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Home > Social Issues
The Invisible Hand
by Bob Powell, 3/25/08
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Below is section 5.5 of the textbook, Business Dynamics: Systems Thinking and Modeling for a Complex World, by John Sterman, Director of the MIT System Dynamics Group, is on "Adam Smith's Invisible Hand and the Feedback Structure of Markets."

This "invisible hand" is the core of "classical economics," known also as "Economics 101." Of course, there's more to economics than this. See Invisible Hand Drops Ball & Economics 101 that describes failures for health insurance, climate change, pollution, potholes, congested highways and other infrastructure backlogs, education, vaccinations, oligopoly and monopoly, long-term investment, poverty, the so-called "labor market", what's called "trade", and economic boom & bust.

5.5 Adam Smith's Invisible Hand and the Feedback Structure of Markets

Adam Smith's invisible hand is one of the most famous metaphors in the English language. Smith realized that a free market creates powerful negative feedback loops that cause prices and profits to be self regulating. While Smith lacked modern tools such as causal diagrams and simulation models, the feedback loops in his description of the functioning of markets are clear. In The Wealth of Nations Smith argued that for any commodity there was a "natural" price which is just "sufficient to pay the rent of the land, the wages of the labor, and the profits of the [capital] stock employed in raising, preparing, and bringing [the commodity] to market ..." In contrast, the actual market price "may either be above, or below, or exactly the same with its natural price" -- that is, markets may at any time be out of equilibrium.

Smith then noted how prices respond to the balance between demand and supply:

The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity ... When the quantity of any commodity which is brought to market falls short of the effectual demand, all those who are willing to pay the whole value ... cannot be supplied with the quantity which they want. Rather than want it altogether, some of them will be willing to give more. A competition will immediately begin among them, and the market price will rise more or less above the natural price.

Similarly, when supply exceeds demand, "[t]he market price will sink more or less below the natural price."

But supply in turn responds to the market price:

If ... the quantity brought to market should at any time fall short of the effectual demand, some of the component parts of its price must rise above their natural rate. If it is rent, the interest of all other landlords will naturally prompt them to prepare more land for the raising of this commodity; if it is wages or profit, the interest of all other labourers and dealers will soon prompt them to employ more labour and stock in preparing and bringing it to market. The quantity brought thither will soon be sufficient to supply the effectual demand. All the different parts of its price will soon sink to their natural rate, and the whole price to its natural price.

See Reading Systems Diagrams for how to read the language of causal loop diagrams.

The "Invisible Hand" feedback structure of markets. Figure 5-26 of Business Dynamics
A simple representation of the feedback structure Smith describes is shown in Figure 5-26. When the price of a commodity rises above the natural price, fewer buyers "will be willing to give more" and more will be forced to "want it altogether." That is, as the price rises relative to the price of substitutes, including all substitute uses for the funds available to the buyer, consumers will seek substitutes or find themselves simply priced out of the market. As demand falls prices will be bid down, forming a negative loop.* At the same time, higher prices increase the profit suppliers can realize, which attracts new entrants to the market and encourages existing producers to increase output. As the supply increases, prices are bid downwards. These two negative feedback loops cause price to adjust until, in the absence of further external shocks, the market reaches equilibrium, with production equal to consumption and price equal to its natural level. Smith concludes:

The natural price, therefore, is as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this centre of repose and continuance, they are constantly tending towards it.

Smith's great insight was to realize that when prices rise above the natural level, producers who seek to maximize their own gain will continue to enter the market until the price is bid down to the point where the return on their capital is no higher (today we would add "on a risk adjusted basis") than that available elsewhere, resulting in competitive prices and an efficient allocation of resources throughout society. He famously concludes:

Every individual endeavors to employ his capital so that its produce may be of greatest value. He generally neither intends to promote the pubic interest, not knows how much he is promoting it. He intends only his own security, only his own gain. And he is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

Smith was thus one of the first systems thinkers to show how the local, intendedly rational self-interested behavior of individual people could, through the feedback processes created by their interactions, lead to unanticipated side effects for all.

[REP Notes:

This societal benefit is an emergent property ... the result of the whole, the collective, being greater than the sum of its parts. There's a certain irony here, given that "good for society" results can come from "self-interested behavior"; it's an excellent example illustrating that there are properties of the collective that are not a feature of the parts. The irony is that economic "conservatives" and libertarians deny the existence of a collective ... there are only individuals. Yet, the core tenet of their ideology depends on just such an emergent property of the collective to justify their ideology.

Similarly, unless you're in on an IPO, "investing" in the stock market, isn't investing; it's speculation ... i.e., gambling. The justification is that a market for stocks provides market liquidity. That liquidity is an emergent property of the stock market.

Oh, oh! "Market-fundamentalist economic "conservatives" and libertarians don't believe in systems effects which are emergent properties of a collective.

Note: One might also observe that the "free market" operates by "price rationing" that enormously serves the interests of the wealthy and not those who are not.]

Of course, Smith's concept of the invisible hand is far more famous as the credo of modern free market capitalism. It is the core of the faith that markets know best. Smith himself, however, was careful to note the limits of the market feedbacks in equilibrating demand and supply at the normal price. "This at least would be the case" Smith notes, "where there was perfect liberty" -- that is, under condition of perfect competition (free entry and exit, free mobility of the factors of production, and free exchange of information on demand, supply, costs, and profits). Where there are monopolies, trade secrets, government regulations, barriers to trade, restrictions on immigration and capital mobility, or other feedbacks outside the simple negative loops coupling supply and demand, Smith notes that prices and profits may rise above the natural level for many years, even decades.

[REP note: Most of what's happening now is not "trade" ... it's "transfer of the factors of production."]

The feedback structure for competitive markets shown in Figure 5-26 is quite useful. Beginning with the general framework, one can disaggregate to show the specific adjustment processes at work in any particular market for both demand and supply. Additional feedbacks besides the demand and supply loops can be added, both positive and negative, and their implications assessed. The time delays, if any, in the reaction of demand and supply to higher prices can be estimated and the implications for the stability of the market explored. If either the demand or supply loop operates strongly and swiftly (high short-run elasticities), then the market will rapidly return to equilibrium if perturbed. However, if there are long delays or weak responses in the loops (low short-run elasticity and high long run elasticity), then the market will be prone to persistent disequilibrium and instability; random shocks in demand or production will excite the oscillatory behavior of the market (see chapters 4 and 20).

5-27 Left: Availability is an important competitive variable in many product markets, and firms regulate production in response to inverntory adequacy and delivery delay.
Not all markets clear through price alone. Few products are commodities for which price is the only consideration: Products and services are increasingly differentiated and companies compete to offer the best availability, delivery reliability, service, functionality, terms of payment, aftermarket support, and so on. In many markets prices do not change fast enough to equilibrate supply and demand and other competitive variables such as availability become important in clearing the market. Prices may be sluggish due to government regulation, the costs and administrative burden of frequent price changes, or considerations of fairness. For example, most people consider it unfair for hardware stores to raise the price of snow shovels after a storm, even though demand may have increased (see Kahneman, Knetsch and Thaler 1986; Thaler 1991).

In many institutional settings price does not mediate markets at all. Most organizations, for example, have no price-mediated markets for offices, parking spaces, senior management attention, and many other scarce resources. In these cases, supply and demand are still coupled via negative feedbacks, but resources are allocated on the basis of availability, politics, perceived fairness, lottery, or other administrative procedures. Figure 5-27 shows examples of non-price-mediated markets. In each case the feedback structure is a set of coupled negative loops which regulate the demand for and supply of a resource. As in the case of price-mediated markets, there may be substantial delays in the adjustments, leading to persistent disequilibria.

Added notes:

These figures are slightly modified as I've explicitly added the "goals" (thermostat equivalents) of the balancing loops (negative feedback loops).

How to read the diagrams in Figure 5-27:

Figure 5-27 Left.
Upper balancing loop: Increased Product Availability (compared to Customer-Expected Product Availability) increases Product Attractiveness, which increases Orders, which increases the Backlog of Unfilled Orders, which decreases Product Availability.
Lower balancing loop: A decrease in Product Availability (compared to Customer-Expected Product Availability) prompts an increase in Desired Production, which (after some production delay) increases Production, which increases Inventory, which increases Product Availability.

5-27 Right: In service settings, higher service quality stimulates demand, but greater demand erodes service quality as waiting time increases, and accuracy, friendliness, and other experiential aspects of the service encounter deterioriate.
In this manner Product Availability is regulated by the two balancing loops.

Figure 5-27 Right.
Upper balancing loop: Increased Service Quality (compared to Customer-Expected Service Quality) increases Customer Satisfaction, which increases the Customer Base, which increases Service Requests, which decreases Service Quality.
Lower balancing loop: A decrease in Service Quality (compared to Customer-Expected Service Quality) decreases the Adequacy of Service, which (after some production delay) prompts an increase in Service Resources, which increases Service Quality.

In this manner Service Quality is regulated by the two balancing loops.
For more on Service Quality, see Service Quality Erosion that describes the structure that can drive entire industries into a vicious cycle of declining service quality.

For a discussion of the Product Life Cycle, see the series of papers that describe the product life cycle structure and extensions to customer service and innovation.





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