Adam Smith described self-interest and competition in a market economy as the "invisible hand" that guides the economy. This episode of the Economic Lowdown Podcast Series explains these concepts and their importance to our understanding of the economic system.
A market economy is an economic system in which individuals own most of the resources - land, labor, and capital - and control their use through voluntary decisions made in the marketplace. It is a system in which the government plays a small role. In this type of economy, two forces - self-interest and competition - play a very important role. The role of self interest and competition was described by economist Adam Smith over 200 years ago and still serves as foundational to our understanding of how market economies function.
Self Interest is the motivator of economic activity.
Why do you go to work? Why do you go to school? There may be many reasons, but at their core you probably go to work and school because you are self-interested. To be self-interested simply means that you seek your own personal gain. You go to work because you want to get paid so you can buy the things you want. You go to school so you can get a better job someday and earn more money to buy the things you want. In fact, most of the economic activity we see around us is the result of self-interested behavior. Adam Smith described it this way in his book, The Wealth of Nations:
"It is not from the benevolence (kindness) of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
So why does the baker choose to bake? The answer is self-interest. The baker wants to earn enough money to feed his family and buy the things he wants and the most effective way he has found to do that is to bake bread for you. In fact his bread has to be good enough and the service friendly enough that you are willing to give up your money freely in exchange for his bread. The baker while serving his self-interest has produced a good that is very valuable to you. The miracle of a market system is that self-interest produces behavior that benefits others.
Is being self-interested greedy? Is it immoral? While the term self-interest has negative connotations, it does not necessarily imply greedy or immoral behavior. Self-interest just means that you seek your goals. In fact, your self-interest might lead you to study hard for your math test, give money to your favorite charity or volunteer at a local school.
Competition is the regulator of economic activity.
Doesn't self-interest lead to price gouging, corruption and cheating? Sometimes it does, but most often it is held in check by competition. Because other self-interested people are competing in the marketplace, my self-interest is held in check. For example, if I were a baker, the only way I would be able to earn your dollars is to produce bread that is better, cheaper or more convenient than the bread produced by the other bakers in town. If I were to increase my price too much, you would likely buy bread from my competitors. If I were to treat you poorly when you enter my store, you would likely buy from my competitors. If my bread were moldy or inferior in any way, you will likely buy from my competitors. In order to earn your money I must provide a high quality good or service at a reasonable price. You will notice that this assumes I have competitors. If I were the only baker in 100 miles, I might be able to charge a high price, sell inferior products, or treat my customers rudely - but even in that case, another self-interested person might see an opportunity to earn a profit and open a competing bakery in town. Thus, competition is the regulator, a check on self-interest because it restrains my ability to take advantage of my customers.
The Invisible Hand
Adam Smith described the opposing, but complementary forces of self-interest and competition as the invisible hand. While producers and consumers are not acting with the intent of serving the needs of others or society, they do. When you work, your goal is to earn money, but in the process you provide a valuable good or service that benefits others and society. The amazing part of this process is that there is very little government control. The bread you buy at the store arrived as the result of hundreds of self-interested people cooperating without a government bread agency managing production at each step along the way. The farmer grew the grain, the mill prepared the flour, the bakery produced the bread, the truck driver delivered the bread to the grocery store, the grocer stocked the shelves and sold the loaf to the consumer all without a Government Secretary of Bread Production telling any of them what, where, when, or how much to produce. It's as if they were being guided by an invisible hand that guided resources to their most valued use. In the words of Adam Smith:
"by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."
The discussion of self-interest and competition usually results in a discussion of the proper role of government regulation. Some see a market economy as largely self-regulating, assuming there are enough firms competing in the market to be a check on self-interest. Others point to examples of fraud where competition has failed to be an adequate check on self-interest - they argue that government must take a more active role regulating economic activity. In fact, much of the fighting among political groups has to do with the question of how much government control is needed to regulate the economy.
To recap, self-interest and competition are very important economic forces. Self-interest is the motivator of economic activity. Competition is the regulator of economic activity. Together they form what Adam Smith called the invisible hand, which guides resources to their most valued use.