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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- [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 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 = 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.

- [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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