Competitive Firms in the Long-Run

Transcription

1 Competitive Firms in the Long-Run EC Selby May 18, 2014 EC Selby Competitive Firms in the Long-Run May 18, / 20

2 Recap So far we have been discussing the short-run for competitive firms The firms want to maximize their short-run profits. Since they are price-takers, they face the following problem max π(q) = R(q) C(q) = Pq C(q) q The profit maximizing level of output always satisfies the condition P = MC(q ) EC Selby Competitive Firms in the Long-Run May 18, / 20

3 If P > ATC the firm is making positive short-run profit if P = ATC the firm is breaking even if P < ATC the firm is making short-run losses if P < AVC the firm must shut down Knowing this then the firm s supply curve is { q S 0 : P < AVC = MC 1 (P) : P AVC We can find the market supply curve by adding up the individual supply curves horizontally The elasticity of supply for the market is E S = QS P P Q S EC Selby Competitive Firms in the Long-Run May 18, / 20

4 Short-run producer surplus can be found as the area between the price and the marginal cost of producing up to q We can calculate producer surplus as PS = R(q ) VC(q ) = (P ATC(q ))q We can also calculate it based on profits: PS = π(q ) + FC What if the firm wants to change it s production process to increase profits? In the short-run, some factors are fixed and so they cannot adapt to technological improvements or change it s scale of operation. However, when we look at the long-run things are much more flexible. EC Selby Competitive Firms in the Long-Run May 18, / 20

5 Choosing Output in the Long-Run Recall that in the long-run, a firm faces a long-run average cost curve that envelopes the short-run average cost curves EC Selby Competitive Firms in the Long-Run May 18, / 20

6 The point at which LMC = LAC, is where long-run average costs are minimized. Price is not necessarily going to be at this point. EC Selby Competitive Firms in the Long-Run May 18, / 20

7 In the short-run, if P = 40, they would choose to produce q 1 because that is the point where P = SMC. At q 1, the firm is making short-run profits π = (40 C) q 1 In the long-run, they can adapt their production process and they would face the LMC curve The firm would choose to produce q 3 in the long-run because P = LMC. At q 3 the firm would make long-run profits π LR = (40 G) q 3 Which is bigger: long-run or short-run profits? What is their profits if P = 30? EC Selby Competitive Firms in the Long-Run May 18, / 20

8 Long Run Competitive Equilibrium Now that we have discussed profit maximizing choices in the long and short-run What do we expect to occur in a long-run equilibrium? We are in a long-run competitive equilibrium when the following hold: 1 All firms in the industry are profit maximizing 2 No firm has the incentive to enter or exit because all firms are earning zero economic profit (that is, they are getting returns that are just as big as what they could get by investing elsewhere) 3 The price of the product is such that the quantity supplied by the industry is exactly equal to the quantity demanded by consumers EC Selby Competitive Firms in the Long-Run May 18, / 20

9 Suppose that firms have identical costs. If, for example, the cost of capital dramatically decreases, then firms will make positive economic profit. If too many firms enter the market responding to a chance of profit, the supply curve will shift right and price will fall At this lower price, some firms will incur losses and supply will shift left. Firms will continue to do this until we end up at the new long run supply curve. A firm will exit the market if it faces long-run loss, or P < LAC EC Selby Competitive Firms in the Long-Run May 18, / 20

10 Consider the firm from earlier: EC Selby Competitive Firms in the Long-Run May 18, / 20

11 This firm is making positive economic profits. If this firm is representative, then all of the firms face the same costs and everyone in the market is making positive profits. As new firms enter the industry seeking this profit, then the market supply curve shifts right and the price drops. The price drops to the point where P = LAC for the firms in the industry. EC Selby Competitive Firms in the Long-Run May 18, / 20

12 EC Selby Competitive Firms in the Long-Run May 18, / 20

13 Example: Suppose we know the following Q D = P Market Demand Q S = 1200P Market Supply C(q) = q2 200 Firm TC MC(q) = q 100 Firm MC What is the equilibrium price and quantity supplied? In equilibrium, condition (3) gives us that Q D = Q S = P = 1200P = 6500 = 1300P = P = 5 = Q = (5) = 6000 EC Selby Competitive Firms in the Long-Run May 18, / 20

14 We now know that market price is P = 5, what output does the firm produce? If the firm is profit maximizing, then P = MC(q) = P = 5 = q 100 = MC = q = 500 What is the firm s profit? π(500) = 5(500) π(q) = Pq C(q) ) ( = Do you expect firms to enter this market or exit? What effect will this have on the the market? EC Selby Competitive Firms in the Long-Run May 18, / 20

15 Industry Long-Run Supply When discussing market supply in the short-run, we could simply add up quantity supplied by each firm as price increases. However, in the long run, when firms enter and exit the market, the market price changes. The long-run supply depends on how output affects the prices that firms must pay for inputs Economies of scale: input prices decline with output Diseconomies of scale: input prices increase with output Neither: input prices do not change with output This leads to three possible outcomes for the supply curve EC Selby Competitive Firms in the Long-Run May 18, / 20

16 Case 1: Constant-Cost Industries A constant cost industry is an industry whose long-run supply curve is horizontal Consider the following figure: EC Selby Competitive Firms in the Long-Run May 18, / 20

17 Originally the market price is P1 and is set by demand curve D 1 and short-run supply curve S 1 A typical firm in this market has constant-costs. That is, when prices of output go up, the AC curve does not change. When P = P 1, the firm produces q 1 Suppose that there is a sudden increase in demand and the demand curve shifts to D 2 In the short-run, prices will go up to P 2 and the typical firm will be making positive economic profits. This induces firms to start entering the market. They will continue to do so until the price is driven back down to P 1. This results in an increase in supply and the short-run supply curve shifts to S 2 Explanation? Neither economies or diseconomies of scale. There is no change in input prices with a change in scale. EC Selby Competitive Firms in the Long-Run May 18, / 20

18 Case 2: Increasing-Cost Industry An increasing-cost industry is an industry whose long-run supply curve is upward sloping As new firms enter the market, increased demand for inputs causes some/all of input prices to increase, resulting in increased AC for the typical firm Consider the following figure: EC Selby Competitive Firms in the Long-Run May 18, / 20

19 Suppose we have the same demand increase as before. When prices go up to P 2, firms start entering the market This causes input prices to increase. This shifts the MC curve left (more expensive to produce the same level of output). This also shifts the AC upward. This leads to an increase in supply, but not as much as under the constant cost situation. The supply curve shifts from S 1 to S 2 and lands a new higher market price of P 3 (it must be higher due to higher input costs - zero economic profit) The long-run supply curve for this industry is upward-sloping. Explanation? Diseconomies of scale. There is increasing input cost with increasing scale. EC Selby Competitive Firms in the Long-Run May 18, / 20

20 Case 3: Decreasing-Cost Industry A decreasing-cost industry is an industry whose long-run supply curve is downward sloping. As firm s enter the market, input prices decline. This leads to the opposite of what happens in the previous case. What does this look like graphically? What might be a possible explanation? EC Selby Competitive Firms in the Long-Run May 18, / 20