Ch7 Competition

1. Ch7 Competition 7.1 The Competitive Firm in the Short Run 7.2 The Competitive Industry in the Short Run 7.3 The Competitive Firm in the Long Run 7.4 The Competitive Industry in the Long Run 7.5 Relaxing the Assumptions 7.6 Applications 7.7 Using the Competitive Model

2. Assumptions for the Competitive Market • Many firms • Consumers do not care which firm they buy from (Yes, in principles you learned that the output had to be identical, but that was a slight overstatement. That people do not care which firm they buy from is enough). • Unrestricted entry and exit in the industry in the long run. • Perfect information about prices (by consumers and producers).

3. Demand for Firm’s Output • Any quantity produced by the firm will be bought in the market at the prevailing price. • Total Revenue = P*Q • MR = TR/Q = P • AR = P*Q/Q = P • So: MR = AR = P

4. ex: Suppose P = $10. Calculate TR, MR, and AR for the following output levels: q TR MR AR 0 1 2 3 4 5

5. ex: Suppose P = $10. Calculate TR, MR, and AR for the following output levels: q TR MR AR 0 $0 1 10 2 20 3 30 4 40 5 50

6. ex: Suppose P = $10. Calculate TR, MR, and AR for the following output levels: q TR MR AR 0 $0 - 1 10 $10 2 20 10 3 30 10 4 40 10 5 50 10

7. ex: Suppose P = $10. Calculate TR, MR, and AR for the following output levels: q TR MR AR 0 $0 - - 1 10 $10 $10 2 20 10 10 3 30 10 10 4 40 10 10 5 50 10 10

8. ex: Suppose P = $10. Calculate TR, MR, and AR for the following output levels: q TR MR AR 0 $0 - - 1 10 $10 $10 2 20 10 10 3 30 10 10 4 40 10 10 5 50 10 10 note: For a competitive firm, MR = AR = P.

9. Firm Supply (Short Run) • It is the qS by the firm at each price. • Firm chooses the q that will maximize profit. The optimal qS will change with price. • Produce good until MR = MC (equimarginal principle) • Profit maximization: Profit=TR – TC • Competitive firm produces a quantity where P = MC • Note: MR curve is flat, so P ≡ MR

10. Marginal Cost and Supply

11. Marginal Cost and Supply Market Price = $12

12. Marginal Cost and Supply Market Price = $16

13. Marginal Cost and Supply Market Price = $10.40

14. MC and Supply • The MC curve tells us the profit maximizing qS by the firm at any price. • Hey, that sounds a whole lot like the definition of a supply curve. • And it is. Since it is the MC curve that determines the relationship between P and the quantity to supply, it IS the firm’s supply curve.

15. Shutdowns and Exits • Does the producer want to produce the good? • Two distinctions • Shutdown: firm stops producing the good but still pays fixed costs • Exit: firm leaves the industry entirely and no longer faces any costs • Firms, in SR, can shutdown but not exit • Remains operational if P > AVC • In LR, can exit Landsburg, Price Theory and Applications, 7th edition

16. Intuition • At the quantity where MR = MC (call it q*) • TR = 20,000 (at q*, where MR = MC) • FC = $15,000 • VC = $17,500 (at q*, where MR = MC) • TC = $32,500 • q = q*:  = 20,000-32,500=-12,500 Compare to shut down (FC) • q = 0:  =-FC =-15,000

17. But what if… • TR = 16,000 (at q*, where MR = MC) • FC = $15,000 • VC = $16,700 (at q*, where MR = MC) • TC = $31,700 • q = q*:  = 16,000-31,700=-15,700 • q = 0:  =-FC = -15,000 • Now shut down, q = 0, is preferable.

18. Decision Rule • q = q* if - < FC, TR>TVC, P>AVC • q = 0 if - > FC, TR<TVC, P<AVC • So q = 0 if the loss from producing is > the FC you pay if you shut down. • Can a change in FC lead to Shut Down? NO, Both FC and the loss at q* increased by the same amount, so you still do not shut down.

19. Graphically

20. ATC and TC 10 8 100 700 Q

21. AVC and VC 5 4 70 300 Q

22. AFC and FC 11 9 7 3 400 800 Q

23. VC, FC, and TC 8 5 100 Q

24. Short-Run Supply Curve • Firms SR supply curve identical to part of SRMC curve that lies above AVC curve • Shutdown otherwise • Upward sloping due to AC and MC U-shape • Diminishing marginal returns to variable factors of production • Elasticity of supply • Percent change in quantity supplied resulting from a 1% change in price Landsburg, Price Theory and Applications, 7th edition

25. EXHIBIT 7.8 The Competitive Firm’s Short-Run Supply Curve Landsburg, Price Theory and Applications, 7th edition

26. Firm with profits or loss

27. Competitive Industry in the SR • All firms in industry competitive • SR is period of time in which no firm can enter or exit the industry • Number of firms cannot change • LR is period of time in which any firm can enter or leave the industry • Industry’s SR supply curve • Sum of SR individual firm supply curves • More elastic than individual supply curves Landsburg, Price Theory and Applications, 7th edition

28. Market Supply

29. Market Supply

30. Competitive Equilibrium • Firms produces where supply (or MC) curve crosses horizontal line at market going price • Increase in FC • Price and quantity remain unchanged • Increase in VC • Raises firms MC curve • Causes some firms to shutdown • Higher market equilibrium price • Firm’s output could go up or down • Increase in industry demand • Higher market equilibrium price • Increase in firm’s output Landsburg, Price Theory and Applications, 7th edition

31. EXHIBIT 7.11 The Competitive Industry and the Competitive Firm Landsburg, Price Theory and Applications, 7th edition

32. EXHIBIT 7.13 A Change in Demand Landsburg, Price Theory and Applications, 7th edition

33. EXHIBIT 7.12 A Rise in Marginal Costs Landsburg, Price Theory and Applications, 7th edition

34. Industry’s Costs • Sum of total cost of all individual firms • To minimize cost of all firms, use equimarginal principle • Insure that MC same for all producers in industry • Automatic because all firms have same price Landsburg, Price Theory and Applications, 7th edition

35. The Invisible Hand • Technical efficiency: Producing whatever level of output is produced at the lowest possible total cost. • Allocative efficiency: Productively efficient and also are producing the goods (including the quantity of each good) that society most highly values. • Competitive markets get us both without anyone paying attention to anything but their own well-being.

36. Hobbes (government control) vs. Smith (market process) • In “Leviathan,” Hobbes claims that only government control prevents life from being “nasty, brutish and short.” • Smith didn’t see it and in 1776 publishes the “Wealth of Nations” in which he describes market processes allocating resources (although he didn’t quite get supply and demand).

37. Apple Czar • produce 50,000,000 apples… and to do it with the fewest resources possible (i.e. at the lowest possible cost) • Randomly shipping seeds to farmers won’t do it. • But say you know each farmer’s MC curve

38. Just Two of Many Farmers Farmer A produces 100 apples and Farmer B produces 200 to start, can you lower total cost?

39. Minimizing Total Cost • To minimize total cost, you keep comparing all farmers and making trade-offs until you cannot tell any farmer to change production without raising total cost of producing apples. • At this point, the MC of the last apple produced at EVERY farm will be the same. • Freakin’ hard work to figure this out.

40. A Better Solution • Or, you could offer each farmer $.50 per apple produced. • Every apple that can be grown for a cost less than $.50 will be produced. All that are more expensive will not. • You have just minimized TC (productive efficiency). • If you don’t get 50,000,000 this year, adjust the price offered next year.

41. An Even BETTER Solution • But how do we know buyers value apples more than $.50 per apple? • If we charge $.50 at the store, then the surplus or shortage would help us decide whether 50,000,000 is the allocatively efficient number.

42. As if Led by an Invisible Hand • Letting demand interact with supply generates that magic price that equilibrates Qs and Qd and generates productive and allocative efficiency (producer and consumer surplus are maximized). • That is, for all but one apple, the MB>MC. For the last apple produced MB = MC.

43. The Competitive Firm in the Long Run • It is important to understand that firms are always in the SR. That is, they are in the SR, then for one decision-making moment they are in the LR, then they are back in the SR again. • At any moment in time, points on the LR cost curves are made up of a point on the SR curves assuming the firm is on its expansion path (that is, the firms is using the optimal level of K).

44. Firm Behavior in the SR and LR

45. Competitive Firm in the LR • Some fixed cost in SR become variable cost in the LR • Firms can enter and exit in the LR • Firms operate where P = LRMC • Remain in industry, LR supply curve identical to LRMC curve • Earning positive profit Landsburg, Price Theory and Applications, 7th edition

46. Profit and the Exit Decision • Profit = TR – TC • Costs includes all foregone opportunities • SR versus LR supply response • Firm LR supply curve more elastic than SR supply curve • Shuts down if price of output falls below average variable cost • Exits if price of output falls below average cost Landsburg, Price Theory and Applications, 7th edition

47. Competitive Industry in the LR • Firms wishing to enter or exit the market do so in the LR • Link between entry and exit and industry’s LR supply curve • LR competitive equilibrium Landsburg, Price Theory and Applications, 7th edition

48. Zero Profit Condition • Economic versus accounting profit • Accounting Profit: profit = TR – Explicit cost • Economic Profit:  = TR – Explicit cost – Implicit cost • All firms earn zero economic profit in the LR • Equally efficient • Produce at the lowest possible average cost Landsburg, Price Theory and Applications, 7th edition

49. * Fourth option is to sell building for $65000 and earn 10% rate of interest. Economic versus Accounting profit

50. EXHIBIT 7.14 The Competitive Firm’s Long-Run Supply Curve Landsburg, Price Theory and Applications, 7th edition