225

In Chapter 7, we explained how the price system—the signaling and incentive system—solves the great economic problem of arranging our limited resources to satisfy as many of our wants as possible. We showed how markets connect the world in a great cooperative endeavor, and how price signals and the accompanying profits and losses create incentives for entrepreneurs to direct labor and capital to their highest value uses. Chapter 7 was a “big picture” view of markets. In Chapter 11, we took a closer look at firms and showed that to maximize profit, a firm wants to (1) produce the quantity such that P = MC, (2) enter industries where P > AC, and (3) exit industries where P < AC. In this chapter, we connect these two perspectives on markets.

We also return in this chapter to the invisible hand. Recall Big Idea Two from Chapter 1, namely the metaphor of the invisible hand. With the right institutions, individuals acting in their self-interest can generate outcomes that are neither part of their intention nor design but that nevertheless have desirable properties. In this chapter, we show exactly this: How the conditions for profit maximization under competition lead entrepreneurs to produce outcomes that they neither intend nor design but that nevertheless have desirable properties.

In particular, we show that the P = MC condition for profit maximization in a competitive market balances production across firms in an industry in just the way that minimizes the total industry costs of production. Second, we show that the entry (P > AC) and exit (P < AC) signals balance production across different industries in just the way that maximizes the total value of production.

226