Minimization of Total Industry Costs of Production

… a core concept in Economic Analysis and Atlas102

Concept description

Alex Tabarrok (reference below, video on right) connects several ideas covered in previous videos about the price system and profit maximization.

Tabarrok says:

“In this video, we begin to understand two basic functions of the Invisible Hand. In competitive markets, the market price (with the help of the Invisible Hand) balances production across firms so that total industry costs are minimized. Competitive markets also connect different industries. By balancing production, the Invisible Hand of the market ensures that the total value of production is maximized across different industries. We’ll use the example of minimizing total costs of corn production, and demonstrate our findings through several charts.”

Tabarrok demonstrates that:

Practice questions

From http://www.mruniversity.com/node/264309, accessed 7 May 2016.

1. Entrepreneurs shift capital and labor across industries in pursuit of profit. Let’s look at this a little more closely. Suppose there are two industries: a high-profit industry, Industry H, and a low-profit industry, Industry L. Answer the questions below about these two industries. If the two industries have similar costs, then what must be true about prices in the two industries?
   1. Prices in Industry H are higher than in Industry L
   2. Prices in Industry H are lower than in Industry L
   3. Indeterminate from the given information
2. Suppose instead that the prices in the two industries were identical. In this case, what must be true about the costs in the two industries?
   1. Costs in Industry H are higher than in Industry L
   2. Costs in Industry H are lower than in Industry L
   3. Indeterminate from the given information
3. Assuming that prices in the two industries were identical, if labor and capital are moved from Industry L to Industry H, are more units of output lost in Industry L or gained in Industry H?
   1. More units of output are lost in Industry L than are gained in Industry
   2. More units of output are gained in Industry H than are lost in Industry
   3. Indeterminate from the given information
4. Suppose that two industries, the pizza industry and the calzone industry, are equally risky, but rates of return on capital investments are 5% in the pizza industry and 8% in the calzone industry. Which way will capital flow—from the pizza industry to the calzone industry, or from the calzone industry to the pizza industry?
   1. From pizza industry to calzone industry
   2. From calzone industry to pizza industry
   3. Indeterminate from the given information
5. We’ve claimed that the efficient way to spread out work across firms in the same industry is to set the marginal cost of production to be the same across firms. Let’s see if this works in an example. Consider a competitive market for rolled steel (measured by the ton) with just two firms: SmallCo and BigCo. If we wanted to be more realistic, we could say there were 100 firms like SmallCo and 100 firms like BigCo, but that would just make the math harder without generating any insight. (We’ll also ignore fixed costs of starting up the firms just to make things a little simpler. ) The two firms have marginal cost schedules like this: What is the total cost of SmallCo producing 6 units of output? 
   1. $60
   2. $130 
   3. $150 
   4. $210 
   5. $280
6. What is the total cost of BigCo producing 6 units of output?
   1. $30 
   2. $60
   3. $90 
   4. $120 
   5. $130
7. What would the price have to be in this competitive market for these two firms to produce a total of 11 tons of steel?
   1. $30 
   2. $40 
   3. $50 
   4. $60 
   5. Indeterminate from the given information
8. What would the total cost be if BigCo were the only firm in the market, and it had to produce 7 tons of rolled steel?
   1. $40 
   2. $70 
   3. $130 
   4. $140 
   5. $170
9. What would total cost be if SmallCo and BigCo let the invisible hand divvy up the work between them to produce 7 tons of rolled steel?
   1. $20 
   2. $30 
   3. $70 
   4. $90 
   5. $130
10. Would it make sense to shut down the more inefficient of the two firms?
    1. Yes
    2. No

Atlas topic, subject, and course

Producer Theory and Competition (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, Minimization of Total Industry Costs of Production (9-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/minimizing-industry-costs-production-invisible-hand, accessed 7 May 2016.

Page created by: Ian Clark, last modified 7 May 2016.

Image: Alex Tabarrok, minute 0.14 of Minimization of Total Industry Costs of Production (9-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/minimizing-industry-costs-production-invisible-hand, accessed 7 May 2016.