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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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