WEBVTT 00:00:00.000 --> 00:00:05.620 ♪ [music] ♪ 00:00:09.090 --> 00:00:13.210 - [Alex] We turn now to the second of our invisible hand properties, 00:00:13.390 --> 00:00:20.160 the balance of industries. 00:00:20.160 --> 00:00:21.160 We're also going to look 00:00:21.160 --> 00:00:23.160 at the gales of creative destruction. 00:00:23.160 --> 00:00:24.580 Invisible hand property number one says 00:00:24.580 --> 00:00:27.580 that the production of any given quantity of a good 00:00:27.580 --> 00:00:32.479 will be allocated across the firms in that industry 00:00:32.659 --> 00:00:35.750 in a way that minimizes total costs. 00:00:35.750 --> 00:00:38.750 But the question is, how much should be produced 00:00:38.750 --> 00:00:39.750 in each industry? 00:00:39.750 --> 00:00:42.420 So invisible hand property number one says, 00:00:42.420 --> 00:00:43.670 if we're going to be producing 200 bushels of wheat 00:00:43.670 --> 00:00:46.820 then we could be rest assured 00:00:46.820 --> 00:00:49.010 that if we have a competitive market -- 00:00:49.010 --> 00:00:52.010 those 200 bushels will be allocated across the different firms 00:00:52.010 --> 00:00:54.980 in a way that minimizes total industry cost. 00:00:54.980 --> 00:00:55.980 But should we be producing 200 bushels of wheat, 00:00:55.980 --> 00:00:57.980 or 500 or 1000? 00:00:57.980 --> 00:01:04.110 How should wheat be compared with corn or automobiles or books? 00:01:04.290 --> 00:01:07.950 It's the second question 00:01:07.950 --> 00:01:10.950 about how the production of goods are balanced across industries 00:01:10.950 --> 00:01:17.230 that invisible hand property number two is all about. 00:01:17.410 --> 00:01:19.340 In order to maximize the value of resources, 00:01:19.340 --> 00:01:22.340 we want each industry to produce the right quantity, 00:01:22.340 --> 00:01:25.670 not too much wheat and not too little wheat, 00:01:25.670 --> 00:01:28.670 but just the right amount. 00:01:28.670 --> 00:01:32.970 And entry or exit is what ensures 00:01:32.970 --> 00:01:35.970 that labor and capital move across industries 00:01:35.970 --> 00:01:37.540 so the production is optimally balanced 00:01:37.540 --> 00:01:40.540 and the greatest use is made of our limited resources. 00:01:40.540 --> 00:01:45.870 And here to show this we actually don't need to use 00:01:46.050 --> 00:01:47.240 any more techniques, 00:01:47.240 --> 00:01:50.240 we just need to sort of reinterpret some of the things 00:01:50.240 --> 00:01:53.090 which we've already done. 00:01:53.090 --> 00:01:54.090 Let's take a look. 00:01:54.090 --> 00:01:56.090 Profit is the signal that allocates capital and labor across industries 00:01:56.090 --> 00:02:03.440 in just such a way that maximizes total value. 00:02:03.620 --> 00:02:04.930 So remember, if price is bigger than average cost, 00:02:04.930 --> 00:02:07.930 that means that profits are above normal. 00:02:07.930 --> 00:02:10.400 Now what does above normal profit mean? 00:02:10.400 --> 00:02:13.400 It means that the output of this industry 00:02:13.400 --> 00:02:15.362 is worth more than the inputs. 00:02:15.362 --> 00:02:18.362 The profit signal is saying we want more of this good. 00:02:18.362 --> 00:02:22.312 This good is worth more than the labor and capital 00:02:22.312 --> 00:02:26.441 being used to create this good, therefore produce more of it. 00:02:26.441 --> 00:02:32.120 So the profit signals and incentivizes capital and labor 00:02:32.300 --> 00:02:36.040 to enter this industry, 00:02:36.040 --> 00:02:39.040 that is to move from a low value industry 00:02:39.040 --> 00:02:41.600 to a high value industry. 00:02:41.600 --> 00:02:44.600 Similarly, if price is less than average cost, 00:02:44.600 --> 00:02:46.570 that means profits are below normal. 00:02:46.570 --> 00:02:49.570 That means that output in this industry 00:02:49.570 --> 00:02:54.960 is worth less than the inputs. 00:02:54.960 --> 00:02:57.960 So the loss signal is saying: we want less of this good. 00:02:57.960 --> 00:03:01.570 Loss signals and incentivizes capital and labor 00:03:01.570 --> 00:03:02.570 to exit the industry, 00:03:02.570 --> 00:03:04.570 that is to move from a low value industry 00:03:04.570 --> 00:03:09.460 where there are losses 00:03:09.460 --> 00:03:12.460 to a high or a higher value industry. 00:03:12.460 --> 00:03:15.800 Because of this entering and exiting, 00:03:15.800 --> 00:03:18.800 the profit rate in all competitive industries 00:03:18.800 --> 00:03:22.360 tends towards the same level. 00:03:22.360 --> 00:03:25.360 And that is what balances production across all industries 00:03:25.360 --> 00:03:28.590 to maximize the total value of production. 00:03:28.590 --> 00:03:31.590 If profit were higher in one industry than in another, 00:03:31.590 --> 00:03:36.020 that says that the output of that industry is worth more, 00:03:36.200 --> 00:03:39.130 therefore we should have more of that good. 00:03:39.130 --> 00:03:42.130 And that's exactly what the entry signal does 00:03:42.130 --> 00:03:45.010 and the same thing is true for exit. 00:03:45.010 --> 00:03:48.010 Let's discuss some implications 00:03:48.010 --> 00:03:49.400 of following these profit and loss signals. 00:03:49.400 --> 00:03:52.400 First, the elimination principle. 00:03:52.400 --> 00:03:58.295 Above normal profits are eliminated by entry 00:03:58.295 --> 00:04:00.000 and below normal profits are eliminated by exit. 00:04:00.000 --> 00:04:03.000 So resources are always tending to move 00:04:03.000 --> 00:04:05.768 towards an increase in the value of production 00:04:05.768 --> 00:04:08.180 and entrepreneurs here are key. 00:04:08.180 --> 00:04:11.180 It's entrepreneurs who move resources 00:04:11.180 --> 00:04:14.790 from unprofitable industries towards profitable industries. 00:04:14.790 --> 00:04:17.790 Another implication of this is that above normal profits 00:04:17.790 --> 00:04:20.962 are always temporary. 00:04:20.962 --> 00:04:23.962 To earn above normal profits, 00:04:23.962 --> 00:04:25.635 you've got to do something different. 00:04:25.635 --> 00:04:28.635 You have to innovate. 00:04:28.635 --> 00:04:33.110 Joseph Schumpeter, the great Austrian economist, 00:04:33.110 --> 00:04:34.110 was very eloquent on the importance of innovation 00:04:34.110 --> 00:04:36.800 in a capitalist economy. 00:04:36.800 --> 00:04:40.050 He said in the textbooks we say what competition is. 00:04:40.230 --> 00:04:42.420 It's all about pushing prices down to average cost 00:04:42.420 --> 00:04:45.420 and creating normal profits. 00:04:45.420 --> 00:04:47.630 But, “In capitalist reality 00:04:47.630 --> 00:04:50.630 as distinguished from its textbook picture, 00:04:50.630 --> 00:04:52.310 the kind of competition that counts 00:04:52.310 --> 00:04:55.310 is competition from the new commodity, 00:04:55.310 --> 00:04:57.460 the new technology, the new source of supply, 00:04:57.460 --> 00:05:00.460 the new type of organization… 00:05:00.460 --> 00:05:02.270 [competition] which strikes not at the margins 00:05:02.270 --> 00:05:05.270 of the profits and the outputs of the existing firms 00:05:05.270 --> 00:05:11.720 but at their very foundations and their very lives. 00:05:11.900 --> 00:05:15.210 This process of creative destruction 00:05:15.210 --> 00:05:18.210 is the essential fact about capitalism.” 00:05:18.210 --> 00:05:22.010 Great statement from Joseph Schumpeter. 00:05:22.010 --> 00:05:25.010 Now the invisible hand is marvelous but it's not miraculous. 00:05:25.010 --> 00:05:27.820 The invisible hand works when we have certain institutions. 00:05:27.820 --> 00:05:30.820 It doesn't always work. 00:05:30.820 --> 00:05:34.170 In particular, the invisible hand will not work 00:05:34.170 --> 00:05:37.170 if prices do not accurately signal cost and benefits. 00:05:37.170 --> 00:05:41.570 If prices don't accurately signal cost and benefits, 00:05:41.750 --> 00:05:46.010 we won't get an optimal balance between industries. 00:05:46.190 --> 00:05:48.730 And later on when we come to talk about externalities, 00:05:48.730 --> 00:05:51.730 we'll present certain situations 00:05:51.730 --> 00:05:54.860 when prices aren't going to be signaling accurately. 00:05:54.860 --> 00:05:57.860 Second, the invisible hand works best 00:05:57.860 --> 00:05:59.550 when markets are competitive. 00:05:59.550 --> 00:06:02.550 When markets are not competitive, 00:06:02.550 --> 00:06:03.720 when we have monopoly and oligopoly, 00:06:03.720 --> 00:06:06.720 this isn't going to work as well. 00:06:06.720 --> 00:06:10.090 And we'll be talking more about this in future chapters 00:06:10.270 --> 00:06:15.270 but you can get the right idea by thinking about the following. 00:06:15.270 --> 00:06:18.270 Monopolists and oligopolists will earn above normal profits 00:06:18.270 --> 00:06:19.960 but entry won't push those profits down. 00:06:19.960 --> 00:06:22.960 That's why they're monopolists and oligopolists -- 00:06:22.960 --> 00:06:26.210 because entry isn't working. 00:06:26.210 --> 00:06:29.210 Because those profits aren't pushed down, 00:06:29.210 --> 00:06:34.380 we'll have too little of that profitable good produced. 00:06:34.560 --> 00:06:39.500 We'll be talking more about this in future chapters. 00:06:39.680 --> 00:06:41.900 Again this is just a little bit of a reminder 00:06:41.900 --> 00:06:42.900 that the invisible hand requires a certain set of institutions 00:06:42.900 --> 00:06:44.900 in order for it to work. 00:06:44.900 --> 00:06:47.530 So just to summarize, 00:06:47.530 --> 00:06:50.530 invisible hand property one says that the P = MC condition 00:06:50.530 --> 00:06:54.720 results in the minimization of total industry costs. 00:06:54.900 --> 00:06:58.550 Invisible hand property two is that entry and exits result 00:06:58.550 --> 00:07:01.550 in the best use of our limited resources. 00:07:01.550 --> 00:07:06.900 The elimination principle says that above normal profits are temporary, 00:07:07.080 --> 00:07:08.620 and indeed to earn above normal profits 00:07:08.620 --> 00:07:09.620 a firm must innovate. 00:07:09.620 --> 00:07:11.620 And this is where the importance of creative destruction 00:07:11.620 --> 00:07:16.460 for a capitalist economy comes from. 00:07:16.640 --> 00:07:18.090 If you really want to profit a lot 00:07:18.090 --> 00:07:21.090 you've got to do something different. 00:07:21.090 --> 00:07:22.090 You've got to bring something new to the table. 00:07:22.090 --> 00:07:24.400 You have to bring in innovation. 00:07:24.400 --> 00:07:26.000 - [Narrator] If you want to test yourself, 00:07:26.000 --> 00:07:29.000 click “Practice Questions.” 00:07:29.000 --> 00:07:35.700 Or, if you're ready to move on, just click “Next Video.” 99:59:59.999 --> 99:59:59.999 ♪ [music] ♪