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- [Alex] In this chapter, we return to the invisible hand.
We're going to show some remarkable properties
of competitive markets, properties that are a product
of human action but not of human design.
That is, these properties have neither been designed nor intended,
nor perhaps even understood by market participants.
And yet through the process of the invisible hand,
a spontaneous order evolves
in which these desirable properties are an outcome.
Let's take a look.
So for context, recall that in earlier chapters
we learned that markets connect
and coordinate actions all over the world.
Think about the rose and the coordination of actions
which was necessary to deliver the fresh rose
to your door on Valentine's Day.
We also learned that a price is a signal
wrapped up in an incentive.
That is, prices signal in what uses resources have the highest value
and they provide an incentive to move resources
to those high-valued uses.
We also learned that firms maximize profits
by doing two things.
First, by producing at the quantity
where price is equal to marginal cost.
And second, by entering an industry when there's profits,
when price is greater than average cost,
and by exiting an industry when there are losses,
when price is less than average cost.
What this chapter is all about is connecting these ideas,
bringing these ideas together.
We're going to show that competitive markets
have two remarkable invisible hand properties.
First, competitive markets balance production
across firms in an industry,
so that total industry costs are minimized
for any given quantity of production.
Second, entry and exit decisions balance production
across different industries
so that the total value of production is maximized.
And we'll explain each of these in turn.
To show how the invisible hand minimizes total industry cost,
we're going to start with what looks to be a quite different problem.
Suppose that you owned two farms
and you want to produce 200 bushels of corn
at the lowest possible cost.
How do you do it?
Well by looking at these two marginal cost curves,
you might reason that since the cost of producing any quantity of corn
is lower on Farm Two than on Farm One,
then maybe the best thing to do
is to produce all 200 units on Farm Two.
I'm going to show you that that's wrong.
Now, let's remember that we could read the cost
of producing the Nth unit of corn
as the height of the marginal cost curve for that unit.
So here's the cost of producing the 200th unit of corn.
Now imagine that you produced all 200 units from Farm Two.
Let's now show a lower cost way of producing 200 units.
For example, suppose you were to produce
25 fewer units on Farm Two.
Your cost will then fall by area A.
Now of course now you're producing 25 units less,
so in order to make up for that decrease in production,
you've got to produce 25 more units from Farm One.
Notice that in order to produce those 25 units on Farm One,
your costs go up by area B.
Now here's the key point --
area A is bigger than area B.
In other words by switching cost from the high marginal cost farm
to the low marginal cost farm, you have decreased your costs
by more than you have increased your costs.
In fact you've created a savings of area C, the difference.
Now if you follow through this logic,
it implies that whenever the marginal cost on one farm
is higher than the marginal cost on the other farm,
you can save money, you can save resources,
by transferring production from where the marginal cost is high
to where the marginal cost is low.
Now what does that mean if you want to minimize
the total cost of production?
The logic we just gave implies
that if you want to minimize the total cost of production,
you should balance your production across the two farms
so that the marginal costs on the two farms are equal.
In this case a 160 units from Farm Two
and 40 units from Farm One.
Again, just think about if that were not the case.
If the marginal cost of production on Farm Two were higher
than on Farm One, then you could always reduce your cost
by producing less on Farm Two and more on Farm One.
But of course the reverse is also true.
If the marginal cost on Farm One were higher than on Farm Two,
you would want to produce less on Farm One
and more on Farm Two.
So the way to minimize your total cost of production
is to produce such that the marginal costs of production
are equal on your two farms.
Now let's consider a much more difficult problem.
Suppose we have Pat's farm located on the West Coast
and Alex's farm thousands of miles away
on the East Coast.
And let us suppose that no one knows
the marginal cost on both of these farms.
Now the problem looks almost impossible.
How could we possibly allocate production
across these two farms to minimize total costs
when no one knows the marginal cost on both of these farms?
Clearly a central planner would not have enough information
to solve this problem.
And yet, the market does solve the problem.
Because even though nobody knows the marginal cost
on both of these farms,
Pat knows the marginal cost on Pat's farm.
Alex knows the marginal cost on Alex's farm.
And both of them know the price of corn.
Now consider, how does Pat profit maximize?
Pat profit maximizes by choosing to produce that quantity
such that price is equal to Pat's marginal cost.
Alex chooses to profit maximize by producing that quantity
such that price is equal to Alex's marginal cost.
And since the price of corn is the same for both of them,
they automatically choose to allocate production
across their two farms such that the marginal cost on Pat's farm
is equal to the marginal cost on Alex's farm.
And production is automatically allocated
so as to minimize total costs.
Now notice that neither Pat nor Alex intend
nor perhaps even understand this result.
It's only through the operation of the market,
through the operation of the invisible hand,
that production is automatically allocated across these two farms
to minimize total cost of production.
Look at what happens when the price changes.
As the price changes so does the allocation of production
across the two farms in just such a way
that total industry costs are minimized.
This is truly a remarkable result
and one that people might not even have suspected
prior to the development of economics
and the ability to see the invisible hand.
So let's summarize invisible hand property number one.
In a competitive market with N firms,
all firms face the same market price.
And to maximize profits, each firm adjusts its production,
adjusts its output,
until price is equal to that firm's marginal cost.
Therefore, the following is going to be true.
Price is equal to the marginal cost of Firm One
which is equal to the marginal cost of Firm Two
which is equal to the marginal cost of Firm N.
Since these marginal costs are all the same,
the total industry costs of production are minimized --
a remarkable result, and one due to the invisible hand.
Next we'll look at invisible hand property number two.
- [Narrator] If you want to test yourself,
click "Practice Questions."
Or, if you're ready to move on just click "Next Video."
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