Chapter 12: Competition and the Invisible Hand

Invisible hand property 1

the P = MC condition balances production across firms in a way that minimizes total industry costs of production

Invisible Hand property 2

Entry and exit signals balance production across different industries in a way that maximizes the total value of production

Minimization of total industry costs of production

to maximize profits, each firm adjusts its output until P = MC

Thus, in a competitive market with N number of firms, P = MC1 = MC2 = … = MCN

results in minimizing total costs for the industry

Overview of Balance of industries

• competitive markets ensure that the right amount of a good is produced

• entrepreneurs seek profit and avoid losses

• profit is a signal that labor and capital are being used productively in satisfying wants

• profit seeking aligns with the social incentive to move labor and capital out of low value industries and into high value industries

Resources flow from low profit to high profit industries

• if P > AC, profits are above normal, causing capital and labor to enter the industry

• If P < AC, profits are below normal, causing capital and labor to exit the industry

• the profit rate of all competitive industries tends toward the same level

Under Balance of industries

the total value of all production is maximized (allocative efficiency)

Elimination Principle

above normal profits are eliminated by entry and below normal profits are eliminated by exit

Implication of the elimination principle

• above normal profits are temporary

• to earn above normal profits, entrepreneurs must innovate

• competition is about innovating

• above normal profits are constantly being eliminated by competition

• new sources of profit are constantly being created through innovation