11. The “invisible hand” of
market prices directs buyers
and sellers toward activities
that promote the general
welfare.
12 Key Elements of Economics
Invisible What?


Adam Smith, The Wealth of
Nations (1776)
“It is his own advantage, indeed,
and not that of society which he
has in his view. But the study of his
own advantage naturally, or rather
necessarily, leads him to prefer
that employment which is most
advantageous to society…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 not part of his
intention.”
What Is the Invisible Hand?


Friedrich von Hayek
(1899-1992)
The primary function of
markets is to provide
information to buyers
and sellers.
The invisible hand of
market prices directs
millions of selfinterested individuals
into cooperative action
and brings their choices
into line with each
other.
The Magic of Markets

Prices:


Market prices give us the information
needed to respond to the concerns of
people all over the world and the
motivation to do so
Prices are what coordinate all of the
activities in the market
Friedrich von Hayek
“I am convinced that if it
were the result of
deliberate human design, and
if the people guided by the
price changes understood
that their decisions have
significance far beyond their
immediate aim, this
mechanism would have been
acclaimed as one of the
greatest triumphs of the
human mind. Its misfortune
is the double one that it is
not the product of human
design and that the people
guided by it usually do not
know why they are made to
do what they do.”
Importance of Prices

We need information in order to decide
what to do with our scarce resources


Producers need to know what consumers and
other producers want
Consumers need to know what producers are
willing to make and what other consumers want
Importance of Prices

Information costs are the costs of
articulating or measuring the values that
humans place on goods and services they
desire from their limited resources and of
knowing how one person’s actions impinge
on the values of others
Importance of Prices


Prices provide knowledge that is complex,
dispersed, and constantly updated
Information is time and place specific and
can not be gathered in a single mind or
group of minds
Importance of Prices


Prices provide information in a condensed
form
Prices provide an incentive to act

May or may not care about others, but prices
make you act “as if” you cared about others
Spontaneous Order



Things constantly happen spontaneously
to make both consumer and producers
better off through exchange.
When guided by market prices, selfinterested individuals will move toward
activities that will promote the general
welfare.
This occurs without any central planning.
The Process of Price
Determination
“The product of
human action,
but not of human
design.”
– Adam Ferguson (1767),
An Essay on the History
of Civil Science
12. Too often long-term
consequences, or the
secondary effects, of an action
are ignored.
12 Key Elements of Economics
Secondary Effects or Long Range
Consequences
A person
“…must trace not merely the immediate
results but the results in the long run, not
merely the primary consequences but the
secondary consequences, and not merely
the effects on some special group but the
effects on everyone.”
- Henry Hazlitt [1979]
Economics in One Lesson
Unintended Consequences

“If we require seatbelts at 55mph why not at
550mph?”

What would happen if we required car seats
on airplanes?
MARKET DISTORTIONS
Price Floors and Price Ceilings
Price cannot fall below a floor
Price cannot rise above a ceiling
PRICE FLOOR
P
S
PF
Pe
D
QD
Qe
QS
Quantity
Supplied is
GREATER
than
Quantity
Demanded.
This leads to
a SURPLUS.
Q
The price is not allowed to go below the price
floor. The price never reaches equilibrium.
Example




Minimum wage set above equilibrium
Higher price will have what effect on
prospective demanders?
Higher price will have what effect on
prospective suppliers?
Price above market clearing price will
SURPLUS
cause a ____________.
PRICE CEILING
P
S
Pe
PC
D
QS
Qe
QD
Quantity
Demanded is
GREATER
than Quantity
Supplied. This
leads to a
SHORTAGE.
Q
The price is not allowed to go above the price
ceiling. The price never reaches equilibrium.
Example




Maximum rent on apartments set below
equilibrium
Lower price will have what effect on
prospective demanders?
Lower price will have what effect on
prospective suppliers?
Price below market clearing price will cause
SHORTAGE
a ____________.
Rent Controls


Intended purpose: Cheaper rental
housing.
Unintended secondary affects: less
investment in rental housing, fewer
rental units available in the future,
decline in the maintenance and quality of
rental units, more difficult to find rental
housing.
Price Controls - The Message





Price controls distort market incentives
They can not change the relative
scarcity of the product
They cause over allocation or under
allocation of resources
They cause arbitrary distributive
effects
But they are great politics!
If policymakers have good
intentions
Will their actions lead to desirable
outcomes?