1. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. People respond to incentives. Here’s what Adam Smith said: u It is not from the benevolence of the butcher, the brewer, and the baker that we expect our dinner, but from their regard to their own self interest.

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Markets are usually a good way to organize economic activity. Adam Smith observed that households and firms interacting in markets act as if they are guided by an “invisible hand.”

3. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Here’s how Adam Smith put it: n …every individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…He intends only his own gain, and he is … led by an invisible hand to promote an end which was no part of his intention.

4. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Markets are usually a good way to organize economic activity. u Households and firms look at prices when they decide what to buy and sell. They thus take account of the social costs of their actions. u Prices [usually] guide individuals to do things that maximize the welfare of society as a whole.

5. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Problem 4.13: Bakery With Limited Capacity

6. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Problem 4.13: Guiding Decentralized Decisions Using Price Signals n When bakery capacity is limited to 300 loaves, the value of a unit of incremental capacity is $.60 n Suppose the bakery is organized in two divisions: äBakers of tourist bread äBakers of local bread n Suppose the Bakery itself can charge these divisions for their use of limited capacity äSince capacity is worth $.60 per loaf at the margin, that’s the appropriate charge

7. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Problem 4.13: Guiding Decentralized Decisions Using Price Signals n When each division is charged $.60 per loaf of bakery capacity that it utilized, in addition to the $1.20 cost of labor and ingredients, it acts as though its marginal cost is $1.20 +.60 = $1.80. n Each division now independently maximizes its profit in view of its marginal revenue and its augmented marginal cost. n Each division independently decides to produce what the central administration would otherwise order it to produce

8. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.