The Invisible Hand & Why Command Systems Fail

1. The Invisible Hand & Why Command Systems Fail Mr. Henry AP Economics

2. 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?

3. 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.

4. 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.

6. 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.

7. 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

8. Why Command Systems Fail? • Command systems face two major problems: • Coordination Problems • Incentive Problems

9. 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)

10. 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.

12. The price of a new car • With the Market Economy, the economy flows in a continuous, repetitive flow of goods & services, resources, and money. Labor, land, capital, entrepreneurial ability

13. Review Questions 1) 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.

14. 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.

15. 3) In terms of the circular flow diagram, businesses obtain revenue through the _____ market and make expenditures in the _____ market. A product; financial B resource; product C product; resource D capital; product C product; resource

16. 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.