11. The “invisible hand” of market prices directs buyers and sellers toward activities that promote the general welfare.12 Key Elements of Economics

Invisible What? Adam Smith, The Wealth of

Nations (1776) “It is his own advantage, indeed,

and not that of society which he has in his view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.”

What Is the Invisible Hand? The primary function

of markets is to provide information to buyers and sellers.

The invisible hand of market prices directs millions of self-interested individuals into cooperative action and brings their choices into line with each other.

Friedrich von Hayek(1899-1992)

The Magic of Markets

Prices: Market prices give us the

information needed to respond to the concerns of people all over the world and the motivation to do so

Prices are what coordinate all of the activities in the market

Friedrich von Hayek“I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do.”

Importance of Prices We need information in order to decide

what to do with our scarce resources

Producers need to know what consumers and other producers want

Consumers need to know what producers are willing to make and what other consumers want

Importance of Prices Information costs are the costs of

articulating or measuring the values that humans place on goods and services they desire from their limited resources and of knowing how one person’s actions impinge on the values of others

Importance of Prices Prices provide knowledge that is

complex, dispersed, and constantly updated

Information is time and place specific and can not be gathered in a single mind or group of minds

Importance of Prices

Prices provide information in a condensed form

Prices provide an incentive to act May or may not care about others, but

prices make you act “as if” you cared about others

Spontaneous Order Things constantly happen

spontaneously to make both consumer and producers better off through exchange.

When guided by market prices, self-interested individuals will move toward activities that will promote the general welfare.

This occurs without any central planning.

The Process of Price Determination

“The product of human action, but not of human design.” – Adam Ferguson (1767), An Essay on the History of Civil Science

12. Too often long-term consequences, or the secondary effects, of an action are ignored.

12 Key Elements of Economics

Secondary Effects or Long Range ConsequencesA person“…must trace not merely the immediate

results but the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone.”

- Henry Hazlitt [1979]Economics in One Lesson

Unintended Consequences

“If we require seatbelts at 55mph why not at 550mph?”

What would happen if we required car seats on airplanes?

Price Floors and Price Ceilings

Price cannot rise above a ceiling

Price cannot fall below a floor

MARKET DISTORTIONS

P

Q

S

D

Pe

Qe

PRICE FLOOR

PF

QSQD

Quantity Supplied is GREATER than Quantity Demanded. This leads to a SURPLUS.

The price is not allowed to go below the price floor. The price never reaches equilibrium.

Example

Minimum wage set above equilibrium Higher price will have what effect on

prospective demanders? Higher price will have what effect on

prospective suppliers? Price above market clearing price will

cause a ____________. SURPLUS

P

Q

S

D

Pe

Qe

PRICE CEILING

PC

QS QD

Quantity Demanded is GREATER than Quantity Supplied. This leads to a SHORTAGE.

The price is not allowed to go above the price ceiling. The price never reaches equilibrium.

Example

Maximum rent on apartments set below equilibrium

Lower price will have what effect on prospective demanders?

Lower price will have what effect on prospective suppliers?

Price below market clearing price will cause a ____________. SHORTAGE

Rent Controls

Intended purpose: Cheaper rental housing.

Unintended secondary affects: less investment in rental housing, fewer rental units available in the future, decline in the maintenance and quality of rental units, more difficult to find rental housing.

Price Controls - The Message

Price controls distort market incentives

They can not change the relative scarcity of the product

They cause over allocation or under allocation of resources

They cause arbitrary distributive effects

But they are great politics!

If policymakers have good intentions

Will their actions lead to desirable outcomes?