Chapter 15 - Chapter 15 The"Invisible Hand and the First...

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Chapter 15 The “Invisible Hand” and the First Welfare Theorem In Chapter 14 we combined all of the pieces of the consumer and producer models to arrive at a definition of market or industry equilibrium. 1 We saw how tastes and budget constraints result in individual output demand and input supply curves which, when added up, result in output market demand and input market supply curves. On the producer side, we similarly saw how production frontiers combine with prices to form individual firm supply and input demand curves that, when added up, result in short run market supply curves and input market demand curves. Furthermore, we saw how the entry and exit of firms results in long run market supply curves that differ from short run curves in goods markets. The individual demand and supply relationships were derived by considering how changing economic environments — i.e. changing input and output prices — would cause consumers, workers and firms to change their behavior. The economic environment itself, however, arises in equilibrium from the many individual decisions that are made in the economy, giving rise to equilibrium prices that consumers and producers in a competitive world take as given when they decide how to behave. The prices that arise in equilibrium therefore serve the purpose of coordinating the many individuals in the market, signaling to consumers how much they should consume, to workers how much they should work and to producers how much they should produce. No one plans this — it happens “spontaneously” as everyone in the economy simply tries to do the best he or she can. The resulting equilibrium is therefore sometimes referred to as a “spontaneous order” created by market forces. This insight that order can emerge without anyone planning it is quite remarkable in and of itself. What is even more remarkable, however, is that, under certain conditions, the spontaneous order generated in a decentralized market precisely mimics what a central planner might wish to implement if he knew everything there was to know about the individuals in the market. Put differently, not only do the incentives in a decentralized market generate a predictable equilibrium, but, under certain conditions, there is no way that the resulting situation could be altered to make some people better off without making anyone worse off. In the language we developed earlier in this book, the spontaneous order of the decentralized market is, under certain conditions, fully efficient. This chapter, and much of the remainder of the book, is devoted to demonstrating this 1 This chapter builds on Chapter 14 and uses the concept of marginal willingness to pay and consumer surplus introduced in Chapter 10.
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516 Chapter 15. The “Invisible Hand” and the First Welfare Theorem important result. We will demonstrate the conditions necessary for the result to hold as well as the real world conditions that might cause the result to break down making room for civil society or government institutions to improve upon the spontaneous order of the market.
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