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building materials and construction labor—are relatively abundant and pro-

vided by nationwide markets.^6

For an increasing-costindustry, output expansion causes increases in the

price of key inputs, thus raising minimum average costs. Here the industry

relies on inputs in limited supply: land, skilled labor, and sophisticated capi-

tal equipment. For instance, if U.S. drilling activity increased by 30 percent

(perhaps due to increases in world oil prices), the typical oil company’s aver-

age cost per barrel of oil could be expected to rise, for a number of reasons.

First, the increase in drilling would bid up the price of drilling rigs and sophis-

ticated seismic equipment. Second, skilled labor (such as chemical engineer-

ing graduates), being in greater demand, would receive higher wages. Third,

because the most promising sites are limited, oil companies would resort to

drilling marginal sites, yielding less oil on average. For an increasing-cost

industry, the result of such increases in average costs is an upward-sloping

long-run supply curve.

MARKET EFFICIENCY

You might be familiar with one of the most famous statements in economics—

Adam Smith’s notion of an “invisible hand”:

Every individual endeavors to employ his capital so that its produce

may be of greatest value. He generally neither intends to promote the

public interest, nor knows how much he is promoting it. He intends

only his own security, only his gain. And he is in this led by an invisible

hand to promote an end which was no part of his intention. By pur-

suing his own interest he frequently promotes that of society more

effectively than when he really intends to promote it.^7

One of the main accomplishments of modern economics has been to examine

carefully the circumstances in which the profit incentive, as mediated by com-

petitive markets, promotes social welfare.^8 Although economists are fond of prov-

ing theorems on this subject, the present approach is more pragmatic. Our aim

is to examine the following proposition: Competitive markets provide efficient amounts

of goods and services at minimum cost to the consumers who are most willing (and able) to

pay for them.This statement is one expression of the notion of market efficiency.Of

(^6) Here it is important to distinguish between long-run and short-run supply. In the short run, an
increased local demand for new housing can bid up the wages of construction labor (and, to some
extent, materials) until additional workers are attracted into the market. In addition, if available
land is limited in rapidly growing metropolitan areas, its price may increase significantly.
(^7) Adam Smith, The Wealth of Nations(1776).
(^8) The study of the relationship between private markets and public welfare is referred to as welfare
economics.
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