Equilibrium and the Invisible Hand PDF

Equilibrium is defined as the set of relative prices that 'clear' markets; a 'general equilibrium' is a complete set of prices to clear all markets. Adam Smith's famous metaphor of an invisible hand is invoked to explain how markets are guided toward equilibrium prices. One interpretation of the 'in...

Equilibrium is defined as the set of relative prices that 'clear' markets; a 'general equilibrium' is a complete set of prices to clear all markets. Adam Smith's famous metaphor of an invisible hand is invoked to explain how markets are guided toward equilibrium prices. One interpretation of the 'invisible hand' analogy is that by producing market clearing prices, the market provides the signals that guide individuals to maximise their utility while also providing the social or public good of ensuring that demand and supply are equilibrated. To understand the invisible hand idea, we could envision a farmers' market held in the public square on a weekend. The farmers bring their fruits and vegetables early on Saturday morning, advertising the prices at which they are willing to make sales. Over the course of the day, some discover they've set them too low (facing a brisk pace of sales that would deplete their inventory too soon) while others have set them too high. At the same time, consumers adjust their reservation prices (the maximum they will pay for a given quantity/quality) as well as their desired quantities in light of offer prices. Prices are adjusted over the weekend to try to maximise revenue while ensuring the farmers do not have to cart home unsold produce. In this narrative, rational behaviour by producers and consumers will adjust prices so that 'supply equals demand'; that is, all fruits and vegetables have been sold. The hand is 'invisible'. guiding individuals and the economy as a whole toward equilibrium, with no need of an authority. For that reason, there is little need for the government to manage the economy. While it is a bit of an analytical leap, the next step in this 'free market' narrative is to stretch the market analogy to the economy as a whole. Surely if all prices and wages were flexible, every market, including the markets for labour of every kind of skill, would clear, with demand equalling supply in each of the markets? Would it be rational for any individual supplier or demander to stubbornly refuse the guidance provided by the invisible hand? It seems that the overall economy might reach a grand general equilibrium with a set of prices and wages (one for each type of product or input to production) that clears every market.