Is There an Invisible Hand?

 

The first Microeconomics concept that students study is that of the demand curve and supply curve. When the two curves meet, the market is in equilibrium. Consumers (the buyers) know how much they want and the price they are ready to pay. Producers (the sellers) know how much the consumer wants and the price they can get for it. And hence everyone ends up happy!

And how exactly do the consumers know the optimum quantity needed and the associated price? That is where the magic of the invisible hand comes. According to the founding father of modern economics, Adam Smith, the market forces make sure that the equilibrium point is achieved, whether through a series of iterations or trials-and-errors. For example, if the producer prices something too high, people will stop consuming it in the same quantities. Then the price would automatically come down. The opposite is also true. Market forces can be exerted by both consumers and producers.

We all know this does not work well in practice. Microeconomic theory has different explanations like imperfect markets, externalities, etc. Let us talk about one of them- information asymmetry. One side has more information than the other. More often, it is the seller who knows what exactly the product is, while the buyer does not. George Akerlof, who won the Economics Nobel Prize in 2001, gave the concept of Adverse Selection in his famous paper called ‘The Market For Lemons’. He described how not properly communicating the product quality to the consumers will make them suspicious that the product being sold is inferior. This leads to a vicious circle when they are not ready to pay a premium price because they suspect the product is inferior. Hence, the producer would only be ready to supply an inferior product from the range that can be offered.

Akerlof suggested that the two ways to counter this are Signalling and Screening. The producer can signal (or communicate) that the product is of superior standard through procedures like quality certificates, product reviews, and more. The consumers can screen the product for quality and find out what it really is. The problem comes when buyers do not have the knowledge or skills for screening, and the sellers are adept at sending false signals- catchy advertisements, misleading claims, and the other tools in their paraphernalia.

That is why free markets are a disaster in many cases like financial markets. No invisible hand works to ensure that the buyers get the right loan or insurance product. A free market is like traffic without traffic police. A strong regulatory framework is absolutely necessary to ensure that order is maintained. And we need bodies with authoritative powers to enforce them. So who will watch the watchmen? The same regulatory bodies can be selectively biased, which sets up conditions for institutionalized corruption. The best solution is to make the bodies autonomous, without any political interference. The appointments and promotions in the regulatory bodies should be done after ‘screening’ the candidates for integrity.

Of course, nothing in the world is perfect. But something is better than nothing. The markets cannot be left open at the mercy of sellers with ulterior motives. It is not always about wisdom- the public often does have complete information.