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

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the balance of industries.

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We're also going to look

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at the gales[br]of creative destruction.

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Invisible hand property[br]number one says

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that the production[br]of any given quantity of a good

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will be allocated[br]across the firms in that industry

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in a way that minimizes[br]total costs.

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But the question is,[br]how much should be produced

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in each industry?

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So invisible hand property[br]number one says

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if we're going to be producing[br]200 bushels of wheat

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then we could be rest assured

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that if we have[br]a competitive market,

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those 200 bushels will be allocated[br]across the different firms

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in a way that minimizes[br]total industry costs.

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But should we be producing[br]200 bushels of wheat,

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or 500 or 1000?

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How should wheat be compared[br]with corn or automobiles or books?

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It's the second question

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about how the production of goods[br]are balanced across industries

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that invisible hand property[br]number two is all about.

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In order to maximize[br]the value of resources,

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we want each industry[br]to produce the right quantity --

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not too much wheat[br]and not too little wheat,

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but just the right amount.

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And entry or exit is what ensures

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that labor and capital[br]move across industries

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so the production[br]is optimally balanced

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and the greatest use[br]is made of our limited resources.

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And here to show this[br]we actually don't need to use

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any more techniques,

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we just need to sort of reinterpret[br]some of the things

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which we've already done.

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Let's take a look.

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Profit is the signal that allocates[br]capital and labor across industries

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in just such a way[br]that maximizes total value.

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So remember, if price is bigger[br]than average cost,

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that means that profits[br]are above normal.

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Now what does[br]above normal profit mean?

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It means that the output[br]of this industry

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is worth more than the inputs.

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The profit signal is saying[br]we want more of this good.

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This good is worth more[br]than the labor and capital

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being used to create this good,[br]therefore produce more of it.

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So the profit signals[br]and incentivizes capital and labor

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to enter this industry,

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that is to move[br]from a low value industry

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to a high value industry.

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Similarly, if price[br]is less than average cost,

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that means profits[br]are below normal.

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That means that[br]output in this industry

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is worth less than the inputs.

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

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Loss signals and incentivizes[br]capital and labor

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to exit the industry,

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that is to move[br]from a low value industry

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where there are losses

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to a high[br]or a higher value industry.

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Because of this entering[br]and exiting,

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the profit rate[br]in all competitive industries

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tends towards the same level.

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And that is what balances production[br]across all industries

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to maximize the total value[br]of production.

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If profit were higher[br]in one industry than in another,

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that says that the output[br]of that industry is worth more,

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therefore we should have[br]more of that good.

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And that's exactly[br]what the entry signal does

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and the same thing[br]is true for exit.

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Let's discuss some implications

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of following these[br]profit and loss signals.

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First, the elimination principle.

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Above normal profits[br]are eliminated by entry

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and below normal profits[br]are eliminated by exit.

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So resources are always[br]tending to move

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towards an increase[br]in the value of production

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and entrepreneurs here are key.

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It's entrepreneurs[br]who move resources

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from unprofitable industries[br]towards profitable industries.

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Another implication of this[br]is that above normal profits

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are always temporary.

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To earn above normal profits,

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

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You have to innovate.

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Joseph Schumpeter,[br]the great Austrian economist,

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was very eloquent[br]on the importance of innovation

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in a capitalist economy.

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

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It's all about pushing prices[br]down to average cost

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and creating normal profits.

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But, “In capitalist reality

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as distinguished[br]from its textbook picture,

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the kind of competition that counts

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is competition[br]from the new commodity,

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the new technology,[br]the new source of supply,

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the new type of organization…

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[competition] which strikes[br]not at the margins

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of the profits and the outputs[br]of the existing firms

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but at their very foundations[br]and their very lives.

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This process of creative destruction

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is the essential fact[br]about capitalism.”

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Great statement[br]from Joseph Schumpeter.

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

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The invisible hand works[br]when we have certain institutions.

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It doesn't always work.

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In particular,[br]the invisible hand will not work

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if prices do not accurately[br]signal cost and benefits.

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

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we won't get an optimal balance[br]between industries.

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And later on when we come[br]to talk about externalities,

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we'll present certain situations

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when prices aren't going[br]to be signaling accurately.

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Second, the invisible hand[br]works best

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when markets are competitive.

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When markets are not competitive,

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when we have monopoly[br]and oligopoly,

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this isn't going to work as well.

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And we'll be talking more[br]about this in future chapters

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but you can get the right idea[br]by thinking about the following.

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Monopolists and oligopolists[br]will earn above normal profits

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but entry won't[br]push those profits down.

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That's why they're monopolists[br]and oligopolists --

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because entry isn't working.

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Because those profits[br]aren't pushed down,

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we'll have too little[br]of that profitable good produced.

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We'll be talking more about this[br]in future chapters.

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Again this is just[br]a little bit of a reminder

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that the invisible hand requires[br]a certain set of institutions

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in order for it to work.

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So just to summarize,

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invisible hand property one says[br]that the P = MC condition

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

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Invisible hand property two[br]is that entry and exit result

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in the best use[br]of our limited resources.

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The elimination principle says that[br]above normal profits are temporary,

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and indeed to earn[br]above normal profits

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a firm must innovate.

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And this is where the importance[br]of creative destruction

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for a capitalist economy comes from.

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If you really want to profit a lot

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

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You've got to bring[br]something new to the table.

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You have to bring in innovation.

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- [Narrator] If you want[br]to test yourself,

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click “Practice Questions.”

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

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