The “Free Hand of the Market” is one of the most know and most venerated theory of modern economies. The invisible hand of the market was a metaphor used by Adam Smith in his book entitled “An Inquiry into the Nature and Causes of the Wealth of Nations” released in 1776.
The Main Concept of the Invisible Hand theory is that a market can auto-regulate itself, without any intervention from the State. This means that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community.
Today we want to touch on the flaws of Adam Smith’s doctrine. Many flaws have already been pointed out. Some weaknesses are the existence of asymmetric information, the signalling of buying expensive products and the changes in fashion and cultures. (If you are interested in reading more about these flaws I recommend you following article ).
In our case study we will consider the university as a closed market. The Consumer side being composed of all the consumers of goods and services, mostly of them being students. And the Providers being consisted of 2 parties which we will elaborate on a bit later.
As a student in Economics the most valuable assets are Energy Drinks. They help you during the intensives and long study-nights. The University and the re-sellers are very aware of that fact and that’s why there is no shortage of Energy Drinks. In the university Campus we have two different vendors who sell the exact same Energy Drink, Red Bull. One of the Vendors being our Canteen and the second Vendor being represented by several vending machines. The intriguing part is the pricing of the Red Bull. Since I have been enrolled in the University of Vienna the Canteen has been selling the drink at a price of 2 Euros whereas, the same drink can be bought at a price of 1,80 Euros in all the vending machines. The surcharge of the Canteen amounts up to 20 Cents, or a price premium of 11%. In fact, the Vending Machines are placed right next to the Canteen. So we have the same product, being sold to the same clientele. Students have the possibility to buy the Red Bull drink in the Vending Machines and just take place in the Canteen. Corresponding to Adam Smith, there should be a reaction from the market in form of price changes or policy restructures to where only students who do not consume are not allowed to use the Canteen facilities. As you can guess none of this has happened.
To go even more into depth, we will use the tool of Marginal Utility often applied in Microeconomics. If you are not familiar with the concept of Marginal Utility I strongly suggest following Video. Students are often in a dire need of money, have a low liquidity and try to generate cash flows by taking on a student job. A lot of Students have to take on debt to be able to study and to sustain a daily routine. Due to this, the Value of Money is very high for Students. This can lead us to the conclusion that the marginal utility or the marginal benefit of money is very high. The universitary environment is a surrounding that values liquidity a lot. So the price premium of 11% should and is a motivation to go buy the Red Bull in the Vending Machine.
What we have not been able to observe was the merge of the prices. The prices still remain the same as they have been. So we can ask the Question: Why do the prices not merge together as praised by Adam Smith?
One possible argument, is an irrational or poor management of both Vendors. This being the Vending Machine Company that doesn’t raise its prices, to have a bigger margin on the sold products. This assumption is arguable, as an increase of prices might lead to a decrease of sells, decreasing the total generated Cash Flows in the University facility. What seems to be poor management is the not decrease of the price of Red Bull at the Canteen. An even minimal decrease in Prices would create an increase in market share ( the market in this case being all the consumers at the university) and the staff would have to constantly refill the shelves with Red Bull.
Another possibility is that the free hand of the market in some cases just doesn’t apply. In some cases, the markets don’t allocate resources efficiently. In these cases, where vendors and Consumers (which in our example by buying the cheaper version of the Energy Drink they do) don’t act rationally. In these cases, it isn’t as straight forward. In following scenarios, the markets don’t correlate to just only one price but they seem to harmonise to a range of acceptable prices.
So we can conclude that even in a market where there are no barriers such as asymmetrical, the markets still fail to allocate the resources effectively. Even though in theory we act rational and always pick the best or cheapest goods and services it just doesn’t happen in practice. Joseph Stiglitz, who was a critic of the invisible Hand, published a book titled Making Globalization Work where he wrote: “the reason that the invisible hand often seems invisible is that it is often not there.”
Sir of Finance 