Hello readers, welcome back to rsira-economic.com. You might be wondering why I am writing another post considering I only published the last post two days ago. However, I recently came across some important economic concepts and I thought it would be useful to share a few ideas with you. This post will be quite short compared to usual as I will only be talking about two key economic ideas: ‘Homo economicus’ and ‘The invisible hand theory’. I might have mentioned these terms in previous posts or you may have come across them before, but since they are so important to economists around the world, I thought it would be beneficial to go a bit further into them. If you have any questions or don’t understand anything discussed in today’s post, feel free to contact me at firstname.lastname@example.org or post your questions in the comments below.
On a side note, I’m sure most of you have been keeping up to date with Brexit and that Theresa May has in fact triggered article 50 of the Lisbon treaty, entering the UK into a period of two years of formal negotiations to determine certain policies and allow for an amicable divorce. This means there really is no turning back now and I’m sorry to say it but, ‘Brexit means Brexit’. In my next post, I will be analyzing this in much more detail and will discuss some of the economic implications as well as provide clarity to the whole issue. You might recall me doing a post on Brexit last year, about what people thought would happen next and the implications of Brexit. It will be interesting to see whether or not the predictions were true and what the future for Britain could look like now. After that post, I will be looking into something quite different that featured recently in the Economist-‘Amazon’s Empire’.
What does it mean?
In economics, the term ‘homo economicus’ also known, as the ‘economic man’ is a concept assumed in many theories, which portrays humans as ‘consistently rational and narrowly self-interested agents’. In general terms ‘homo economics’ attempts to maximize utility (satisfaction) for consumers and profit for producers. This theory stands in contrast to the concepts of behavioral economics and homo ‘reciprocans’ (which emphasises human cooperation).
‘Homo economicus’ essentially defines the ideal economic man who only acts rationally and pursues wealth for his own self-interest given the constraints he faces. The economic man is described as one who avoids unnecessary work by using rational judgment. In game theory ‘homo economicus’ is involved as in all the scenarios/situations perfect rationality is assumed.
To what extent is it true?
The idea is often criticized, with many economists claiming that people are mostly irrational e.g. purchasing a car (a depreciating asset is irrational) yet people still buy cars. It is however the prevalent model of human behavior among economists.
Most social scientists believe that human behavior is often complex, contradictory, imperfect and unpredictable. On the flipside, Economists, use the model, ‘Homo economicus’, who is endowed with perfect (or abnormally high) rationality, self-interest and knowledge. Besides the obvious fact that humans aren’t perfect, the model suffers from other basic problems. Humans are ultimately driven by their emotions, not their logic, and emotions are often irrational. Nor are humans 100 percent self-interested. They perform generous acts like charity, volunteering, lending a helping hand, parenting and even giving one’s life for one’s country. They also perform self-destructive acts like substance abuse, negative addiction, negative risk-taking, procrastination, and suicide. Nor are people highly knowledgeable about all their affairs; they can be expert in only a few topics at a time. The reasons why economists use such a flawed model like Homo economicus is because it makes their economic analysis simpler and allows them to generate results that confirm their hypotheses. Such methodology, however can lead to inaccurate conclusions.
Adam Smith’s invisible hand theory
Those of you who are studying or have studied economics are bound to have come across Adam Smith. He is what people refer to as ‘the father-figure of economics’ and if you ever wondered where economics came from and how all this demand and supply stuff really started in the first place; it was down to this guy. Perhaps one of his most famous ideas was the ‘invisible hand theory’, which was first proposed in his book “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776), usually abbreviated as ‘The Wealth of Nations’. It is considered his masterpiece and was the first modern work of economics.
Adam Smith’s research was extensive and there is a wealth of information about him and his ideas online. Today I will just be looking at one of his concepts: ‘The Invisible Hand Theory’.
What does it mean?
The definition of it is:
The unobservable market force that helps the demand and supply of goods in a free market to reach equilibrium automatically.
What exactly is it?
Adam Smith assumed that an economy can work well in a free market scenario where everyone will work for his/her own interest. He explained that an economy will comparatively work and function well if the government will leave people alone to buy and sell freely among themselves. He suggested that if people were allowed to trade freely, self-interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand. In a free market scenario where there are no regulations or restrictions imposed by the government, if someone charges less, the customer will buy from him. Therefore, you have to lower your price or offer something better than your competitor. Whenever enough people demand something, the market will supply it and everyone will be happy. The seller ends up getting the price and the buyer will get better goods at the desired price.
Perhaps one of Adam smith’s most famous quotes, which was in ‘The Wealth of Nations’ is:
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.”
This essentially means that, if an individual can profit by manufacturing some product or supplying some service, Smith reasoned, he will in fact do so. His very ability to turn that profit proves that other members of the society must want those goods or services. In this way, the full spectrum of society’s needs will be met through the pursuit of individual self-interest. Such a free-market economy should work smoothly and efficiently without any global management as if guided and organized by Smith’s famous invisible hand.