Markets: Perfect Competition & Supply Curve (K&W, Ch 15) PDF

MARKETS KRUGMAN & WELLS CHAPTER 15: PERFECT COMPETITION & SUPPLY CURVE Pauline Rutsaert  WHERE DOES THE MARKET SUPPLY COME FROM? ▪ In Chapter 10, we studied where the market demand came from: ▪ Each consumer maximizes his/her utility subject to budget line; individual demand is d...

MARKETS KRUGMAN & WELLS CHAPTER 15: PERFECT COMPETITION & SUPPLY CURVE Pauline Rutsaert  WHERE DOES THE MARKET SUPPLY COME FROM? ▪ In Chapter 10, we studied where the market demand came from: ▪ Each consumer maximizes his/her utility subject to budget line; individual demand is downward sloping due to substitution and income effects; market demand is the sum of all consumers’ demands; ▪ In Chapter 11, we studied firm’s production and costs ▪ Various costs (total, average, fixed, variable, marginal); how they relate to each other; difference between the short run and the long run ▪ In Chapter 12, we study where the market supply comes from and what the market equilibrium is: ▪ To understand individual firm’s supply, we must look into the firm’s output decision knowing that it wants to maximize profits and minimize costs ▪ Market supply is the sum of the individual firm’s supplies ▪ Market equilibrium is found at the intersection of market demand and market supply  FIRM AND MARKET SUPPLY – EXAMPLE: XMAS TREE MARKET ▪ Before 1950s: go to forest and cut your own Xmas tree ▪ After 1950s: Population growth + forest loss ⇒ market opportunity: Xmas tree farms develop ▪ Supply of Xmas trees ▪ Standardized product ⇒ price-taking behavior ▪ Farms supply trees to maximize profit ▪ industry supply is sum of all farms’ supply ▪ Growing takes time ⇒ inelastic in short-run ▪ More elastic in long-run: increase capacity, new farmers enter  CHAPTER 12 – LEARNING OBJECTIVES ▪ What a perfectly competitive market is and the characteristics of a perfectly competitive industry ▪ How a price-taking producer determines its profit–maximizing quantity of output ▪ How to assess whether or not a producer is profitable and why an unprofitable producer may continue to operate in the short run ▪ Why industries behave differently in the short run and the long run ▪ What determines the industry supply curve in both the short run and the long run  PERFECT COMPETITIVE MARKET ▪ In a perfectly competitive market, both consumers and producers are price-takers => Their actions have no effect on the price ▪ As a general rule, consumers are price-takers ▪ Whether producers are price-takers or not depend on the industry characteristics: As a general rule, 1. market share distribution (Market share: the fraction of the consumers are price-takers. total industry output accounted for by that producer’s output) 2. Level of product standardization (Standardized product - aka commodity - consumers regard different sellers’ products as equivalent) 3. Ease of entry and exit by firms in the market => producers are price takers if small market share, standardized product and free entry and exit Standardized products prevent producers from increasing prices without making losses  PERFECTLY COMPETITIVE INDUSTRY Two necessary conditions for an industry (producer-side Kellogg’s US of the market) to be perfectly competitive market share is 30%: restricting 1. Atomistic producers: there must be many producers, production will none of whom have a large market share likely cause industry prices to ▪ If large market share: change in production will significantly rise affect overall quantity supplied in the market and so price may change – which goes against price-taking behaviors 2. Standardized products (“commodities”): all products Wheat is literally the same good, must be regarded as equivalent by the consumers regardless who sells it. ▪ If some products are differentiated, producers can increase their price without losing all sales to a competitor – which goes against price-taking behaviors  FREE ENTRY AND EXIT ▪ Most perfectly competitive industries also feature free entry and exit of firms into/out of the industry ▪ New producers can easily enter into an industry and existing producers can easily leave ▪ This ensures number of producers can adjust to changing market conditions, keeping market share low and price-taking behavior in effect. Barriers to entry often Most, but not all. Quotas limit entry in preclude perfect Alaskan crab fishing, but enough competition. incumbents means price-taking producers Illegal if there’s a patent. Hard to enter if you need to build a railway.  PRACTICE QUESTION 1 Which of the following markets is likely to be the most competitive? a) cable television b) automobiles and trucks c) oil refining d) farm commodities  PRODUCTION AND PROFITS ▪ Implicit assumption: every firm wants to maximize profits ▪ A firm’s total revenue (TR) equals the price multiplied with the quantity sold TR = P × Q ▪ Profit equals total revenue (TR) minus total cost (TC): Profit = TR - TC ▪ How to choose how much to produce in order to maximize profit? Marginal analysis Recall the profit-maximizing principle of marginal analysis: the optimal amount of an activity is the level at which marginal benefit equals marginal cost.  MARGINAL COST AND MARGINAL REVENUE ▪ Marginal Cost (MC): change in total costs generated by the production of an additional unit of output MC = ΔTC/ΔQ ▪ Marginal Revenue (MR): change in total revenue generated by the sale of an additional unit of output MR = ΔTR/ΔQ ▪ Price-taking firms: the MR is the good’s market price Changing quantity ΔQ MR = P has no effect on price: ΔTR = P × ΔQ ▪ Price-taking firms receive P in revenue from selling one more unit ▪ They can sell as much as they want at the market price and their action has no impact on price ▪ The marginal revenue curve for the firms is therefore flat/horizontal at the market price => firms face a horizontal, perfectly elastic demand curve that is equivalent to its marginal revenue curve.  OPTIMAL OUTPUT RULE ▪ Optimal output rule: profit is maximized at the quantity of output where marginal revenue equals marginal cost MR = MC ▪ Why? ▪ Each additional unit implies extra costs and extra revenues ▪ MR > MC: producing a unit adds more to revenue than cost ⇒ Q↑ ▪ MR < MC: producing a unit adds less to revenue than cost ⇒ Q↓ ▪ With perfect competition: MR = P, so the perfect competition profit- maximizing rule is to choose the quantity of output where P = MC  OPTIMAL OUTPUT RULE: EXAMPLE ▪ As long as increasing production by one more unit creates more MR than MC, it makes sense to do it. Increasing output from 40 to 50 leads The optimal to an positive output rule leads marginal gain; to choose output increasing it further level equal to 50 to 60 leads to a negative marginal gain  PITFALLS ▪ What if marginal revenue and marginal cost aren’t exactly equal? ▪ What do you do if there is no output level at which marginal revenue equals marginal cost? ▪ In that case, you produce the largest quantity for which marginal revenue exceeds marginal cost. ▪ This tip holds for any exercise in which you look for quantities at which marginal cost equal marginal benefit (incl. marginal utility equals marginal cost) ▪ This issue arises regularly when dealing with discrete quantities; this is why economists use continuous quantities in most models.  PRICE-TAKING FIRM’S PROFIT-MAXIMIZING QUANTITY Graphical Price, cost of example tree MC Optimal $24 point 20 E Market MR = P 18 price 16 12 Optimal output rule 8 Profit is maximized at the quantity 6 where price equals marginal cost 0 10 20 30 40 50 60 70 Quantity of trees Profit-maximizing quantity  PROFITABILITY OF PRODUCTION ▪ MR = MC maximizes profits, but are profits positive? ▪ Profit equals total revenue minus the total cost can be written in 2 ways: ▪ TR – TC = P×Q – TC = (P-TC/Q) × Q = (P-ATC) × Q ▪ At what prices is production profitable, i.e., profit larger than zero? Scenario Equivalent to Outcome If TR > TC  P > ATC Firm is profitable If TR = TC  P = ATC Firm breaks even If TR < TC  P < ATC Firm incurs a loss ▪ The break-even price of a price-taking firm is the market price at which it earns zero profit.  PROFITABILITY OF PRODUCTION Price, cost of Graphical tree Market price = $18 The firm is profitable because example P > min ATC MC E $18.00 MR = P Profit Per-unit profit = $18 14.40 ATC 14.00 – $14.40 C Z = $3.60 The ATC of producing 50 is $14.40 Total profit = $3.60 × 50 = $180.00 0 10 20 30 40 50 60 70 Quantity of trees Optimal output  PROFITABILITY OF PRODUCTION If the market price happens to be Graphical Market price = $14 P = min ATC example Price, cost of tree the firms breaks even at optimal Q $30 i.e. makes zero profit Minimum average MC (Recall: MC = ATC at min ATC) total cost 18 ATC Break- C 14 MR = P even price 0 10 20 30 40 50 60 70 Quantity of trees Minimum-cost output  PROFITABILITY OF PRODUCTION Graphical If the market price is example P < min ATC the firm incurs a loss. Loss = 30x(10-14.67) = - 140.1  PRACTICE QUESTION 2 If a firm is earning positive economic profit, it must be the case that: a) price is less than average cost. b) price is equal to average cost. c) price is equal to total cost. d) price is greater than average cost.  THE SHORT-RUN PRODUCTION DECISION ▪ Fixed costs in the short-run cannot be changed ▪ are paid whether or not the firm produces Fixed costs are sunk costs in the ▪ So are irrelevant to decision about whether to produce or shut down short run ▪ Variable costs can be saved by not producing ▪ The firm will produce as long as it can cover all their variable costs and some of fixed costs – though it will be at a loss. (Note if P=min AVC, firm is indifferent between producing and not producing, so may not produce.) The firm will produce in the short-run as long as P is equal or larger than min AVC ▪ Shut-down price: minimum average variable cost ▪ The minimum price at which the firm will still produce in the short run ▪ When the market price is below minimum average variable cost, a firm should cease production immediately.  PRACTICE QUESTION 3 If Gnomes-R-Us (a competitive firm) produces where the marginal cost curve intersects with the average total cost curve at its minimum point, the firm will earn: a) positive economic profits. b) zero economic profits. c) a short-run loss.  PRACTICE QUESTION 4 Fixed Variable Decision Revenue Profit Costs Costs Stay Open $100 $50 $75 –$75 Shutdown $100 $0 $0 –$100 ▪ In the short run? ▪ A) Stay open ▪ B) Shutdown  PRACTICE QUESTION 5 Should a competitive firm keep producing even if it faces short-run losses and is producing at a point on its MC curve that is above the minimum AVC curve? a) Yes, it is earning normal profits. b) Yes, because it covers its variable costs and some fixed costs. c) No, it should never incur losses.  THE SHORT-RUN INDIVIDUAL SUPPLY CURVE MC curve (above Figure 12-4 shut-down price) is the firm’s supply curve. Temporary shutdown is routine in seasonal industries For every price above minimum AVC a firm will produce the quantity determined by the intersection of price and the MC curve … … but will stop producing in the short run if the market price falls below the shut-down price  PRODUCTION IN THE LONG RUN ▪ Firms can adjust all inputs in the long-run ▪ Fixed costs can now be varied (purchase/sale) ▪ choose the level of fixed cost that minimizes the average total cost for the desired output level ▪ Incurring no fixed costs is an option ⇒ firm entry/exit available in long run The firm will produce in the long-run as long as P is equal or larger than min ATC If there is free exit/entry ▪ Firms exit if not profitable (P < min ATC) ▪ Positive profits will cause new producers to enter in long run ▪ Important distinction between industry supply curve in LR and SR THE LONG-RUN INDIVIDUAL SUPPLY CURVE In the long run, all costs are variable (no fixed cost) and hence the average total cost curve is the same as the average variable cost curve. The long run individual supply curve is the MC curve above the minimum LR ATC curve  SUMMING UP: INDIVIDUAL FIRM’S SUPPLY CURVE Profitability and production conditions in LR Result (minimum ATC = break-even price) P > minimum ATC Firm produces and is profitable. Entry into industry in the long run. P = minimum ATC Firm produces and breaks even. No entry into or exit from industry in the long run. P < minimum ATC Firm does not produce because unprofitable. Exit from industry in the long run. Profitability and production conditions in the SR Result (minimum AVC = shut-down price) P > minimum AVC Firm produces in the short run. If P < minimum ATC, firm makes losses because it covers variable cost and some but not all of the fixed cost. If P > minimum ATC, firm makes profits because it covers all variable cost and fixed cost P = minimum AVC Firm is indifferent between producing in the short run or not. It makes losses because it just covers variable cost. P < minimum AVC Firm shuts down in the short run. Does not cover variable cost.  THE INDUSTRY SUPPLY CURVE ▪ The industry supply curve ▪ is the horizontal sum of all the individual supply curves ▪ shows the relationship between the price of a good and the total output of the industry as a whole. ▪ In the short-run, the industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. ▪ In the long-run, the industry supply curve shows how the quantity supplied by an industry depends on the market price after all entry into and exit from has taken place.  THE SHORT-RUN INDUSTRY SUPPLY CURVE ▪ In the short run, the number of producers is fixed. Price, cost of tree ▪ The SR industry supply is the Short-run industry quantity supplied in an industry $26 supply curve, S given a fixed number of producers 22 18 ▪ P↑ ⇒ Q↑ because 14 1. Existing firms that were producing 10 produce more 2. Some existing firms that were not Smallest shut- producing start producing down price 0 1000 2000 3000 4000 5000 6000 Quantity of trees ▪ 2 9  THE SHORT-RUN MARKET EQUILIBRIUM Figure 12-5 The short-run market equilibrium: the quantity supplied equals the quantity demanded, taking the number of producers as given.  ENTRY AND EXIT IN THE LONG-RUN ▪ In the long run, firms enter into the market and/or exit the market in response to profitability ▪ Q: why would a firm enter an industry if the market price is only slightly greater than the break-even price? Profits will be neglible. TC = explicit + implicit cost ▪ A: We are using economic profit as our measure ▪ If the market price is above the break-even level (no matter how slightly), the firm can earn more in this industry than it could doing anything else  THE LONG-RUN INDUSTRY SUPPLY CURVE (a) Existing firm’s response (b) Short-run and long-run market (c) Existing firm’s response to to increase in demand response to increase in demand new entrants Price, Price Price, Long-run industry Higher industry cost cost An increase in supply curve output from new demand raises entrants drive price and price and profit S1 S2 profit. MC back down. MC $18 Y Y ATC YMKT ATC 14 X XMKT ZMKT D2 Z Positive economic D1 Increase in output from profits are often too new entrants good to be true. 0 Quantity 0 QX QY QZ Quantity 0 Quantity The Long-run Industry Supply Curve shows how the quantity supplied responds to the price once firms have had time to enter or exit  THE LONG-RUN INDUSTRY SUPPLY CURVE ▪ The long-run supply curve is perfectly elastic if costs are constant across the industry for all firms (same cost structure with perfectly elastic input supply) ▪ The long-run industry supply curve slopes upward when producers use an input that is in limited supply. As the industry expands, the price of that input goes up, and later entrants have a higher cost structure than early entrants. Such industries are said to have increasing costs. ▪ The long-run industry supply curve slopes downward when an industry faces increasing returns to scale, in which average costs fall as output rises. ▪ In all 3 cases, the long-run price elasticity of supply is higher than the short- run price elasticity whenever there is free entry and exit.  THE LONG-RUN MARKET EQUILIBRIUM: ENTRY (a) Market (b) Individual firm Price, cost Price, cost of tree S1 S2 S3 of tree MC Assume only one choice of fixed cost $18 EMKT $18 E if they operate: SRATC = LRATC DMKT 16 16 Short-run Long-run D ATC equilibrium equilibrium CMKT 14 14 C D 0 5000 7500 10,000 0 30 40 45 50 60 Quantity of trees Quantity of trees ▪ If market price > minimum ATC, firms are profitable → attracts new entrants ▪ Long-run equilibrium: no producer has remaining incentive to enter/exit ▪ Free entry/exit: economic profits are zero at the long-run equilibrium  SHORT-RUN VS LONG-RUN INDUSTRY SUPPLY CURVES The long-run industry supply curve is Price Short-run industry supply always flatter — more elastic — than curve, S the short-run industry supply curve. Why? In the long run Long-run ▪ A higher price attracts new entrants in the industry supply long run, raising industry output and curve, LRS lowering price. ▪ A fall in price induces existing producers to exit in the long run, reducing industry output and raising price. In the short run ▪ The number of producers is given and some of their inputs are fixed, the scope for increasing and decreasing quantities in response to a change in demand is Quantity therefore reduced  COST OF PRODUCTION AND EFFICIENCY IN LONG RUN EQUILIBRIUM ▪ Three important conclusions relating to long-run equilibrium in a perfectly competitive industry: 1. The value of marginal cost is the same for all firms 2. With free entry and exit each firm will have zero economic profits in the long-run equilibrium 1. Except if the industry shows increasing costs in the long run, in which case the earlier entrants may make positive profits while the later entrant do not 3. The equilibrium is efficient: no mutually beneficial transactions go unexploited  PRACTICE QUESTION 6 The long-run market equilibrium in a perfectly competitive industry with identical firms results in all firms: a) earning zero economic profit. b) producing the quantity associated with their break-even price. c) producing the profit-maximizing quantity at which MR = MC. d) All of the above statements are true.  SUMMARY ▪ In a perfectly competitive market, all producers and all consumers are price- takers—no one’s actions can influence the market price ▪ The conditions for a perfectly competitive industry are: 1. There are many producers, none of whom have a large market share 2. The industry produces a standardized product or commodity (goods that consumers regard as equivalent) 3. There is Free entry and exit into and from the industry ▪ Firms act according to the optimal output rule: produce the quantity at which marginal revenue equals marginal cost ▪ For a price-taking firm, marginal revenue is equal to price  SUMMARY ▪ In the short run: ▪ If market price > ATC (break-even price) then the firm is profitable ▪ If market price = ATC (break-even price) then the firm breaks even ▪ If AVC (shut-down price) < market price < ATC (break-even price) then the firm is unprofitable but keeps producing ▪ If ACV (shut-down price) ≥ market price then the firm stops producing ▪ The short-run individual supply curve is equal to the firm’s marginal cost above the shut-down price  SUMMARY ▪ The short-run industry supply curve is the sum of individual supply curves given that the number of firms is fixed ▪ The long-run industry supply curve is the industry supply curve given sufficient time for entry and exit to occur ▪ The long-run industry supply curve is always more elastic than the short-run industry supply curve. ▪ In the long-run market equilibrium producers have no incentive to enter or exit ▪ Free entry and exit means that each firm earns zero economic profit—producing the output corresponding to its minimum average total cost