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See the Invisible Hand Understand Your World Tyler Cowen and Alex Tabarrok The Romance Roses in February in Chicago. Quite incredible. Where do the Roses come from? Not from nearby greenhouses! Bloemenveiling photo by Wilfried Overwater. Markets are Cooperative A rose is a truly international product. The market for roses links romantic Americans with South American flower growers, Dutch clocks, Finnish cell phones, Colombian coffee (to keep the pilots awake) and much more. Hundreds of thousands of people from Ecuador to Chicago cooperated to bring the rose to our handsome young man and they did so voluntarily, on the basis of self interest, and without central direction - this is the invisible hand in action. Markets are Creative When oil was cheap roses were grown in heated greenhouses in NY and PA. A rising price of oil in the 1970s was a signal to entrepreneurs to look for ways to use less oil so they could reduce the costs of growing roses. Entrepreneurs discovered that transporting millions of roses thousands of miles was cheaper and greener (!) than growing them locally so rose production moved to Ecuador, Colombia, Kenya, Thailand and other countries with warmer climates. Markets are Connected Markets are connected in a complex web. When one price changes every other price responds as entrepreneurs recalculate and reconfigure to help solve the “great economic problem” of producing as many valuable goods as possible from our limited resources. Map of the World Wide Web (Barrett Lyon OPTE Project) Modern Principles: The Rose The rose is a symbol of worldwide cooperation. The story of the rose demonstrates the power of trade and the creativity of entrepreneurs as they respond to the dual role of prices as signals and incentives. The rose illustrates the invisible hand – how markets generate cooperation and coordination around the world. Through the operation of prices and the invisible hand we see coordination across people and markets. What happens when the invisible hand is not allowed to operate? The Economics of Price Controls Teaching Principles with Economic History On a quiet Sunday in August of 1971, President Richard Nixon shocked the nation by freezing all prices and wages in the United States. It was now illegal to raise prices--even if buyers and sellers voluntarily agreed to the change. Nixon’s order…was supposed to hold for only 90 days, it would have lasting effects for over a decade. Price Controls 1. Shortages 2. Reductions in product quality. 3. Wasteful lines and other search costs 4. Loss of gains from trade 5. Misallocation of resources Shortages • Price controls under Nixon led to shortages of wool, copper, aluminum, vinyl, denim, paper, plastic and more. A shortage of vinyl in 1973 forced Capitol Records to melt down slowsellers so they could keep pressing Beatles’ albums. Econ p. 132, Micro p.132, Macro p.66 Price Controls and Shortages When the quantity demanded exceeds the quantity supplied someone is going to be disappointed. p. 134 Econ, p. 134 Micro, p. 68 Macro. Price Controls Reduce Quality • Price controls create shortages: Buyers are scrambling to get more at the controlled price -> Sellers have more customers than they need (or want). • Sellers can reduce quality, cut costs, and still sell all their units. • Full-service gas stations stopped operating. • 2’’ by 4’’ lumber shrank to 1 5/8’’ by 3 5/8’’. • To help deal with the shortage of paper some newspapers switched to a smaller font size. • The Great Matzoh Ball Debate The Great Matzoh Ball Debate Econ p.133, Micro p. 133, Macro p. 67 Price Controls and the Misallocation of Resources The Role of Prices A Price is a Signal Wrapped Up in an Incentive Seeing the “Invisible Hand” throughout Principles of Economics The True Importance of the P=MC Condition of Profit Maximization How to Minimize the Total Costs of Corn Production Across Two Farms Farm Two Farm One MC1 $ Increase in Costs Savings C = A-B $ Decrease in Costs MC2 $200th unit C A B 0 25 Quantity (Bushels of Corn) Cost of Producing 200th Unit 175 200 Quantity (Bushels of Corn) To Minimize Total Costs Set MC1=MC2 Farm Two Farm One MC1 $ $ MC2 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) Pat Sets P =MC1 , Alex sets P =MC2 A Much More Difficult Problem as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn $2.50 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) Pat Sets P =MC1 , Alex sets P =MC2 as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) Pat Sets P =MC1 , Alex sets P =MC2 as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) Pat Sets P =MC1 , Alex sets P =MC2 as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) The True Importance of the P=MC Condition is P=MC1=MC2 …=MCN Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn $2.50 0 40 Quantity (Bushels of Corn) 160 Quantity (Bushels of Corn) Institutions and the Invisible Hand • The invisible hand does not operate in a vacuum. It is a product of institutions such as: Property Rights. Competitive and Open Markets. A Dependable Legal System. Honest Government. Political Stability. A Natural Experiment • Let’s compare two countries with the same culture, the same people, and the same history but one of these countries has none of the institutions necessary for the invisible hand to operate and one of them has all of them (at least to some degree.) Institutions and the Invisible Hand • The invisible hand does not operate in a vacuum. It is a product of institutions such as: Property Rights. Competitive and Open Markets. A Dependable Legal System. Honest Government. Political Stability. Property Rights and the Free Rider Problem • In 1949, the Communists under Mao abolished private property in China. • In the “Great Leap Forward” (1958-61) farmers were put to work on collectives of up to 5,000 families. • The result was mass starvation. The Heroes of Xiaogang Village • In 1978, farmers from 18 households in Xiaogang Village risked their lives by secretly ending land communism. • The villagers divided the collective land by household. Each household would deliver a quota to the government but they would keep whatever remained. • A clause in their secret contract translates “If any word about this is divulged and one of us is put in prison, other team members shall share the responsibility to bring up his child till he or she is 18.” Farmers from 18 households signed a secret life-and-death agreement with their thumb prints. China Today. The Second Chinese Revolution • Under the “household responsibility system” output in Xiaogang village increased by a factor of 6. • The household responsibility system spread rapidly and by 1982 became the official system. • China’s second revolution had begun. A sculpture in Xiaogang Memorial Hall commemorating the secret beginning of China's rural reform. China is Growing Fast 2000 4000 6000 Real GDP Per Capita, 1952-2004 0 1978 1950 1960 Source: Penn World Tables 1970 1980 Year 1990 2000 Sometimes the Invisible Hand Isn’t Invisible it’s Absent • If you can see the invisible hand you can also see when it is absent. • A better understanding of the invisible hand creates a better understanding of the conditions required for the invisible hand to operate. What Signal is Being Sent? What Incentives? Corollary: A Price is a Signal Wrong Price→Wrong Signal Wrapped Up In an →Wrong Incentive Incentive Seeing the Invisible Hand Worldwide cooperation and coordination. The importance of the price system. The dual role of prices as signals and as incentives. The many effects of price controls. The minimization of the total costs of production as a result of profit maximization. A product of human action but not of human design! The operation of the invisible hand depends on institutions. Seeing the invisible hand also means seeing when it is absent. Teaching the Invisible Hand SeeTheInvisibleHandResourceBank.com • Videos, powerpoints, experiments, and blog posts that are especially relevant to teaching principles of economics. Keyed to chapters in MP but useable by anyone. E.g. for this lecture: • Aalsmeer Flower Market. • Nixon’s Price Controls and Drowning Chickens. • The Secret Agreement that Revolutionized China See the Invisible Hand Understand Your World Tyler Cowen and Alex Tabarrok