Competition and the Invisible Hand

1. Competition and the Invisible Hand

2. Invisible Hand Property 1: The Minimization of Total Industry Costs of Production Invisible Hand Property 2: The Balance of Industries Creative Destruction The Invisible Hand Works with Competitive Markets For applications, click here To Try it! questions

4. Invisible Hand Property #1 • The Minimization of the Total Costs of Production • Total costs of production in a competitive industry will be minimized if all firms choose to produce where P = MC • In a competitive market with N firms, the following must be true: • P = MC1 = MC2 = … = MCN • Higher-cost firms will produce less output • Lower-cost firms will produce more output

5. Comparing Marginal Costs To next Try it! Farm 2 has a lower marginal cost of producing corn than Farm 1. So should we use Farm 2 only? Yes No

6. Invisible Hand Property #1 To Minimize the Total Costs of Production, Two Farms Choose Output to Make Marginal Costs Equal Price Farm 2 Farm 1 MC1 Price MC2 MC1 MC2 Bushels of Corn Bushels of Corn 75 125 200

7. Invisible Hand Property #1 If we produce a few bushels less on Farm 2 and a few bushels more on Farm 1, costs fall by area A and rise by the smaller area B so total costs fall. Farm 2 Price Price Farm 1 MC1 more here less here MC2 A B Bushels of Corn Bushels of Corn 197 200

8. Invisible Hand Property #1 • In short, the Invisible Hand Property #1 argues that even though no actor in a market economy intends to do so, in a free market P = MC1 = MC2 = … = MCN and as a result the total costs of production are minimized. • (with no central planning!)

9. To next Try it! If we look at a number of firms in a competitive market, we know that the firm with the highest level of output is also the firm with the lowest marginal cost. the firm with the lowest average cost. the firm with the highest marginal cost. the firm with the highest price.

10. Invisible Hand Property #2: The Balance of Industries • Profits encourage entry while losses encourage exit; entry reduces profit, and exit reduces losses. • The Elimination Principle states that above normal profits are eliminated by entry, and below normal profits are eliminated by exit. Profits pop up, but soon get whacked.

11. Invisible Hand Property #2: The Balance of Industries • Invisible hand property #2 = entry and exit decisions not only work to eliminate profits and losses, they work to ensure that labor and capital move across industries to optimally balance production so that the greatest use is made of our limited resources.

12. Creative Destruction • Since no one profits from the commonplace, an entrepreneur must innovate to earn above normal profits. • Furthermore,those who fail to innovate will be displaced by those who do through what economist Joseph Schumpeter the process of Creative Destruction.

13. The Invisible Hand Works with Competitive Markets Don’t forget that the invisible hand works only in certain circumstances. It’s important that prices accurately signal costs and benefits (no externalities) and That markets are competitive (no monopoly or oligopoly)…. Otherwise, the invisible hand is less powerful.

14. To next Try it! In a competitive industry, if a firm wants to continue to earn positive economic profits, it must try to prevent other firms from entering the industry. try to raise its prices to earn more revenue. innovate and find new ways of producing output. force its suppliers to lower the price they charge for raw materials.

15. Back to Let's suppose that the demand for allergists increases in California. How does the invisible hand respond to this demand? Allergists from other states (or countries) could move to California. Surgeons, hematologists, and other doctors in California could switch over to allergy after some retraining. New people could enter medical school, specialize in allergy, and move to California. All of the above are correct.