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 Signal

AND 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
What if wePdon’t
=MC1know
, Alexthe
sets
MCP =MC
of each
2
as a result
producer?
MC1=MC2

Pat’s Farm Alex’s Farm

$ MC1 $

MC2

$2.50 Price of
Corn

0 40 Quantity 160 Quantity

(Bushels of Corn) (Bushels of Corn)
Pat Sets P =MC1 , Alex sets P =MC2
as a result MC1=MC2

Pat’s Farm Alex’s Farm

$ MC1 $

MC2
Price of
Corn

0 40 Quantity 160 Quantity

(Bushels of Corn) (Bushels of Corn)
Pat Sets P =MC1 , Alex sets P =MC2
as a result MC1=MC2

Pat’s Farm Alex’s Farm

$ MC1 $

MC2
Price of
Corn

0 40 Quantity 160 Quantity

(Bushels of Corn) (Bushels of Corn)
Pat Sets P =MC1 , Alex sets P =MC2
as a result MC1=MC2

Pat’s Farm Alex’s Farm

$ MC1 $

MC2

Price of
Corn

0 40 Quantity 160 Quantity

(Bushels of Corn) (Bushels of Corn)
The True Importance of the P=MC Condition
is P=MC1=MC2 …=MCN

Pat’s Farm Alex’s Farm

$ MC1 $

MC2

Price of
$2.50
Corn

0 40 Quantity 160 Quantity

(Bushels of Corn) (Bushels of Corn)
Competitive Markets
Individual (Typical) Market
Cost($) Firm MC ATC P (all firms & consumers)
S1

MR1= P1

D1

q1 Firm output (q) Q1 Market

output (Q)
Competitive Markets Suppose DEMAND shifts?

Individual (Typical) Market

Cost($) Firm MC ATC P (all firms & consumers)
S1

MR1= P1

Minimum
ATC
D1

q1 Firm output (q) Q1 Market

output (Q)
 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
Farmers from 18 households signed a secret
is divulged and one of us is put in
life-and-death agreement with their thumb
prison, other team members shall prints. China Today.
share the responsibility to bring
up his child till he or she is 18.”
What happened in 1978?