What assumptions about the economy must be true for the invisible hand to work? To what extent are those assumptions valid in the real world?

The invisible hand is a concept in economics, introduced by Adam Smith, which states that in a free market, an individual pursuing their self-interest indirectly promotes the welfare of society as a whole. For the invisible hand to work, certain assumptions about the economy must hold true.

There are several key assumptions in order for the invisible hand to work effectively: a. Perfect competition: There are a large number of buyers and sellers such that no individual buyer or seller has any influence over the market price. b. Perfect information: Buyers and sellers have full information about the prices, quality, and availability of goods and services. c. No externalities: Goods and services produced have no external effects on third parties (positive or negative). d. Rational decision-making: Economic agents make rational decisions based on their self-interest and utility maximization.

Let's now evaluate the extent to which these assumptions are valid in the real world: a. Perfect competition: In the real world, perfect competition is rarely observed. Many markets have a limited number of suppliers, leading to monopolistic or oligopolistic competition. Some markets are also characterized by the presence of barriers to entry, which prevents the realization of perfect competition. b. Perfect information: In most real-world situations, buyers and sellers do not have perfect information. Information asymmetries can exist, leading to market failures or inefficient outcomes (e.g. adverse selection, moral hazard). c. No externalities: The production and consumption of goods and services often create externalities, both positive (e.g. education) and negative (e.g. pollution). In these cases, the invisible hand may not lead to the most efficient outcome, and government intervention may be necessary. d. Rational decision-making: Human decision-making is not always rational, as individuals can be influenced by cognitive biases, heuristics, and emotions. Behavioral economics explores how these factors affect decision-making and market outcomes.

While the concept of the invisible hand has some merits, it is important to recognize that its assumptions are not perfectly valid in the real world. Some of the assumptions, such as perfect competition and perfect information, are rarely observed. In addition, externalities and irrational decision-making can lead to market failures and inefficient outcomes. Understanding these limitations helps inform the appropriate role of government intervention in addressing market failures and promoting societal welfare.