The Invisible Hand

Posted by PITHOCRATES - April 16th, 2012

Economics 101

A Command Economy Reduces the Overall Economic Output because those Managing the Economy don’t Understand It

Command economy?  Or free market capitalism?  Which works better?  Well, let’s find out with a little experiment.  Let’s go back in time.  Say ancient Mesopotamia.  Just after they developed mass farming.  And produced some of the first food surpluses.  Allowing the rise of a middle class of artisans.  Now let’s look at what could have been the first two of these artisans.  A potter.  And a winemaker.  Who probably weren’t the first two artisans.  But will suffice for our little experiment.

The winemaker needs some pottery vessels to store and sell his wine in.  And the potter enjoys drinking wine.  They each have something the other wants.  And because we’re so far back in time there is no money yet.  We’re still only bartering at this time.  Trading the goods we make with each other.  But in our experiment the high priest of the civilization is also the economic planner.  This priest communicates to the civilization’s gods.  And guides the civilization in pleasing their gods.  Which he is very good at.  For he knows all of the old teachings and rituals.  But he doesn’t know a thing about pottery or winemaking.  But he looks at an empty pottery vessel and a pottery vessel full of wine and sees that the vessel volume equals the volume of wine.  And deems the price of one pottery vessel is the amount of wine one pottery vessel holds.

Well, the potter is quite happy with this price.  Because he is skilled.  And can dig up some clay.  Throw it on the potter’s wheel and knock out vessel after vessel.  Glaze them and fire them in the kiln.  Even working by himself he can achieve some economies of scale.  By repeating this process every day.  Something the winemaker isn’t quite able to.  For he makes wine by the batch.  Because each step in the process takes a lot of time.  Maintaining his grape vines.  Then picking the grapes.  Carrying them back to his winery.  Putting them into his winepress.  Squeezing the juice out of the grapes.  Putting the grape juice in large vats to ferment.  Monitoring the process.  When he determines the process is complete he fills the small pottery vessels with wine.  When it was finally ready for ‘sale’ and consumption.  Considering all the work it took him to make one vessel of wine the winemaker was not at all happy with the price the high priest set.  And instead builds his own potter’s wheel and kiln to make his own vessels.  Greatly increasing his workload.  And reducing his winemaking output.  While the potter loses a potentially large customer.  Thus reducing the amount pottery he makes.  Reducing overall economic output in the command economy.

The Invisible Hand makes sure we use our Limited Resources Efficiently to Make the Things People want Most

In this command economy the civilization suffered a deadweight loss.  Economic resources went unused.  They could have created more economic benefits with the available resources.  They could have made more pottery.  And made more wine.  Perhaps even creating some jobs to help with the economic output of efficiently using the available resources.  But they didn’t.  Because of the fixed prices economic resources went unused.  Thus creating a market equilibrium lower than where it could be.  Hence the deadweight loss.  Now let’s look at the same example with only one difference.  The high priest does NOT set prices.

In a barter economy people agree to trade the goods they make.  And now the potter and the winemaker are free to determine what they think is a fair trade.  That is, they set the price of pottery in wine.  And the price they agree on is one they find mutually acceptable.  Where the potter agrees to trade an amount of his pottery for an amount of wine.  And the winemaker agrees to trade an amount of his wine for an amount of pottery.  Everyone wins.  For the potter gets an amount of wine he values more than the pottery he traded for the wine.  The winemaker gets an amount of pottery he values more than the wine he traded for the pottery.  And the civilization wins because at this mutually agreed upon price both the potter and the winemaker increase their production.  Providing the civilization with more of their goods.  The potter and the winemaker may even hire people to help them produce more goods to meet this higher demand.  Thus increasing the level of happiness in the civilization.  By increasing the amount of economic activity.  Moving the market equilibrium to a higher level of economic output.  And thus reducing the deadweight loss.  By using the available resources in the most efficient manner.  As determined by these mutually agreed upon prices.

This is the Invisible Hand in action.  An economic concept put forth by Scottish economist Adam Smith (1723-1790) in his The Wealth of Nations (1776).  In a competitive market place where traders set the price for their economic trade (not a command economy) two things happen.  First, resources flow to where we demand them most.  That is, to the buyers willing to pay the highest price.  Second, because of the competitive market place only those companies that sell at the low prices the market demands stay in business.  Which means that they have to use those resources as efficiently as possible.  Especially when they’re paying the highest prices for them.  And all of this happens because of the Invisible Hand. 

History has Proven that no Government Bureaucrat can do a Better Job than the Invisible Hand

Those who favor a command economy (or more government intervention into market forces) say the economy is too complex for us to leave it to its own devices.  That without a smart government bureaucrat managing this complex thing we cannot reach a market equilibrium that maximizes economic output.  Whereas Adam Smith says it is because the economy is so complex that no one is smart enough to manage it.  Just as a high priest doesn’t understand pottery or winemaking a smart government bureaucrat cannot hope to understand all the intricacies of a complex economy.  Nor can they ever hope to understand what millions upon millions of consumers want to buy most.  But the beautiful thing is we don’t have to.

The multitudes make individual decisions just like our potter and winemaker.  Where everyone is looking to maximize their own value.  And when they agree on a mutual acceptable price all parties in the trade win.  While making sure our resources flow to where they are demanded most.  And that we use these valuable and limited resources most efficiently.  Thus maximizing overall happiness in our country.  Reducing deadweight losses to a minimum.  And obtaining a market equilibrium that maximizes economic activity.  All of which happens with no one in charge.  As if an Invisible Hand guides us in the market place to make all the right decisions to maximize this economic output.  And our happiness.

So which is better?  Command economy or free market capitalism.  Well, if you’re being honest you have to choose Adam Smith’s Invisible Hand and free market capitalism.  For history has proven that no government bureaucrat can do a better job than the Invisible Hand.  Not the Soviets.  Not the Chinese Communist (under Chairman Mao).  Not the Cubans.  Not the North Koreans.  Even the Americans failed when their government actively intervened in the private economy.  Something that President Jimmy ‘one-term’ Carter knows only too well.  So based on our hypothetical Mesopotamian example, and history in general, free market capitalism is, and always has been, and always will be, better than a command economy.

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