About the “Invisible Hand of the Market”

The Structure of the Production Cost

Before talking about the features of the market today, it is necessary to say a few words about the “invisible hand of the market”. There are a lot of jokes about this so-called “invisible hand”; however, jokes aside, Adam Smith had some grounds to refer to this “hand”.

First of all, we should look at the classical theory of free market. For example, if there is a village where there is a place with many stalls to where villagers bring produce (cucumbers, tomatoes, potatoes, and so on) for sale. Then, there are buyers of those products, for example, travelers and tourists. In this scenario we assume an ideal environment, as there is no government to collect taxes or mafia to “shake down” the locals, thus the goods prices are set solely by the market. Thus, prices can reach equilibrium rather quickly, taking into account different circumstances such as small differences in the quality of products, the desire of some merchants to quickly sell their stock and exit the market, and so on. This situation with all its idealizations is the “invisible hand of the market”.

Note that if new merchants arrive to such a market and begin to sell large quantities of goods at significantly lower prices to undermine local market equilibrium, a practice that is called “dumping”, these merchants can quickly destroy the entire market by their practices. Thus, these “foreign” merchants would have to be driven out of the market as otherwise they would drive out local merchants. If a government plays a role in this arrangement, then the government may open a store as in the USSR with low prices that. The government can afford to keep the prices low even if the products in that store are not of high quality. Well, in case that there is some sort of a criminal organization that forces the locals to give some of the profits for “protection”, then the prices cannot be low. In that case there is a “hand”, a criminal hand, on the throats and in the pockets of local merchants, even if unseen to the public, yet certainly felt by the market.

Now imagine that there is an increase in the division of labor. This fundamentally means that new problems will arise due to appearance of the intermediary buyers, the middlemen. Now producers have to include profits that these middlemen want to gain into costs of their products besides the profits that the producers want for themselves. Thus, presence of the middlemen means that another “invisible hand” gets hold of the market.

The outcome of this situation is that when goods (or services) are sold the resulting profits are divided among all participants of the production chain. Of course, in reality the participants usually get their share before the goods reach the consumer; however, one way or another, the consumer pays for it all in the end. Now how do all the people who participate in production share the profits? So, if all the other things are equal, then the “invisible hand of the market” ought to make profits in every link of the production chain equal. Here we talk about participants profits, and not their incomes!

If the profits become too small at some point of a production, then the relevant manufacturers leave the market, which in turn will make the intermediary goods used in production scarce and this would drive the prices up and consequently the profits increase too. If the profit becomes too great in the corresponding sector, then new manufacturers would rush in driving the price down, thus diminishing the profits. Note that the price of a particular good is never sets at ”equilibrium”, but rather fluctuates around some equilibrium state “determined” by the same “invisible hand.” However, this idyllic situation is kept only as long as we do not take into consideration some other factors, namely the financial market.

Why is the financial market so important in this situation? It had been already stated that most of the profits are derived once the product reaches its consumer who pays for it all passed once the product passes all the intermediaries. Since the manufacturer cannot wait until the product reaches its consumer, someone has to pay the manufacturer beforehand. Usually it is a bank, which issues funds either the manufacturer or the buyer or even to both. Here, the bank is interested in returning its investments along with the interest to the investments. For example, if the bank loaned  a lot of funds to a manufacturer, then the bank is interested in that consumers would buy the products which the manufacturer sells. To make sure that the consumers buy the said products, the bank would make sure that the consumers have money. At the same time, the bank would make sure that the competitors have problems with that.

Similarly, large corporate interests intervene to the process of profit distribution by standing in the way of producers trying connecting to the market.  A classic example of this process is presence of the monopolistic corporate intermediaries in the agricultural market. The corporations keep the farmers under control by keeping market prices inflated, thus diverting profits to themselves rather than to the farmers.

This arrangement leads to situation in which the entire production system depends heavily upon various financial and economic institutions which means that the real distribution of profits in the supply chain moves further away from the “true” equilibrium. If the bank experiences a growth in the cost of lending (that is due to purely external), the overall production cost will increase. The increased cost would decrease demand for the product. This decreased demand is going to destroy the weakest links in the production chain, the ones who receive the minimal profits. This scenario would ultimately lead to a difficult situation on the market and an increase in unemployment but to destruction of an entire industry simply because some of the manufacturers of intermediary goods would cease to exist.

At the same time, reliance on a belief that the ones who over decades profited from “ripping off” people who actually deserved their share of profits (from the point of view of the uniform distribution) is rather naive. Not to mention that often the people involved in this line of business cannot change anything since they are bound by many strict obligations to people and entities that are outside of the production system and thus do not have a fairly vague idea of how detrimental their actions are to the people who are actually involved in the business. But that is not all; as if funds are issued to consumers this leads demand concentration in some “prestigious” segments of the market. These segments may be different for different levels of consumption; nonetheless they pose a serious threat as they also disrupt the market equilibrium.

The above-mentioned institutions, the banks and the large corporate interests, usually have the greatest leverage in the production chain, thus they generally obtain the maximum profits. Thus, if a sharp reduction of the supply in this sector occurs, the profits may go down below the critical level even if all other players do not change their supplies at all. As a result, there is again a situation in which there is a high risk of a collapse of the entire production system.

All of the above arguments, which of course can be further complemented, are for the sole purpose of showing that today’s economic mechanisms have very little in common with Adam Smith’s theory of the “invisible hand of the market”. Another reason is to show that the current crisis destroys the principles of the classical economic model that support this outdated model and which do not reflect modern economic reality.

  Тranslated by Anton Toukaev. All rights reserved.
Reprint or other commercial use of the site materials is allowed only with the editorial board permission.

The original material is in Russian and can be accessed at “worldcrisis.ru”.

Link: http://worldcrisis.ru/crisis/1168796