Why are price signals and market competition so important to a market economy? When prices accurately signal costs and benefits and markets are competitive, the

Why are price signals and market competition so important to a market economy? When prices accurately signal costs and benefits and markets are competitive, the Invisible Hand ensures that costs are minimized and production is maximized. If these conditions aren’t met, market inefficiencies arise and the Invisible Hand cannot do its work. In this video, we show how two major processes, creative destruction and the elimination principle, work with the Invisible Hand to create a competitive marketplace that works for producers and consumers.

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We turn now to the second of our invisible hand properties, the balance of industries. We're also going to look at the gales of creative destruction.

 

Invisible hand property number one says that the production of any given quantity of a good will be allocated across the firms in that industry in a way that minimizes total costs. But the question is, how much should be produced in each industry? So invisible hand property number one says if we're going to be producing 200 bushels of wheat then we could be rest assured that if we have a competitive market, those 200 bushels will be allocated across the different firms in a way that minimizes total industry costs. But should we be producing 200 bushels of wheat, or 500 or 1000?

 

How should wheat be compared with corn or automobiles or books? It's the second question about how the production of goods are balanced across industries that invisible hand property number two is all about. In order to maximize the value of resources, we want each industry to produce the right quantity -- not too much wheat and not too little wheat, but just the right amount. And entry or exit is what ensures that labor and capital move across industries so the production is optimally balanced and the greatest use is made of our limited resources. And here to show this we actually don't need to use any more techniques, we just need to sort of reinterpret some of the things which we've already done. Let's take a look.

 

Profit is the signal that allocates capital and labor across industries in just such a way that maximizes total value. So remember, if price is bigger than average cost, that means that profits are above normal. Now what does above normal profit mean? It means that the output of this industry is worth more than the inputs. The profit signal is saying we want more of this good. This good is worth more than the labor and capital being used to create this good, therefore produce more of it. So the profit signals and incentivizes capital and labor to enter this industry, that is to move from a low value industry to a high value industry.

 

Similarly, if price is less than average cost, that means profits are below normal. That means that output in this industry is worth less than the inputs. So the loss signal is saying: we want less of this good. Loss signals and incentivizes capital and labor to exit the industry, that is to move from a low value industry where there are losses to a high or a higher value industry. Because of this entering and exiting, the profit rate in all competitive industries tends towards the same level. And that is what balances production across all industries to maximize the total value of production. If profit were higher in one industry than in another, that says that the output of that industry is worth more, therefore we should have more of that good. And that's exactly what the entry signal does and the same thing is true for exit.

 

Let's discuss some implications of following these profit and loss signals. First, the elimination principle. Above normal profits are eliminated by entry and below normal profits are eliminated by exit. So resources are always tending to move towards an increase in the value of production and entrepreneurs here are key. It's entrepreneurs who move resources from unprofitable industries towards profitable industries.

Another implication of this is that above normal profits are always temporary. To earn above normal profits, you've got to do something different. You have to innovate. Joseph Schumpeter, the great Austrian economist, was very eloquent on the importance of innovation in a capitalist economy. He said in the textbooks we say what competition is. It's all about pushing prices down to average cost and creating normal profits. But, “In capitalist reality as distinguished from its textbook picture, the kind of competition that counts is competition from the new commodity, the new technology, the new source of supply, the new type of organization… which strikes not at the margins of the profits and the outputs of the existing firms but at their very foundations and their very lives. This process of creative destruction is the essential fact about capitalism.” Great statement from Joseph Schumpeter.

 

Now the invisible hand is marvelous but it's not miraculous. The invisible hand works when we have certain institutions. It doesn't always work. In particular, the invisible hand will not work if prices do not accurately signal cost and benefits. If prices don't accurately signal cost and benefits, we won't get an optimal balance between industries. And later on when we come to talk about externalities, we'll present certain situations when prices aren't going to be signaling accurately.

 

Second, the invisible hand works best when markets are competitive. When markets are not competitive, when we have monopoly and oligopoly, this isn't going to work as well. And we'll be talking more about this in future chapters but you can get the right idea by thinking about the following. Monopolists and oligopolists will earn above normal profits but entry won't push those profits down. That's why they're monopolists and oligopolists -- because entry isn't working. Because those profits aren't pushed down, we'll have too little of that profitable good produced. We'll be talking more about this in future chapters. Again this is just a little bit of a reminder that the invisible hand requires a certain set of institutions in order for it to work.

 

So just to summarize, invisible hand property one says that the P = MC condition results in the minimization of total industry costs. Invisible hand property two is that entry and exit result in the best use of our limited resources. The elimination principle says that above normal profits are temporary, and indeed to earn above normal profits a firm must innovate. And this is where the importance of creative destruction for a capitalist economy comes from. If you really want to profit a lot you've got to do something different. You've got to bring something new to the table. You have to bring in innovation.

 

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Show 1 Answer (Answer provided by Alex Tabarrok)
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Remember that we are discussing competitive industries. If some industries aren't competitive then profits will be higher in those industries and they will stay high. In such a case, we do not get a balance across industries and in fact we will get too few resources in the highly profitable industry.

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Show 1 Answer (Answer provided by Ion Sterpan)
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The answer to the first question is yes. Technology" in the widest sense means "way of doing things". Imagine a competitive process in a industry where at first, the members of that industry have different ways of doing things. Some of them make more profits some less. The concept of competitive market assumes that each member of the industry sees, understands, and can copy the others' technology. The ones who make less profit will naturally imitate the ones who make more. The concept of competitive markets also means that non-members of the industry can easily enter the industry and "compete on price", which means to replicate the production process but sell cheaper. The same concept means that entrants are practically infinitely many. Thi smeans there will always some new competitor coming in to compete on price. The equilibrium outcome is thus that given a technology, entry will erode profits to zero. What can you do then do make a profit in a competitive market? Come up with a new way of doing things. And make money for as long as it takes other to imitate you.
The answer to the second question is no, as you already guessed when you said "absurd". Education is a service performed by people - teachers. If teachers knew which new technologies will make a profit, they would do business instead of teaching. What teachers can do though is to a) teach students to be open to the 'idea' of commercial innovation and teach students to recognize the kinds of non-commercial innovation that destroy wealth (various kinds of fraud, theft and political enterprises whose object is to transfer wealth from some groups to others).

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