Adam Smith posits that an ‘invisible hand’ operates in free markets. As long as economic agents (consumers and producers) act in self-interest in a competitive market with perfect information, the ‘invisible hand’ will allocate resources in society’s best interest. Basically all agents maximizing their own self-interest means everyone acts in their own self-interest so society acts in its own best interest.
The ‘invisible hand’ acts through the price mechanism. The price mechanism refers to the way in which demand and supply interact to change prices and allocate resources. Prices allocate resources in three ways:
At the market price for a good, only those consumers with sufficient effective demand can buy the good, those with a lower effective demand cannot buy the good. So goods are rationed by prices. As resources (and therefore goods) become less scarce, supply becomes more plentiful, price falls and more consumers can buy the good.
Incentives affect choices. Higher prices incentivize producers to increase quantity supplied because they can earn higher profits. Lower prices incentivize consumers to increase quantity demanded because they can buy more goods per £ spent.
Prices reflect market conditions and send signals to agents. An increase in demand causes prices to rise and signals to firms to increase quantity supplied. An increase in supply causes prices to fall and signals to consumers to increase quantity demanded.