1 00:00:00,000 --> 00:00:05,620 âŞ[music]⪠2 00:00:09,090 --> 00:00:13,210 - We turn now to the second of our invisible hand properties, the balance of 3 00:00:13,390 --> 00:00:22,980 industries. We're also going to look at the gales of creative destruction. 4 00:00:23,160 --> 00:00:27,400 Invisible hand property number one says that the production of any given quantity 5 00:00:27,580 --> 00:00:32,479 of a good will be allocated across the firms in that industry in a way that 6 00:00:32,659 --> 00:00:38,570 minimizes total costs. But the question is how much should be produced in each 7 00:00:38,750 --> 00:00:42,240 industry? So invisible hand property number one says if we're going to be 8 00:00:42,420 --> 00:00:46,490 producing 200 bushels of wheat that we could be rest assured that if we have a 9 00:00:46,670 --> 00:00:51,830 competitive market, those 200 bushels will be allocated across the different firms in 10 00:00:52,010 --> 00:00:57,800 a way that minimizes total industry cost. But should we be producing 200 bushels of 11 00:00:57,980 --> 00:01:04,110 wheat or 500 or 1000? How should wheat be compared with corn or automobiles or 12 00:01:04,290 --> 00:01:10,770 books? It's the second question about how the production of goods are balanced 13 00:01:10,950 --> 00:01:17,230 across industries that invisible hand property number two is all about. In order 14 00:01:17,410 --> 00:01:22,160 to maximize the value of resources, we want each industry to produce the right 15 00:01:22,340 --> 00:01:28,490 quantity, not too much wheat and not too little wheat, but just the right amount. 16 00:01:28,670 --> 00:01:35,790 And entry or exit is what ensures that labor and capital move across industries 17 00:01:35,970 --> 00:01:40,360 so the production is optimally balanced and the greatest use is made of our 18 00:01:40,540 --> 00:01:45,870 limited resources. And here to show this we actually don't read the news anymore 19 00:01:46,050 --> 00:01:50,060 techniques, we just need to sort of reinterpret some of the things which we've 20 00:01:50,240 --> 00:01:55,910 already done. Let's take a look. Profit is the signal that allocates capital and 21 00:01:56,090 --> 00:02:03,440 labor across industries in just such a way that maximizes total value. So remember, 22 00:02:03,620 --> 00:02:07,750 if price is bigger than average cost that means that profits are above normal. Now 23 00:02:07,930 --> 00:02:13,400 what does above normal profit mean? It means that the output of this industry 24 00:02:13,400 --> 00:02:18,362 is worth more than the inputs. The profit signal is saying 25 00:02:18,362 --> 00:02:22,312 we want more of this good. This good is worth more 26 00:02:22,312 --> 00:02:26,441 than the labor and capital being used to create this good, 27 00:02:26,441 --> 00:02:32,120 therefore produce more of it. So the profit signals and incentivizes capital 28 00:02:32,300 --> 00:02:38,860 and labor to enter this industry, that is to move from a low value industry to a 29 00:02:39,040 --> 00:02:44,420 high value industry. Similarly if price is less than average cost, that means 30 00:02:44,600 --> 00:02:49,390 profits are below normal. That means that output in this industry is worth less than 31 00:02:49,570 --> 00:02:57,780 the inputs. So the loss signal is saying we want less of this good. Loss signals 32 00:02:57,960 --> 00:03:04,390 and incentivizes capital and labor to exit the industry, that is to move from a low 33 00:03:04,570 --> 00:03:12,280 value industry where there are losses to a high or a higher value industry. Because 34 00:03:12,460 --> 00:03:18,620 of this entering and exiting, the profit rate in all competitive industries tends 35 00:03:18,800 --> 00:03:25,180 towards the same level and that is what balances production across all industries 36 00:03:25,360 --> 00:03:31,410 to maximize the total value of production. If profit were higher in one industry than 37 00:03:31,590 --> 00:03:36,020 in another, that says that the output of that industry is worth more, therefore we 38 00:03:36,200 --> 00:03:41,950 should have more of that good. And that's exactly what the entry signal does and the 39 00:03:42,130 --> 00:03:47,830 same thing is true for exit. Let's discuss some implications of following these 40 00:03:48,010 --> 00:03:52,400 profit and loss signals. First, the elimination principle. 41 00:03:52,400 --> 00:03:58,295 Above normal profits are eliminated by entry and below normal profits 42 00:03:58,295 --> 00:04:03,000 are eliminated by exit. So resources are always tending to move 43 00:04:03,000 --> 00:04:05,768 towards an increase in the value of production 44 00:04:05,768 --> 00:04:11,000 and entrepreneurs here are key. It's entrepreneurs who move resources from 45 00:04:11,180 --> 00:04:17,610 unprofitable industries towards profitable industries. Another implication of this is 46 00:04:17,790 --> 00:04:23,962 that above normal profits are always temporary. To earn above normal profits, 47 00:04:23,962 --> 00:04:28,635 you've got to do something different. You have to innovate. 48 00:04:28,635 --> 00:04:33,110 Joseph Schumpeter, the great Austrian economist was very eloquent 49 00:04:33,110 --> 00:04:36,800 on the importance of innovation in a capitalist economy. 50 00:04:36,800 --> 00:04:40,050 He said in the textbooks we say what competition is. It's 51 00:04:40,230 --> 00:04:45,240 all about pushing prices down to average cost and creating normal profits. But in 52 00:04:45,420 --> 00:04:50,450 capitalist reality as distinguished from its textbook picture, the kind of 53 00:04:50,630 --> 00:04:55,130 competition that counts is competition from the new commodity, the new 54 00:04:55,310 --> 00:05:00,280 technology, the new source of supply, the new type of organization. Competition 55 00:05:00,460 --> 00:05:05,090 which strikes not at the margins of the profits and the outputs of the existing 56 00:05:05,270 --> 00:05:11,720 firms but at their very foundations and their very lives. This process of creative 57 00:05:11,900 --> 00:05:18,030 destruction is the essential fact about capitalism. Great statement from Joseph 58 00:05:18,210 --> 00:05:24,830 Schumpeter. Now the invisible hand is marvelous but it's not miraculous. The 59 00:05:25,010 --> 00:05:30,640 invisible hand works when we have certain institutions. It doesn't always work. In 60 00:05:30,820 --> 00:05:36,990 particular, the invisible hand will not work if prices do not accurately signal 61 00:05:37,170 --> 00:05:41,570 cost and benefits. If prices don't accurately signal cost and benefits, we 62 00:05:41,750 --> 00:05:46,010 won't get an optimal balance between industries. And later on when we come to 63 00:05:46,190 --> 00:05:51,550 talk about externalities, we'll present certain situations when prices aren't 64 00:05:51,730 --> 00:05:57,680 going to be signaling accurately. Second, the invisible hand works best when markets 65 00:05:57,860 --> 00:06:02,370 are competitive. When markets are not competitive, when we have monopoly and 66 00:06:02,550 --> 00:06:06,540 oligopoly, this isn't going to work as well and we'll be talking more about this 67 00:06:06,720 --> 00:06:10,090 in future chapters but you can get the right idea by thinking about the 68 00:06:10,270 --> 00:06:18,090 following. Monopolists and oligopolists will earn above normal profits but entry 69 00:06:18,270 --> 00:06:22,780 won't push those profits down. That's why they're monopolists and oligopolists 70 00:06:22,960 --> 00:06:29,030 because entry isn't working. Because those profits aren't pushed down, we'll have too 71 00:06:29,210 --> 00:06:34,380 little of that profitable good produced. We'll be talking more about this 72 00:06:34,560 --> 00:06:39,500 in future chapters. Again this is just a little bit of a reminder that the 73 00:06:39,680 --> 00:06:44,720 invisible hand requires a certain set of institutions in order for it to work. So 74 00:06:44,900 --> 00:06:50,350 just to summarize, invisible hand property one says that the P equals MC condition 75 00:06:50,530 --> 00:06:54,720 results in the minimization of total industry costs. Invisible hand property 76 00:06:54,900 --> 00:07:01,370 two is that entry and exits result in the best use of our limited resources. The 77 00:07:01,550 --> 00:07:06,900 elimination principle says that above normal profits are temporary and indeed to 78 00:07:07,080 --> 00:07:11,440 earn above normal profits a firm must innovate. And this is where the importance 79 00:07:11,620 --> 00:07:16,460 of creative destruction for a capitalist economy comes from. If you really want to 80 00:07:16,640 --> 00:07:20,910 profit a lot you've got to do something different. You've got to bring something 81 00:07:21,090 --> 00:07:24,220 new to the table. You have to bring in innovation. 82 00:07:24,400 --> 00:07:29,000 - [male voice] If you want to test yourself, click Practice Questions, 83 00:07:29,000 --> 00:07:35,700 or if you're ready to move on, just click Next Video.