The theory of supply and demand was developed in the 1800s based on work by Adam Smith in The Wealth of Nations in 1776. The purpose of this theory was to explain how markets work to allocate resources. Discuss what happens when a market is out of equilibrium, according to this theory.

Smith argued that by giving everyone the freedom to produce and exchange goods as they pleased (free trade) and opening the markets up to domestic and foreign competition, people's natural self-interest would promote greater prosperity than could stringent government regulations. (2] Smith believed humans ultimately promote public interest through their everyday economic choices. In The Wealth of Nations he wrote: He generally, indeed, neither intends to promote the public interest nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (2] This free-market force which Adam Smith called the invisible hand needed support to bring about its magic. In particular, the market that emerged from an increasing division of labor, both within production processes and throughout society, created a series of mutual interdependencies. These relationships promoted social welfare through individual profit motives. [2] In other words, if you specialize as a baker and produce only bread, you mustrely on somebody else for your clothes, your meat, and your beer. Meanwhile, the people that specialize in clothes must rely on you for their bread, and so on. Prosperity emanates from the market that develops when people need goods and services that they can't create themselves. FAST FACT Adam Smith is generally regarded as the father of modern economics. The Invisible Hand The automatic pricing and distribution mechanisms in the economy (Smith's invisible hand) interact directly and indirectly with centralized, top-down planning authorities. Human Nature vs. Government Policy The invisible hand is not an actual, distinguishable entity. Instead, it is the sum of many phenomena that occur naturally when consumers and producers engage in commerce. Smith's insight was one of the most important in the history of economics. It remains one of the chief justifications for free-market ideologies. [2]Modern interpretations of the invisible hand theorem suggest that the means of production and distribution should be privately owned and that iftrade occurs unfettered by regulation, in turn, society will flourish organically. These interpretations compete with the concept and function of government. [2] Government is not serendipitous. It is prescriptive and intentional. Politicians, regulators, and those who exercise legal force {such as the courts, police, and military) pursue defined goals through coercion. In contrast, macroeconomic forcessupply and demand, buying and selling, profit and lossoccur voluntarily until government policy inhibits or overrides them. In this sense, it is accurate to conclude that government affects the invisible hand, not the other way around. Government Interference in Free Markets The absence of market mechanisms frustrates government planning. Some economists refer to this as the economic calculation problem. 1When people and businesses make decisions based on theirwillingness to pay money for a good or service, that information is captured dynamically in the price mechanism. This, in turn, allocates resources automatically toward the most valued ends. 1v'v'hen governments interfere with this process, unwanted shortages and surpluses tend to occur. Considerthe massive gas shortages in the United States during the 1970s. The then newly formed gganization of Petroleum gporting Countries (OPEC) cut production to raise oil prices. The Nixon and Ford administrations responded by introducing price controls to limit the cost of gasoline to American consumers. The goal was to make cheap gas available to the public.l3- Instead, gas stations had no incentive to stay open for more than a few hours. Oil companies had no incentive to increase production domestically. Consumers had every incentive to buy more gasoline than they needed. Large- scale shortages and gas lines resulted. Those gas lines disappeared almost immediately after controls were eliminated and prices were allowed to rise. While some might be tempted to say that the invisible hand limits government, that would n't necessarily be correct. Rather, the forces that guide voluntary economic activity toward large societal benefit are the same forces that limit the effectiveness of government intervention