lecture18 - The Invisible Hand Adam Smith argued that the...

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1 The Invisible Hand • Adam Smith argued that the workings of the market led to desirable social outcomes. • “Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self-love, and never talk to them of our own necessities but of their advantages.” Welfare Theorems • We have seen for a two-good, two-person exchange economy two welfare theorems: – First Welfare Theorem: Competitive equilibrium is Pareto optimal – Second Welfare Theorem: Any Pareto optimal outcome can be achieved as the outcome of a competitive equilibrium with suitable transfers. • It turns out these welfare theorems hold when production is allowed as well. Efficiency in Production • When considering an economy with production, we need to modify our notion of optimality. • An allocation of resources is efficient in production if no further reallocation would permit more of one good to be produced without necessarily reducing the output of some other good. Three Rules for Efficient Production • Each firm uses inputs in the “right” proportions. – The rate of technical substitution is the same for every good the firm produces. – This will be true if firms minimize costs. • Inputs are “correctly” allocated across firms. – The marginal physical product of any resource in production of a particular good is the same no matter which firm produces that good. – If this did not hold, those firms that were inefficient would have higher costs and would go out of business in a competitive equilibrium.
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