Transcript The short-run industry supply curve

SLIDES
BY
SOLINA LINDAHL
CHAPTER
12
Perfect Competition and
the Supply Curve
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
 What a perfectly competitive market is and the
characteristics of a perfectly competitive industry
 How a price-taking producer determines its profit –
maximizing quantity of output
 How to assess whether or not a producer is profitable
and why an unprofitable producer may continue to
operate in the short run
 Why industries behave differently in the short run and
the long run
 What determines the industry supply curve in both
the short run and the long run
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PERFECT COMPETITION: KEY
CHARACTERISTICS
1. There are many buyers and sellers, each
with a small market share.
Market share: the fraction of the total
industry output accounted for by that
producer’s output.
This means both sellers and buyers are
price- takers; their actions have no
effect on price.
Each participant is a drop in the bucket.
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LEARN BY DOING: PRACTICE QUESTION
Which of the following markets is likely
to be the most competitive?
a) Cable television
b) Automobiles and trucks
c) Oil refining
d) Farm commodities
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PERFECT COMPETITION: KEY
CHARACTERISTICS
2. The product is standardized across sellers.
Standardized product (aka “commodity”):
Consumers regard different sellers’ products as
equivalent.
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ECONOMICS
IN ACTION
WHAT’S A STANDARDIZED PRODUCT?
Are Korean kimchi producers’ claims to be
believed? Is Japanese kimchi different (and
inferior to the Korean ‘real thing’?
As far as economists are concerned, the
products are different only if the consumers
believe them to be.
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PERFECT COMPETITION: KEY
CHARACTERISTICS
A third likely feature:
3. Free entry and exit
Free entry and exit: New producers
can easily enter into an industry and
existing producers can easily leave
that industry.
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PRODUCTION AND PROFITS
Since each firm is a price-taker, each firm’s
total revenue will be equal to price × quantity
sold, or
TR = P × Q
And Profit = total revenue – total cost, or
Profit = TR – TC
But there is another way to think about it…
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USING MARGINAL ANALYSIS TO
MAXIMIZE PROFIT
(When market price = $18) profit is highest
at Q = 50, which is also the point where
marginal cost = marginal revenue.
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MARGINAL REVENUE AND THE
OPTIMAL OUTPUT RULE
Marginal revenue: change in total revenue
generated by an additional unit of output.
MR = ΔTR/ΔQ
For price-taking firms, MR is simply the good’s market
price.
Optimal output rule: Profit is maximized by
producing the quantity of output at which the
marginal revenue of the last unit produced is equal
to its marginal cost.
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EXPLAINING THE OPTIMAL OUTPUT
RULE
Why is profit maximized where MR = MC?
Each time the firm produces another unit, there
are extra costs and extra revenues.
If producing another unit adds more to revenue
than cost, profit will increase.
Because if MR > MC, producing more will add to profit.
And if MR < MC, producing less will add to profit.
Since MR = P for competitive firms, the profitmaximizing rule is: Choose the quantity of output
where P = MC.
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COSTS AND PRODUCTION IN THE
SHORT RUN
As long as increasing production by one more unit creates
more MR than MC, it makes sense to do it.
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THE SHORT RUN AND THE LONG RUN
Reminder: In the short run, plant size is fixed.
We focus here on short-run profit
maximization at a given plant size.
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THE PRICE-TAKING FIRM’S PROFITMAXIMIZING QUANTITY OF OUTPUT
Price, cost
of tree
MC
Optimal
point
$24
20
Market
18
price
16
E
MR = P
12
8
6
0
10
20
30
40
50
60
70
Quantity of trees
Profit-maximizing
quantity
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WHAT IF MARGINAL REVENUE AND
MARGINAL COST AREN’T EXACTLY EQUAL?
What do you do if there is no output level
at which marginal revenue equals
marginal cost?
In that case, you produce the largest
quantity for which marginal revenue
exceeds marginal cost.
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WHEN IS PRODUCTION PROFITABLE?
*Recall we are using economic profit, which
includes implicit costs. It is normal for a firm’s
economic profit to be zero.
If TR > TC, the firm is profitable.
If TR = TC, the firm breaks even.
If TR < TC, the firm incurs a loss.
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PROFITABILITY AND THE MARKET
PRICE
Price, cost
of tree
If the price is
just high
enough to
cover ATC and
if it chooses the
Q where
MR = MC, the
firm will break
even.
$30
MC
Minimum average
total cost
18
ATC
C
Break- 14
even
price
0
10
20
30
MR = P
40
50
60
70
Quantity of trees
Minimum-cost
output
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PROFITABILITY AND THE MARKET
PRICE
Price, cost
of tree
The farm is profitable
because P > min ATC
($14).
Market price = $18
Minimum
average
total cost
MC
E
$18.00
Break- 14.40
14.00
even
price
MR = P
ATC
Profit
Per-unit profit =
$18 – $14.40
= $3.60
Z
C
The ATC of
producing
5 is $14.40
0
10
20
30
40
50
60
Total profit =
$3.60 × 5 =
$18.00
70
Quantity of trees
Optimal
output
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CALCULATING TOTAL COSTS AND
PROFIT
Profit = TR − TC = (TR/Q − TC/Q) × Q, or
Profit = (P − ATC) × Q
Break-even price of a price-taking firm
is the market price at which it earns
zero profit.
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LEARN BY DOING: PRACTICE QUESTION
If a firm is earning positive economic
profit, it must be the case that:
a)
b)
c)
d)
price
price
price
price
is
is
is
is
less than average cost.
equal to average cost.
equal to total cost.
greater than average cost.
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LEARN BY DOING: PRACTICE QUESTION
Ralph opened a small shop selling bags of
trail mix. The price of the mix is $5, and the
market for trail mix is very competitive. At
what quantity will Ralph produce?
a) 7
b) 10
c) 14
d) 18
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LEARN BY DOING: PRACTICE QUESTION
Ralph opened a small shop selling bags of
trail mix. When the price is $5, how much
profit will Ralph make?
a) $0
b) $14
c) $52
d) $68
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PROFITABILITY AND THE MARKET
PRICE
Market price = $10
Price, cost
of tree
Minimum
average
total cost
Breakeven
price
MC
ATC
Y
$14.67
14.00
C
Loss
10.00
MR = P
A
0
10
The farm’s per unit
loss: $10.00 –
$14.67 = –$4.67.
Total loss: 3 ×
–$4.67 = approx.
(–$14.00).
20
30
40
50
60
70 Quantity of trees
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SHOULD I STAY OR SHOULD I GO?
Losses don’t mean immediate
shutdown.
Remember, fixed costs must be paid
whether or not the firm produces in the
short run.
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SHOULD I STAY OR SHOULD I GO?
Firms will choose to produce (even at a
loss) if they can cover their variable AND
SOME of their fixed costs.
Shortcut: Is the price at or below the shutdown price?
Shut-down price: minimum average variable
cost.
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THE SHORT-RUN PRODUCTION DECISION:
A SIMPLE EXAMPLE
A firm should stay open in the short run if it can cover its variable costs.
Decision
Fixed Costs
Variable Costs
Revenue
Profit
Shutdown
$100
0
0
–$100
Stay Open
100
50
75
–75
He’ll stay in business… for now.
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LEARN BY DOING: PRACTICE QUESTION
If Gnomes-R-Us (a competitive
firm) produces where the
marginal cost curve intersects
with the average total cost
curve at its minimum point, the
firm will earn:
a) positive economic profits.
b) zero economic profits.
c) a short-run loss.
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LEARN BY DOING: PRACTICE QUESTION
Should a competitive firm keep
producing even if it faces short-run
losses (and is producing at a point on
its MC curve that is above the minimum
AVC curve)?
a)
b)
Yes, it is earning normal profits.
Yes, because it covers its variable
costs and some fixed costs.
No, it should never incur losses.
c)
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LEARN BY DOING: PRACTICE QUESTION
If the market price is $5, about how much will
this firm produce?
a) 0
b) 30
c) 60
d) 95
e) 100
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THE SHORT-RUN INDIVIDUAL SUPPLY
CURVE
A firm will produce at every price above minimum ATC where price
intersects the MC curve…
…but will stop producing in
Price, cost
the short run if the market
of tree
price falls below the shutShort-run
individual
down price...
supply
curve
$18
A
0
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AVC
C
B
…so the MC
curve (above
shut-down price)
is the firm’s
supply curve.
ATC
E
14
12
Shut-down
10
price
C
MC
Minimum
average
variable cost
30 35
40
2
5
0
1
50
Quantity
W
O R T of
H trees
P
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SHOULD I STAY OR SHOULD I GO?
Summary:
In the short run, a firm will produce if P
> shutdown price (min AVC).
A firm will NOT produce if P < min AVC.
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ECONOMICS
IN ACTION
FARMERS MOVE UP
THEIR SUPPLY CURVES
Increased ethanol
demand raised the
price of corn- so
farmers are planting
more and more (and
buying more
Although farmers were taking a big gamble
fertilizer, which is
by cutting the size of their other crops to
getting more
plant more corn, their decision made good
expensive in return) economic sense.
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THE INDUSTRY SUPPLY CURVE
If P > break-even (min ATC), firms are
profitable.
This profit attracts new entrants.
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THE SHORT-RUN INDUSTRY SUPPLY
CURVE
The short-run industry supply curve: how the Q supplied by an industry
depends on the market price (given a fixed number of producers).
Price, cost
of tree
Short-run industry
supply curve, S
$26
22
Market
price
A higher price
means more
firms are
willing to
supply.
EMKT
18
D
14
Shut-down 10
price
0
C
O
2000
P
Y
R
I
G
3000
H
T
2
4000
0
1
5
5000
W
O
R
6000
T
H
P
7000
U
B
L
I
Quantity of trees
S
H
E
R
S
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THE LONG-RUN MARKET EQUILIBRIUM
(a) Market
Price,
cost of
tree
$18
(b) Individual firm
S2
S1
Price,
cost of
tree
$18.00
S3
EMKT
DMKT
16
MC
E
A
16.00
ATC
D
B
14.40
Breakeven 14.00
price
CMKT
14
D
0
5000
7500
10,000
Quantity of trees
C
0
30
Z
Y
40 45
50
60
Quantity of trees
New firms enter as long as there is economic profit (P > min ATC).
A market is in long-run equilibrium when the quantity supplied equals the
quantity demanded, given that sufficient time has elapsed for entry into and
exit from the industry to occur.
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THE EFFECT OF AN INCREASE IN
DEMAND: NOW AND LATER
Price,
cost
(a) Existing firm’s
response to increase in
demand
An increase
in demand
raises price
and profit.
$18
14
Y
(b) Short-run and long-run
market response to increase
in demand
Price
Price,
cost
Long-run industry
supply curve
S1
MC
ATC
Higher industry
output from
new entrants
drive price and
profit back
down.
S2
YMKT
X
(a) Existing firm’s
response to new entrants
Y
LRS
ATC
Z
ZMKT D2
XMKT
MC
D1
0
Quantity
The LRS shows how the
quantity supplied responds
to the price (once producers
have had time to enter or
exit the industry)
C O P Y R I G H T
0
QXQY
QZ Quantity
0
Quantity
Increase in output
from new entrants
D↑  P↑  profits  entry  S↑  P↓  back to
Back to
zero profit (on LRS curve).
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COMPARING THE SHORT-RUN AND
LONG-RUN INDUSTRY SUPPLY CURVES
Price
Short-run industry
supply curve, S
Long-run
industry
supply curve,
LRS
The long-run industry supply
curve is always flatter—more
elastic—than the short-run
industry supply curve.
Quantity
This is because of
entry and exit:
 A higher price
attracts new
entrants in the long
run, raising industry
output and
lowering price.
 A fall in price
induces existing
producers to exit in
the long run,
reducing industry
output and raising
price.
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ECONOMIC PROFIT, AGAIN
Q: Why would a firm would want to enter an
industry if the market price is only slightly
greater than the break-even price?
A: We are using economic profit as our
measure, so if the market price is above the
break-even level (no matter how slightly), the
firm can earn more in this industry than it could
elsewhere.
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LEARN BY DOING: PRACTICE QUESTION
The long-run market equilibrium in a
perfectly competitive industry with
identical firms results in all firms:
a) earning zero economic profit.
b) producing the quantity associated
with their break-even price.
c) producing the profit-maximizing
quantity at which MR = MC.
d) All of the above statements are
true.
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