The Invisible Hand

Free market economists will often talk of the invisible hand of the market. Acting like a god, guiding humanity toward the best possible outcome. Critics will point out cases where this outcome differs from their ideal, and claim regulation is needed to prevent market failure.

A free market simply means that both parties freely choose to enter into the transaction. If either the buyer or seller did not benefit they would refuse to trade. So its more like an invisible handshake. When a third party gets involved it often leads to market failure. People will end up making decisions that leave someone worse off.

One of the best illustrations is airline tickets. If your employer is paying for the flight you will choose a business class ticket. However, if instead you were given cash and allowed to keep the change, most people would choose a cheaper ticket. In the first case you are paying more than you value the ticket, ie, you are worse off. The airline can exploit the market failure and charge a premium price for business class tickets.

On the supply side, think of an agent selling a house. If they have the power to accept any price they will simply sell it as cheap as possible to guarantee a sale. No sale, means no commission for them. Leaving the former owner worse off.

Not all bad decisions are market failure. Many commentators claim that people not saving for their retirement is market failure so the government must make pension saving compulsory. People are simply choosing to have a better life now and a lower standard of living in the future. Just like choosing to go shopping instead of saving up for a holiday.

Market failure is when a person makes a choice fully aware it will leave someone worse off. Either your spending someone else’s money, selling someone else’s goods, committing fraud or damaging other people’s property.