12
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Competition and the
Invisible Hand
1
CHAPTER OUTLINE
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
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questions
2
Food for Thought….
Some good blogs and other sites to get the juices flowing:
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
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Try it!
Farm 2 has a lower marginal cost of producing corn
than Farm 1. So should we use Farm 2 only?
a) Yes
b) No
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Invisible Hand Property #1
To Minimize the Total Costs of Production, Two Farms Choose Output to Make
Marginal Costs Equal
Price
Price
Farm 1
Farm 2
MC1
MC2
MC1
75
6
MC2
Bushels
of Corn
125
200
Bushels
of Corn
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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.
Price
Price
Farm 1
Farm 2
MC1
more
here
less
here
MC2
A
B
Bushels of
Corn
7
197
200
Bushels of
Corn
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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!)
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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
a) the firm with
b) the firm with
c) the firm with
cost.
d) the firm with
the lowest marginal cost.
the lowest average cost.
the highest marginal
the highest price.
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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.
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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.
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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.
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SEE THE INVISIBLE HAND
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.
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In a competitive industry, if a firm wants to
continue to earn positive economic profits, it
must
a) try to prevent other firms from entering the
industry.
b) try to raise its prices to earn more revenue.
c) innovate and find new ways of producing
output.
d) force its suppliers to lower the price they
charge for raw materials.
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Let's suppose that the demand for allergists increases
in California. How does the invisible hand respond to
this demand?
a)
b)
c)
d)
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.
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