The Invisible Hand (or The Allocative Function of Prices) (or The True Importance of Economic Profit)

The Invisible Hand(or The Allocative Function of Prices)(or The True Importance of Economic

Profit)

The Invisible Hand

• “Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; 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.”

• What is this invisible hand leading us?

Prices and the Invisible Hand

Price acts as a SignalAND an Incentive

The Role of Prices

• Price increases.– It’s a signal that people want more of it.

– It’s an incentive for producers to provide more of it -economic profit.

• Price decreases.– It’s a signal that people don’t want as much of it.

– It’s an incentive for producers to provide less of it (more of other goods and services) – economic losses.

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

What if we don’t know the MC of each producer?

$2.50 Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

The True Importance of the P=MC Condition is P=MC1=MC2 …=MCN

Price of Corn

$2.50

D1

S1

Competitive Markets

MC ATCCost($)

Firm output (q)

P

Marketoutput (Q)

P1

Q1q1

Individual (Typical) Firm

MR1=

Market(all firms & consumers)

MinimumATC

MC

Competitive Markets

PMarket

(all firms & consumers)Individual (Typical)

Firm

P1MR1=

D1

ATCS1

Cost($)

Firm output (q)q1Market

output (Q)Q1

Suppose DEMAND shifts?

So what?

• Not many markets are perfectly competitive.– Agriculture represents < 2% of workforce.

• Same dynamics at play in non-competitive markets.– Always MR vs. MC; if P↑, MR↑, regardless of the

industry.

– As P↑, firms will produce more, because it will exceed the MC for more units and for a larger number of firms.

Consider the following markets

• In the last 5 years, what’s happened to the amounts of:

• Bars and restaurants downtown, electric vehicles, reality TV, 3-D printing, social media sites, touch screen phones/tablets, sports networks, movies starring Bradley Cooper?

• Print News, music stores, movie rental stores, post offices, sitcoms, soap operas, movies starring Keanu Reeves?

• Why?

How does it work?

• People don’t rent DVDs as much as they used to (demand decreases). What happens?

• Blockbuster Movies, Hollywood Video, Movie Gallery, etc.

How does it work?

• Millions of people stream videos from home (demand increases). What happens?

• Netflix, Hulu, TiVo, Apple TV, Roku, Google Chromecast, Blinkbox, Blockbuster OnDemand, Armstrong OnDemand, Redbox Instant, Amazon Instant Video, HBO Streaming, CBS Streaming, etc.

Prices, Signals and Incentives - The Invisible Hand!

• Why Central Planning Doesn’t Work

– Even if mandating production were ‘ok’

• Couldn’t possibly know how much consumers want/need of all different goods and services, and how they change over time.

• Couldn’t possibly know the marginal costs of all producers.

• So, couldn’t possibly efficiently allocate production between firms, or goods/services between consumers.

The allocative function of prices

• “by directing that industry in such a manner as its produce may be of the greatest value”

• Price changes direct resources toward their most productive uses.– Price increases, economic profits can be made, more

of it is produced

– Price decreases, economic losses are suffered, less of it is produced

• What’s the big deal?

A Natural Experiment

• Suppose there were two countries with the same culture, the same people, the same history, that are about the same size and have about the same income. One of these countries uses central planning and one of them uses market forces (the invisible hand).

A lot of other factors at play…

• Maybe it’s not the invisible hand, but other factors…

So what if we could take one country, have them start with central planning, then suddenly allow market forces to work?

What happens without incentives?

• In 1949, the Communists under Mao abolished private property in China.

• In the “Great Leap Forward” (1958-61) farmers were put to work on collectives of up to 5,000 families.

• The result was mass starvation.

The Heroes of Xiaogang Village

• In 1978, farmers from 18 households in Xiaogang Village risked their lives by secretly ending land communism.

• The villagers divided the collective land by household. Each household would deliver a quota to the government but they would keep whatever remained.

• A clause in their secret contract translates “If any word about this is divulged and one of us is put in prison, other team members shall share the responsibility to bring up his child till he or she is 18.”

Farmers from 18 households signed a secret life-and-death agreement with their thumb prints. China Today.

What happened in 1978?