Chapter 12 ECON

Notice that profits encourage entry, but what happens to price and profits when firms enter an industry?

As firms enter, supply increases and the price declines, which reduces profits. Losses encourage exit, but what happens to price and profits when firms exit an industry? As firms exit, supply decreases and the price increases, which increases profit (reduces losses). Thus, there is a tendency for the profit rate in all competitive industries to go to zero (normal profits).

elimination principle

Above-normal profits are eliminated by entry and below-normal profits are eliminated by exit The elimination principle says that above-normal profits are temporary. Great ideas are soon adopted by others; they diffuse throughout the economy and become commonplace—and no one profits from the commonplace. Since no one profits from the commonplace, to earn above-normal profits an entrepreneur must innovate. serves as both a warning and an opportunity to entrepreneurs. Stand still and fall behind. Leap ahead and profits may follow. In a dynamic economy, there is a constant dance between elimination and innovation. Above-normal profits are constantly being eliminated by competition, and new sources of profit are constantly being created through innovation.

in a competitive market with N firms, the following will be true

P=MC1=MC2=...=MCN where MC1 is the marginal cost of firm 1, MC2 is the marginal cost of firm 2, and so forth Put these two statements together and it follows that the way to minimize the total costs of production is to produce just so much on each farm so that the marginal costs of production are equalized, MC1=MC2

Economist Joseph Schumpeter

[But] in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization ... competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. . . . This process of Creative Destruction is the essential fact about capitalism

Invisible Hand Property 1 says that

even though no actor in a market economy intends to do so, in a free market P=MC1=MC2=...=MCN and, as a result, the total industry costs of production are minimized.

in a dynamic economy,

resources are always moving toward an increase in the value of production entrepreneurs listen to price signals and they move capital and labor from unprofitable industries to profitable industries

So, in a competitive market,

the incentives that entrepreneurs have to seek profit and avoid losses align with the social incentive to move labor and capital out of low-value industries and into high-value industries.

if markets are not competitive

the invisible hand does not work perfectly