The invisible hand is a theory invented by Adam Smith to illustrate how those who pursue wealth by following their particular self-interest. In general, in The Wealth of Nations and other writings, Adam Smith states that, in capitalism, a particular individual’s efforts to take full advantage on their own gains in a free market welfare society. By pursuing their own interest, they regularly promotes that of the public more effectively than when they have the real intention on promoting it.
A real life example of how the invisible hand theory being applied in the queue for a shop checkout. For instance, by applying the invisible hand theory, each customer are acting selfishly in order to maximize their own self-interest. That is, to checkout in the shortest time as possible, regardless of caring other customer’s feeling. Thus, every customer end up queuing in lines all the same distance. Therefore, it is clearly the most efficient way.
Criticism of the ‘Invisible Hand’
An externality is the influence of one person’s act on the welfare of a bystander. Consumers or producers tend to fail to take into account of their actions on passer-by. There are two externalities such as external cost and external benefits. External cost is pollution. For example, if a chemical factory does not control the smoke it emits and responsible towards the entire cost of it, it will most likely to emit too much smoke. As for external benefit is the creation of knowledge. When a scientist discovered a new knowledge, he produces a precious resources that other people could take advantage on.
(N. Gregory Mankiw, 2000)
Market power is referring to the power of a person to overly influence market prices. In this case, the invisible hand theory will lead to monopoly. A market may fail due to the abuses of monopoly power as monopoly earn large profits and restraint markets from achieving efficiency use of resources. For instance, everyone in the town needs oil but there is only one company that has it. Thus, the owner of the oil company is granted a monopoly position where the owner has the power to decide the price. The owner is not discipline to the strict competition which the invisible keeps in play of personal interest. As a result, monopoly creates a deadweight loss. Therefore, it is necessary to regulate the prices that the monopolist charges in order to achieve economic efficiency.
(Douglas Mc Taggart, Christopher Findlay, Michael Parkin, 1999)
A public good is a good or service that is consumed at the same time by every person and usually it is used even if they don’t pay for it. For example, public goods such as national defence and the enforcement of law and order. Free market would too small a quantity of public goods due to people who enjoy the benefits a particular activity without paying for it. Therefore, it creates a free rider problem. Besides, it is not in each person’s concern to buy his or her share of a public goods. Therefore, a free market usually produces less than the effective amount.
(Douglas Mc Taggart, Christopher Findlay, Michael Parkin, 1999)
In each economy, there are four core macroeconomics objective such as economic growth, price stability, full employment, and balance of payment.
Economic growth is defined as the increase in the quantity of goods and services produced by an economy as time passes. It is also an increase of real output per capita. Typically, economic growth is measured by calculating the percent rate of increase in real gross domestic product, or GDP. The inflation rate is usually subtracted during identifying GDP in order to remove the distorting effect on the price of goods and services. Thus, the importance of economic growth are:-
(Amacher & Ulbrich, 1995)
Increase in the Standard of Living
If there is a positive economic growth, it indicates that the economy of the country is growing positively. Thus, the standard of living of people in the country generally will be upgraded as they have extra income to use which then improve their living lifestyle. Therefore, it is crucial as the economic growth act as an indicator of the direction of the standard of living of a country.
Increase in the Employment Rate
If there is a positive economy growth, the country most likely to hire more workers to handle with the rise in production of product and services. The result of economic growth make more goods in order to meet the increasing demand as the people are much richer. Thus, there is a necessity to hire more workers and employees resulting in the increase of employment rate.
Wealth of nation
A country able to identify the wealth of the nation. The more richer the nation, the more goods and services the country able to produce. Therefore, there is a relationship between the wealth of nation and economic growth. (www.helium.com)
Price stability refers to a situation in which the price in an economy stays stable or constant. Therefore, an economy is not facing any inflation or deflation. Thus, it is important for a country to have price stability.
Full employment will happen when all of the economy’s resources involved in production of output. Full employment can be an employment of resources such as labour, land , capital, and entrepreneurship. Thus, an economy is said to be in full employment when the rate of unemployment is 5 to 5 1/2 percent and the capacity utilization rate at 85 percent.
It is important to achieve full employment because the resources produced are to fulfil people’s needs and wants and thus reduces scarcity problem. However, if the resources are not in use, there will be no production ongoing and satisfaction will never be achieved.
Balance of Payment
Balance of payment is defined as the records of all transactions done between consumers, government, businesses, and all the people in the country. A country’s balance of payments usually prepared annually to identify the summary of the flow of goods and services, assets in and out of a country.
((Amacher & Ulbrich, 1995)
Factor of production
Goods & Services
Government Expenditure (G)
Taxes ( T)
The above diagram shows the circular flow diagram of 3-sector model that describes the production is converted into factor income during the year and the factor income is then converted to expenditure. In 3-sector model, it includes government sector which intervenes the market by imposing taxes and government expenditure. Taxes are imposed to businesses and consumers whilst government expenditure are money spent on the country that benefits people and businesses.
First of all, on the above diagram there are only three sectors in the economy as stated households, firms, and government. The households own and supply the factor of production such as land, labour, capital, and entrepreneur for the firms. In contrast, the firms employ factor of production from the households in order to create productions for sales. These exchange between households and firms are known as real flows.
Then, in return of the resources given by the households, the business sector pays income or wages for the factor of production given.
When the business sector make purchases for scarce resources to make production, they sell their products and services to households in order to earn income.
Ultimately, the income earned by the producers will come from the expenditure by the households.
When the government intervene, taxes are given to both households and firms. For example, households have to pay income taxes for people who have a job while firms have to give taxes such as petrol duties. Then, government expenditure for households are benefits while for firms are subsidies.
Price ceilings and floors
taxes , subsidies, and quotas
External costs and external benefits