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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