system of free market capitalism.

As a result, the business climate of the United States developed with a general understanding that voluntary private markets are more productive than government-run economies. Even government rules sometimes try to incorporate the invisible hand. Former Fed Chairman Ben Bernanke explained the "market-based approach is regulation by the invisible hand" which "aims to align the incentives of market participants with the objectives of the regulator."
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