MGT Notes

Reference, ‘Principles of Economics,’ by N. Gregory Mankiw, 3e, Pg 9

A Market economy can be defined by contrasting it with a ‘Centrally Planned’ economy, wherein the decisions of a central planner are replaced by the decisions of an economy’s firms and households. Firms decide who to hire and what to make. Households decide which firms to work for and what to buy with their incomes. Thus, firms and households interact in the marketplace where prices and self-interest guide their decisions.

One may argue that since no one is looking out for the economic well-being of society as a whole and everyone is interested in their own well-being, this system is flawed. Adam Smith gave us the term ‘invisible hand,’ which stands for an instrument that guides firms’ and households’ interactions to achieve desirable outcomes that maximize the well-being of society. Prices are the instruments with which the invisible hand directs economic activity. Since the value of goods and services to society as well as the cost of making it are reflected in the price, markets unknowingly take social benefits into account while participating in the economy. In this way, prices are free to respond to market forces.