Question

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?

Short answer

• The two assumptions are - 1. Every individual must be selfish in nature and collectively this leads to the greater good for society, 2. Every individual must have complete information of the goods or services they are consuming.
• The 1st assumption is completely valid in the real world but the 2nd assumption is not valid.

Step-by-step solution

Step 1. Definition of invisible hand

When people work hard to make their living, they create economic output and consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. Adam Smith named this property the invisible hand.

Step 2. Assumptions that are considered to be true for invisible hand to work -  

1. Every individual must be selfish and intend only his own gain. This collective selfish nature of every individual promotes better outcomes for society more effectively than when individuals intend to benefit society.
2. Every individual must have complete information and understanding of the goods or services they are consuming.

Step 3. Validation of the assumptions in the real world

• The 1st assumption is completely valid in the real world. Most people in the real world work only for their own benefit. By pursuing selfish profit maximization and competition, consumers are provided with higher quality and cheaper products.
• The 2nd assumption is not valid in the real world as it is next to impossible for an individual to have complete information about every goods or services and what they are consuming.