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- [Alex] We turn now to the second of our invisible hand properties,
the balance of industries.
We're also going to look
at the gales of creative destruction.
Invisible hand property number one says
that the production of any given quantity of a good
will be allocated across the firms in that industry
in a way that minimizes total costs.
But the question is, how much should be produced
in each industry?
So invisible hand property number one says
if we're going to be producing 200 bushels of wheat
then we could be rest assured
that if we have a competitive market,
those 200 bushels will be allocated across the different firms
in a way that minimizes total industry costs.
But should we be producing 200 bushels of wheat,
or 500 or 1000?
How should wheat be compared with corn or automobiles or books?
It's the second question
about how the production of goods are balanced across industries
that invisible hand property number two is all about.
In order to maximize the value of resources,
we want each industry to produce the right quantity --
not too much wheat and not too little wheat,
but just the right amount.
And entry or exit is what ensures
that labor and capital move across industries
so the production is optimally balanced
and the greatest use is made of our limited resources.
And here to show this we actually don't need to use
any more techniques,
we just need to sort of reinterpret some of the things
which we've already done.
Let's take a look.
Profit is the signal that allocates capital and labor across industries
in just such a way that maximizes total value.
So remember, if price is bigger than average cost,
that means that profits are above normal.
Now what does above normal profit mean?
It means that the output of this industry
is worth more than the inputs.
The profit signal is saying we want more of this good.
This good is worth more than the labor and capital
being used to create this good, therefore produce more of it.
So the profit signals and incentivizes capital and labor
to enter this industry,
that is to move from a low value industry
to a high value industry.
Similarly, if price is less than average cost,
that means profits are below normal.
That means that output in this industry
is worth less than the inputs.
So the loss signal is saying: we want less of this good.
Loss signals and incentivizes capital and labor
to exit the industry,
that is to move from a low value industry
where there are losses
to a high or a higher value industry.
Because of this entering and exiting,
the profit rate in all competitive industries
tends towards the same level.
And that is what balances production across all industries
to maximize the total value of production.
If profit were higher in one industry than in another,
that says that the output of that industry is worth more,
therefore we should have more of that good.
And that's exactly what the entry signal does
and the same thing is true for exit.
Let's discuss some implications
of following these profit and loss signals.
First, the elimination principle.
Above normal profits are eliminated by entry
and below normal profits are eliminated by exit.
So resources are always tending to move
towards an increase in the value of production
and entrepreneurs here are key.
It's entrepreneurs who move resources
from unprofitable industries towards profitable industries.
Another implication of this is that above normal profits
are always temporary.
To earn above normal profits,
you've got to do something different.
You have to innovate.
Joseph Schumpeter, the great Austrian economist,
was very eloquent on the importance of innovation
in a capitalist economy.
He said in the textbooks we say what competition is.
It's all about pushing prices down to average cost
and creating normal profits.
But, “In capitalist reality
as distinguished from its textbook picture,
the kind of competition that counts
is competition from the new commodity,
the new technology, the new source of supply,
the new type of organization…
[competition] which strikes not at the margins
of the profits and the outputs of the existing firms
but at their very foundations and their very lives.
This process of creative destruction
is the essential fact about capitalism.”
Great statement from Joseph Schumpeter.
Now the invisible hand is marvelous but it's not miraculous.
The invisible hand works when we have certain institutions.
It doesn't always work.
In particular, the invisible hand will not work
if prices do not accurately signal cost and benefits.
If prices don't accurately signal cost and benefits,
we won't get an optimal balance between industries.
And later on when we come to talk about externalities,
we'll present certain situations
when prices aren't going to be signaling accurately.
Second, the invisible hand works best
when markets are competitive.
When markets are not competitive,
when we have monopoly and oligopoly,
this isn't going to work as well.
And we'll be talking more about this in future chapters
but you can get the right idea by thinking about the following.
Monopolists and oligopolists will earn above normal profits
but entry won't push those profits down.
That's why they're monopolists and oligopolists --
because entry isn't working.
Because those profits aren't pushed down,
we'll have too little of that profitable good produced.
We'll be talking more about this in future chapters.
Again this is just a little bit of a reminder
that the invisible hand requires a certain set of institutions
in order for it to work.
So just to summarize,
invisible hand property one says that the P = MC condition
results in the minimization of total industry costs.
Invisible hand property two is that entry and exit result
in the best use of our limited resources.
The elimination principle says that above normal profits are temporary,
and indeed to earn above normal profits
a firm must innovate.
And this is where the importance of creative destruction
for a capitalist economy comes from.
If you really want to profit a lot
you've got to do something different.
You've got to bring something new to the table.
You have to bring in innovation.
- [Narrator] If you want to test yourself,
click “Practice Questions.”
Or, if you're ready to move on, just click “Next Video.”
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