Resources in economic science is scarce, this is because the amount of availability of resources are limited while the demands are unlimited. This include into one of economic problems, therefore this essay will criticise, does this limited resources could get allocated effectively by the market, or known as the “invisible hand” by Adam Smith1, where supply and demand or production and consumption (Danny, 1996) hold an important role in the allocation activities.
This essay also will explain about how the role of the “invisible hand” is being replaced in the America economic activities by the “visible hand”, a system where the role of manager or the managerial coordination become more important in economic activities (Chandler, 1977), which introduced by Alfred D. Chandler in his book; “The Invisible Hand: The Managerial Revolution in American Business. Moreover, the goal of this paper is to analyze why invisible hand had been replaced and which method is better, between invisible hand and visible hand, to coordinate the economic activities and make the available resources used effectively.
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This essay will be divided into 4 parts; first, the understanding about the invisible hand. Second, at what level of effectivity does this invisible hand or market force could allocate the resources. Third, the replacement of invisible hand by the visible hand in the America business and the last part is conclusion of which method that better to be implemented in business today.
Invisible hand represent the natural feeling of human that motivate and direct their behavior (Wight, 2007). Invisible hand in economic term by Adam Smith means natural forces that trigger a price mechanism to happen in the market and is affected by the existing self-interest, competition and supply and demand (Olsen, 2002), and the government does not involved, which means economic activities are coordinated by the market. In the economic activities, each side will try to maximising their self-interest or according to Gerald Housemand is their needs and wants (Houseman, 2006), and this interaction will cause the exchange of goods and services in the market. Moreover, with the competition exist, it would affect the supply and demands that in the end it will create a price in the market which called an equilibrium price, where the quantity of the buyer willing to buy equal to the quantity prepared by the seller on a certain price (Dawson, 1989).
As shown by point E, where demand curve D intersect with supply curve S in the figure below:
How effective does invisible hand or market force allocating the resources
According to Hayek2, in a free market condition, resources are being used optimal and efficiently. A Free market definition is a condition of the market where there is no intervention from government in the transaction of an individual or a company, whether inside or outside the country, and embrace a perfect competition and perfect information.
Since there is a perfect information in free market which make the producer could see the signal from the consumen by seeing the movement of the market price or it could also says, price act as sufficient statistic, making the producer would be able to allocate the resources to be more efficient to fullfil the consumer preferences. In this matter, the producers only able to change the quantity or allocating the resources to be more effective for their economic activities, since in perfect competition both sellers and buyers are price takers (Douma and Schreuder, 2008). Because of that, this could cause the market force or invisible hand to be able to allocate the resources more effective.
On the other hand, a resources allocation had been optimal if the total welfare from every sides, the buyers and the sellers, is maximised (Dawson, 1989). Or in economical term definition, it is when marginal benefit equal to marginal cost, as the picture shown below:
Marginal benefit is an additional satisfaction or benefit gain by the consumer if it adds one item consumed. The more they consume the lower their satisfaction level in using those items. Meanwhile, a marginal cost is a additional cost that needed to make one additional output. Therefore, the resources allocation are optimal when the welfare of each party has been fulfilled by the limited number of those resources.
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Market force are able to allocate the resources optimaly as has been said by several economist, such as Adam Smith, Friedrich Hayek and Graham Dawson3. But in my opinion, this statement only could applied on a certain condition because free market activities in the long term will cause agglomeration of producers since if the free market running fairly, there will be no one company that can make economic profit in the long run, so consequently they will be dominate the market or in the other words make collusion, a few suppliers confederated in markets to set price that give more profit for them (Douma and Schreuder, 2008), and affect the quality of product decrease, so it will give detriment to consumer and welfare will not be distribute evenly.
Moreover, as has been said by Stiglitz together with Bruce Greenwald that when there is imperfect information, pareto efficient in competitive market can not be achieved (wikipedia.org) and when resources are not able to be allocated efficiently then there is a market failure in the economic system. A market failure could be caused by:
Externalities is where the production and consumption of goods give impact or cost on the third party and prices that existed in the market does not shown total cost and benefit produced, which means prices not act as sufficient statistic. For example, when a teacher bought a Documentary CD about the cycle life of one species, this would affect to the third parties, where all the students and the other teachers on that school could watch and get the knowledge from the movie. In this matter, positive externality occurs which is giving extra benefit to other parties.
2. Public goods
Public goods according to Nicholas Bardsley is a thing that even it has been consumed by one party, it wont reducing the availability for the other people (Bardsley, 2000) and people who did not pay are still be able to take benefit and take free ride from the person who has paid it. This things of course will cause a market failure, since logically the producers will not produce an item that will not give any economic profit and causing the supply in the market become ineffective for the allocation resources. As a solution to bring back the effectiveness of resources allocation is by government intervention, where the government provides the goods and the payment are taken from the tax as supported by Dawson in his article.
3. Non-competitive market
“a cynic might say of perfect competition what Bemard Shaw said of Christianity: The only trouble with it is that it has never been tried” (Samuelson, 1976. p.43). He explain that perfect competition is really difficult to met in the real world. Moreover, in imperfect competition such as monopoly and other things equal would make allocator resources become unefficient because the producers will have power to control the prices and make higher profits since they only have a few competitor. This causing welfare become unable to spread evenly, and dominated by producers.
The other opinion came from a social point of view, according to Dwight D. Murphey in his journal about market and morality: Do Market Economies Allocate Resources Optimally, market are able to allocate the resources in an effective way because there are sovereignty from customer as a society and this sovereignty causing quantity demanded exist in the market, and it indicate a signal for the producers to allocate the resources effectively and make a profit. Nevertheless, he said that this things should be reconsidered, since society are a group of individual that gather to make a cooperative profit and it is not always society's decision reflecting individual desire. Likewise in economic system, demand that formed in the market is demand from aggregate consumer as a society so it could be said that it is only value judgemental.
The replacement of invisible hand by visible hand in American business
As Chandler has mentioned in his book, that business in America before 1840 run in a traditional way, where there are many firm runs a single-unit business and commonly with single product in one area and operated by a small number of owners or an individual (Chandler, 1977). The system that being used at that time is a putting-out system and inside contracting system (MINTA BINTANG14). In putting-out system, centre agent gather intermediates good which produced by their subcontractor in their own place, and then finished in the center by the merchant. By using this system, there is an advantage such as equipment optimalize and efficient by every subcontractor because they using their self-equipments. Nevertheless, the disadvantages of this system is that a high transportation cost because every single intermediate goods came from different places and also the lack of transportation development become one of the factors. Moreover, this system caused a difficulty in improving the quality of the product (Sidney Pollard, 1965). To solve the problem of putting-out system, then the entrepreneur start to use inside contracting system, a system in which manufacturer make a contract with the subcontractor and gave space within factories to reduce the transportation cost and to make it easier to control and supervised the subcontractor. But, this system make the equipment become ineffective, since the contractor only concern to their economic profit that will produced during the contract period.
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On the traditional business enterprise in America, said that economical activities still influenced and controlled by the market and price mechanism (Chandler, 1977), which means controlled by invisible hand of market forces since producer produce goods to fulfill the demand. Moreover, Adam Smith argued that invisible hand will strengthen the efficient company since they can optimalize the resources and make an ineffective company become weaker and at the end can not survive in the competition as Herbert Spencer's phrase on his book, Principle of Biology (1864, vol. 1, p. 444), “the survival is the fittest”. But in reality, seeing that both systems are used at that time, putting-out and inside contracting make transaction cost become high and the company or the firm runs inefficient.
But as the time goes by, after railroad founded and developed, it makes distribution process become a lot easier (Chandler, 1977) and it reduce the transportation cost. This thing make a lot of company expand their businesses and start to open their, as COPHIN phrase on his journal jaskdaskdajd
“Standard microeconomic theory indicates that such a reduction in transportation costs will result in a rise in the least-cost scale of production, and, indeed, industrial enterprises after 1850 began to build new plants of unprecedented size”. Moreover, because of the increasing of human population and increasing per capita income in America lead to the increasing in demand significantly make the entrepreneur realize the important of administrative coordination by a manager to control the branch.
Then in the late nineteenth, American business start to know a modern business enterprise where it is really different with the traditional enterprise. Its running a multi unit businesses in different areas (Chandler, 1977), it seems this is because the management has realize the important of an effective action in competition and start to maximize in using the equipment that will lead to the increasing in the number of goods produced, and in the end it will require another branch in other area to sell the products. Besides that, considering from a transaction cost point of view, a firm will be more effective if they have a multi-unit businesses since it would make both transaction cost and cost of market transaction reduce. For example is Ligna furniture company, a company that handcrafting a furniture in Indonesia and already distributed internationally, the company have a furniture line of business and also have timber business as their line, therefore Ligna is able to produce a furniture with a woods that comes from their other line of business. This kind of business process make a transaction cost becomes cheaper for Ligna company and there is also cost for market transaction, as supported by Douma and Schreuder that transaction cost in the market wil be higher than cost of internal coordination (Douma and Schreuder, 2008), moreover the quality of the product could also get controlled to compete with the other company.
Besides that, in the modern enterprise, the role of middle manager is very important since each unit of the company operates as an independent enterprise and it is the responsibility of each local manager to reduce the cost. This would lead to a specialization in the managerial function, divisional of labor, and also the managerial hierarchy. Since by manager role, company could achieve corporate effectiveness by enhancing productivity, control the cost, maximize resources utilization and finally set a price that affordable for customer but also can compete with other competitors and not depend on market forces.
In conclusion, although there is many opinions that invisible hand will allocate the resources efficiently and distribute the welfare evenly, but in fact it is only working on certain condition and can not work when market failure exist. Moreover, invisible hand tend to take more time until it reach appropriate price where the resources used optimally. On the other hand, by using visible hand, the process of setting the price and allocate the resources relatively faster because it coordinated by manager. For example is when Soros10 causing crisis in Indonesia and Asia in 1997. In that case, Soros take the advantages from the weakness of invisible hand that need longer time to determine exhange rate for currency in market by his visible hand. He made fund manager and bought the whole lot dollar until supply for dollar decrease and make the exchange rate for dollar increase significantly in the market, then he resell the currency and got high profit from that. This action made the value of other currency in Asia fell drastically and cause the crisis.
Moreover, because of many businesses or economic activity today run by large company that has power, so market force or invisible hand can not work efficiently anymore because it will tend to emerging imperfect competition. To solve and watch over this economic activity, so it needs intervention from government which is categorized as visible hand. Furthermore, for the company, the effectiveness will be achieved by visible hand of management by controlling the production activity than waiting the market set a price by price mechanism. So that, visible hand more appropriate to be implemented than using invisible hand in allocating the resources in business today.