Business 33001: Microeconomics

Business 33001: Microeconomics Owen Zidar University of Chicago Booth School of Business Week 5 Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 1 / 57

Today s Class 1 Midterm 2 Two Examples of Firm Optimization 3 Market Equilibrium (Identical Firms) 4 Market Equilibrium (non-identical Firms) 5 Profits 6 Analytical Framework for Industry-Level Equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 2 / 57

4 Supplemental: use an analytical framework to quantify these forces If my supplier s borrowing cost go up 10%, how much will they raise prices? If my supplier just moved production to Mexico, how much could they lower their prices and still break even? How much will labor demand decrease in the steel industry if oil prices decline 50%? Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 3 / 57 Motivation: why should you care? 1 Apply last week s insights on firm optimization Moneyball Mobilizing voters 2 Understand industry supply and entry decisions Why are there starbucks on every corner? Under what conditions do firm profits induce entry? 3 Understand impact of changes in demand Impact on industry prices and output Impact on input markets (e.g. labor)

Firm Optimization in Practice Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 4 / 57

Firm Optimization: Review from last week Inputs X with prices w Output Y = F (X ) with value V Firm optimization gives us the following marginal condition: VF i = w i Value of output Marginal product = marginal cost of input Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 5 / 57

Implications VF i = w i V = w i F i Cost per marginal unit of output must be the same for all factors Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 6 / 57

Application #1: Moneyball Baseball team Output is wins V is value of a win X are player attributes w are prices of player attributes Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 7 / 57

Source: Hakes and Sauer (2006). Example from Jesse Shapiro. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 8 / 57

Source: Hakes and Sauer (2006). Example from Jesse Shapiro. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 9 / 57

Application #2: Getting Out the Vote Winning Elections: Parties are trying to mobilize voters Differences in effectiveness must reflect differences in w or V Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 10 / 57

Source: Nickerson (2006). Example from Jesse Shapiro. Observe: modes of contact differ widely in F i, but hardly in w i F i Observe: Implied value of a vote V = $25 (typical range of $12 to $20). Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 11 / 57

Market Equilibrium (with Identical Firms) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 12 / 57

Starbucks on every corner 1 1 Source: http://www.theatlantic.com/international/archive/2014/05/mapping-theworld-of-starbucks/371630/ Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 13 / 57

Deriving Market Supply Last class we derived the supply of an individual firm To derive the market supply curve, simply sum the firm s supply curves horizontally Suppose we have two firms 1 Firm 1 would produce X 1a at price P a and X 1b at price P b 2 Firm 2 would produce X 2a at price P a and X 2b at price P b The market supply at is X 1a + X 2a at P a The market supply at is X 2b + X 2b at P b Higher prices tend to induce higher market supply Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 14 / 57

Deriving Market Supply Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 15 / 57

Determining Equilibrium Market Price With market supply of the firms in the industry, we can determine the equilibrium price by the intersection of supply and demand The market price then enables us to determine the output and profit levels of individual firms Suppose there are N identical 2 firms in a competitive industry (e.g. wheat farmers) 2 Note that we are beginning by assuming that all firms in the industry have the same cost curves (in this identical firms case), which provides a useful model of production and competitive supply Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 16 / 57

Market Equilibrium (in the short-run) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 17 / 57

Market Equilibrium (in the short-run) Notice the price P exceeds average cost, so each firm is profitable in the short-run (because we defined the equilibrium while holding the number of firms constant at N) It seems reasonable to assume that firms can t enter immediately so this equilibrium will prevail for a while However, in a longer time frame, there is no reason why other firms cannot enter (or exit) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 18 / 57

Market equilibrium with entry (in the medium-run) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 19 / 57

Market Equilibrium (in the medium-run) The medium run equilibrium price P n was lower than the short run price P. This price reduction caused each firm in the industry to cut back sales (which are picked up by the new firm) It also reduced the profits of each firm in the industry Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 20 / 57

Market equilibrium (in the long-run) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 21 / 57

Market Equilibrium (in the long-run) In the long-run equilibrium: Entry will have continued until price equals the level of minimum average cost of the identical firms All firms earn zero profits All firms produce at the minimum average cost level of output At this point, consumers receive the product at the lowest possible production cost (i.e., the min average cost) Takeaway: The supply side pins down P. Demand side pins down Q. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 22 / 57

Starbucks on every corner: Demand-side pins down scale Suppose that each Starbucks sells 500 cups per day. Need 20K stores to sell 10M cups per day. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 23 / 57

Starbucks on every corner: Demand-side pins down scale Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 24 / 57

What happens if demand increases? Suppose the price increases from the long-run price P to P s due to an increase in demand Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 25 / 57

Market equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 26 / 57

What happens if demand increases? Higher prices induce each firm to produce more output (SR) Price will exceed costs, so firms will earn profits (in the SR) The rise in profits will induce entry (in the medium-run) Entry shifts the supply curve to the right, lowering the price back to its original level Firms will enter as long as they can earn a profit (i.e., as long as price exceeds minimum average cost) Takeaway: In the long-run, we will have more firms, a lower price, greater total output and smaller output per firm than in the short-run equilibrium following the increase in demand Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 27 / 57

Effect of D on a Competitive Market with Identical Firms Short Run Long Run Long vs Short Run Price Increase Unchanged Decrease Total Output Increase Increase Increase Output per Firm Increase Unchanged Decrease Profit Increase Unchanged Decrease Number of Firms Unchanged Increase Increase Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 28 / 57

Market Equilibrium (non-identical Firms) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 29 / 57

Market Equilibrium (with heterogeneous firms) The competitive identical firm model is useful for analyzing the market effects of changes in demand and other conditions However, the assumption that firms all have the same cost curves seems unrealistic This assumption ignores the important role of comparative advantage If we allow firms to have different cost curves, then we can determine which firms will enter the industry and which firms will remain out of the industry (recall the oil example from the first class) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 30 / 57

Let s begin with the same initial market equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 31 / 57

Market Equilibrium (with heterogeneous firms) In the short-run, we have this particular firm earning profits The difference between this case and the identical firm case comes in the long-run What will distinguish firms is the level of minimum average cost A firm will enter the industry as long as the price exceeds minimum average cost (i.e., that firm s entry price) In the long run: All firms outside the industry will have minimum average costs greater than the current equilibrium price (making entry unattractive) All firms in the industry will have minimum average costs at or below the current price Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 32 / 57

Market equilibrium with heterogeneous firms Firm B will not be in the industry. Firm A, with lower cost of production, will be. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 33 / 57

The Marginal firm Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 34 / 57

The Marginal firm If there are many firms with different cost curves, then the highest-cost firm currently in the industry will earn approximately zero profits This firm is the current marginal firm, i.e., it will be the first firm to leave the industry if the price falls Firms with lower cost will earn positive profits in the long-run Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 35 / 57

What happens if demand increases? The short-run effect of an increase in demand is the same as in the identical firm case Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 36 / 57

What happens if demand increases? The marginal firm, which used to make zero profits, now earns positive profits Profits induce entry Entry shifts the supply curve to the right Entry stops when the market price has fallen below the minimum average cost level of firms still outside the market The last firm to enter is now the marginal firm Since these entering firms have higher costs than the existing firms, the new market price will still be higher than the original market prices Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 37 / 57

What happens if demand increases? Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 38 / 57

What happens if demand increases? In the case with identical firms, the long-run supply curve was horizontal at the level of minimum cost With heterogeneous firms, the long-run supply curve is upward-sloping That is, the price must rise to induce additional firms to enter the industry and expand industry output Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 39 / 57

Effect of D on Competitive Market (non-identical firms) Short Run Long Run Long vs Short Run Price Increase Increase Decrease Total Output Increase Increase Increase Output per Firm Increase Increase Decrease Profit Increase Increase Decrease Number of Firms Unchanged Increase Increase Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 40 / 57

Profits Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 41 / 57

Profits We just saw that non-identical firms can earn profits even in the long-run That is, firms can have receipts in excess of the opportunity costs of their inputs even in the long run Does this imply that these firms will earn accounting profits in the long run? In general, they will not appear to be earning a greater than normal rate of return in the long run Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 42 / 57

Profit Example Setup Suppose we purchase a wheat farm that provides us with exactly a normal rate of return on our investment For example, we pay $100K for the land and earn a net return of $10K and the interest rate is 10% zero accounting profits Suppose there is an Increase in Demand for Wheat We now earn $15K per year on our investment and hence it would appear that we would make $5K per year in profit However, this neglects the fact that the value of the land we own will now rise! Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 43 / 57

Profit Example Investors would flock to buy wheat land since it provides a 15% return This will bid up the price of land until the land price increases to $150,000 (since this is the price at which the normal rate of return equals the 10% market rate At the news, higher price for land, we once again make zero accounting profits. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 44 / 57

Economic Rents Since we were willing to use the land to grow wheat even for a return of $10K per year, the return on land in its next best alternative (example, corn farming) must be less than $10K, say $8K in this case. The opportunity cost of the land (or another use) is $8K per year. At the same time, the opportunity cost of the investment in the land, $10K per year, would equal the rental rate of the land The difference between the competitive price and the next best alternative (outside the current market) is economic rent or quasi-rent The quasi-rent on an asset such as land is the rise in the price above its next best available alternative which is necessary to eliminate profits Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 45 / 57

Economic Rents in the Example After the rise in demand and the price of land rose to $150K, then the rental rates were $15K per year The next best alternative is still $8K, so the rental rate is make up of $8K of opportunity cost and $7K of economic or quasi-rents In this case, accounting profits are eliminated by the fact that the economic profit (i.e., $15K-$8K) is allocated to the accounting cost of the land Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 46 / 57

Costs versus rents From an economic perspective, rents are very different than costs. Costs affect the production decisions of firms; economic rents do not. For example, take two different farms One farm is the one from our example, i.e., it yields a return of $15K per year in the production of wheat and has a next best alternative of $8K per year in corn production. The second plot also yields $15K per year in the production of wheat but has an opportunity cost of $15K in the production of corn While both earn zero accounting profits, the first earn $7K in economic profits. Only the second earns zero profits and hence only it is the marginal firm For instance, if the price of wheat fell so that the return on both farms were $14K, only the second farm will no longer produce wheat. The first farm will still produce and will simply suffer a $1K loss in quasi-rents. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 47 / 57

Rents for other types of assets 1 In equilibrium, rents are allocated to specific assets (e.g. land in the example) 2 Any asset that yields a rate of return greater than its opportunity cost in another use is a specific asset that can earn rents (i.e., its return is specific to its use) 3 For instance, specific assets include patents, productive facilities, rights to production, highly productive managers, government licenses, etc. Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 48 / 57

SUPPLEMENTAL MATERIAL: Industry-Level Equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 49 / 57

What does an Industry Equilibrium look like? 1 Output market clearing Y = D(P) 2 Production function Y = F (K, L) 3 Price of output equals average cost (i.e., P = AC) P = C(w, r, 1) 4 Firm is cost minimizing L = C w (w, r, 1) K = C r (w, r, 1) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 50 / 57

What does an Industry Equilibrium look like? In terms of percentage changes, we have: 1 Output market clearing Y = ε D P 2 Production function Y = s L L + s K K 3 Price of output equals average cost (i.e. P = AC) P = s L w + s K r 4 Firm is cost minimizing L/K = σ r/w L K = σ( r w) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 51 / 57

4. Firm is cost minimizing How much do firms substitute as w /r changes? Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 52 / 57

What does an Industry Equilibrium look like? What do we have? 3 price changes: w, r, P 3 quantity changes: L, K, Y 4 equations Need to set some changes to zero Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 53 / 57

What does an Industry Equilibrium look like? Let s use the framework to answer the following questions 1 Why does labor demand decline when wages increase? Long-run: when r = 0 2 What happens to labor demand if the price of oil dropped 50%? (time permitting) Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 54 / 57

Labor Demand in the Long-Run Consider the impact of a wage increase in the long-run (when r = 0) 1 Output market clearing 2 Production function Y = ε D P Y = s L L + s K K 3 Price of output equals average cost (i.e. P = AC) 4 Firm is cost minimizing P = s L w + s K r }{{} =0 L K = σ( }{{} r w) =0 Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 55 / 57

Impact of a wage increase in the long-run (when r = 0) 1 From [P=AC], prices will increase: P = s L w 2 From the output market, output will decline: Y = ε D }{{} P =s L w 3 We can substitute K from cost min. into the production function Y = s L L + s K K Y = s L L + s K ( L + σ w) 4 We can use the size of the output decline Y s L L + s K ( L + σ w) = Y }{{} =ε D s L w Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 56 / 57

Impact of a wage increase in the long-run (when r = 0) Collecting terms reveals why labor demand declines: s L L + s K ( L + σ w) = ε D s L w L = ε D s L w }{{} Scale Effect L w = }{{} s Lε D <0 s K σ }{{} <0 The long run labor elasticity combines two forces: s K σ w }{{} Substituion Effect 1 Higher wages raise prices (promotional to labor s share), which reduces the scale of production 2 Higher wages induce substitution away from labor towards capital Owen Zidar (Chicago Booth) Microeconomics Week 5: Industry Supply 57 / 57