Robert Whaples and the Modern Principles

A blog on my teaching with Modern Principles of Economics by Tyler Cowen and Alex Tabarrok

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Competition and the Invisible Hand

Posted by Robert Whaples on October 1, 2009

Last Friday I gave the mid-term exam in my Intro to Econ course.  I graded the exams in a series of airports and Continental Airlines jets and returned them to my students on Monday.  The exam was hard, but the students did fairly well.

Yesterday we began chapter 10 of Cowen and Tabarrok, “Profits, Prices, and Costs under Competition,” which focuses on three key decisions that a firm must make: what price to set? (no brainer for these price takers), what quantity to produce?, and when to enter or exit an industry?  Teaching this chapter has been a bit of a struggle for me because it touches so lightly on the typical firm’s cost structure — there is not an average fixed cost curve or an average variable cost curve to be seen.  While the world doesn’t revolve around AVC or AFC curves and it’s easy enough to ignore them, I prefer not to because I think it’s useful for students to understand the difference between short-run and long-run decisions and to grapple with the idea that part of maximizing profits is minimizing losses — which may be in the form of producing at a loss or shutting down temporarily.  Thus, I approached the chapter with a twenty-five minute detour on MPL, APL, AVC, ATC, AFC, and MC before contemplating how a firm in a competitive industry will behave.  I present to students the two rules of profit maximization: Rule 1 — if the price is too low, shut down (if P < min AVC); Rule 2 — if the price is above this produce until MC is about equal to MR.

The great strength of this chapter is its ability to link profit-maximizing firms’ behavior and interaction back to the good of society, through Invisible Hand Property #1 (even though no actor in the market intends to do so, in a free market P = MC1 = MC2 = … MCn and as a result the total costs to society are minimized) and Invisible Hand Property #2 (entry and exit decisions not only work to eliminate profits, they work to ensure that labor and capital move across industries to optimally balance production so that the greatest use is made of our limited resources).  Translation for those who weren’t paying attention:  A market economy conserves resources and uses them wisely. Pursuing profits conserves resources and uses them wisely.  Do detractors of the market get this point?

There’s also a two-paragraph detour on Schumpeter, Creative Destruction and the need for entrepreneurs to innovate in order to earn above-normal profits.  Allocating a little more page space to this set of insights would be a great idea.

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