The Flaw Of The Invisible Hand

Introductions to economics usually start with gushing tales about the magic of the free market. It is usually stated that the free market allows everyone to get the best quality goods at the cheapest prices. The magical invisible hand guides everyone to the best place without any unnecessary government intervention. Below is a link to a video typical of the kind. (I’ll ignore for the moment that it completely misrepresents what Adam Smith said). Its short and simple, but it is a simple argument. This is the typical free market argument with its claim that left alone it will bring the best world for everyone.

So in the video it compares two bakers offering bread and the consumer chooses either the cheaper or bigger baguette. The first charges £1, the second 50p, causing the first to charge 50p, causing the second to offer a larger baguette. Surely clear example of how the free market makes everyone better off, right?

However there are several reasons why reality isn’t so straight forward. There are several reasons why consumers may not buy the cheapest bread. First of all they don’t know what they’re buying (asymmetric information). For all I know this bread could be made from cheap dirty bread that will give them a disease. Unless I get sick instantly, there is no way for me to know the cause and act upon it. If it slowly wears down my health over years like cigarettes, there is no way for me to know. So just because something is cheaper doesn’t mean it’s better.

The second reason someone may pay more for one good rather than another is conspicuous consumption. Expensive goods are a sign of wealth. Unlike ordinary people, I can afford the luxury bread, therefore showing my success in life (obviously bread isn’t the only sign of success but a house full of luxury goods is). We are social creatures and view ourselves in comparison to others. So if I can afford better food and goods, I am better off, and implicitly a better person.

There is also the matter of fashion and culture. A purchase is not simply a question of what is cheapest, but what is cool. No one wants to drive around in a banger, be wearing the wrong sort of clothes or even eating the wrong kind of food. So people will buy the more expensive kind of bread even if it isn’t any better simply because it is fashionable. If you think I’m exaggerating, watch the number of people who will repeatedly buy disgusting bread simply because it is foreign and therefore exotic.

You might argue that if one shop charges a higher price for the same good, consumers will simply switch to a cheaper place. Unfortunately that’s not how our minds work. In fact as Dan Ariely discovered in his book Predictably Irrational, paying more for a good makes us value it more. He ran an experiment where he gave some people a drug valued $2.50 and others the same drug worth 10c (what he didn’t tell participants was that the drug was only a placebo). Almost all of the $2.50 drug people reported pain relief while only half of the 10c people did. Because they were paying more the valued the same item more. So if I increase the price of a baguette above the market rate, consumers will value these baguettes more and be willing to pay the higher price.

There is also the question of externalities or costs that aren’t included in the price. So you may think one baguette is cheaper but really it’s so bad for your health that it costs you more in later life. Or the reason it’s so cheap is that it uses old toxic smokestacks which emit dangerous pollutants into the atmosphere. It could upgrade to newer and cleaner facilities but that will cost it more and force up the price. Or its competitive advantage could be based on exploiting cheap labour in the third world.

So while in the video and all stories about the free market, when offered a clear choice between two goods (something that rarely happens), consumers will pick either the cheaper or the better quality one (though how consumers are supposed to measure quality is never explained). However there are many reasons why they might not. Problems of asymmetric information, conspicuous consumption, fashion, subjective valuing and externalities all prevent consumers from automatically choosing the cheapest option. They are all barriers to the market reaching an effective outcome. As long as they exist, it cannot be claimed that the free market will lead to the best situation for everyone.


Filed under Economics

25 responses to “The Flaw Of The Invisible Hand

  1. What on earth is your course like? Mine’s in fact relatively benign: still ridiculous, but not ideologically charged. You and others have, however, given me the impression that most courses are much more ‘free market lunatic’ than mine.

    • Its pretty much generally assumed that the free market is efficient and leads to the best outcome. I don’t think the lecturers realise how ideological they are and its almost a throwaway remark to say that the market is perfect. Only the briefest of mentions is given to market failures and these are quickly brushed under the carpet. My textbooks bears a disturbing resemblance to the arguments made by Milton Freidman. And then there’s plenty of ridiculousness thrown in on top.

      • GaryAKABubba

        No free market advocate argues that markets are “perfect”. What they argue is that markets work best when they are meddled with by government the least.

        There is no such thing as perfection in virtually any subject. There are only choices between one strategy or another.

        Free market advocates argue that a free market is better than a regulated market.

  2. Or the baker of the smaller loaf could look at what the other baker does and charge more for his loaf (one loaf, one quid, sounds fair) and then the maker of the larger loaf says, I can sell loafs half this size for the same amount and cuts his loaf size.

    The primary problem is the business’s interests do not encompass the customers. Until they do, all systems distort.

  3. Neilsen, I seem to agree with you on most things you say. I for one would go to a coffee house where I know the coffee is overpriced because of ambiance, the service and simply because as you say it feels cool.
    There are several reasons why free market will not result in the best situation for everyone. I know of friends who will buy cheap and others who look for just that expensive piece.

  4. An excellent piece….would you mind if I reblogged it on my sight Opus Libertas?

  5. GM

    “They are all barriers to the market reaching an effective outcome. As long as they exist, it cannot be claimed that the free market will lead to the best situation for everyone.”

    Compared to what – compared to perfect competition, which is impossible?

    • Exactly. Unfortunately a great number of economists (libertarians in particular) don’t realise or ignore this point and act as though perfect competition is the natural occurance in the absence of government. The Mises Institute, Cato, Heritage etc are the most blatant examples of this

      • GM

        With all due respect, you are betraying complete and total ignorance of what these people actually say. This is not the right way to attack any point of view.

        • You may not be aware of this but perfect competition is the first introduction economic students get to economics. It is still taught as standard in my 3rd year of my degree. Many libertarians and conservatives base their opposition to government intervention on the idea that competition will solve any problem and lead to the best outcome. Austrian theorists differ in this but when it comes to public policy recommendations most of them act on assumptions of if not perfect competition, something close to it.

          • GM

            I am speaking as someone who is considered by some to have a very high understanding of Austrian economics, who has spoken personally with many of the modern authors in Austrian economics, etc., and my opinion is that you have close to zero understanding of Austrian economics. This is not a surprise, since you have studied a mainstream economics degree. Your understanding of mainstream economics sounds like it is very strong. The mistake is that you lump Austrian economics and libertarianism in with various neoclassical and centre-right points of view, and you think you are offering a valid critique. You aren’t. Perfect competition is a concept which Austrians have spent a great deal of time attacking. The Austrian criticisms of perfect competition are just as deep and fundamental as your own, if not more. Please read some actual Austrian/libertarian works and show why they are wrong, instead of attacking points of view which no Austrian would defend.

            I haven’t watched this lecture in its entirety myself (I’ve read all of Man, Economy and State), but it’s an example of actual Austrian economics.

            • I think a distinction needs to be made between theoretical and public economics. Austrians can be quite sophisticated when it comes to theory, particularly when it comes to issues like the business cycle and disequilibrium. However when it comes to public policy they can be overly simplistic and as extreme as the Tea Party. when discussing public issues can be simply competition=good and government =bad, as though most of their sophistication must be hidden behind doors.

              This is very common among economists. Paul Krugman is great when discussing the election and Republicans economic plans, but when it comes to theory he’s quite poor. Likewise there was a big gap between Milton Friedman the theorist and the simplistic cliches he uses in his notorious youtube videos.

              I will admit that you probably know a lot more about Austrian economics than I do (I’ll watch the video as soon as I have time). Its mainly an American school that hasn’t crossed the Atlantic (ironically). Its almost disappointing to see potentially good economists ignore their own research and end up sounding identical to neo-classical economists. Ask an Austrian to write an article on about unions, minimum wage, taxes or the stimulus and the result will be almost identical to a neo-classical economist, especially to a lay reader.

  6. Reblogged this on Opus Libertas and commented:
    A piece written by one of my followers (as in blog follower)……..

  7. Well done article and I agree with a lot of your critique of the “invisible hand” of the market. I still think it’s the best option for everyone though. Just because something is not perfect does not mean it is not the best option.

  8. patrick

    As far as I understand Adam smith used the analogy of the invisible hand to explain exchange. He never claimed markets provided the best outcome. Do you know who gave it the meaning you attached to it?

    • Smith barely used the term invisible hand himself and he did not mean it the way it is now associated. I don’t know how it caught on as a term or who gave it such prominence.

  9. GaryAKABubba

    Putting photos of books on one’s page makes them appear intelligent. And using terms like “externalities”, is supposed to do the same thing I guess.

    The nonsense in this article can’t be overlooked. His straw man and wild random economic influences painted as fundamentals just dig him into a hole of irrationally persistent tail chasing.

    All value is subjective. He tries and fails to state this or comprehend it. But if he had, then he could have gone on to understand that no free market idealist would ever assert that the cheap bread is always the best. The best is whatever the buyer decides it is. He’s right to point out the motivation of vanity, but he fails to grasp that not everyone values each luxury item the same, which is why free markets tend to create massive amounts of choice.

    He builds his own myth of libertarian free market principles, based on a single simplified assertion in a video that is designed specifically to inspire people with humor.

    To argue that the fundamental concept of free markets is that everyone will always sell their bread at the cheapest price is laughably absurd, and in fact the video doesn’t even state this. It actually states that competitors will either raise their prices or “provide something better”.

    And as I’ve already stated, since “better” is defined subjectively by the consumers, it is up to producers to do the market experimentation necessary to figure out what their consumers think “better” would be. And that subjective nature also creates the varied amount of choices a free market tends to encourage, since people rarely agree what the best qualities in anything (much less bread) will be.

    And if those consumers value more difficult to define factors in the product, like long term health concerns, or factory working conditions, they will eventually influence the market to produce those qualities as well.

    Side tracking into pollution completely disregards the fact that pollution is a trespass which is adeptly reconciled by upholding the private property rights of those people affected by the pollution, not by the consumers of the product, who don’t necessarily have any skin in that game.

    People that try to undermine the spirit of free market economics seldom do so by actually representing that spirit accurately. Of course it is easier to slam an idea when you lie about what that idea is.

    • Those who cannot debate insult and you certainly confirm this. Rather than pointing out where you disagree with me, you climb your high horse so convinced of your own superiority that you hardly feel the need to condescend and explain why you disagree.

      “Putting photos of books on one’s page makes them appear intelligent.”

      For someone so arrogant about their own superiority, this is a bit odd to say as I don’t have any photos on this page.

      “All value is subjective. He tries and fails to state this or comprehend it.”

      Saying value is subjective is both obvious and useless. All you say is that the price is whatever the price is. If people pay $5 the price is $5. I left this out because it adds nothing to the debate.

      “And if those consumers value more difficult to define factors in the product, like long term health concerns, or factory working conditions, they will eventually influence the market to produce those qualities as well.”

      Do you know anyone at all who has ever chosen which bread to buy based on factory working conditions?

      “Side tracking into pollution completely disregards the fact that pollution is a trespass which is adeptly reconciled by upholding the private property rights of those people affected by the pollution, not by the consumers of the product, who don’t necessarily have any skin in that game.”

      So all the people of the country as supposed to bond together to recieve compensation (however slight it may be) from every contributor to air pollution? Global warming can be combated by “upholding private property rights”? Its so obvious, why didn’t anyone think of it earlier? If I didn’t know any better, I would have thought it was a poor solution.

      Of course polluting companies can always ignore the complaints of those around them and continue to do as they wish on their own property. If the government won’t intervene and consumers will not boycott, whose to stop them?

  10. GaryAKABubba – you are the best!

  11. Pingback: The Red Bull Dilemna – siroffinance

  12. loli

    Don’t forget to site your sources. One of the most important things one should know before writing an article

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