The True Importance of the P=MC Condition of Profit Maximization

The True Importance of the P=MC Condition of Profit Maximization

How to Minimize the Total Costs of Corn Production Across Two Farms Farm Two Farm One MC1 $ $ MC2 $200th unit A C Savings C = A-B Cost of Producing 200th Unit B 25 0 175 200 Quantity (Bushels of Corn) Quantity (Bushels of Corn) Decrease in Costs Increase in Costs

To Minimize Total Costs Set MC1=MC2 MC1 $ $ Farm Two Farm One MC2 160 40 0 Quantity (Bushels of Corn) Quantity (Bushels of Corn)

A Much More Difficult Problem. What if we don’t know the MC of each producer? Pat Sets P=MC1 , Alex sets P=MC2 as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn $2.50 160 40 0 Quantity (Bushels of Corn) Quantity (Bushels of Corn)

The Role of Prices A Price is a Signal Wrapped Up in an Incentive

The Invisible Hand • “Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” • What is this invisible hand leading us?

The Role of Prices • Price increases. • It’s a signal that people want more of it. • It’s an incentive for producers to provide more of it. • Price decreases. • It’s a signal that people don’t want as much of it. • It’s an incentive for producers to provide less of it.

A Much More Difficult Problem. What if we don’t know the MC of each producer? Pat Sets P=MC1 , Alex sets P=MC2 as a result MC1=MC2 Alex’s Farm Pat’s Farm MC1 $ $ MC2 Price of Corn $2.50 160 40 0 Quantity (Bushels of Corn) Quantity (Bushels of Corn)

Pat Sets P=MC1 , Alex sets P=MC2 as a result MC1=MC2 MC1 $ $ Alex’s Farm Pat’s Farm MC2 Price of Corn 160 40 0 Quantity (Bushels of Corn) Quantity (Bushels of Corn)

The True Importance of the P=MCCondition is P=MC1=MC2 …=MCN MC1 $ $ Alex’s Farm Pat’s Farm MC2 Price of Corn $2.50 160 40 0 Quantity (Bushels of Corn) Quantity (Bushels of Corn)

So what? • Not many markets are perfectly competitive. • Agriculture represents < 2% of workforce. • Same dynamics at play in non-competitive markets. • Always MR vs. MC; if P↑, MR↑, regardless of the industry. • As P↑, firms will produce more, because it will exceed the MC for a larger amount (and for a larger number of firms).

Consider the following markets • In the last 5 years, what’s happened to the amounts of: • Bars/restaurants downtown, healthcare facilities, 3-D movies, movies starring James Franco, reality television shows, social media sites, touch screen phones/tablets? • Newspapers, music stores, movie rental stores, post offices, sitcoms, movies starring Keanu Reeves? • Why?

Prices, Signals and Incentives - The Invisible Hand! • Why Central Planning Doesn’t Work • Even if mandating production were ‘ok’ • Couldn’t possibly know how much consumers want/need of all different goods and services. • Couldn’t possibly know all of the marginal costs of all producers. • So, couldn’t possibly efficiently allocate production between firms, or goods/services between consumers. • The allocative function of prices. What’s the big deal?

A Natural Experiment • Suppose there were two countries with the same culture, the same people, the same history, that are about the same size and have about the same income. One of these countries uses central planning and one of them uses market forces (the invisible hand).

A lot of other factors at play… • Maybe it’s not the invisible hand, but other factors… So what if we could take one country, have them start with central planning, then suddenly allow market forces to work?

What happened in 1978?

The True Importance of the P=MC Condition of Profit Maximization