#### Transcript Introduction to Microeconomics

```Introduction to Microeconomics
Long-run profit
Dropping the Assumption of the
short-run
• The short-run is defined by whether you can vary any factor
of production
• This typically means piece-work labour (I can hire and fire
with complete freedom)
• In most cases contracts/regulations impede the freedom of
the firm
– Labour law requires two weeks notice
– Professional sports contracts often have “no cut” clauses
• What is the short-run for the following
–
–
–
–
Hot dog stand?
Flower shop?
Law firm?
Car assembly plant?
Three Types of Profit
• Accounting profit = Total Revenue – explicit costs
(payments a firm makes to its factors of
production and other suppliers)
• Economic profit = Total Revenue - explicit costs implicit costs (opportunity costs of the resources
supplied by the firm’s owners)
• Normal profit = accounting profits - economic
profit
– The opportunity cost of resources supplied by the
firm’s owners.
LO1: Difference Between Accounting and Economic
Ch6-3
Profit
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FIGURE 6.1: The Difference Between Accounting Profit and
Economic Profit
Total
revenue
Explicit
costs
Explicit
costs
Accounting
Profit
Normal profit =
opportunity cost of
resources supplied
by owners of firm
(a)
(b)
Economic
profit
(c)
Ch6-4
LO1: Difference
Between Accounting and Economic Profit
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Firm, the Market, and a Shift in the Short-Run Supply: Responses
of a Wheat Farm and the Wheat Market
MCS
0.08*12,000 = 960
SRS
E2
SRS′
ATCS
2.12
2.12
E1
E3
D′
D
• ATCs represents the lowest cost per unit of
•Bernard
his production
12 000
wheat
that increase
can be achieved
for any to
given
bu at the
of \$2.12/bu.
quantity
of cost
wheat.
•Totalis economic
= (\$2.20• MCs
a short-runprofit
marginal
cost curve.
\$2.12)(12000) = 960/year.
• There are 1000 farmers in the market,
• Assume
the demand
rises
to D’,
SRS
is the short-run
supply
curve
forprice
the
increase
to
\$2.20
• InE1
the
run,
Farmers
will enter the
market,
is long
the
SR
and
LR equilibrium
•E2industry
is the short-run
where
until theequilibrium,
price of wheat
falls low
farmers
product
12 million
bu/year
and
enough
to reduce
economic
profit
to zero.
make
profit.
• E3aniseconomic
the long-run
equilibrium.
LO2: Economic
profit and economic loss and entry or © 2012 McGraw-Hill
Ch6-5
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exit
Long-Run Average Cost
ATC 1
ATC 2
ATC 4 ATC 5
ATC 3
LRAC
LO3: Difference between
Long Run and Short Run
Ch6-6
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Long-Run Average Cost and Perfectly
Competitive Markets
• Long-Run Average Cost (LRAC).
– In the long run, firms can change their capital stock
and thereby choose their size of operation.
– Each size of firm has its own Average Total Cost curve.
– LRAC is the minimum average cost for a given level of
output.
• Long-Run Competitive Equilibrium.
– Price is at the minimum of LRAC.
• If price is higher, firms producing at minimum LRAC can
make an economic profit and will enter industry.
– All firms operate at the size that minimizes LRAC.
LO3 & LO4: Difference
between Long Run and
Short Run, Long run
operation at minimum point
Ch6-7
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Long-Run Supply (LRS) in a Perfectly Competitive Market—Case I:
Constant Opportunity Cost of Inputs
LRAC
SRS′
SRS
ATCs
LRS
D′
D
Q1 Q2 Q3
Panel (a) shows the firm’s long-run average cost curve, while panel (b) shows
that long-run market supply is horizontal and pertains to a constant cost
industry.
Ch6-8
LO4: Long run
operation at minimum point of LRAC
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Long-Run Market Supply – 2 cases
• Case I: Cost of Additional Inputs is Constant.
– Any increase in price will cause economic profits.
– New firms will enter until the price is driven back to the
level where it started.
– Long-Run Supply (LRS) is therefore perfectly elastic.
• Case II: Cost of Additional Inputs Rises.
– Increase in Price causes economic profits for existing firms.
– New firms enter, driving down product price.
• but also bidding up the price of inputs.
• and thereby increasing industry costs.
– Product price falls, but not to where it started.
– Long-Run Supply (LRS) is upward sloping.
Ch6-9
LO4: Long run
operation at minimum point of LRAC
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FIGURE 6.5: Long-Run Supply (LRS) in a Perfectly Competitive
Market—Case II: Cost of Inputs Rises as Short-Run Supply
Increases
LRAC2
SRS
SRS′
LRS
LRAC1
D
As the number of farms increases in
response to an increase in the demand
for wheat, long-run average cost
increases from LRAC1 to LRAC2.
D′
complete, market price is higher, so
long-run market supply has a positive
slope and pertains to an increasing cost
industry.
Ch6-10
LO4:
Long run
operation at minimum point of LRAC
Why?
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Firm Size and the Shape of the LongRun Average Cost Curve
• It is possible that minimum LRAC can be
achieved over a wide range of output.
– If so, then different firm sizes can coexist in
long-run equilibrium.
• We can divide the LRAC curve into 3 regions
– Economies of scale: LRAC falling.
– Constant returns to scale: LRAC constant.
– Diseconomies of scale: LRAC rising.
LO5: Economies of scale, constant returns to scale, and diseconomies
of
Ch6-11
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scale
FIGURE 6.6: Long-Run Average Cost and Returns to Scale
I: Economies
of scale
II: Constant
returns to
scale
III: Diseconomies
of scale
LRAC
Minimum long-run
average cost
Minimum efficient
quantity
© 2012 McGraw-Hill Ryerson LO5: Economies of scale, constant returns to scale, and diseconomies of
Ch6-12
Limited scale
Free Entry and Exit
• Barrier to entry:
– Anything that prevents new suppliers from entering a
market.
• Natural (e.g., product compatibility).
– Barriers to entry allow price to be higher than the
opportunity costs of production.
• Freedom to leave a market is just as important as
freedom to enter.
• Without reasonably free entry and exit, the
competitive market will not force prices down to
minimum long-run-average cost.
Ch6-13
LO6: Difference
between economic profit and economic rent
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Economic Rent
• That part of the payment for a factor of
production that exceeds the owner’s reservation
price.
– Reservation price: The price below which the owner
would not supply the factor.
• Unlike economic profit, which is driven toward
zero by competition, economic rent may persist
for extended periods.
• Economic rent accrues to inputs that cannot be
replicated easily.
Ch6-14
LO6: Difference
between economic profit and economic rent
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Cost-Saving Innovations
• Firms that develop and introduce cost-saving
innovations:
– Reap economic profits in the short run.
• Supply curves shift rightward as new firms enter.
• Product prices fall.
• Firms that do not use the new technology will suffer
economic losses.
• Competition implies that the cost savings of
new technology are passed along to
consumers.
Ch6-15
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Example 6.7: How do cost-saving
innovations affect economic profit?
•
•
•
•
•
•
Forty merchant marine companies carry oil from the Middle East to the east
coast of Canada. The cost per trip, is \$500 000.
A navigator on one ship finds a new route, which results in fuel savings of \$20
000/trip.
At the beginning, the firm with the more efficient route will earn an economic
profit of \$20 000/trip.
As others begin to adopt the new route, their individual supply curves shift
downward.
The market supply curve also shift downward, which will result in a lower market
price for shipping and a decline in economic profit.
When all firms have adopted the new route, the long-run supply curve for the
industry will have shifted downward by \$20 000/trip, and each earns a normal
profit.
Ch6-16
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The Impact of Improvement in Technology on Long-Run Supply
Technological improvement
causes long-run supply to
shift to the right. If demand
remains constant in this
graph, which represents the
market for wheat, the price
of wheat will be lower in
2005 than it was in 1955.
Ch6-17
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Capital Intensive Industries
· Capital intensive industries, have high fixed
costs relative to variable costs.
· Average costs decline without any
diseconomy of scale
· Marginal costs always lie below average
costs
· If the market is initially perfectly
competitive, it will not remain that way
(firms will race to maximize profit and
constantly expand) – one firm will be left.
E
P=MR
F
F’
ATC
C
E
MC
A
B
C’
B’
Source:
Microeconomics by
Source:
Microeconomics by
Joseph Schumpeter 1883 – 1950
• “Capitalism [...] is by nature a form or method of
economic change and not only never is but never
can be stationary. [...]
• The opening up of new markets, foreign or
domestic, and the organizational development
from the craft shop and factory to such concerns
as U.S. Steel illustrate the same process of
industrial mutation [...] that incessantly
revolutionizes the economic structure from
within, incessantly destroying the old one,
incessantly creating a new one.
• This process of Creative Destruction is the
essential fact about capitalism. It is what
capitalism consists in and what every capitalist
concern has got to live in.”
Schumpeter starts with
the circular flow
The basic circular flow of income
model consists of seven
assumptions:
•
•
•
•
•
The economy consists of two sectors:
households and firms.
Households spend all of their income (Y) on
goods and services or consumption (C).
There is no saving (S).
All output (O) produced by firms is
purchased by households through their
expenditure (E).
There is no financial or government sector.
It is a closed economy with no exports or
imports.
http://en.wikipedia.org/wiki/Circular_flow,
accessed Oct 15, 2012
The entrepreneur is the hero for
Schumpeter
• Profit motive creates the incentive to disrupt
production/consumption cycles
– Steve Jobs
– Bill Gates
– Anita Roddick
– Ray Kroc
Can Apple Still Work Magic?
• http://video.ft.com/v/1821265005001/Big-Apple