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The market allocates resources

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Published: Mon, 5 Dec 2016

Introduction

The market allocates resources efficiently by the price system. The “invisible hand” of Adam Smith is a system of prices, which will promote the producers and consumers making their own decision. Consumers make purchase decisions on the basis of “utility maximization” while producers make marketing decisions according to the principle of “profit maximization”. Based on the changes in prices, the markets guide resources toward the most efficient aspects of allocation between supply and demand.

Chandler (1977) presented that the enterprise’s internal administration and coordination as the “visible hand” was replacing the “visible hand” of market mechanisms. With the rise of modern business enterprise and its managers, the large modern enterprise was gradually replaced the small traditional family firm and was taking over the coordination function of economy activities and resource allocations, as well as its management team were becoming the most influential group of economic decision makers.

Actually, the “visible hand” is not a denial of the “visible hand”. The effect of both “invisible hand” and “visible hand” is conditional. Therefore, the “visible hand” was not completely replacing the “visible hand”; it was a kind of supplement and development of the “invisible hand” from the perspective of administrative coordination.

How effective the market allocates resources

For market, the price system is the coordinating device that takes care of allocation. Price, which makes balance between the consumers’ demands and the producers’ supply, is achieved through interaction in the market. The process of market interaction is what we call the “invisible hand”.

Demand and supply affect the market interaction. On one hand, consumer’s demand for a commodity depends on its price to a large extent. The total demand will go up if the price goes down. This is the rule of demand. On the other hand, the total supply of goods is also determined by its price. The total supply will go up if the price goes up. This is the law of supply.

Figure 1 illustrates that when a commodity oversupply and the price will drop, on the contrary, it will stimulate consumption, so that increase the demand. Besides, it will inhibit the production, hence reduce the supply. Market equilibrium occurs when the supply curve and demand curve meet. The meeting point of supply and demand needs to be achieved through price adjustments. At this time, resources will be allocated in a variety of purposes through price. The market will out of equilibrium no matter supply excess demand or demand overrun supply. The price will then be adjusted until equilibrium comes back.

However, the “invisible hand” is not a panacea. In real life, the market has its limitation in allocating resources. The “invisible hand” of market can be effectively only in the perfectly competitive market. Public goods, externality, monopoly, market control lag, as well as the unbalanced information may lead to the disorder and chaos of the market economy. For example, according to statistics from “Sina Finance”, there were 80 big department stores in 2005 in Beijing. A Beijing person’s average purchasing power was one- third of a person’s buying power in Tokyo, while the number of large shopping malls was 8 times greater than it in Tokyo. This Phenomenon made a general decline in department stores’ economic benefits, thus malls closed down one after another. It shows that market has a certain degree of blindness and the market mechanism does not always achieve their ideal state.

The management was affecting the economy as a “Visible Hand”

Chandler posed the “Visible hand” of management, which was playing an ever-increasing key role in the allocation of resources. Today, the companies are not the small workshops anymore in the time of Adam Smith. Modern business enterprises were replacing small traditional enterprises. Some of them can be as rich as a country, which have great powers to directly affect national economy and even politics; moreover, they may make sense to the relationships between countries as well. The company’s management was playing a significant impact on the allocation of resources.

Chandler indicates that before the rise of the modern enterprise, the small personally owned and managed firm was a single-unite firm, which charges a single economic function and operating a single product line in one location. Thus the activities of these small traditional enterprises were coordinated and controlled by market and price system. In contrast, most of the modern business enterprise is multi-unit enterprise, which has its own administrative office, handles various types of products and services and operates diverse types of economic activities in different areas. Therefore the activity of these unites and transactions between them were internalized. They were coordinated and controlled by salaried managers rather than market mechanisms.

As some propositions which Chandler mentioned in “The Visible Hand” (1977), can provide that the “visible hand” of management coordination was replacing the “invisible hand” of market mechanisms.

Fist of all, small traditional business will replaced by modern multiunit business when administrative coordination allowed lower costs, greater productivity, and higher profits than coordination by market mechanisms. Modern enterprises interiorized the transactions, which transacted between some business units before. This internalization may reduce transaction costs and information costs, improve productivity, provide a more stable cash flow and thus reduce costs to improved profits.

Secondly, only by forming a formal managerial hierarchy can the advantages of the internal activities of many business units be created. In modern business enterprises, middle managers control and coordinate the production and distribution in the company. Meanwhile, top managers are not only evaluate and coordinate with the intermediate managers, but also replaced the market for future production and distribution of resource allocation.

Thirdly, the management system promotes the company’s specialization and sustainable development. The majority of the traditional enterprises are partnerships and family firms, which were always short-lived. In contrast, management hierarchy allows the functions of company be maintained even the staff turnover and makes the salaried managers becoming more professional through various formal trainings. The managerial authority and ownership of enterprise can be divided when the business scale and the scope of operational diversity of business developed to a certain level, meanwhile the manager become more and more professional

From the viewpoint of Chandler, to manage and coordinate this ‘visible hands’, compared to the ‘invisible hands’, could not only bring huge productivity and profits, but also enhance the competitiveness of capital. Thus, it could largely promote the productivity and consumption which caused by the revolution of organization management. That is what called ‘the revolution of business enterprise management’

It cannot be denied that the “visible hand” has become a more and more crucial role in the contemporary economy, but there are still some defects in the view of Chandler’s “visible hand”. First of all, Chandler’s over-praise of the executive of corporation is just partly making sense to some extent. Managers may hide various levels of opportunism and potential trickery, such as the Enron scandal, as well as high-paying CEO scandal. Secondly, Chandler’s understanding of large enterprise is not entirely accurate. Enterprises are expanding for large enterprises, because there is some kind of asset specificity. Enterprises expanding the scale do not mean that it is capable enough to build up its strength. Take the American slaughter Gustavus in 19th century as an example, he run a train transport business and freezer factory because it was the best way that he could control the quality and efficiency of meat-packing. He worried about that he would be plot in secret by his competitor if buying transport services and freezers from others.

It is obviously that internal management of large enterprise would not substitute the regulatory action of market, the “visible hand” would play a role only in the case of management mechanism can produce greater productivity than the market mechanism and internal coordination costs are cheaper than the market transaction costs.

To sum up, the market allocates resources efficiently by making equilibrium between demand and supply through the price system, while the “visible hand” coordinates and allocates resources by management. Every sword has its two sides. Both the “invisible hand” and the “visible hand” have their strength and weakness. The “visible hand” can not totally replace the “visible hand”, while the “visible hand” is the supplement and development of the “invisible hand” from the aspect of management coordination. They supplement each other to ensure the allocation of resource processed efficiently.

References:

  • Alfred D., Jr. Chandler (1977) The Visible Hand The Managerial Revolution in American Business Massachusetts and London: Belknap Press of Harvard University Press. P.1-4, P6-9
  • Eitan Goldman & Gary Gorton (2000 ) The Visible Hand, The Invisible Hand And Efficiency. National Bureau of Economic Research. JEL NO.D21, G30
  • Economypedia [online]. [Accessed 1th December 2009]. Available from World Wide Web : < http://www.economypedia.com/wiki/index.php?title=Production_function >
  • Economypedia [online]. [Accessed 1th December 2009]. Available from World Wide Web : < http://www.economypedia.com/wiki/index.php?title=Market_interaction >
  • Jintang Wang & Wenfan Zhong (1995) Modern American large enterprise and American society. Wuhan: Wuhan University Press. P3-5
  • Wikipedia [online]. [Accessed 1th December 2009]. Available from World Wide Web : < http://en.wikipedia.org/wiki/The_Visible_Hand >
  • Wikipedia [online]. [Accessed 1th December 2009]. Available from World Wide Web :
  • Sean, Douma & Hein, Schreuder (2008) Economic Approaches to Organizations Essex: Pearson Education. P.3-5, P9-10, P12-19, P28-38, P42-44, P46-51, P56-60
  • Sina [online]. [Accessed 1th December 2009]. Available from World Wide Web : < http://finance.sina.com.cn/b/20040607/1147799840.shtml>

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