♪ [music] ♪ – [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.” ♪ [music] ♪