Adam Smith and The Market Scot philosopher and originator of our concepts of capitalism Self interest as an incentive in economic decisions The concept of the invisible hand: that self interested decisions will, when taken together, result in a benefit to society. Developed the main theoretical underpinnings of captitalism.

Characteristics of the “pure” market Private ownership of private property Individuals and businesses own most of the private property (land and capital) a. right to negotiate binding contracts b. right to use and dispose of property 2. Private property rights encourage investment, innovation, exchange of assets, and economic growth.

Private Property cont. 3. Private property rights extend to intellectual property as well through the use of trademarks, patents, and copyrights.

Characteristic #2 B. Freedom of enterprise and choice exist 1. Freedom of enterprise: entrepreneurs and businesses have freedom to use resources, produce products of their choice, and to sell these in the markets of their choice

#2 cont 2. Freedom of choice: a. Owners of property and money resources can use these as they choose b. Workers can choose training, occupation and job of choice c. Consumers may spend income as they choose to best satisfy wants. This is known as “consumer sovereignty”.

Self Interest #3 C. Self – Interest 1. Self Interest is one driving force in market economies. Entrepreneurs attempt to maximize profit or minimize loss, consumers attempt to maximize satisfaction, resource suppliers attempt to maximize income. 2. As each attempts to maximize profit, satisfaction, or income, the economy will benefit if competition exists in the market place.

Competition #4 Competition 1. Large numbers of sellers mean no one single producer can control the price or market supply. 2. Large numbers of buyers mean no one single consumer or employer can control price or market demand 3. Generally, these conditions mean producers can enter or leave the market easily. Entry and exit with ease is a state of the pure/competitive market

Markets and Prices E. Markets systems announce the decisions of producers and buyers in the product and resource markets. Supply and demand graphs illustrate this A change in market price signals that a change of some kind has occurred in that market Those who respond to the signals will be rewarded with income or profit

Necessity of Technology and Capital Goods F. Competition, freedom of choice, self interest, and potential for profit provide the incentives for capital accumulation (invest-ment). Advanced technology and capital goods use roundabout efficient methods of production

Specialization G. Specialization results in efficiencies 1. People can take advantage of differences in ability and skill 2. People with identical skills may benefit from specializing and improving skills 3. Specialization saves time as people don’t have to shift from one task to another

Specialization cont 4. Geographic specialization is important: Regional and international specialization take advantage of localized resources. A caveat: Specialization does not necessarily mean that everyone will be able to take advantage nor does it imply that people will be happy to specialize. In industrial societies specialization may, in fact, be disincentivizing.

Use of Money as a Medium for Exchange Money substitutes for barter This requires coincidence of wants Willingness to accept money in place of goods allows 3 way trades ( or multiple trades)

Active but LIMITED government I. Markets tend to underproduce goods with social benefits and overproduce goods with social costs. Markets also tend toward monopoly and tend to become more unstable over time. Government can play a role in guiding market forces to avoid these issues.

Markets at Work The market is made up of billions of producers and consumers making trillions of decisions. All of whom are trying to maximize self interest It is a mechanism which provides consumers and producers a forum to respond to each other

Markets at Work The four fundamental questions of any economic system. Whether market or socialist or traditional all systems must satisfy these questions. 1. What g/s will be produced? 2. How will the g/s be produced? 3. Who will get the g/s? 4. How will the system accommodate change?

What will be produced? Business responds to consumers’ wants and desires in order to be profitable When business responds properly to these, profit and allocative efficiency will occur Economically, profit and income are the same. Profit must be received if a producer is going to continue to produce in an industry

What will be produced? Normal profits are the return to the producer that is necessary for him to continue to produce that product. Any revenue beyond normal profit is called pure or economic profit If an industry is producing pure or economic profit additional producers move into that industry. Supply will increase, prices will tend to decrease, reducing and eliminating economic profit for some producers

What will be produced? When this occurs and producers experience economic loss, some will leave the industry, contracting supply of that product, price will increase, and economic profit will return to that industry. Consumer sovereignty is also a key to determining the types and quantities of goods and services to be produced

What will be produced? Purchases will help determine which goods are wanted or desired and eliminate those which are not. This will determine what industries and firms are successful and which are not. Business must consider and match production choices with consumer choices or face loss and bankruptcy

How will goods and services be produced? The market encourages and rewards those who are achieving productive efficiency or what is called least cost production Least cost production: locating firms in optimum locale, considering all resources costs, and considering best technology and producing with these

How will goods and services be produced? The most efficient techniques will be the one that produces a given amount of output for the smallest input of resources when inputs and outputs are measured in money terms

Who will get the goods and services? This answer is related directly to the distribution of income in any economy Products will go to those able and willing to pay for them and to no one else Ownership of resources, productivity of resources, and relative supply of resources will determine income and the distribution of it. This is linked to the resource market as they determine income.

How will the market accommodate change? Markets accommodate change by using consumer taste and the guiding function of price An increase in D for some products leads to higher prices for those products A decrease in D for other products leads to lower prices for those products.

Accommodating change Increased D leads to higher prices that induce producers to make more of that product ( more output=more supply) Higher prices also encourage other firms to enter the industry accelerating the production of more output (supply) The opposite is true for lower prices and lowered D.

Tech Change and the Market Markets encourage change by rewarding technological innovation which allows lower production costs and the accumulation of capital by certain firms who do this. The spread of new techniques will lower pupc as well as price Creative Destruction: when new products and techniques destroy the market positions of firms who are not willing or able to adjust to the new conditions prevailing in the market.

The “Invisible Hand” Competition is the controlling mechanism of any market. It guarantees response to consumer wants and forces firms to adopt the most efficient manner of production As Smith said, this “invisible hand” promotes public interest through a primary focus on self interest. By attempting to maximize profit, firms will also produce those goods and services most wanted by society.