12 Key Elements of Economics 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.” Page 32

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 won the Nobel Prize for Economics in 1974. He called the market system a “marvel” since just one indicator—the price of a product—carries so much information that it guides buyers and sellers to make decisions that help both obtain what they want. 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 6

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.” Prices are not the product of human design in that no person plans the prices for the products of a country. Rather, prices are the result of human action but not human design.

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 It can be costly to gather this information. If we use politics then we gather the info through votes, if we use markets then we gather the info through prices

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 Key Elements of Economics 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 Consequences A 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? Stossel Micro Clip #1 – Opportunity Costs, Tradeoffs and Secondary Effects (4:48) - discuss example of requiring car seats for young children on airplanes leading to more deaths

Price Floors and Price Ceilings MARKET DISTORTIONS Price Floors and Price Ceilings Price cannot fall below a floor Price cannot rise above a ceiling

PRICE FLOOR P S Quantity Supplied is GREATER than Quantity Demanded. This leads to a SURPLUS. PF Pe D QD Qe QS Q 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 In this case the surplus is called UNEMPLOYMENT. Anything that causes a worker to cost more to employers will reduce employment – like mandated benefits.

PRICE CEILING P S Quantity Demanded is GREATER than Quantity Supplied. This leads to a SHORTAGE. Pe PC D QS Qe QD Q 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 ____________. Show Stossel Micro Clip #5 – Rent Control (5:00) More people will want to rent the apartments at the lower price. Less people will want to supply their apartments for rent at the lower price. Land lords will have the incentive not to fix any problems. 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! Applied Economics: Thinking Beyond Stage One – Thomas Sowell

If policymakers have good intentions Will their actions lead to desirable outcomes?