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♪[music]♪

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- [Alex] We turn now to the second of our[br]invisible hand properties, the balance of

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industries. We're also going to look at[br]the gales of creative destruction.

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Invisible hand property number one says[br]that the production of any given quantity

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of a good will be allocated across the[br]firms in that industry in a way that

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minimizes total costs. But the question is,[br]how much should be produced in each

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industry? So invisible hand property[br]number one says, if we're going to be

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producing 200 bushels of wheat then we[br]could be rest assured that if we have a

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competitive market, those 200 bushels will[br]be allocated across the different firms in

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a way that minimizes total industry cost.[br]But should we be producing 200 bushels of

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wheat, or 500 or 1000? How should wheat [br]be compared with corn or automobiles or

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books? It's the second question about how[br]the production of goods are balanced

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across industries that invisible hand[br]property number two is all about. In order

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to maximize the value of resources, we[br]want each industry to produce the right

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quantity, not too much wheat and not too[br]little wheat, but just the right amount.

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And entry or exit is what ensures that[br]labor and capital move across industries

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so the production is optimally balanced[br]and the greatest use is made of our

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limited resources. And here to show this[br]we actually don't need to use any more

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techniques, we just need to sort of[br]reinterpret some of the things which we've

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already done. Let's take a look. Profit is[br]the signal that allocates capital and

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labor across industries in just such a way[br]that maximizes total value. So remember,

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if price is bigger than average cost, that[br]means that profits are above normal. Now

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what does above normal profit mean?[br]It means that the output of this industry

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is worth more than the inputs.[br]The profit signal is saying:

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we want more of this good.[br]This good is worth more

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than the labor and capital[br]being used to create this good,

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therefore produce more of it. So the[br]profit signals and incentivizes capital

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and labor to enter this industry, that is[br]to move from a low value industry to a

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high value industry. Similarly, if price[br]is less than average cost, that means

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profits are below normal. That means that[br]output in this industry is worth less than

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the inputs. So the loss signal is saying:[br]we want less of this good. Loss signals

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and incentivizes capital and labor to exit[br]the industry, that is to move from a low

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value industry where there are losses to a[br]high or a higher value industry. Because

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of this entering and exiting, the profit[br]rate in all competitive industries tends

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towards the same level. And that is what[br]balances production across all industries

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to maximize the total value of production.[br]If profit were higher in one industry than

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in another, that says that the output of[br]that industry is worth more, therefore we

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should have more of that good. And that's[br]exactly what the entry signal does and the

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same thing is true for exit. Let's discuss[br]some implications of following these

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profit and loss signals. First,[br]the elimination principle.

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Above normal profits are eliminated[br]by entry and below normal profits

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are eliminated by exit. So resources[br]are always tending to move

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towards an increase in [br]the value of production

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and entrepreneurs here are key. It's [br]entrepreneurs who move resources from

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unprofitable industries towards profitable[br]industries. Another implication of this is

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that above normal profits are always[br]temporary. To earn above normal profits,

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you've got to do something different.[br]You have to innovate.

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Joseph Schumpeter, the great Austrian[br]economist, was very eloquent

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on the importance of innovation[br]in a capitalist economy.

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He said in the textbooks we say [br]what competition is. It's

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all about pushing prices down to average[br]cost and creating normal profits. But, “In

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capitalist reality as distinguished from[br]its textbook picture, the kind of

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competition that counts is competition[br]from the new commodity, the new

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technology, the new source of supply, the[br]new type of organization…[competition]

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which strikes not at the margins of the[br]profits and the outputs of the existing

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firms but at their very foundations and[br]their very lives. This process of creative

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destruction is the essential fact about[br]capitalism.” Great statement from Joseph

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Schumpeter. Now the invisible hand is[br]marvelous but it's not miraculous. The

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invisible hand works when we have certain[br]institutions. It doesn't always work. In

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particular, the invisible hand will not[br]work if prices do not accurately signal

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cost and benefits. If prices don't[br]accurately signal cost and benefits, we

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won't get an optimal balance between[br]industries. And later on when we come to

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talk about externalities, we'll present[br]certain situations when prices aren't

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going to be signaling accurately. Second,[br]the invisible hand works best when markets

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are competitive. When markets are not[br]competitive, when we have monopoly and

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oligopoly, this isn't going to work as[br]well. And we'll be talking more about this

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in future chapters but you can get [br]the right idea by thinking about the

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following. Monopolists and oligopolists[br]will earn above normal profits but entry

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won't push those profits down. That's why[br]they're monopolists and oligopolists

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because entry isn't working. Because those[br]profits aren't pushed down, we'll have too

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little of that profitable good produced.[br]We'll be talking more about this

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in future chapters. Again this is just [br]a little bit of a reminder that the

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invisible hand requires a certain set of[br]institutions in order for it to work. So

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just to summarize, invisible hand property[br]one says that the P = MC condition

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results in the minimization of total[br]industry costs. Invisible hand property

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two is that entry and exits result in the[br]best use of our limited resources. The

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elimination principle says that above normal [br]profits are temporary, and indeed to

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earn above normal profits a firm must[br]innovate. And this is where the importance

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of creative destruction for a capitalist[br]economy comes from. If you really want to

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profit a lot you've got to do something[br]different. You've got to bring something

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new to the table. You have [br]to bring in innovation.

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- [Announcer] If you want to test[br]yourself, click “Practice Questions.”

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Or, if you're ready to move on,[br]just click “Next Video.”