See the Invisible HandUnderstand Your

WorldTyler 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. Shortages2. Reductions in

product quality.3. Wasteful lines and

other search costs4. Loss of gains from

trade5. 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 slow-sellers 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 SignalWrapped Up

in an Incentive

Seeing the “Invisible Hand” throughout

Principles of Economics

The True Importanceof the

P=MC Condition of Profit Maximization

A

How to Minimize the Total Costs of Corn Production Across Two Farms

Increase in Costs

SavingsC = A-B Decrease

in Costs

$200th unit

Cost of Producing 200th Unit

MC1

Quantity(Bushels of Corn)

0 25

$

Farm One

MC2

Quantity(Bushels of Corn)

200175

$

Farm Two

C

B

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Farm One Farm Two

To Minimize Total Costs Set MC1=MC2

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

A Much More Difficult Problem

$2.50 Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets P =MC1 , Alex sets P =MC2

as a result MC1=MC2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

The True Importance of the P=MC Condition is P=MC1=MC2 …=MCN

Price of Corn

$2.50

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.

ü

ü

ü

ü

ü

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.

ü

ü

ü

ü

ü

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.

1978

02

000

400

06

000

Re

al G

DP

Per

Ca

pita

1950 1960 1970 1980 1990 2000Year

Source: Penn World Tables

Real GDP Per Capita, 1952-2004

China is Growing Fast

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:Wrong Price→Wrong Signal

→Wrong Incentive

A Price is a Signal Wrapped Up In an

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 HandSeeTheInvisibleHandResourceBank.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 HandUnderstand Your

WorldTyler Cowen and Alex Tabarrok