Review
The supply function:
1. The individual firm’s supply is calculated in two steps:
First, we figure out whether the firm produces or shuts down, is the price greater than the shutdown price?
Second, if the firm produces, how much? (given by the mc(q)=p)
2.
The total market supply is the sum of the amount supplied by each individual firm
Useful remember:
A firm that maximizes profits always produces at point where mc(q)=p, the firm makes profits if ATC(q)>p and the firm loses money if ATC(q)<p

Perfectly Competitive Market
Topics:
1. Definition of a Perfectly Competitive Market
2.Short Run Equilibrium
3. Long Run Equilibrium

Perfectly Competitive Market
Key definition: A perfectly competitive market satisfies the following conditions:
1. Fragmented industry consists of many small buyers and sellers
2. Buyers and Sellers are “price takers”:
Each buyer ’ s purchases are small and do not effect the market price
- Each seller is small and does not effect the market price
-Each seller cannot effect the price of inputs
3. Firms produce identical products
4. Perfect information about prices
5. All firms have the equal access to inputs , they have the same technology, and there is free entry . Implies that firms have identical long run cost functions

Perfectly Competitive Market

Short Run Equilibrium
short run equilibrium is a pair of price and quantity (Q,P) such that :
1.
Each producer maximizes profits given price p
2.
Markets clear
Q
 i n 

1
Q s i
( P )

Q d
( P )
Where Q s i (P) is firm i ’s individual profit maximization output given price P.

Short Run Equilibrium
short run equilibrium

Short Run Equilibrium
short run equilibrium
Typical firm produces Q* where MR=MC and if 100 firms make up the market then market supply must equal 100Q*

Short Run Equilibrium
Suppose a market consists of 300 identical firms, all with the same cost curve:
TC(q)= 0.1 + 150q 2 . Consumers demand is given by Q d (P) = 60 – P. What is the equilibrium price and quantity?
Do firms make positive profits at the market equilibrium?
Step 1: Derive individual supply curve
FC=0.1 (all are sunk, NSC= 0) ; AVC(q) = 150q; MC(q)=300q
Since min{AVC(q)}=0, the firm always produces.
The profit maximizing condition: MC(q)=MR(q), we have that 300q=p, or q s (P) = P/300 .
Step 2: derive the market supply curve
Q s (P) = 300 q s (P) =300(P/300) = P
Step 3: solve for equilibrium
Q s (P)= Q d (P) or P= 60 – P and
P*= 30, Q* = 30 and each firm produces q* = 30/300=.1

Short Run Equilibrium
Do firms make positive profits at the market equilibrium?
Condition for positive profits: p* >ATC(q*)
ATC (q)= TC(q)/q = 0.1/q + 150q.
Since each firm produces q* = 0.1, we have that ATC(q*)=15<30= p*,
Therefore P* > ATC(q*) and profits are positive
The profit of each firm is: Pq-TC(q)= 30*0.1-(0.1+150*0.1^2)=1.4

Short Run Equilibrium
What happens when the number of firms increases from 300 to 500?
The single firm’s supply is unchanged: mc(q)=P and q s (P) = P/300
But now, market supply increases to Q(P)=400* (P/300) and for markets to clear we have that :
500* (P/300)= 60 – P or P=22.5 and Q= 37.5 and the individual firm produces q= 37.5/500=0.075
Does each firm make earn a profit ? Condition for positive profits: p* >ATC(q*);
ATC (q)= 0.1/q + 150q= 0.1/0.075+150*0.075 = 11.25 < 22.5
The profit of each firm Pq-TC(q)= 22.5*0.075-(0.1+150*0.075^2)=1.3

Short Run Equilibrium
What happens when the number of firms increase?
Market supply is increased, prices drop, and each firm produces less.

Long Run Equilibrium
Question : What happens in the long run?
The long run differs from the short run in two key ways:
1. Firms can adjust all inputs and there are no sunk costs.
2. There is entry and exit : the number of firms in the industry can change as well. A firm that suffer loses can leave the market, and a firm that anticipates gains can enter.

Long Run Equilibrium
Since there are no sunk costs, the firm shuts down if p<minATC(Q) = Ps, and the supply is given by:
P = MC(Q) for P > Ps and the firm exits if P < Ps

Long Run Equilibrium
Key definition:
A long run equilibrium is a price P*, quantity Q* and number of firms n, such that:
1. Individual firms maximize profits , each firm produces q* such that: P*=mc(q*)
2. Markets clear , market demand equals market supply, Q d (P*) = Q* = Q s (P*)
Where the aggregate supply Q s (P*)=nq*
3. No firm wants to exit or enter. This implies that firms must not be making profits or suffering loses: Zero profits
The difference from the short run is the zero profit condition.
It relies on the assumptions that firms can exit, so no losses are incurred, and there are always firms that can enter, so no profits can be gained.
Why?

Long Run Equilibrium
Key Property:
The zero profit condition implies that in the long run each firm is producing a quantity q such that ATC(q) is at the minimum point. Why?
i. If p<ATC(q) firms exit and the market price will rise (why?). If p>ATC(q) there are profits, firms will enter and the market price will fall (why?).
Thus p=ATC(q) ii. Since each firm is maximizing profits, each firm chooses a quantity q such that mc(q)=P.
The only quantity level where mc(q)=p=ATC(q) is the minimum of the ATC curve.
Market demand

Long Run Equilibrium
Key Property:
In the long run, the market price p and each individual firm’s output q, must be such that: mc(q)=P=ATC(q),
Market demand

Long Run Equilibrium
Example: Suppose a certain market has the following demand function: Q d (P) =
25000-1000P. Firms have the cost function TC(q) = 40q - q 2 + .01q
3 . What is the market equilibrium?
We solve this in three steps :
1. Calculate the individual firm’s optimal output level and then get the market price.
From zero profits: ATC(q)=P and from profit maximization, mc(q)=p. Together, ATC(q)=mc(q), and we can solve for q. AC(q) = 40 – q + .01q
2 and MC(q) = 40 – 2q + .03q
2
And we have that q* = 50 the price is P* = 15
2. Calculate the market quantity . Since the price is P* = 15, from the market demand we can calculate the market quantity: Q d (P) = 25000-1000P, and Q d (15)= 10,000
3. Calculate the number of firms . Given the market quantity, and the individual firm’s quantity produced we can calculate the number of firms: nq*=Q*, and since total output Q*= 10,000 and each firm produces q*=50 units, there must be n=10,000/50=200 firms.

Long Run Equilibrium
Long Run
Step 1: Individual firm’s output mc(q)=ATC(q)=p
Step 2: Market quantity Use Price from step 1 and market demand to calculate the market quantity
Step 3: Number of firms Calculate the number of firm’s
Short Run mc(q)=p
Calculate market supply, use market clearing condition to get price and quantity
Number of firms is given. Calculate individual firm’s output

Long Run Supply Curve
P
0 p
Definition: The Long Run Market Supply Curve maps the quantity of output supplied for each given price. The supply of firms takes place after all long run adjustments of inputs, and entry or exit of firms.
The zero profit condition pins down the long run supply.
SRS
LRATC=LRS
Output expansion or contraction in the industry occurs along a horizontal line corresponding to the minimum level of long run average cost.
D
Q
Q
0

Long Run Market Dynamics
Example of industry dynamics The Super Tanker Industry
Super Tankers are large ships used for transport (usually oil). A super tanker can cost around $100 million.
In the 60s and early 70s, the demand for Tankers was high, mainly driven by the high demand for oil, 500 new super Tankers were constructed. But in the 70s prices for service of Tankers collapsed, due to the oil embargo. Short run supply is inelastic, as Tankers have no alternative value. It took years for the industry to adjust. In 1978, over 20 million tons worth of tanker capacity was sold for scrap.

Long Run Market Dynamics
In general, the long run dynamics of prices are shaped by supply side effects (such as economies of scale) and demand side effects (such as network externalities – think of cell phones).
For example, the revenue cycle of computer memory chips (DRAM)
$50
$40
$30
$20
$10
$0
1992 1994 1996 1998 2000 2002 2004
Question:
What causes such price cycles?

Long Run Market Dynamics

Long Run Market Dynamics
P
P
1
P
0
SRS Initially market price increase, and output increases.
LRATC=LRS
What happens next?
Q
0
Q
1
D
0
Q
D
1

Long Run Market Dynamics
P
P
1
P
0
SRS
0
Q
0
Q
1
Q
2
D
0
Q
SRS
2
LRATC=LRS
Since prices rise, p>ATC, and each firm earns a profit. Leads to entry and an increase in supply.
D
1
In the new equilibrium:
- Price decreases to the original price
- Output further increases.
- The number of firms increase.

Long Run Market Dynamics
P
SRS
2
SRS
0
D
1
D
0
Q
LRS
Initially market price decreases, and output decreases.
What happens next?
Since prices fall, p<ATC, each firm suffers a loss. Leads to exit and a further decrease in supply.
In the new equilibrium:
- Price rise to the original price
- Output further decreases.
- The number of firms decreases.

Long Run Market Dynamics
The previous analysis made two simplifying assumptions:
1.
As the number of firms increases, the costs of each individual firm do not change
2.
As prices change, consumers do not change their behavior

Long Run Market Dynamics
Key definition
1. In a constant-cost Industry an increase in industry output does not affect the prices of inputs.
2. In an increasing-cost Industry an increase in industry output increases the prices of inputs.
3. In a decreasing-cost Industry an increase in industry output decreases the prices of inputs.

Long Run Market Dynamics
Increasing-cost Industry: an increase in demand Step 1 Initial effect: prices rise.
Since prices fall, p>ATC, each firm makes a profit in the short run.
Leads to entry.
Step 2 Entry has two effects : i.
Industry supply increases ii.
Individual firm’s costs increase
In the new equilibrium:
- Price rise above the original price
- Output increases.
- Number of firms increases
- Average total costs are higher

Long Run Market Dynamics
Decreasing-cost Industry: an increase in demand
Step 1 Initial effect: prices rise.
Since prices fall, p>ATC, each firm makes a profit in the short run.
Leads to entry.
Step 2 Entry has two effects : i.
Industry supply increases ii.
Individual firm’s costs decreases
In the new equilibrium:
- Price fall bellow the original price
- Output increases.
- Number of firms increases
- Average total costs are lower

Long Run Supply Curve
Definition:
The Long Run Market Supply Curve maps the quantity of output supplied for each given price. The supply of firms takes place after all long run adjustments of inputs, and entry or exit of firms.

Long Run Market Dynamics
1. In a constant-cost Industry long run supply is horizontal
2. In an increasing-cost Industry long run supply increases
3. In a decreasing-cost Industry long run supply decreases

Long Run Market Dynamics
Example of decreasing cost industry: The US Ethanol market
Ethanol is a liquid produced (mostly) from corn, and can be used to produce, amongst other things, bio-fuel.
In 2000s there was a sharp increase in demand, increasing prices.
As the industry grew, the price of corn rose sharply, increasing the production costs
As a result, the number of new plants fell sharply

Long Run Market Dynamics
Example of increasing cost industry: The computer memory market
1.
Most costs are fixed (expensive plants, low production costs), leads to vertical short run supply curves
2.
Economies of scale costs have decreases 30% per year
3.
Demand adjust dynamically toward a long run equilibrium
P
0
2
1
SRS
0
SRS
1
SRD
0
SRD
2
LRS
LRD
Q
$50
$40
$30
$20
$10
$0
1992 1994 1996 1998 2000 2002 2004

Producer Surplus
Difference between surplus and profit
If a firm produces with better inputs it generates a surplus.

Producer Surplus
•
Definitions
The reservation value is the return that the owner of an input could get by deploying the input in its best alternative use outside the industry.
The economic rent that is the difference between the maximum value that a firm is willing to pay for the services of the input and input ’ s reservation value.

Producer Surplus
Producer Surplus is the area above the market supply curve and below the market price. It is a monetary measure of the benefit that producers or other input suppliers derive from producing a good and selling it at particular price.