AS

Invisible Hand Property 1

The Minimization of Total Costs of Production

  • Invisible hand property 1: in a competitive industry, the total industry costs of production are minimized
  • A firm in a competitive industry increases output until P = MC
    • Every firm in the same industry faces the same prices
  • In a competitive market with N firms:
    • P = MC1 = MC2 = … = MCN
    • MC1 is the marginal cost of firm 1, MC2 is the marginal cost of firm 2, and so on
  • Example:
    • You own two farms that you grow corn on
    • Farm 1 is on a hilly region where it is costly to seed and plow
    • Farm 2 is on ideal land for growing corn
    • You want to grow 200 bushels
    • The lowest-cost way to produce that amount is to produce all 200 bushels on Farm 2
    • The marginal costs of production on Farm 2 are lower than on Farm 1 for any level of output
    • What if you produced all 200 bushels on Farm 2 and no bushels on Farm 1?
    • How do you lower your total costs of production?
    • Instead of producing all 200 bushels on Farm 2, produce 197 on Farm 2 and 3 on Farm 1
    • When your produce on Farm 2, your costs of production decrease (this is the marginal cost of producing those last few bushels on Farm 1
  • You should continue producing fewer bushels on Farm 2 and more on Farm 1 if the marginal costs of production of Farm 2 exceed those on Farm 1
    • produce less on Farm 2 and more on Farm 1 if MC2 > MC1
  • You should switch production to from Farm 1 to Farm 2 if MC1 > MC2
  • The way to minimize the total costs of production is to produce just so much on each farm so that the marginal costs of production are equalized (MC1 = MC2)
  • If you own both farms, you can allocate production across the two farms so that the marginal costs of production are equal and so the total costs of production are minimized
  • Another situation:
    • Farm 1 is in North Carolina and owned by Sandy and Farm 2 is in Iowa and owned by Pat
    • Sandy and Pat will never meet
    • Sandy and Pat sell their corn in the same market so each of them sees the same price of corn
    • How will they each maximize their profits?
    • Sandy will set P = MC1 and Pat will set P = MC2
    • This means that MC1 = MC2
    • If P = MC1 = MC2, then total costs of production are minimized
    • This means that a free market can mimic an ideal central planner
    • If Sandy and Pat only know their own market then they can still choose the output levels that minimize their own total costs
    • A central planner can’t allocate production correctly if it doesn’t know one of the other markets