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11. The “invisible hand” of market prices directs buyers and sellers toward activities that promote the general welfare.12 Key Elements of Economics
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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.”
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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)
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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
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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.”
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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
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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
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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
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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
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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.
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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
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12. Too often long-term consequences, or the secondary effects, of an action are ignored.
12 Key Elements of Economics
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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
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Unintended Consequences
“If we require seatbelts at 55mph why not at 550mph?”
What would happen if we required car seats on airplanes?
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Price Floors and Price Ceilings
Price cannot rise above a ceiling
Price cannot fall below a floor
MARKET DISTORTIONS
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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.
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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
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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.
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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
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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.
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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!
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If policymakers have good intentions
Will their actions lead to desirable outcomes?