We have shown in this chapter that competitive markets have some desirable “invisible hand” properties, but don’t forget that the invisible hand works only in certain circumstances. For the competitive process to work, for example, it’s important that prices accurately signal costs and benefits. But we already know from Chapter 10 on externalities that prices do not always accurately signal costs and benefits. We can now see from another perspective why this is a problem. If prices don’t accurately signal costs and benefits, then Invisible Hand Property 2 won’t work perfectly and there will not be an ideal balance between industries. We will get too few resources in some industries and too many resources in other industries.

Similarly, if markets are not competitive, then the invisible hand doesn’t work as well. We will be taking up the problem of monopoly in Chapter 13 and oligopoly (a few firms but not many) in Chapter 15, but we can point to the basic issue here. Monopolists and oligopolists earn above-normal profits. We know that if an industry earns above-normal profits, we would like resources to move to that industry, but without the pressure of the competitive process, not enough resources will move and profits will not be eliminated. We can see right away, therefore, that output will be too low in a monopoly or in an oligopoly.

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We will also be showing in Chapter 19 on public goods and the tragedy of the commons that for some types of goods, self-interest either doesn’t align with the social interest or sometimes it may align in the wrong direction. All this remind us of the basic point: Good institutions align self-interest with the social interest, but good institutions are sometimes hard to find or create.