Transcript Lecture 6: Perfect Competition

Econ 1000 Lecture 6:
Perfect Competition
C.L. Mattoli
(C) Red Hill Capital Corp., Delaware, USA
2008
1
Prologue
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Businesses are stuck in the short run,
although the length of the short run can vary
depending on the business.
The point is that, in most businesses it is not
possible to change everything quickly.
For example, if you own a store, it will not be
easy to move the location. To move will
require fitting out the new place, changing
business cards, advertising the new location,
etc.
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Prologue
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Other changes for other businesses might be
even longer.
Thus, businesses will have some inputs that
are fixed and others that can be more easily
varied, like man (woman) hours.
When we begin production and go from 0
units to the first, that will require adding some
variable input, for example, labor, to the fixed.
Given that, we can calculate the output per
unit of the variable input, e.g., labor.
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Prologue
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There is efficiency gained when you add,
for example, a second unit of labor.
Suppose that the company consists of 2
machines, fixed inputs. The first machine
does the roughing out of the products and
the second machine is a finishing machine.
With one laborer she has to do the roughing
out, then, move over to the other machine
to finish the product. It is very inefficient.
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Prologue
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There is an efficiency gain, and the two can
produce more than 2 times the output of
one laborer.
The marginal product is the change in
output that occurs by adding one more unit
of variable input. So it is a unit cost,
specifically, for the next unit.
As more units of input are added, there will
continue to be efficiency gains, up to a
point, then, efficiency begins to be lost.
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Prologue
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As a result, the extra (marginal) output
(product) increases, peaks, then, decreases.
There is also an average output per unit of
input.
Using the average-marginal rule, the average
output per unit of input will increase, as
marginal product increases.
Average variable cost per unit of output is
inversely related to average output per unit
variable input, i.e., 1/[output/variable input] =
variable input/output.
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Prologue
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For example, 2 employees/2.2 tons of
grapes = 0.91 employees/ton of grapes.
So, it costs 0.91 employees per unit of
grapes.
Thus, as MP increases, average cost
decreases, and vice versa.
As output increases, the fixed input is also
spread over more units, so total cost per
unit decreases, then increases.
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Prologue
MC will be inverse to MP, as the
change in output per input increasing
means the cost per new unit is
decreasing.
 Then, we can use the averagemarginal rule to look at cost curves.
 We give a diagrammatic summary of
the basic concepts in the next few
slides.

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Marginal Product
Marginal
Product
Marginal Product
Marginal Product
Employees
Marginal Product
0
0.0
1.0
1
1.0
0.5
2
1.2
3
1.1
4
0.9
5
0.6
6
0.2
1.5
0.0
0
2
4
6
8
Employees
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MP vs. MC
MP vs. MC
Labor MP
Output
600
TVC MC/unit
1.4
1.2
500
0
0.0
0
0
1
1.0
1
100
100.00
2
1.2
2.2
200
83.33
3
1.1
3.3
300
90.91
1.0
0.8
MP
Cost ($)
400
300
0.6
200
0.4
100
4
0.9
4.2
400
111.11
5
0.6
4.8
500
166.67
6
0.2
5
600
500.00
0.2
0
0.0
0
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4
6
Output
10
AC & MC
Average and Marginal Costs vs.
Output
160.00
Unit Cost($)
140.00
MC
120.00
100.00
80.00
ATC
60.00
AVC
40.00
AFC
20.00
0.00
0
2
4
6
8
Quantity
10
12
14
Q
TC MC
0
100
---
1
150
50 100.00
50.00 150.00
2
184
34
50.00
42.00
92.00
3
208
24
33.33
36.00
69.33
4
227
19
25.00
31.75
56.75
5
250
23
20.00
30.00
50.00
6
280
30
16.67
30.00
46.67
7
318
38
14.29
31.14
45.43
8
366
48
12.50
33.25
45.75
9
425
59
11.11
36.11
47.22
10
500
75
10.00
40.00
50.00
11
595
95
9.09
45.00
54.09
12
712 117
8.33
51.00
59.33
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AFC
AVC
AC
---
---
---
11
This week
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Chapter 7
Perfect Competition
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Objectives
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We will describe market structure.
We will finally get to a bottom line: profits.
We will look at what it means for a market
to be perfectly competitive.
We will see why governments around the
world promote market competition.
We will examine how the internet is
changing the structure of world markets
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2008
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Where we are coming from
We have studied the ideas of supply
and demand, on their own, and
examined the underlying motivations
that lead to the general shapes of
supply and demand curves.
 Then, we looked at general
interactions between supply and
demand to get market equilibrium,
and think about how changes in
equilibrium might occur.

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Where we are coming from
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People are motivated by self-interest, but that
self-interest leads to competition on both
sides, supply and demand, and, in the end,
self-interest serves society and results in
positive benefits.
On the demand side, self-interest is manifest
in wants, desires, and needs, but it also
tempers the price that they will pay for things.
That puts limits on the supply side: they
cannot simply charge whatever they want.
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Where we are coming from
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What suppliers charge will affect not only how
much they sell but also the total revenue that
they will be able to take in.
Last week we examined output, its
motivations, and its limitations.
Suppliers want to make profits but they have
to face certain constraints.
We saw that there is a short-run, in which
only certain changes can be made to change
the ability to supply, and a longer-run, in
which more can be done to change supply.
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Where we are coming from
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We examined the cost side and found that
suppliers face diminishing returns to inputs.
Diminishing returns means that suppliers will
face changing unit costs, which will affect
their eventual profitability.
We also saw that they might face changing
costs structures depending on their size,
which are manifest in concepts of economies
of scale: bigger, itself, might result in a
longer-run way to reduce unit cost.
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Where we are coming from
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Suppliers, eventually, might also face
diseconomies of scale because of the
organizational structure of business, in
general.
In the end, that means that suppliers will,
in most cases, always face a cost
structure that will limit their ability to make
profits.
This week, we examine profitability in the
case of perfectly competitive markets.
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Market Structures
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Market Structure
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Firms sell things under a number of different
sets of market conditions, which
economists refer to as market structures.
Economists then go on to identify several
basic forms of market structure characterized
by certain key features.
The basic characteristics that shape market
structure, include the number of firms in
the industry, the differentiability of
products, ease of entry and exit in the
market, and availability and dissemination
of information.
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Market Structure
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Those characteristics are indicative of the degree
of competition firms face in a market.
If there are more firms, there are more places to
buy something.
If the products of those firms are more or less
interchangeable, there is no reason to go to one
firm than to another, except, perhaps for other
reasons of convenience.
If entry into the industry is easy, firms already in
the industry will face the threat of more
competition. If it is difficult, they will face less of
a threat.
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The Basic Market Structures
Based on these simple parameters,
there will be a range of
competitiveness by firms in markets,
ranging from none to a lot.
 In a monopoly, there is one seller
who dominates the market.
 Then, there might be only a few large
firms that dominate a market in an
oligopoly.

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The Basic Market Structures
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After that, there might be monopolistic
competition, in which products are
differentiable, and there are many
sellers, but monopolists compete to get
people to like their product instead of
the others.
Finally, there is perfect competition,
which is the focus of this lecture.
We summarize features of the various
market structures, in the next slide.
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Comparative Market Structures
Structure
# of sellers
Product
Entry
Examples
Perfect
Competition
Large
Homogeneous
Very easy
Small crops,
commodities
markets
Monopolistic
competition
Large
Differentiable
Easy
Restaurants,
motels, clothing
or other types
of boutiques
Oligopoly
Few
Usually
differentiable;
can be homo
Difficult
Airlines,
Automobile
manufacturing,
oil production
Monopoly
One
Unique
Extremely
difficult
Public utilities
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The Elements of Perfect
Competition
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Perfect Competition

1.
Perfect competition means,
basically, that no single firm can
gain a competitive advantage over
the others. That will be the case
under a few rudimentary conditions.
If there are many small firms, none
of which has a large enough share
of total output (total supply) that it
can affect market price.
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Perfect Competition


In addition, it must be assumed that the
suppliers do not collude but act
independently.
Example would be egg farmers. There
are thousands of egg farmers. If one
decides to raise his price, it will have no
affect on the going market price for
eggs.
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Perfect Competition
2.

Next, we assume the product is
fungible (homogeneous,
indistinguishable, standardized, all
the same).
That way, no single supplier is able
to gain a competitive advantage
through advertising, quality
distinction, or even convenience of
location.
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Perfect Competition
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Buyers are indifferent about which
supplier they go to. There are no
famous brand names. No one
knows Coke and Pepsi. They just
know cola.
For example, fishmonger Ho’s
lobster (long xia) is no better than
fishmonger Chen’s lobster. They all
come from the same sea.
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Perfect Competition
3.


Ease of both entry and exit are part of the
basis for perfect competition.
That means, first, that there are no barriers
to entry, like, startup cost (financial),
technical, licensing, patent, permit, or
government-imposed barriers.
In that regard, anyone will be able to enter
the market, on the one hand, and will not
be discouraged by penalties, like
investment, contractual, or legal reasons,
to exit the business, on the other hand.
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Perfect Competition
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Resources are completely mobile to
freely enter and exit the market.
That is especially important in an industry
in decline, in order for prices to adjust
quickly.
Easy entry assures that excess profits
will not persist. Others seeing juicy profits
will quickly enter the industry, and prices
will be competitive.
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Perfect Competition


For example, you go into the bicycle
rental business. You buy a bicycle and a
cell phone to start your business, and you
can easily close the business any time.
A further assumption is that market
participants are well-informed and welleducated about the product, including
knowledge of the product, its production
costs, and prices.
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Perfect World (No one’s Perfect)
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The idea of perfect competition is a
perfect world ideal. Models are not
reality but only try to approximate it
under simplified ideal conditions.
The world is not perfect and rational.
There is no perfect information. There
is convenience of going to a store one
block from you instead of one mile. Selfinterest can lead to bad behavior.
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Perfect World (No one’s Perfect)
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However, we expect markets, like farm
products, inter-city trucking, or
housecleaning services, to be close to
the competitive model. There are many
sellers, and products are very similar.
Moreover, the model can provide a
benchmark against which real-world
market structure and performance can
be judged.
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Competition and Policy
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In chapter 4, we saw that lack of competition
can lead to market failures that result in
inefficient outcomes.
On the other hand, perfectly competitive
markets will lead to maximum efficiency.
In that regard, governments around the
world have devoted much regulation and
legislation to promote efficiency by
encouraging competition and to
discourage anti-competitive behavior
through legal and financial penalties.
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ACCC: Australia’s Competition Watchdog
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In Australia, for example, The Australian
Competition and Consumer Commission
(ACCC) is the statutory authority charged
with oversight and enforcement of the
relevant Trade Practices Act that deal with
competition.
The objective of The Act is to enhance the
welfare of Australians by promoting
competition and fair trading and providing
for consumer protection.
The ACCC also administers the Price
Surveillance Act.
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ACCC Objectives
1.
2.
3.
4.
5.
Improve competition and efficiency in
markets
Foster fair trade practices in well-informed
markets.
Promote competitive pricing when possible
and restrain prices in markets where
competition is less than effective
Inform and educate the community about
the Trade Practices Act
Use resources efficiently and effectively
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New Zealand Commerce Commission
(NZCC) Goals
1.
2.
3.
Dynamic markets and all goods and
services produced at competitive prices
Consumers confident of information they
receive when making choices
Regulated industries constrained from
making excess profits, face incentives to
invest, and share efficiency gains with
consumers.
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Policy Goals, Summarized
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Even if not all industries are naturally
competitive, government policies
encourage efficiency by encouraging them to
act as if they are competitive.
Even though not all people practice
enlightened self-interest, policy seeks to ban
unethical behavior.
Bad behaviors that governments seek to
eliminate are: colluding to raise price/
profitability, exercising monopoly power at
the expense of consumers, and misleading
advertising.
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Policy Goals, Summarized
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The authorities can order breakups of
companies that have gained too much
market power.
They can disallow mergers that would
result in too much market power residing in
one company.
They can disallow false advertising.
They can impose price controls, like many
countries do with public utility companies.
They can impose fines and compensatory
damages for bad behaviors,
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Information
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Information is one of the most important
things in business.
Businesses need to keep some information
secret, otherwise their competitors will gain
advantage.
The importance of information is highlighted
by the large role that disclosure of information
and its accuracy play in competition and
securities laws around the world.
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Consequences of Perfect
Competition for Suppliers
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Price Taker, not Price Maker
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In a perfectly competitive market,
market price is determined by aggregate
supply and demand.
Moreover, consumers have perfect
information about the actual market price.
The product is fungible, and the firm
faces competition from inside the industry
and the threat of others entering the
industry.
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Price Taker, not Price Maker
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An individual firm is small and has no control
to affect price (no market power), and if it
tried to charge a higher-than-market price,
informed consumers would not purchase
from that firm because they can switch to
another supplier with no effort, at all (he is
right next door with the proper price).
Thus, a firm is a price taker: it will
necessarily have to sell at the going market
price or sell nothing, at all.
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Price Taker, not Price Maker

In that regard, we can think of the individual firm as facing a
completely horizontal, perfectly elastic demand curve.
The firm must supply any amount that it can and wants to supply
at the going market price or consumers will simply turn to another
of the many other suppliers.
The International Market for Electronic Components
Market Aggregates
Individual Firms
120
Price per unit
(dollars)

100
80
70
60
40
20
0
20 40
60 80 100
Quantity of output
(1000’s units/hour)
0
5
10
Quantity of output
(units/hour)
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Each Firm Faces Perfect Elastic Demand
In the above, graphical example, the
individual firm’s output is several units
per hour, while the industry output is
an aggregate of 60,000 units/hr. at
equilibrium with total demand.
 Equilibrium occurs at a price of
$70/unit.
 Therefore, a firm must take that price,
no matter what it’s output.

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Each Firm Faces Perfect Elastic Demand


It, effectively, faces horizontal
demand, on its part, because no matter
how much output it supplies, that is the
price that people will be willing to pay
for its product.
As we learned, when demand is
horizontal, perfect elastic, a firm
charging a higher price than that where
supply intersects the demand curve will
sell nothing.
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Each Firm Faces Perfect Elastic Demand


On the other hand, selling at a price,
below the one price in demand, would
be stupid because he can sell the same
amount at a higher price.
Moreover, a downward change in price
would, in that case, also lead to a
decrease in revenues because the firm
will not be able to increase sales by
decreasing price ([ΔQ/Q]/[ΔP/P] = ED =
0).
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Short-run Profit Maximization:
Perfect Competition
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The Framework


At the beginning of module 3, we
discussed how elasticity of demand puts
a constraint on the supplier because
changing price can have different affects
on total revenues.
In perfect competition, the constraint
becomes one fixed price against which
the supplier must judge his costs and
ability to make a profit.
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The Framework



In the last lecture, we analyzed the
elements of increasing and diminishing
returns and cost constraints, which
suppliers face.
Now, we can put it all together and analyze
profit.
We saw how the unit cost curves were Ushaped with minimums due to a
maximum in marginal product, which
comes at the point of diminishing returns.
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The Framework




Profits = revenues – costs.
On supply and demand curves we show
price per units, and the average cost figures
show cost per unit.
We shall look at two methods to determine
maximum profits: the total revenue-total
cost approach and the marginal revenue
equals marginal cost method.
We are in the short-run.
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Industry: Output, Revenue, Cost & Profit



We show possible
output, revenue, cost,
and profits for a
mythical company in
our mythical electronic
component industry, in
tabular form, here.
The data, in graphical
form, is shown on the
next page.
It continues MAT
ATM’s from the
previous lecture.
units
TR
TC
Profits
MC
MR
0
0
100
-100
1
70
150
-80
50
70
2
140
184
-44
34
70
3
210
208
2
24
70
4
280
227
53
19
70
5
350
250
100
23
70
6
420
280
140
30
70
7
490
318
172
38
70
8
560
366
194
48
70
9
630
425
205
59
70
10
700
500
200
75
70
11
770
595
175
95
70
12
840
712
128
117
70
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Industry: Output, Revenue, Cost & Profit
Total Revenue & Cost

As you can see
from the table
and the figures,
maximum profit
occurs at 9 unit.
It is also between
8 and 10 units
that marginal cost
equals marginal
revenues.
Profit
900
800
Break-even
700
600
$

500
Loss
400
300
200
100
0
Units
Profits
Profits
250
200
150
100
50
0
-50 0
-100
-150
1
2
3
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5
6
7
8
9 10 11 12
54
Analysis of the data and discussion




Given a market equilibrium price of
$70, we calculate TR = $70 x unit
output.
Profits = TR – TC.
Marginal revenues are always equal to
$70 because unit price never changes:
MR = P.
Marginal cost is changing unit cost:
ΔTC/ΔQ = MC.
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Analysis of the data and discussion
The firm has fixed costs, so there
are losses until output reaches 3
units, which is an approximate breakeven point (profit = $2 = almost zero).
 After that, profitability comes, but
maximum profits are at around 9
units/hour.
 Maximum profit will be $205 per hour.
 Above 9 units/hour profit declines.

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Marginal Revenue = Marginal cost




Marginal revenue is equal to the extra
revenue from one more unit of output MR =
ΔTR/ΔQ.
In a perfectly competitive industry, the MR
will always equal market price per unit, and
the TR will be on a straight line with constant
slope = MR.
Max profits will occur at MC = MR, Profit = TR
– TC.
ΔProfit/ΔQ = ΔTR/ΔQ – ΔTC/ΔQ = MR – MC.
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Marginal Revenue = Marginal cost



That equation tells us that profit will
increase (ΔProfit/ΔQ > 0; positive change
in profit) if MR > MC.
That simply says that the extra revenue
you get from selling that one extra unit,
MR, is greater than the extra cost that you
take on to produce that extra unit, MC.
Therefore, there will be an addition to
profits.
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Marginal Revenue = Marginal cost



Profit will stop increasing (ΔProfit/ΔQ =
0) when MR=MC.
And profit will begin to decrease
(ΔProfit/ΔQ < 0; negative change in profit)
after that point when MC > MR.
It is only logical that total profits should
decline at that point since the extra
revenue that you take in, MR, is less than
the extra cost that you incur, MC.
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Marginal Revenue = Marginal cost
So you will actually be subtracting the
difference, MC – MR, from profits that
have already been booked.
 Then, we have the MR=MC Rule
which says that maximum profits or
minimum loss will occur at the point
where MR=MC.

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MR = MC


We can take the cost
curves from last
week’s lecture and
spreadsheet files and
combine it with MR,
this week.
Max profit/min loss
occurs at MR=MC
Then, profit is equal
to the area contained
in the yellow square.
Average and Marginal Costs vs.
Output
160.00
140.00
Unit Cost($)

MC
ATC
120.00
100.00
Profit
80.00
MR
60.00
AVC
40.00
20.00
AFC
0.00
0
2
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6
8
10
12
14
Quantity
61
Loss Minimization


160.00
140.00
Unit Cost($)
Similarly, when a firm
faces a MR less than its
unit cost at any output,
again it should choose
output when MC=MR.
Then, it will minimize
its short-run losses.
At that point the spread
(loss) between ATC
and MR will be a
minimum.
MC
120.00
100.00
80.00
ATC
60.00
40.00
MR
20.00
0.00
0
2
4
6
8
10
12
14
Quantity
Losing Firm
0
-50
0
1
2
3
4
5
6
7
8
9
10
11
-100
Loss

Average and Marginal Costs vs.
Output
-150
-200
-250
-300
-350
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Units
62
Average and Marginal Costs vs.
Output
160.00
Unit Cost($)
140.00
120.00
100.00
80.00
60.00
40.00
20.00
0.00
0
2
4
6
8
10
12
14
Quantity
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Shutting Down: MR < AVC


When MR finally falls
below AVC, then, MR
= MC < AVC at all
possible outputs.
That means that
revenues cannot even
cover part of fixed cost
per unit, which can
happen when MR <
AVC.
Thus, the firm should
exit the business.
Average and Marginal Costs vs.
Output
160.00
140.00
Unit Cost($)

MC
120.00
100.00
Shut down
point
80.00
60.00
AVC
40.00
MR
20.00
0.00
0
2
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6
8
10
12
14
Quantity
64
Example: Motel at the beach




During the summer season, Mom’s Motel
offers rooms for $100 per night.
Fixed cost/room, including insurance,
depreciation, and taxes is $50/room (AFC).
AVC, including electricity, water, and room
cleaning is $25/room.
In the off-season, would it be ok to charge
$40/night for a room, or would it be better to
just close the motel and let mom take a
vacation?
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Example Analysis



Since AVC = $25, if the motel charges
$40/night for a room, it will have $15 left over
after pay for AFC/room.
That leftover $15 of revenues, while not
enough to actually recover all AFC per room,
will at least go towards paying some of it.
Since the AFC has to be paid whether or not
the motel is open, it is better business sense
to at least pay for some by charging only
$40/night than to close down and not recover
any at all.
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Break Time

Please take a 10 minute break
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Short-run Supply Curves:
Perfect Competition
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Individual Firm’s Possible Supply



We looked at costs interacting with
revenues and discovered some general
rules for a firm to remain in business.
For it to make sense for a firm to remain in
business, MR must be equal to or above
the minimum variable cost, the point at
which MC = AVC.
Otherwise the firm cannot cover any FC,
and it will go deeper and deeper into debt.
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Individual Firm’s Possible Supply



After that condition is met, the firm should
supply the quantity that corresponds to
MR = MC. Then, it will maximize its profits.
Thus, the supply curve for a firm is
represented by its MC curve above the
AVC curve, as shown in the next slide.
The MC curve represents the best
possibilities for profit that the firm can face,
in terms of what it should supply.
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Firm Supply Curve MC ≥ AVC

As long as MC equal to or greater than AVC, it is
beneficial for a firm to offer supply
160.00
140.00
Supply
Possibilities
= MC ≥ AVC
120.00
100.00
Demand
Possibilities
= MR
80.00
60.00
40.00
20.00
0.00
0
2
4
6
8
Quantity
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12
14
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Industry Short-run supply




Then, we do the same for each individual firm
in the industry: their supply curves will be their
MC curves above the minimum AVC curves.
If their minimum AVC curves are above MR,
the only price in the market, they should be or
will be out of business.
Short-run industry supply curve is, then, the
sum of all of the individual supply curves
constructed as above and in the last slide.
We illustrate the construction in the next slide.
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Industry Short-run supply




The short-run supply curve is the sum of all individual
MC supply curves.
For 2 firms, for example, we have the situation depicted,
below.
We have put in two possible horizontal demand curves,
also, to expand description and detail.
We assume that input prices remain the same as output
expands.
Firm A
+
=
MCB
MCA
$90
Firm B
Industry
MCB + MCA
+
=
$45
7
10
11
15
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25
73
Short-run Equilibrium
Adding in the an aggregate demand
schedule gives an interaction to find
market price and quantity in
equilibrium.
 Firms will earn a profit, as long as the
MR = an equilibrium price is above,
not only the AVC, but also the ATC.
 Profit = QP(=MR) – Q[AFC + AVC]

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Short-run Equilibrium
They will minimize loss by supplying
on MC=MR, below ATC but above
AVC.
 Short-run equilibrium will retain until
something happens that changes it.
 We show the situation for an
individual firm and the industry in the
next slide.

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Short-run Equilibrium


For a firm and the industry. Equilibrium is at $90/unit
with quantity demanded and supplied = 10,000 units.
At that price the hypothetical firm produces 10 units.
Profit = [Price/unit – ATC] x Q
Hypothetical Individual Firm
P
MC
ATC
90
75
Aggregate Market
D
MR
Profits
50
S = ΣMC
25
0
10
Q = units
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76
Long-run Supply Curves:
Perfect Competition
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The long-run




In the long-run, all inputs become variable.
Existing firms can react to opportunities for
profits by expanding or down-sizing,
buying or selling PP&E or other inputs that
remain fixed in the short-run.
Opportunities for profit will attract new
firms, while losses will cause firms to exit
the business.
Free entry and exit are a crucial part of
perfectly competitive markets.
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Long-run Equilibrium
Variability of all inputs means that a
firm can decide to completely shut
down, if it is earning less than normal
profits (negative economic profits).
 New firms will enter, if they see that
existing firms are earning above
normal profits.
 Entry/exit of firms is the key factor in
long-run market equilibrium.

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Long-run Equilibrium




If new firms enter, supply is increased,
price decreases for the interaction of the old
demand curve with the new supply curve.
The process will continue until there are no
more above normal profits to be had.
If firms exit, supply will shift left, price will
increase, and a new equilibrium will come
when economic profits get up to the zero
level, above loss levels.
In the next slide, we show a firm in long-run
equilibrium.
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A Typical Firm in Long-run Equilibrium


P = MR = SRMC = SRATC = LRAC.
In LR equilibrium, firms will operate at the
minimum of LRAC.
Causal Chain
SRMC
Entry/Exit
Of Firms
SRATC
LRAC
MR
Zero LR
Economic Profits
Long-Run
Equilibrium
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Typical Firm in LR Equilibrium

Relating it back to the LR graph from last
lecture:
SRMC
SRATC
LRAC
MR
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P = MR = SRMC = SRATC = LRAC



We have established the P = MR =SRMC
concept, already.
Also, SRMC = SRATC is the short run
minimum level for profits to cover all costs.
In the long-run, a firm will also want to be
at the minimum in the LRAC curve, also,
because larger or smaller operations will
be on either side of that minimum will have
higher average total costs.
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P = MR = SRMC = SRATC = LRAC



Thus, LR equilibrium can occur only
after all firms have adjusted to that
perfect minimal cost point.
As long as no variables change, there is
no reason for a firm to produce a new level
of output. Everything is the best that it can
be.
There is no reason to change size of plant
or anything else.
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P = MR = SRMC = SRATC = LRAC
Since all firms are happy where they
are, the industry will be in equilibrium.
 There is no extra profit to cause new
entries and enough profit to keep all
existing producers.
 The price in the LR equilibrium is the
best price that can be achieved.

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P = MR = SRMC = SRATC = LRAC



The market is acting perfectly efficiently
and consumer welfare is maximized.
Since things are constantly changing
(even world population, for example),
LR equilibrium will not often be
achieved, and
Most of the time markets will just be
moving in the direction of an apparent
LR equilibrium state.
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3 Types of Long-run Supply
Curves
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LR supply




A perfect competitive industry’s LR supply
curve shows the quantities that the industry
will supply at various equilibrium prices after
all entry and exit has been completed.
The shape of the LR supply curve depends
on the response of prices of inputs as new
firms enter an industry.
There are three possibilities, increasing,
flat and decreasing costs.
We look at each, in turn.
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Constant Cost Industry



A constant cost industry is one in which
the expansion of output by entry of
new firms into the industry has no affect
on the firm’s cost curves.
Consider an upward shift in demand (see
next slide).
In response to the demand shift, in the
short run, price will rise along the supply
curve to a new short-run equilibrium.
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Constant Cost Industry

At that new equilibrium, existing firms
will adjust output along their supply
curves, and they will increase profits
to above normal.

As a result of excess profits, new firms
will be induced to enter the industry.
Then, supply will increase until there are
no abnormal profits.

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Constant Cost Industry



Old firms will adjust down their SRMC supply
curves to the point that they were at before
the change with the new equilibrium price of
new demand met by new supply at an
expanded quantity.
Since we have no increases in costs at the
expanded output, the new equilibrium price
should be the same as the original
equilibrium price before demand increased.
In that regard, the change in equilibrium price
traces out a straight line (see figure in next
slide), and that is the long-term supply curve.
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Constant Cost Industry

Causal Chain
Increase
In demand
sets higher
equilibrium
Entry of
New firms
Increases
supply
Initial
Equilibrium
Price is
restored
Firm
Industry
S1
SRMC
MR2
Perfectly
Elastic
Long-run
Supply curve
SRATC
D1
S2
LRAC
LR
Supply
Curve
MR1
D2
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Constant Cost Industry




If you imagine that the reverse situation
happens and demand decreases:
New SR equilibrium will be at a lower
price.
That means that firms are making less
than normal profits.
Thus, firms will exit the business, supply
will decrease, and price will eventually be
restored at the original equilibrium price
with a lower quantity supplied.
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Decreasing Cost Industry
As new firms enter a decreasing
cost industry, input prices fall as
total output expands.
 A decreasing-cost industry is one in
which expansion of industry output by
the entry of new firms decreases
firm’s costs.
 Consider, for example, the computer
market.

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Decreasing Cost Industry



As output of computers increase, suppliers
of computer chips might experience
economies-of-scale cost decreases,
themselves, and be able to supply a larger
computer industry with cheaper chips.
Thus, computer makers will be able to
decrease their costs as a direct result of
their industry expansion.
Then (see slide below), an increase in
demand will cause a temporary increase
in price, resulting in expanded profits.
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Decreasing Cost Industry




As new entrants into the market a new
supply curve will develop at which all
suppliers have a new cost curve, below the
original one.
Tracing out the straight line between
equilibrium prices is a downward sloping
curve.
Thus, the LR supply curve, in this case, is
downward sloping.
See the next slide for a graphical illustration for
this case.
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Decreasing Cost Industry

Causal Chain
Increase
In demand
sets higher
Equilibrium price
Entry of new
Firms
Increases
supply
Equilibrium
Price and
ATC
decrease
Firm
MR2
MR1
Downward
Sloping
LR supply
curve
Industry
SRATC1
D1
S1
S2
SRATC2
MR3
LR
Supply
Curve
D2
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Increasing Cost Industry
 As
an increasing cost industry
expands its output with the entry
of new firms, prices of inputs rise.
 As the industry uses more labor,
land, machinery, and raw
materials, the demand for greater
quantities drives up some or all of
their prices.
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Increasing Cost Industry
For example, suppose that the
home electronics industry uses a
significant percentage of electrical
engineers, in the country, and it
decides to expand.
 Then, salaries of electrical
engineers, who are in limited
supply, will increase, and the cost
of home electronics might increase.

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Increasing Cost Industry




It is believed that most industries, in
practice, are increasing-cost industries.
As a result, the long-run supply curve of such
industries is the usual upward-sloping supply
curve that we are familiar with.
We show what happens in such an increasing
cost industry in the slide, below.
Demand increases, causing a temporary
increase in equilibrium price, up the old supply
curve, and a chance to earn abnormal profits.
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Increasing Cost Industry
In response to this excess profit
potential, new firms enter the
industry, and supply expands.
 As a result, price begins to decrease.
 However, because of increasing costs
for everyone in the industry, there is a
new ATC cost structure curve which
is shifted upward from the initial one.

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Increasing Cost Industry
Then, the equilibrium price declines to
a level, which is above the initial
equilibrium price.
 Thus, the LR supply curve traced out
by the overall movement between
initial and final market equilibriums is
upward sloping.
 See the figures for details..

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Increasing Cost Industry

Causal Chain
Increase
In demand
sets higher
Equilibrium price
MR2
MR3
Entry of new
Firms
Increases
supply
SRATC2
Equilibrium
Price and
ATC
increase
D1
Upward
Sloping
LR supply
curve
S1
S2
SRATC1
LR
Supply
Curve
MR1
D2
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The Internet & Global
Markets
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The Internet and the Global Marketplace
The development of the internet has
increased competition on a global
basis.
 With the existence of the internet,
information is more readily available,
and it is as easy to order a book or a
new coat, on-line, as it is to make a
phone call to your local book or
clothing boutique.

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The Internet and the Global Marketplace


Now, a girl with a bedroom full of books
can market her books to people as
easily as someone who has a book
store. Both offer their own
convenience.
The store has books on display that you
can page through, the girl has excerpts
of books on her website and you don’t
even need to take a walk to the store.
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The Internet and the Global Marketplace



It also has done away with the monopolies
that people have locally or geographically.
Previously, one would have to invest in
opening a local store. Now, a bookseller
from a small town in Guangdong province
can offer books to a person in New York
City.
In that regard, barriers to entry to many
markets have been lowered by the internet
and the ability to do browsing, buying and
selling, on-line.
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The Internet and the Global Marketplace
It has also allowed communication
among buyers and sellers in
fragmented markets, like collectibles
and art.
 Now a local dealer in 19th century
pottery can find current prices, online, at auction markets, like E-bay,
and can adjust her prices according
to a larger market with more
information.

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The Internet and the Global Marketplace

Securities markets and commodities futures
markets have also become more efficient
because of the internet. Previously, a person
could call his broker on the phone and place an
order. Now, with the internet, a person can
open his computer and enter orders to trade
securities on-line or be directly connected to
major exchanges, like the New York Stock
Exchange or the Sydney Futures Exchange,
even if they live in a small village in western
China.
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The Internet and the Global Marketplace

Smaller businesses, even with no actual
storefront in their house but only a dinghy
storeroom in the back, can now compete
directly with larger players who have large
beautiful stores in elegant cites around the
world and they can increase their reach in
markets, from a local market that they would
be stuck in, selling dresses in a small town, to
selling their dresses around the world,
competing with other sellers in a globalized
marketplace.
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The Internet and the Global Marketplace


Consumers, too, can look around the
whole world for competitive price, quality,
and information.
Thus, the internet revolution has the
potential to close the gap between
idealized economic models of perfect
competition and the reality that exists
because of previous barriers to entry that
have been battered down by electronic
commerce.
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Ask Yourself
1.
2.
A horizontal demand curve is perfectly elastic.
Can you explain what it means, in terms of
perfect elasticity, its definition and
consequences, when we say that a firm in a
perfectly competitive industry faces a horizontal
demand curve?
You are a seller of a good in a perfectly
competitive industry. You decide to make a
famous brand name for your product and hire a
marketing firm to develop the brand name and
engage in an extensive advertising campaign.
What will be the result in terms of your sales,
costs, and profits?
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Ask Yourself
3.
4.
5.
Why is it important to assume that there are no
entry or exit costs in building a model of perfect
competition?
At the point P=MR=SRATC=SRMC, what are
profits? Why can a firm operate at zero profit:
does it mean that the owners of the business
are benefactors, not entrepreneurs, and earn
no money for themselves but just run the
business for the benefit of others?
Can you explain, in words and pictures, why
MC will have a minimum when MP has its
peak?
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Ask Yourself
6.
7.
8.
Can you explain why we allow monopolies in
businesses, like electricity and water
suppliers? After we do allow that, what else
do we do to such industries?
As it turns out, many people do not have
enlightened self-interest but, instead, are
greedy? How do modern societies deal with
that?
Can you explain in words why maximum
profits will happen when P=MC=MR?
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Ask Yourself
9.
10.
Can you explain why we refer to businesses,
like expensive exclusive restaurants or small
expensive clothing boutiques, as
monopolistic competition?
In the past, we have argued that supply
curves are upward sloping. What does the
LR supply curve look like for a decreasing
cost industry? Can you give some
examples of industries that might be
decreasing-cost industries, and can you
explain why they are, when prices of most
things go up, not down?
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Fill in the table
1.
2.
Fill in the table.
Graph the TR, MR,
MC, and TC
curves, and discuss
the intersection
points of the
various curves.
units
TR
0
0
50
1
50
90
2
100
120
3
150
130
4
200
140
5
250
160
6
300
190
7
350
230
8
400
280
9
450
335
10
500
395
11
550
470
12
600
550
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TC
MR
MC
Profits
116
Homework



Chapter 7:
Questions/Problems 1-13
Multiple Choice 1-17
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Next Week




We begin a new module:
We leave microeconomic studies and move on to
macroeconomics.
Covers chapters 11 and 12 (part) introducing
some macroeconomic concepts and the business
cycle.
Also, don’t forget, your on-line exam is coming
up.
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END
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