The Invisible Hand & Why Command Systems Fail

Mr. HenryAP Economics

Review 5 Fundamental Questions:• What will be produced?• How will the goods and services be produced?• Who will get the output?• How will the system accommodate change?• How will the system promote progress?

Equation:• Total Profits = Total Cost – Total Revenue• Total Cost = Presource * Qresource

• Total Revenue = Price * Qsold

• Table 2.1 ($15 worth of soap): If Bar Soap, Inc. sold 50 bars of soap daily at .25C each, would Bar Soap, Inc. continue to stay in business?

The “Invisible Hand”

• Adam Smith, in 1776, wrote The Wealth of Nations in which he noted that the operation of a market system creates a curious unity between private interests and social interests.

Self Interest• Self-interest is what induces responses appropriate to

the changes in society’s wants. Competition controls or guides self-interest such that self-interest automatically and quite unintentionally furthers the best interest of society.

The Market System:• Promotes the efficient uses of resources by guiding them

into the production of goods and services most wanted by society

• Encourages skill acquisition, hard work, and innovation. These are incentives because working harder leads to higher income which =‘s higher standard of living

• Allows for the freedom of enterprise and choice.

• As we will see in the spring, economists (Keynes, Friedman, Hayek) and politicians (Supply-Side vs. Demand-Side) alike have their viewpoints on how the market system should work

Why Command Systems Fail?

• Command systems face two major problems:A) Coordination ProblemsB) Incentive Problems

• Central planners have to coordinate millions of individual decisions by consumers, resource suppliers, and businesses.

• Because new products & inventions arise, planners would suppress product variety and focus on only 1 or 2 products.

• Managers and workers worried about quantity, not quality, targets. So distortions of what was made occurred.

• Example: Nails (tons of nails vs. # of nails) = (large nails produced vs. small nails produced)

• Because central planners determined the output, when they misjudged how many items to produce, there were persistent shortages and surpluses of goods.

• Managers had no incentive to adjust production levels in response to shortages and surpluses.

• There was no incentive to do better. A higher standard of living meant moving up the political hierarchy, not working harder.

• With the Market Economy, the economy flows in a continuous, repetitive flow of goods & services, resources, and money.

Labor, land, capital, entrepreneurial ability

The price of a new car

Review Questions1) Suppose industry A is realizing substantial economic profit. Which of the following best describes what will happen in this competitive market?A Firms will leave the industry and output will fall.B Firms will enter the industry and output will fall.C Firms will leave the industry and output will rise.D Firms will enter the industry and output will rise.

D Firms will enter the industry and output will rise.

2) According to the concept of the "invisible hand," if Susie opens and operates a profitable childcare center, then:

A government should regulate the business to ensure quality.B the profit Susie earns indicates that she is overcharging for her services.C she has served society's interests by providing a desired good or service.D this demonstrates that consumer sovereignty is not present in this market.

C she has served society's interests by providing a desired good or service.

3) In terms of the circular flow diagram, businesses obtain revenue through the _____ market and make expenditures in the _____ market.

A product; financialB resource; productC product; resourceD capital; product

C product; resource

4) Since World War II:

A North Korea's command economy has significantly outperformed South Korea's market economy.

B South Korea's command economy has significantly outperformed North Korea's market economy.

C North Korea's market economy has significantly outperformed South Korea's command economy.

D South Korea's market economy has significantly outperformed North Korea's command economy.

D South Korea's market economy has significantly outperformed North Korea's command economy.