Question

Identify each of the following quotes as being an example of either: the coordination problem, the invisible hand, creative destruction, or the incentive problem. a. "If you compare a list of today's most powerful and profitable companies with a similar list from 30 years ago, you will sce lots of new entrics." b. "Managers in the old Soviet Union often sacrificed product quality and varicty because they were being awarded bonuses for quantitative, not qualitative, targets." c. "Each day, central planners in the old Sovict Union were tasked with sctting 27 million prices-correctly." d. "It is not from the bencvolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest".

Short answer

a. Creative destruction; b. Incentive problem; c. Coordination problem; d. Invisible hand.

Step-by-step solution

Identify Quote A

This quote is describing the entry and exit of firms in the market over time, highlighting new entries that manage to become powerful and profitable. This constant turnover exemplifies 'creative destruction,' which is the process where new innovations replace outdated companies or technologies.

Identify Quote B

The quote refers to managers receiving incentives for specific targets, which often results in poor product quality. This is known as the 'incentive problem,' where the wrong metrics lead to undesired outcomes.

Identify Quote C

This quote highlights the difficulty of central planners having to set millions of different prices accurately. This is an example of the 'coordination problem,' which describes the complexity of coordinating an entire economy's needs centrally.

Identify Quote D

The quote from Adam Smith discusses how individuals' self-interested actions lead to societal benefits, summarized by the concept known as the 'invisible hand.' This is where personal pursuits inadvertently promote the economic well-being of society.

Key concepts

Creative Destruction

Creative destruction is a powerful economic concept introduced by economist Joseph Schumpeter. It represents the dynamic process through which innovation and technological progress drive economic growth.
By introducing new products, services, or technologies, old businesses and models are often rendered obsolete. Imagine when smartphones began to replace traditional mobile phones, or how streaming services like Netflix knocked out DVD rental stores.
Creative destruction can seem harsh, as it involves the displacement of old industries and potential job loss. However, it is crucial for overall economic advancement as it encourages businesses to continually innovate and improve.
When we look at market turnover and how some companies thrive while others don't, we see creative destruction at play – pushing the economy towards efficiency and innovation.

Incentive Problem

An incentive problem arises when there is a disconnect between the goals of individuals or groups and the broader objective they are supposed to achieve.
For example, if a company's reward system emphasizes quantity over quality, employees might focus on producing more items rather than ensuring those items meet high standards. This can lead to poor-quality products reaching consumers, contrary to what the company ultimately desires.
Incentives need to be aligned correctly to ensure everyone works towards a common, beneficial goal. It's like when teachers focus solely on test scores rather than understanding and learning. It might increase grades temporarily, but doesn't guarantee real knowledge acquisition.
A well-designed incentive system can lead to improved productivity and quality, while poorly designed systems can encourage destructive shortcuts or errors.

Coordination Problem

Coordination problems appear when it's difficult to align all aspects of an economic system, especially in centralized economies. Picture this situation: central planners in an economy must decide countless interconnected prices daily.
This complexity often results in inefficiencies, as one central authority cannot effectively manage the intricate web of supply and demand across countless goods and services, ultimately leading to resource misallocation and production inefficiencies.
The Soviet Union serves as an example, where planners struggled with setting prices and producing enough goods due to an overwhelming number of variables to balance.
In contrast, decentralized economies rely on markets to self-regulate through the interaction of supply and demand, mitigating such coordination problems.

Invisible Hand

The invisible hand, a term coined by Adam Smith, describes how individuals pursuing their self-interest inadvertently benefit society as a whole.
This happens because people naturally seek to improve their living conditions by engaging in economic activities that cater to consumer demands.
Think of a baker who bakes bread to earn a living. The baker doesn’t donate bread out of a sense of charity but seeks to sell it, motivated by personal gain. Yet, in the process, the baker satisfies consumers’ need for bread, contributing to societal well-being.
The invisible hand highlights how decentralized decision-making by individuals in free markets can lead to the most efficient resource distribution, fostering economic growth and prosperity.