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Chapter 8 Perfect Competition (Part IV) © 2004 Thomson Learning/South-Western Profit Maximization It is assumed that the goal of each firm is to maximize profits. – – 2 Since each firm is a price taker, this implies that each firm product where price equals long-run marginal cost. This equilibrium condition, P = MC determines the firm’s output choice and its choice of inputs that minimize their long-run costs. Entry and Exit The perfectly competitive model assumes that firms entail no special costs when they exit and enter the market. – – 3 Firms will be enticed to enter the market when economic profits are positive. Firms will leave the market when economic profits are negative. Entry and Exit Entry will cause the short-run market supply curve to shift outward causing the market price to fall. – 4 This will continue until positive economic profits are no longer available. Exit causes the short-run market supply curve to shift inward causing the market price to increase, eliminating the economic losses. Long-Run Equilibrium 5 For purposes of this chapter, it is assumed that all firms producing a particular good have identical cost curves. Thus, in the long-run equilibrium all firms earn zero economic profits. Firms will produce at minimum average total costs where P = MC and P = AC. Long-Run Equilibrium 6 P = MC results from the assumption that firm’s are profit maximizers. P = AC results because market forces cause long run economic profits to equal zero. In the long run, firm owners will only earn normal returns on their investments. Long-Run Supply: The Constant Cost Case 7 The constant cost case is a market in which entry or exit has no effect on the cost curves of firms. Figure 8.7 demonstrates long-run equilibrium for the constant cost case. Figure 8.7 (b) shows that market where the market demand and supply curves are D and S, respectively, and equilibrium price is P1. FIGURE 8.7: Long-Run Equilibrium for a Perfectly Competitive Constant Market: Cost Case Price Price SMC MC S AC P 1 D 0 q1 (a) Typical Firm 8 Output 0 Q1 Quantity per week (b) Total Market FIGURE 8.7: Long-Run Equilibrium for a Perfectly Competitive Constant Market: Cost Case Price Price SMC MC S AC P2 P 1 D D 0 q1 q2 (a) Typical Firm 9 Output 0 Q1 Q 2 Quantity per week (b) Total Market FIGURE 8.7: Long-Run Equilibrium for a Perfectly Competitive Constant Market: Cost Case Price Price SMC MC S AC S’ P2 LS P 1 D D 0 q1 q2 (a) Typical Firm 10 Output 0 Q1 Q2 Q3 Quantity per week (b) Total Market Long-Run Supply: The Constant Cost Case 11 The typical firm will produce output level q1 which results in Q1 in the market. The typical firm is maximizing profits since price is equal to long-run marginal cost. The typical firm is earning zero economic profits since price equals long-run average total costs. There is no incentive for exit or entry. A Shift in Demand 12 If demand increases to D’, the short-run price will increase to P2. A typical firm will maximize profits by producing q2 which will result in short-run economic profits (P2 > AC). Positive economic profits cause new firms to enter the market until economic profits again equal zero. A Shift in Demand 13 Since costs do no increase with entry, the typical firm’s costs curves do not change. The supply curve shifts to S’ where the equilibrium price returns to P1 and the typical firm produces q1 again. The new long-run equilibrium output will be Q3 with more firms in the market. Long-Run Supply Curve 14 Regardless of the shift in demand, market forces will cause the equilibrium price to return to P1 in the long-run. The long-run supply curve is horizontal at the low point of the firms long-run average total cost curves. This long-run supply curve is labeled LS in Figure 8.7 (b). APPLICATION 8.3: Movie Rentals 15 Movies have been available for home rental since the 1920s. The basic rental business has consistently exhibited the characteristics of a constant cost industry. By the end of the 1980s, more than 70% of U.S. households owned VHS tape players. At first the rental industry was quite profitable, but there were no significant barriers to entry. APPLICATION 8.3: Movie Rentals 16 Because inputs used by the industry (low-wage workers and simple rental space) were readily available at market prices, the industry had a perfectly elastic long-run supply curve – it could easily meet exploding demand with no increase in price. The number of tape rental outlets grew fourfold and the standard price for rental of a movies fell to about $1.50 per night. APPLICATION 8.3: Movie Rentals 17 Introduction of DVD technology in the mid1990s followed a similar path. Once a critical threshold of households owned DVD players, the rental market for movies on DVD emerged quickly. Again, the absence of barriers to entry together with the ready availability of inputs resulted in a close approximation to the constant cost model. APPLICATION 8.3: Movie Rentals 18 This elastic supply response has also dictated a strict market test for innovations in the movie rental business – such innovations must be cost-competitive with existing methods of distribution or they will not be adopted. The fate of “Divx” technology provides an instructive example. Because consumers had to purchase special equipment, Divx gained few adherents and was largely abandoned by the start of 1999. Shape of the Long-Run Supply Curve: The Increasing Cost Case The increasing cost case is a market in which the entry of firms increases firms’ costs. – – – 19 New firms may increase demand for scarce inputs driving up their prices. New firms may impose external costs in the form of air or water pollution. New firms may place strains on public facilities increasing costs for all firms in the market.