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

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