Transcript SUPPLY AND PRICING IN COMPETITIVE MARKETS

SUPPLY AND PRICING IN
COMPETITIVE MARKETS
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Principles of
Microeconomic Theory,
ECO 284
John Eastwood
CBA 247
523-7353
e-mail address:
[email protected]
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SCP Paradigm
Structure  Conduct  Performance of an
industry.
 Economists classify industries into four
broad categories:
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Pure Competition
Monopolistic Competition
Oligopoly
Monopoly
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The Theory of Pure Competition
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Assumptions:
Many Sellers and Buyers
Identical Products
Easy Entry and Exit (in the Long Run)
“Perfect Competition” Assumes Perfect
Information and Mobility.
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The Purely Competitive Firm As
"Price Taker"
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“Price takers are buyers or sellers who are
so small relative to a market that the effects
of their transactions are inconsequential for
market prices.”
page 193, Byrns & Stone.
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The Demand Curve in Pure
Competition
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The demand curve for the product of a
purely competitive firm is perfectly elastic
(horizontal).
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The Marginal Revenue Curve in
Pure Competition
MR is the change in TR from a one unit
change in quantity, q.
 If the firm sells one more unit, its TR
increases by P.
 Price and MR are equal (in Pure Comp)
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TR  ( Pq )
q
MR 

P
P
q
q
q
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Price Equals Average Revenue
Average Revenue, equals TR divided by
quantity, q.
 If the firm sells all of its output at the same
price (P), then P = AR.
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TR Pq
AR 
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P
q
q
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PURE COMPETITION IN THE
SHORT RUN
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Profit Maximization
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Using TR & TC.
Using MR & MC.
If a firm is losing money, should it continue
to produce?
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Minimizing losses
Shut-down point
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Profit Maximization
Firms will attempt to earn the greatest
possible profit.
 Profit equals Total Revenue minus Total
Cost: p = TR - TC
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The Profit Maximization Rule:
Produce where MR = MC.
There is only one output level at which the
MC curve cuts the MR curve from below.
 This output level will maximize profits or
minimize losses (unless P < AVC).
 Profit = P(q) - ATC(q) = (P - ATC) q
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When P  ATC, it pays to produce.
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The firm will maximize its profits by
producing the quantity that equates MR and
MC.
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P > ATC. The firm will earn a positive
economic profit (TR > TC).
P = ATC. The firm will earn its opportunity cost
(TR = TC), a zero economic profit.
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When P < ATC it may pay to
produce in the short run.
AVC < P < ATC. The firm can pay all its
variable costs, plus part of its fixed costs.
Thus it can minimize losses by producing
where MR = MC in the SR.
 P < AVC. The firm should shut-down in the
SR. Its losses will equal its fixed costs.
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In the long run it will either need to reduce its costs or exit the industry.
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The Firm’s Short-Run Supply
The firm produces (in SR) if P  AVC, but
shuts down if P< AVC.
 In Pure Competition, P = MR.
 The firm will produce the quantity where P
= MR = MC.
 It follows that the MC curve above the
minimum point of AVC is the SR supply
curve of the firm.
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Short-Run Industry Supply
. . . equals the horizontal sum of the shortrun supply curves of all the firms in the
industry.
 Long-run Industry Supply is more elastic
than SR or Market-Period Supply.
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PURE COMPETITION IN THE
LONG RUN
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How Profits Direct Resource Allocation
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Economic Profits Attract New Firms.
Economic Losses Cause Firms to Exit.
Long-Run Equilibrium for the Firm
 Long-Run Industry Supply
 Economic Efficiency
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Economic Profits Attract New Firms
Assume that P = MC > ATC in SR equil.
 For simplicity, assume that resource prices
and technology are fixed in LR, all firms
face the same costs.
 TR > TC implies that new firms will enter.
Short-Run Industry Supply shifts to the
right; market price falls. “Old” firms
decrease their q as price falls.
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Losses May Cause Firms to Exit
Assume that P = MC < ATC in SR equil.
 Again assume that resource prices and
technology are fixed in LR, all firms face
the same costs.
 TR < TC implies that some firms will exit.
Short-Run Industry Supply shifts to the left;
market price rises. Survivors increase their
q as price rises.
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Characteristics of Long-Run
Equilibrium:
P = minimum short-run ATC. Each firm in
the industry is earning a "normal profit."
There is no incentive for new firms to enter
or for existing firms to exit.
 P = minimum long-run ATC. The firm has
no incentive to change the size of its plant
or the scale of its operations. Technical
Efficiency is achieved.
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Industry Adjustment to an
Increase in Demand
The Long-Run Industry Supply Curve
(a horizontal sum of long-run MC).
 As demand increases, market price will
increase. Existing firms will expand output
(moving along their short-run supply
curves) and earn positive economic profits
in the short run.
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Industry Adjustment to an
Increase in Demand (LR)
In the long run, new firms will enter,
shifting the short run industry supply curve
to the right.
 Market price will decrease as a result, but
how much?
 A single firm is too small to affect factor
prices, but when an industry expands,
resource prices may change.
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Slope of the Long-Run Industry
Supply Curve (LS)
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If identical firms use general inputs, such as
unskilled labor, that can be attracted from a
vast ocean of other uses without affecting
the prices of those general inputs, we get the
case known as a Constant-Cost Industry,
which implies a flat LS.
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Increasing-Cost Industries
If an industry uses specialized resources, LS
must slope upward.
 To produce more, the industry must either
employ less suitable inputs, or pay higher
prices to hire specialized inputs away from
other industries.
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Decreasing Cost Industries
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The entry of new firms causes falling input
prices. Falling factor prices shift the cost
curves downward, and the short-run
industry supply curve shifts to the right.
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Decreasing Cost -- LS has a negative slope
Eventually, the falling product price catches
up with the decreasing costs, profits are
squeezed out, and entry ceases.
 The new long-run equilibrium occurs at a
lower product price because lower resource
prices have shifted the cost curves down.
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What might cause Decreasing Costs?
Economic development
 IRS in supply industries
 Gains in Process Technology
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External v. Internal Economies
These economies associated with expanding
industry output are external to the firm. No
single firm can affect resource prices.
 Economies of scale are internal to the firm
-- its long-run average costs decline as it
expands the scale of its operations.
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Competitive Markets are Efficient
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Technical (or Productive) Efficiency requires
minimizing the opportunity cost of producing a
given level of output.
Allocative Efficiency requires national output
mirrors what people want and are willing and able
to buy.
Distributive Efficiency requires that specific goods
be used by the people who value them relatively
the most.
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Pareto Efficiency
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Pareto Efficiency occurs when no possible
reorganization of production can make anyone
better off without making someone else worse off.
Under conditions of Pareto Efficiency, one
person's utility can be increased only by lowering
someone else's utility.
Pareto Efficiency combines the notions of
Technical, Allocative, and Distributive eff.
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In Short- and Long-Run
Equilibrium, P = MC
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When price equals marginal cost, the last unit
produced cost an amount equal to what the last
buyer was willing to pay.
Under certain conditions, this achieves efficiency
in both allocation and distribution.
In the absence of external benefits and costs,
Marginal Social Benefits = Marginal Social Costs.
With economy-wide PC, resources earn their
opportunity costs.
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A Simple Competitive Economy
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Assumptions:
– All individuals are identical farmers (ability and taste).
– As people increase their work and leisure hours are
curtailed, each additional hour of work becomes
increasingly tiresome.
– Each extra unit of food consumed brings diminished
marginal utility, MU, which we will measure in dollars
(maximum willingness-to-pay, WTP).
– Because food production takes place on fixed plots of
land, by the law of diminishing returns, each extra
minute of work brings less and less extra food.
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Equilibrium
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Add the identical marginal cost (MC) curves of
our identical farmers to get the upward sloping
industry supply curve.
Add the identical demand (MU) curves of our
identical consumers to get the downward sloping
industry demand curve. The intersection of
demand and supply is competitive equilibrium.
A careful analysis of this competitive equilibrium
will show that it achieves Pareto Efficiency:
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Output Mirrors People’s Demands
P = MU. Consumers choose food purchases
up to the amount P = MU.
 Each person is gaining P dollars of
satisfaction from the last unit of food
consumed.
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Allocative Efficiency, P = MC
Each farmer supplies labor up to the point
where the price of food exactly equals the
MC of the last unit of food supplied.
 The price here is the satisfaction lost by
working that last bit of time needed to grow
that last unit of food.
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MU = P = MC
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MU = MC. This means that the satisfaction
gained from the last unit of food consumed
exactly equals the satisfaction lost from the
labor required to produce that last unit of
food.
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Consumer & Producer Surplus
A brief review:
 Economic surplus is the excess of utility
over costs of production. It is equal to
consumer surplus (excess of consumer
utility over price paid) plus producer
surplus (excess of producer revenues over
cost).
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Efficiency and Surplus
Pareto Efficiency requires production of the
maximum amount of economic surplus out
of society’s resources.
 Competitive equilibrium maximizes the
economic surplus.
 If the economy operates at any point other
than the competitive equilibrium point, it
will be inefficient.
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Equilibrium With Many Markets
Can a Purely Competitive economy be
efficient if it contains millions of firms,
hundreds of millions of people, and
countless commodities?
 The answer is yes, if certain conditions
hold.
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Conditions:
1. A Purely Competitive Economy:
All markets must be purely competitive.
Buyers and sellers must be well informed,
Markets must exist for all outputs.
2. No Externalities.
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A System of Purely Competitive
Markets
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For those industries where there are many
reasonably informed consumers, many
mutually competing producers, and
negligible externalities, a system of purely
competitive markets will produce the
maximum economic surplus.
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Consumer Sovereignty
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Competitive markets synthesize
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the willingness of people possessing dollar
votes to pay for goods (demand) with
the marginal costs of those goods (supply).
Under ideal conditions, competitive markets
achieve Pareto Efficiency, in which no
person’s utility may be raised without
lowering that of another.
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Model v. Real World
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We cannot say that laissez-faire competition
results in the greatest happiness of the
greatest number of people.
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Imperfect competition is common.
Externalities are pervasive.
People are not equally endowed with
purchasing power.
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Efficiency Vs. Equity
A society does not live on efficiency alone.
Philosophers and others ask, "Efficiency for
what? And for whom?"
 A society may decide to lessen efficiency to
improve equity.
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Economies of Scale and the End
of Pure Competition.
Suppose that a firm in pure competition
faces falling long-run marginal and average
costs. MC cuts the P = MR line from above.
The firm can increase its profit by
expanding output.
 Further, it will find its advantage growing as
it gets larger.
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IRS Leads to Imperfect Competition
One or a few firms will expand their output
to the point where they supply a significant
share of the industry's total output.
 The industry then becomes imperfectly
competitive.
 Many studies have found IRS in a wide
range of non-agricultural industries.
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