Profits, Entry and Exit: the Basis for the 'Invisible Hand - The 'invisible hand' theory

4 important questions on Profits, Entry and Exit: the Basis for the 'Invisible Hand - The 'invisible hand' theory

In the free-enterprise system, market prices serves two important and distinct functions:

  • Rationing function of price = to distribute scarce goods to those consumers who value them most highly
  • Allocative function of price = to direct resources away from overcrowded markets and towards markets that are undeserved

The 'invisible hand' theory of Adam Smith is:

The theory that the actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources.

Two attractive features of of the invisible hand concept are:

  1. The market outcome is efficient in the long run (price equals marginal costs).
  2. The price buyers must pay is no higher than the cost incurred by suppliers.
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The allocative function of price cannot operate unless firms can enter new markets and leave existing ones at will. Barriers to entry are:

Any force that prevents firms from entering a new market.

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