Topic 3 product markets lecture 16
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Topic 3 Product Markets: Lecture 16. The circular flow model. (Topic 1). Agent: Households. Demand. Supply. Market: Goods/Services. Market: Inputs. (Topic 3). (Topic 4). Agent: Firms. Demand. Supply. (Topic 2). (Topic 5 = Structure and efficiency).

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Topic 3 Product Markets: Lecture 16

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Topic 3 product markets lecture 16

Topic 3 Product Markets:Lecture 16

  • The circular flow model

(Topic 1)

Agent:

Households

Demand

Supply

Market:

Goods/Services

Market:

Inputs

(Topic 3)

(Topic 4)

Agent:

Firms

Demand

Supply

(Topic 2)

(Topic 5 = Structure and efficiency)

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 16

Topic 3 :Lecture 16

Markets differ by nature/extent of competition.

So far, we have assumed (at least implicitly) that there is just one firm in the market, confronting the entire market demand: a monopolist.

Now consider the extreme opposite case of ‘perfect competition’ – then we’ll look at perhaps more realistic intermediate cases.

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 161

Topic 3 :Lecture 16

Perfect competition

All (the very many) firms are assumed identical and will set the same price (each is a price-taker) because:

a firm cannot charge more than the competitive market price (assuming homogeneous goods and perfect information)

a firm cannot charge less than the market price (free entry means that all firms will just break even at the market price)

each firm is so ‘small’ it does not affect market price. Hence:

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 162

Topic 3 :Lecture 16

Perfect competition

Consider the individual firm i:

p

pc

pc = d

x

The firm is a price-taker at the market price. Demand is perfectly elastic.

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 163

Topic 3 :Lecture 16

Perfect competition

p

pc

pc = d = mr

x

Because the firm does not have to reduce price to sell an extra unit (because it is so ‘small’), the marginal revenue is equal to price. Hence, p = d = mr.

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 164

Topic 3 Lecture 16

This diagram is the same as that in Lecture 15 Slide 2, except that we now have d=mr=p as perfectly elastic.

SATC

p

SMC

SAVC

pc

pc = d = mr

x

What is the firm’s chosen output level?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 165

Topic 3 Lecture 16

SATC

p

SMC

SAVC

pc

pc = d = mr

x

Suppose market price rises: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 166

Topic 3 Lecture 16

SMC

SATC

p

SAVC

pc

pc = d = mr

x

Suppose market price falls: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 167

Topic 3 Lecture 16

SATC

p

SMC = s

SAVC

pc

pc = d = mr

x

Suppose market price falls further: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 168

Topic 3 :Lecture 16

Perfect competition

Now consider the long run and also where market price comes from:

p

p

S

Market price is where market supply meets market demand.

Market demand is exogenous.

What determines market supply?

The market price determines the demand curve faced by the individual firm.

And hence also mr.

pc = d = mr

pc

D

x

Xc

X

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 169

Topic 3 :Lecture 16

Perfect competition

Here we add the firm’s cost curves (and hence its supply curve): for the long run.

p

p

S

lmc = s

lac

Can you say where this market supply curve, S, comes from?

pc

pc = d = mr

D

x

Xc

X

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1610

Topic 3 :Lecture 16

Perfect competition

This industry is in equilibrium: why?

Define and Explain

Recall that we are assuming that all firms are identical. So this is the ‘representative firm’.

p

p

lmc = s

lac

This is the long-run industry supply curve for a fixed number of firms, n.

pc

pc = d = mr

D

x*

x

Xc = nx*

X

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1611

Topic 3 :Lecture 16

Perfect competition

We now want to derive the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

Suppose there is an (exogenous) increase in the level of market demand.

pc

pc = d = mr

D

x*

x

Xc = nx*

X

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1612

Topic 3 :Lecture 16

Perfect competition

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

pc

pc = d = mr

D’

D

x*

x

Xc = nx*

X

The initial effect is that market price will rise so that supply by the n firms is equal to demand. Each firm is producing increased output. What can you say about profits? And industry equilibrium?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1613

Topic 3 :Lecture 16

Perfect competition

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

pc

pc = d = mr

D’

D

x*

x

Xc = nx*

X

New firms will enter the industry (why?). How do we show this in the diagram?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1614

Topic 3 :Lecture 16

Perfect competition

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

pc

pc = d = mr

D’

D

x*

x

Xc = nx*

Xc = (n+E)x*

X

New firms enter the industry.

Where does this process take us? (What are we assuming about new firms and about industry costs?)

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1615

Topic 3 :Lecture 16

Perfect competition

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

pc

pc = d = mr

D’

D

x*

x

Xc = nx*

Xc = (n+E)x*

X

So, in the new equilibrium following the increase in demand: market output is higher; price is unchanged; each of the original firms has returned to its original actions, there are more firms.

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1616

Topic 3 :Lecture 16

Perfect competition

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

p

p

lmc = s

lac

LRSS

pc

pc = d = mr

D’

D

x*

x

Xc = nx*

Xc = (n+E)x*

X

What does the long-run industry supply curve look like? It is perfectly elastic. Essentially, this is because new firms can enter the market without needing the market price to remain higher than at the initial equilibrium.

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1617

Topic 3 :Lecture 16

Perfect competition

What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents?

p

p

lmci = s

lac

pc

pc = d = mr

We are assuming that firms are not equally efficient.

So this is the ‘marginal firm,’ initially.

D’

D

xi

x

Xc

X

Originally, there is a marginal firm, i, which just breaks even. Then demand shifts and each of the original n firms raises output. So firm i now makes a supernormal profit. Then what happens?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1618

Topic 3 :Lecture 16

Perfect competition

What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents?

p

p

lmci = s

lac

b

LRSS??

pc

a

pc = d = mr

D’

D

xi

x

Xc

X

New firms enter: the number is now n+E. Could this be the new equilibrium?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1619

Topic 3 :Lecture 16

Perfect competition

What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents?

lacj

p

p

lmci,j = s

laci

b

LRSS??

pc

a

pc = d = mr

D’

D

x*

x

Xc = nx*

Xc = (n+E)x*

X

Point ‘b’ will be an equilibrium if . . . ? And so the LRSS is where?

Robin Naylor, Department of Economics, Warwick


Topic 3 lecture 1620

Topic 3 :Lecture 16

Perfect competition

What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents?

lacj

p

p

lmci,j = s

laci

LRSS??

b

pc

a

pc = d = mr

D’

D

x*

x

Xc = nx*

Xc = (n+E)x*

X

Point ‘b’ will be an equilibrium if . . . ? And so the LRSS is where? And the intuition?

What else would make the long-run industry supply curve upward-sloping (imperfectly elastic)?

Robin Naylor, Department of Economics, Warwick


Topic 2 lecture 16

Topic 2: Lecture 16

  • Now read B&B 4th Ed., pp. 328-341, 345-352, 353-366.

  • Note that in B&B (eg p. 337) a distinction is drawn between 2 types of short-run fixed cost:

    • Sunk Fixed Costs and

    • Non-sunk Fixed Costs.

  • I’m not making that distinction in lectures as, for simplicity, I’m assuming that all Fixed Costs are Sunk (i.e., unavoidable even if output is zero).

  • Robin Naylor, Department of Economics, Warwick


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