Transcript entry
The output decision for a competitive firm: To maximize profit, produce the output level for which: MR = MC (that is, p = MC) . . . unless p < AVC. In that case, shut-down (produce zero output) for the short-run. If AVC < p < ATC, continue to produce in short-run, but exit in long-run if market conditions don’t improve. These rules describe the supply curve of the firm -showing how output varies as price varies. Add AVC (which tends to be “U-shaped” also). Start with conventional cost curves. ($/widget) For prices (like p1) that are < min AVC, MC ATC p3 AVC p2 min AVC p1 q1= 0 q2 q3 . . . profit-max output is zero. For prices (like p2, p3) that are > min AVC, . . . profit-max output is determined by p = MC. (widgets/day) “Connecting the dots” gives us the short-run supply curve for the competitive firm. Drawing the short-run supply curve for a competitive firm. For prices below min AVC, profit-max output is zero. ($/widget) MC ATC AVC min AVC One “branch” of supply curve coincides with vertical axis. At prices above min AVC, firm supplies positive output. Second “branch” of supply curve traces MC. (widgets/day) Firm’s short-run supply slopes up . . . because MC slopes up . . . because of diminishing MP. Now that we’ve derived the short-run supply curve for a competitive firm, the next step is to investigate equilibrium for the industry . . . . . . in the short-run, and in the long-run. Recall: Short-run: Employment level of fixed factors (“factory”) cannot be adjusted. Long-run: “Fixed” factors become variable. Existing firms can expand or “downsize” their plants. But we also assume that new firms can enter, . . . . . . and existing firms can exit. In this analysis (to keep things simple!), we’ll ignore the possibility of firms expanding or downsizing . . . . . . and focus instead on effects of entry and exit. So, in the short-run: Fixed number of identical firms. (same technology, same cost curves). In the long-run: Depending on market conditions (Is this a “profitable industry?”), some new firms (identical to existing ones) might enter . . . . . . or some existing firms might exit. Going from firm supply to industry supply: ($/widget) ($/widget) Supply MC p2 AVC p1 q1 q2 (widgets/day) Let’s say there are 100 firms in industry. Q1=100 x q1 Q2=100 x q2 When price = p1, firm supply = q1 . . . and industry supply = 100 x q1 When price = p2, firm supply = q2 . . . and industry supply = 100 x q2 Industry supply is horizontal sum of 100 copies of firm supply (MC). Short-run equilibrium for the competitive industry. ($/widget) Industry Representative firm (1 of 100 identical) Supply MC p1 ATC q1 (widgets/ day) Demand Q1 = 100 x q1 Industry supply is the horizontal sum of firm supplies. Supply and demand determine equilibrium price; p1, let’s call it. Facing price p1, each firm maximizes profit by producing q1. Industry output is 100 x q1; Q1, let’s call it. In this short-run equilibrium, each firm makes positive profit. Remember, this is positive economic profit. Each firm is more-than-covering opportunity costs . . . . . . including opportunity costs of owners’ inputs (labor, financial capital, etc.) In other words, owners’ resources are earning a higher return in this industry than they would in next-best alternative use. Positive profit attracts more investment to the industry. Entry of new firms occurs in long-run. Entry of new firms and its effect on equilibrium: ($/widget) Industry Representative firm (1 of 100 identical) Demand MC S1 S2 p1 ATC q1 Q1 = 100 x q1 The short-run (positive profit) equilibrium from the previous slide. (Industry supply now denoted “S1.”) Let’s say that positive profit attracts 5 new firms (to start). Industry supply shifts to the right: S1 S2. Entry of new firms and its effect on equilibrium: ($/widget) Representative firm (1 of 100 identical) MC Industry Demand S2 ATC p2 q2 Price falls to p2. Q2 = 105 x q2 Each firm produces q2 (a little less than before). Industry supplies Q2 (a little more than before). Firms still earn positive profit . . . so there’s still incentive for entry. Industry supply shifts further to the right with additional entry. Long-run equilibrium: ($/widget) Representative firm (1 of 100 identical) MC Industry Demand S3 ATC p* q* Q* = 108 x q* Entry incentive is eliminated (long-run equilibrium reached) when firms earn zero profit. (Let’s say this takes entry of 3 more firms; bringing total to 108.) Each firm produces q*. Price: p* = min ATC. Industry output: Q* = 108 x q*. Things to notice about long-run equilibrium: Firms operate at the “efficient scale” (the quantity of output that minimizes ATC) . . . . . . and price equals minimum ATC. This means that profit is zero. (Very important to distinguish between “accounting profit” and “economic profit.”) We get this result because of “free entry and exit” of firms. We can use what we’ve learned to investigate the response of a competitive industry to a demand shift. When demand increases (for example) . . . . . . how do price, firm output, and industry output respond . . . . . . in the short-run? . . . in the long-run? Let’s start with a long-run (zero-profit) equilibrium: ($/wdgt) Rep. firm p2 ($/wdgt) MC Industry D1 D2 S1 ATC p1 q1 q2 (wdgts/ day) Q1 Q2 (wdgts/ day) Then demand increases to D2. In the short-run (with number of firms fixed), equil. moves up S1. Price increases to p2. Each firm increases output to q2. Industry quantity increases to Q2. Each firm makes positive profit! Positive profit is an incentive for entry of new firms. ($/wdgt) Rep. firm p2 MC Industry ($/wdgt) D1 D2 S1 ATC p1 q1 q2 (wdgts/ day) Q1 Q2 As entry occurs, supply curve shifts right. This brings price back down some, reducing profit of rep. firm. Entry continues until original price is restored. (wdgts/ day) Positive profit is an incentive for entry of new firms. ($/wdgt) Rep. firm p2 MC ($/wdgt) Industry D1 D2 S1 S2 ATC p1 q1 q2 (wdgts/ day) Q1 Q2 Q3 (wdgts/ day) Entry continues until original price is restored. In new long-run (zero profit) equilibrium: price = p1 and firm quantity = q1 (just like at the beginning) industry quantity = Q3 (there are more firms than before) Recap: Response to demand increase. ($/wdgt) Rep. firm MC p2 ($/wdgt) Industry D1 D2 S1 S2 ATC p1 q1 q2 Short-run response. (wdgts/ day) Q1 Q2 Q3 (wdgts/ day) Recap: Response to demand increase. ($/wdgt) Rep. firm MC p2 ($/wdgt) Industry D1 D2 S1 ATC p1 q1 q2 (wdgts/ day) Long-run response. Connecting original LR equilibrium . . . . . . and new LR equilibrium . . . . . . gives long-run supply curve. S2 SLR Q1 Q2 Q3 (wdgts/ day) An exercise to test your understanding of the dynamics of competitive industries: Start with a long-run (zero profit) equilibrium. Assume that demand decreases. (Hint: This time, the mechanism for long-run change will be exit, not entry.)