V 654: The Rationales for Contracting and Privatization

The Invisible Hand: The Idealized Competitive Model

The Preference for Private Sector Solutions Over the last decade the use of the private

sector has become the standard policy option.

The preference for private sector solutions often relies on arguments about the advantages of the market.

Terms such as “the invisible hand” and the “marvel of the market” underscore the idea that the market is a self-regulating magical mechanism…

The Invisible Hand The term was coined by Adam Smith in 1776

(A Theory of Moral Sentiments; Wealth of Nation).

It describes the self- regulating nature of the market.

The “marvel of the market” is a short-hand argument against government intervention and/or government coercion (e.g. Milton Friedman of the University of Chicago).

According the argument, the invisible hand is capable (by itself) of efficiently allocating resources in society.

The Invisible Hand The main factors that drive the efficiency of

the market are self-interest and competition.  

This is the founding justification for the economic philosophy of laissez faire.

To understand why the market works so well we start with the properties of the idealized competitive market.

The Idealized Competitive Market

Has large numbers of profit maximizing firms and utility maximizing consumers (many sellers/ producers and many buyers)

The buyers and sellers are motivated by self-interest- Economists would say producers want to maximize profit and consumers want to maximize their utility.

The self-interested behaviors of these economic actors lead to patterns of consumption and production that are efficient.

Efficiency The term “efficiency” has a special meaning in

economics. The idea is that the idealized competitive market is

always moving toward a “Pareto efficient” allocation of goods.

Pareto Optimality:This strict criterion of efficiency is met when a system

allocates resources in such a way that no further reallocation of goods can increase any individual’s utility without diminishing the utility of others.

A given policy is Pareto efficient in this strict sense if it increases the well-being of at least one individual without diminishing that of others.

Keep in mind- There are other ways to judge outcomes. Even if the market, when working perfectly, is Pareto efficient, the question arises: Is this the outcome that is most important?

Efficiency – The Simple Model Each individual has a utility (one’s perception

about what’s needed for his/her own well-being).

More utility implies more well-being.People maximize their well-being by using their

incomes to purchase goods and services they believe give them the greatest utility.

We assume the more of any good you get, the more utility you get –up to a point. (Utility declines once an additional unit does not provide more value).

People also sell labor and land- these are inputs for producers.

Efficiency – The Simple Model There are also assumptions about producers and

production.Firms attempt to maximize profits by buying inputs to

produce goods for sale. They use technology to convert inputs to outputs.They make decisions based on the cost to produce. They behave competitively in the sense that they

cannot change the price of factor inputs by their individual actions.

Resources/ inputs are needed to produce each unit of output. At a point, an additional unit of output requires at least as many inputs to produce as the preceding unit.

The Equilibrium Outcome In a simple world, a set of prices arises that

distributes factor inputs to firms and goods to persons in such a way that it is not possible for anyone to find a reallocation that would make at least one person better off without making at least one person worse off.

This is a Pareto efficient allocation. A Pareto efficient allocation of goods and services

always maximizes social (consumer and producer) surplus.

Simply put, the net benefit to both consumers and producers is highest when the market is working.

But markets are not always efficient …The question becomes, under what

conditions do either consumers or producers get more or less ?

What conditions produce more goods or services than needed?

What conditions produce higher than optimal prices?

What factors disturb the self-regulating nature of the market?

Next Next we will look at the counter argument:

The market, under certain conditions, fails. Market failure is a concept within

economic theory wherein the allocation of goods and services by a free market is not efficient.

Market failures can be viewed as scenarios where the pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view

Additional SourcesWeimer, David and Adrian Vining. 2005.

Chapter 4 in Policy Analysis Practice and Concepts 4th edition. Upper Saddle River, NJ: Pearson.

For an overview of the history of general equilibrium theory, Weintraub, Roy E. 1983. “On the Existence of a Competitive Equilibrium: 1940-1954,” Journal of Economic Review 21(1): 1-39.