The Balance of Industries and Creative Destruction

Why are price signals and market competition so important to a market economy? When prices accurately signal costs and benefits and markets are competitive, the Invisible Hand ensures that costs are minimized and production is maximized. If these conditions aren’t met, market inefficiencies arise and the Invisible Hand cannot do its work. In this video, we show how two major processes, creative destruction and the elimination principle, work with the Invisible Hand to create a competitive marketplace that works for producers and consumers.

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- 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 that 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 cost.
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 equals MC condition

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

two is that entry and exits 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.

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