The Invisible Hand & Why
Command Systems Fail
Mr. Henry
AP Economics
Review 5 Fundamental Questions:
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What will be produced?
How will the goods and services be produced?
Who will get the output?
How will the system accommodate change?
How will the system promote progress?
Equation:
• Total Profits = Total Cost – Total Revenue
• Total Cost = Presource * Qresource
• Total Revenue = Price * Qsold
• Table 2.1 ($15 worth of soap): If Bar Soap, Inc. sold 50 bars
of soap daily at .25C each, would Bar Soap, Inc. continue
to stay in business?
The “Invisible Hand”
• Adam Smith, in 1776,
wrote The Wealth of
Nations in which he
noted that the operation
of a market system
creates a curious unity
between private
interests and social
interests.
Self Interest
• Self-interest is what induces responses appropriate to
the changes in society’s wants. Competition controls
or guides self-interest such that self-interest
automatically and quite unintentionally furthers the
best interest of society.
The Market System:
• Promotes the efficient uses of resources by guiding them
into the production of goods and services most wanted
by society
• Encourages skill acquisition, hard work, and innovation.
These are incentives because working harder leads to
higher income which =‘s higher standard of living
• Allows for the freedom of enterprise and choice.
• As we will see in the spring, economists (Keynes,
Friedman, Hayek) and politicians (Supply-Side vs.
Demand-Side) alike have their viewpoints on how
the market system should work
Why Command Systems Fail?
• Command systems face two major problems:
A) Coordination Problems
B) Incentive Problems
• Central planners have to coordinate millions of individual
decisions by consumers, resource suppliers, and businesses.
• Because new products & inventions arise, planners would
suppress product variety and focus on only 1 or 2 products.
• Managers and workers worried about quantity, not quality,
targets. So distortions of what was made occurred.
• Example: Nails (tons of nails vs. # of nails) = (large nails
produced vs. small nails produced)
• Because central planners determined the output, when
they misjudged how many items to produce, there
were persistent shortages and surpluses of goods.
• Managers had no incentive to adjust production levels
in response to shortages and surpluses.
• There was no incentive to do better. A higher standard
of living meant moving up the political hierarchy, not
working harder.
• With the Market Economy, the economy flows in a
continuous, repetitive flow of goods & services,
resources, and money.
The price of a new car
Labor, land, capital,
entrepreneurial ability
Review Questions
1) Suppose industry A is realizing substantial
economic profit. Which of the following best
describes what will happen in this competitive
market?
A Firms will leave the industry and output will fall.
B Firms will enter the industry and output will fall.
C Firms will leave the industry and output will rise.
D Firms will enter the industry and output will rise.
D Firms will enter the industry and output will rise.
2) According to the concept of the "invisible hand,"
if Susie opens and operates a profitable childcare
center, then:
A government should regulate the business to ensure
quality.
B the profit Susie earns indicates that she is overcharging
for her services.
C she has served society's interests by providing a
desired good or service.
D this demonstrates that consumer sovereignty is not
present in this market.
C she has served society's interests by providing a
desired good or service.
3) In terms of the circular flow diagram,
businesses obtain revenue through the _____
market and make expenditures in the _____
market.
A product; financial
B resource; product
C product; resource
D capital; product
C product; resource
4) Since World War II:
A North Korea's command economy has significantly
outperformed South Korea's market economy.
B South Korea's command economy has significantly
outperformed North Korea's market economy.
C North Korea's market economy has significantly
outperformed South Korea's command economy.
D South Korea's market economy has significantly
outperformed North Korea's command economy.
D South Korea's market economy has significantly
outperformed North Korea's command economy.