Transcript Lecture_10 - kingscollege.net

Lecture 10: The Theory of
Competitive Supply
Readings: Chapter 12
The Theory of Competitive Supply
Q: What does the firm’s technology and costs have
to do with supply decisions?
 We earlier discussed how the firm maximizes
profits by adopting strategies in which the MR of
an activity equals the MC.
 We now have to explore the firm’s revenue side
to understand its decision-making.
The Theory of Competitive Supply
Q: We know how to derive the firm’s cost curves.
What does the firm’s revenue curve look like?
 The firm’s total revenue curve will depend on the
nature of competition (or market structure). We
begin by assuming that firms face Perfect
Competition. Next lecture we will explore
various forms of Imperfect Competition.
The Theory of Competitive Supply
Q: What characterizes a perfect competition?
 There are several characteristics:

Many small firms.

Homogeneous product.

Entry into the industry is easy.

All firm’s view the market price as being
something over which they have no control
over – firms are price takers.
 Example: Wheat farmer
The Theory of Competitive Supply
Q: What does the revenue curve of a firm in a
perfectly competitive industry look like?
 Because the firm is small and a price taker:

The firm can sell as much as it produces
without altering the market price. Therefore,
demand is perfectly elastic at the market p.

The firm’s total revenue is simply: TR = pq
Figure 11.1a,b
Demand, Price, and Revenue
in Perfect Competition
P
P
S
50
50
25
Swanky’s
demand
curve
AR = MR
25
D
0
9
20
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
0
10
20
Q
(b) Firm
Textbook p. 235
Figure 11.1c Demand, Price, and Revenue in Perfect
Competition: Swanky’s Total Revenue
TR
TR = pq
500
225
0
9
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20
Q
Textbook p. 235
The Theory of Competitive Supply
 For a firm in a competitive industry we have
derived:

Its short and long-run cost curves

Its total revenue curve
Q: If a firm in a perfectly competitive firm is profit
maximizing, what is its best quantity strategy?
 Profits will be maximized if the firm chooses to
produce where the TR and TC curves are at the
maximum distance
The Firm’s Output Decision

At low output levels, the
firm incurs an economic
loss—it can’t cover its
fixed costs.

At intermediate output
levels, the firm makes
an economic profit.
The Firm’s Output Decision


At high output levels,
the firm again incurs
an economic loss—
now the firm faces
steeply rising costs
because of diminishing
returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a
day.
The Theory of Competitive Supply
Q: Suppose the manager of the firm wants to
maximize profits, but does not know the full TR
and TC curves. What is her best strategy?
 The manager knows enough to follow the
following rules:

if MR > MC, firm ↑Q to ↑ profit

if MR < MC, firm  Q to ↑ profit

If MR = MC, then profits are being
maximized and the manager should stop.
The Theory of Competitive Supply
Q: Is it not true that modern university educated
managers, accountants, and engineers are able
to draw the TR and TC curves for the firm, and
so immediately find the optimal strategy?
 No! Professional managers do not have the
information needed to immediately find the
optimal strategy.
Q: What is a smart manager to do?
 Focus on the marginal costs and revenue!
The Firm’s Output Decision

If MR > MC, economic
profit increases if
output increases.

If MR < MC,
economic profit
decreases if output
increases.

If MR = MC, economic
profit decreases if
output changes in either
direction, so economic
profit is maximized.
The Theory of Competitive Supply
Q: Will this strategy always provide the firm with
economic profits?
 No. If prices are low or costs are high, this
strategy may fail to provide a positive profit, but
it is still the best strategy as it minimizes losses.
Q:How is the firm’s strategy related to its profits?
 Adding the ATC curve to the picture makes it
possible to measure the profits (or losses) from
a strategy choice.
Figure 11.4a Three Possible Profit Outcomes
in the Short Run: Economic Profit
P
MC
ATC
25.00
AR = MR
Economic profit
20.33
0
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Textbook p. 239
Figure 11.4b Three Possible Profit Outcomes
in the Short Run: Normal Profit
P
MC
Break-even
point
AR = MR
20.00
0
Copyright © 1997 Addison-Wesley Publishers Ltd.
ATC
8
Q
Textbook p. 239
Figure 11.4c Three Possible Profit Outcomes
in the Short Run: Economic Loss
P
MC
ATC
20.14
Economic loss
AR = MR
17.00
0
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Q
Textbook p. 239
The Theory of Competitive Supply
 As the preceding diagrams make clear, there
are three possible short-run outcomes:

P > ATC  economic profits

P = ATC  zero economic profits (break-
even point at minimum ATC; firm just
earning normal profits)

P < ATC  economic losses
(firm earning less than normal profits)
continued
The Theory of Competitive Supply
Q: What does a firm do if it faces economic losses?
 For firm suffering economic losses

if P > AVC, firm continues to produce

if P < AVC, firm temporarily shuts down

shutdown point at minimum AVC
 Important Implication  Perfectly competitive
firm's supply curve is MC curve above minimum
AVC
Figure 11.5a
Swanky’s Supply Curve: Marginal Cost
and Average Variable Cost
P
MC
31
MR2
25
MR1
Shutdown
point
s
AVC
MR0
17
0
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Textbook p. 240
Figure 11.5b
Swanky’s Supply Curve
P
S
31
25
s
17
0
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7
9 10
Q
Textbook p. 240
The Theory of Competitive Supply
Q: If the firm’s short run supply curve is the MC curve
above the AVC curve, what is the industry supply
curve?
 Short-run industry supply curve is horizontal sum
of individual firm supply curves
 Example: In the next slide it is assumed that there
are 10 firms with identical costs in the competitive
industry.
Deriving Industry Supply
P
P
S
MC
25
25.00
20
17
20.00
17.00
0
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
ATC
Normal
profit
7
0
8
9
Q
(b) Firm
Textbook p. 242
The Theory of Competitive Supply
 Equilibrium market price and quantity
determined by industry demand and supply
curves
 In short run, perfectly competitive firms can
make economic profit, normal profit (zero
economic profit), or suffer economic loss
 In short run, number of firms and plant size fixed
Figure 11.7
Short-Run Equilibrium
P
P
S
MC
25
25.00
20
17
20.00
17.00
ATC
Normal
profit
Econ.
loss
0
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
Figure 11.7
Short-Run Equilibrium
P
P
S
ATC
25.00
25
17
0
MC
Econ. profit
Normal
profit
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
The Theory of Competitive Supply
Q: What happens industry over the long-run?
 Economic profits/losses are signals for firms to
enter/exit industry  reallocation of resources

economic profits  new entry  rightward
shift industry S  P  profits

economic losses  existing firms exit 
leftward shift industry S  P↑  losses
 Long-Run Equilibrium when economic profits = 0
continued
Figure 11.8
Entry and Exit
P
SA
SO
SB
30
23
20
17
D
10
0
6
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8
9
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Textbook p. 243
Economic Losses cause firms to exit, which
causes supply to decrease (shift in).
P
P
S
MC
25
25.00
20
17
20.00
17.00
ATC
Normal
profit
Econ.
loss
0
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
Economic Profit attracts entry, which causes
supply to increase (shift out)
P
S
MC
ATC
25.00
25
17
0
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
The Theory of Competitive Supply
 In long-run competitive equilibrium

MR = P = MC;
firms maximize short-run profits

P = minimum ATC;
economic profits are zero;
no incentive for firms to enter or exit

P = minimum LRAC;
optimum plant size;
no incentive for firm to change plant size
Figure 11.9
Plant Size and Long-Run Equilibrium
P
MCo
SRAC0
MC1
SRAC1
LRAC
25
MR0
20
MR1
m
Short-run
profit-maximizing
point
0
6
Copyright © 1997 Addison-Wesley Publishers Ltd.
Long-run
competitive
equilibrium
8
Q
Textbook p. 245
The Theory of Competitive Supply
Q: What happens when changing tastes reduce
demand?




demand shifts left  P 
Firms to move down their MC curve and
supply less (q ) reducing the amount sold
in the market (Q ).
The lower price also creates losses  over
time, firms exit causing industry supply to
decline (shift left) P
In the long run, enough firms exit so
remaining firms earn normal profit (zero
economic profit).
continued
Impact of a permanent decline in demand
P
P
S
MC
25
25.00
20
17
20.00
17.00
ATC
Normal
profit
Econ.
loss
0
7
8
9
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
The Theory of Competitive Supply
Q: What happens when technology improves?

firm’s MC and ATC shift down

shift in MC causes Supply to shift down by
the same amount as the MC curves shifted
down.

Price falls, but costs fall further so that the
firm earns economic profits.

Profits attract entry which causes price to
fall further, industry output rises, while firm
output falls.
continued
Impact of a permanent improvement in production
technology
P
P
S
MC
ATC
25
20
17
0
70
80
90
(a) Industry
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
7
0
8
9
Q
(b) Firm
Textbook p. 242
The Theory of Competitive Supply
 We have seen how over the long-run the short-
run supply relationship can shift because of
entry and exit by firms, and because of
investment in new plant.
Q: Is there a long-run supply curve that takes into
account entry, exit and investment?
 Yes, and the shape of this long-run relationship
will depend on whether there are external
economies or diseconomies of scale.
continued
The Theory of Competitive Supply
Q: What are external economies and external
diseconomies of scale?

external economies of scale: are factors
beyond control of firm that lower costs as
industry output

external diseconomies of scale: are factors
beyond control of firm that raise costs as
industry output
The Theory of Competitive Supply
Q: Example of external diseconomy of scale?
 David Ricardo pointed out that as wheat
production expanded, more land would have to
be pushed into cultivation. This causes the
demand for land to rise, which in turn increases
the price of land. As land is an important input
into wheat production, the average and marginal
cost of wheat would rise as output increased.
 Implication: The long-run supply curve for wheat
would be upward sloping.
P
30
23
D
10
0
6
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7
10 Q
Textbook p. 243
The Theory of Competitive Supply
Q: Example of external economy of scale?
 An important cost of business is the cost of
manufactured factor inputs. As an industry
grows, more and more specialized firms
providing these inputs begin to appear. If this
creates greater competition, the costs of
manufactured inputs can fall driving average and
marginal costs down.
 Implication: The long-run supply curve for such
an industry would be downward sloping.
P
D
0
Copyright © 1997 Addison-Wesley Publishers Ltd.
Q
Textbook p. 243
The Theory of Competitive Supply
 Summing Up

Long-run industry supply curve shows how
industry quantity supplied varies as market
price varies after all possible adjustments,
including changes in plant size and number
of firms

Shape of long-run industry supply curve
depends on the existence of external
economies or diseconomies
continued
The Theory of Competitive Supply
 Long-run industry supply curve is

horizontal for constant cost industry

upward sloping for increasing cost industry
with external diseconomies

downward sloping for decreasing cost
industry with external economies
continued
The Theory of Competitive Supply
Q: What is missing from our theory of supply?
 How firms make supply decisions in industries
with imperfect competition.
Q: Despite the weakness of the present theory is it
useful in attempting to understand and predict
supply?
 Yes. While very few markets are perfectly
competitive, there is often sufficient competition
so that the perfectly competitive model can
provide a first approximation of behaviour.