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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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