Competition and
Market Equilibrium
Perfect Competition
• Defining Characteristic is lack of market power
– Price Takers
• How do we get there?
– Homogeneous output (or homogeneous enough)
– Enough buyers and sellers that no one (or group
thereof acting together) can effect demand or
supply enough to affect market price
– Perfect information (all participants know the
market price)
– Free entry and exit in the long run (to ensure price =
MC)
Supply and Demand
• The workhorse model of economics assumes
perfectly competitive markets.
• Seems odd since so few markets satisfy all
conditions, but predictive power holds for
markets that are less competitive.
Why do economists like them so much
• With competitive markets, when all goods are
private, there are no externalities and we don’t
worry about income distribution…
• Markets
– Produce goods at the lowest possible cost (technical
efficiency)
– Commit all resources to their highest use (we
produce the mix of goods people want as cheaply as
possible)
– Goods and services are consumed by those who
value them most (maximize economic surplus, but
not utility)
Technical Efficiency:
Two Apple Growers of Many
$
$
SMC
$1.20
SMC
$1.00
q*
q
q*
q
• Both farmers are producing at q* to start. Total cost of production can be lowered
if Farmer Blue produces one fewer apple and Farmer Red produces one more.
• To minimize total cost of producing apples, the SMC of the last apple produced
by every farmer must be the same.
• Perfectly competitive industries get this result.
Allocative Efficiency
Ratio of market price = ratio of MC
Oranges
Slope  MRT 
MCo po

MCa pa
Qo
Qa
Apples
Wow!
• Any and all units of a good or service that can be
produced at an opportunity cost below the value
of the good to consumers will be produced (and
should be produced).
• What coordinates all this magic? Price.
• Price
– signals opportunity cost of resources to producers so
they can minimize cost and know how much to
produce and when to enter or exit production.
– Signals to consumers the value of the resources in
production so that goods and services are consumed
only by those whose value exceeds cost.
This IS the Invisible Hand
• Adam Smith:
– Efficient Resource Allocation: Markets minimize the
cost of production (only the lowest cost producers
produce)
– Consumer Surplus Maximization: Markets maximize
the consumer surplus in consumption (highest value
consumers consume)
– All and only units where benefit > cost will be
produced
– And not only in one market for one good, but for all
markets and all goods*
* except for those pesky market failures
Competition vs Non-competitive
Markets
• While prices create technical efficiency and
promote efficient rationing in less than
competitive situations, allocative efficiency is
lacking (monopolists underproduce)
• Only in perfect competition is economic
surplus maximized.
• MB=MC for last unit produced, no deadweight
loss.
Demand
• Demand is simply the horizontal sum of
individual demand curves
• No short vs long run… although…
• Demand becomes more elastic over time as
time allows individuals to find substitutes.
Market Demand
p
30
• Assume a market with 3 individuals:
x1 = 25 – 2px
x2 = 45 – 1.5px
x3 = 50 – 2.5px
• The market demand curve is the horizontal sum
X = 120 – 6px (P = 20-.143X)
• Except for the kinks. This equation is for
this line
20
D
12.50
25
45
50
Q
Firm and Market Supply
• Very Short Run: Quantities of all inputs are
fixed.
• Short Run: At least one input, but not all, are
fixed.
• Long Run: Quantities of all inputs used are
variable.
Market Adjustment in the
Very Short Run
When quantity is fixed in the very
short run and demand increases, price
will rise but quantity will not change as
firms cannot increase production.
P
VSRS
SRS
Demand for plywood
increases as a hurricane
approaches.
D’
D
Q
Market Adjustment in the
Very Short Run
Similarly, there can be a supply shock
(e.g. hurricane) that shifts supply back
P
S’
S
D
Q
Market Adjustment in the
Very Short Run
P
S’
S
Gasoline: Price rises with supply shift.
Assume an excise tax on gasoline.
Politicians call for suspending the tax,
but in the short run price will be
unaffected as neither supply or
demand would shift as a result.
Tax
Tax
D
Q
Market Adjustment in the
Very Short Run
P
S’
S
Gasoline: Price rises with supply shift.
Assume an excise tax on gasoline.
Politicians call for suspending the tax,
but in the short run price will be
unaffected as neither supply or
demand would shift as a result.
Tax
D
Q
Short Run/Long Run Model
• The more usual analysis.
• Short Run
– Firms produce where MR = SMC
– Firms may shut down in the short run
– Market supply is the horizontal sum of all firms in the
industry (no entry or exit in the short run)
• Long Run
– Price driven to the break-even price as firms enter/exit
to seek profits and avoid losses
– Profits = 0
– Firm on expansion path
– Capital at the level that minimizes SAC
Long and Short Run Cost Curves
• Assume we start here.
$
SMC
MC
SAC
AC
AVC
q
Short Run
• Short Run supply is SMC at P > min(AVC)
– Yes, firms will produce at lower prices in SR than LR.
$
SMC
MC
SAC
AC
SAVC
q
Short Run Firm Supply (Algebra)
SMC Above AVC
Supply = Marginal Cost
1 3
SC  FC  q
6
SMC  .5q2
Firm supply, SMC  P
p  .5q2
q  2p
Shutdown price
Quantity where slope of AVC = 0
1
1
VC  q3 , AVC  q2
6
6
dAVC 1
 q  0 where q = 0
dq
3
Or at q where AVC  SMC
1 2 1 2
q  q
6
2
1 2
q  0 where q = 0
3
Short Run Market Supply (Algebra)
Supply = Marginal Cost (above AVC)
Firm supply:
q  2p
Market supply with N firms:
Q=N* 2p
Short Run, Firm and Market
• Assume we start here for short run.
SMC
$
SAC
$
SRS
q  2P
Q=N* 2P
SAVC
PSD
D
q
q
Long Run
• Assume IRS and then DRS (no CRS)
$
SMC
MC
SAC
AC
AVC
q
Firm Long Run Supply
• q where P = MC so long as π ≥0 (P> PBE)
$
Firm LRS
AC
MC
PBE
q
Long Run Firm Supply (Algebra)
MC above AC
Supply = Marginal Cost
1
C  q2
8
MC  .25q
Firm supply, MC  P
P  .25q
q  4p
Break-even price
1
1
1
C  q2 , AC  q, MC  q
8
8
4
Quantity where slope of AC = 0
dAC 1
  0, at any q
dq 8
Or at the quantity where AC  MC
1
1
q q
8
4
1
q  0 where q = 0
4
Long Run Market Supply
• Long run firm supply: q=4P
• So long run market supply: Q=N(4P)?
• NO!!!
Long Run Firms Enter and Exit until
profit = 0 and market price = PBE
• In long run: P →PBE and π →0
$
MC
AC
PBE
qLR
q
Long Run Market Supply
• Firms enter and exit so that in the long run,
LRS = the quantity demanded at the pBE
SMC
P
SAC
P
MC
AC
S
Assumes
constant
cost
industry,
more to
come on
that!
PBE
LRS
PSD
D
q
Q
Shocks
• Change in demand
• Change in FC
• Change in VC
Change in Demand
• Short Run: price up, Δ Q is n*Δq, π > 0
SMC
$
SRS1
$
ATC
AVC
PBE
D
D
q1 q2
q
Q1 Q2
Q
Change in Demand
• Long run: Firms enter, π > 0
SMC
$
SRS1
$
SRS2
ATC
AVC
PBE
D
D
q1 q2
q
Q2 Q3
Q
Change in Demand
• Long Run Supply: If the PBE does not change, the
market will always supply the Qd at PBE .
SMC
$
$
SRS2
ATC
AVC
LRS
PBE
D
D
q1
q
Q3
Q
Comparative Statics Analysis
• In the long run, the number of firms in the
industry will vary from one long-run
equilibrium to another
• Assume that we are examining a constant-cost
industry
• Suppose that the initial long-run equilibrium
industry output is Q0 and the typical firm’s
output is q* (where AC is minimized)
• The equilibrium number of firms in the
industry N1 = Q1/q1*
Comparative Statics Analysis
• A shift in demand that changes the
equilibrium industry output to Q3 will change
the equilibrium number of firms to
N3 = Q3/q1*
• The change in the number of firms is
Q 3  Q1
N3  N1 
q*
• In a constant cost industry q*will not change,
so only the size of the shift in demand will
affect the change in n.
Change in FC
• Short Run: MC is unaffected, so qs is unaffected,
so PM is unaffected. But firms suffer losses.
SMC
$
SRS1
$
ATC
AVC
PBE
D
q1
q
Q1
Q
Change in FC
• Long run: Firms exit until the PM = the new PBE .
• With higher price of K, firms use less.
• Change in firm level of output is unknown.
$
PBE2
ATC’
SMC’
SRS1
$
AVC’
PBE1
D
q3
q
Q1
Q
Change in FC
• Long run: Firms exit until the PM = the new PBE.
SMC’
$
SRS1
$
SAC’
PBE2
AVC’
LRS2
LRS1
PBE1
D
q3
q
Q3
Q1
Q
Change in VC
• Short Run: MC is affected, so qs is affected, as is
PM . Firms suffer losses, as the higher price does
not cover the higher cost.
SMC
$
SRS1
$
ATC
AVC
PBE
D
q1
If AVC > P, firms will shut down.
q
Q1
Q
Change in VC
• While firm supply decreases, qs is unknown as
we don’t know the change in price. However,
change in MC > change in P.
SRS2
SMC
$
SRS1
$
ATC
AVC
PBE
D
q1
If AVC > P, firms will shut down.
q
Q2Q1
Q
Change in VC
• Again, with higher costs, and PBE, the LRS curve
will shift upwards. The new q* (and optimal K)
could be higher or lower.
SRS
SRS
3
SMC
$
2
SRS1
$
ATC
PBE2
AVC
LRS2
LRS1
PBE1
D
q3
q
Q3
Q1
Q
Comparative Statics Analysis
• The effect of a change in input prices
– we need to know how much minimum average
cost is affected
– we need to know how an increase in long-run
equilibrium price will affect quantity demanded
Comparative Statics Analysis
• The optimal level of output for each firm may
also be affected
• Therefore, the change in the number of firms
becomes
Q3
Q1
N3  N1  *  *
q3 q1
• And the relative changes in Q and q* will
determine the change in N.
Comparative Statics, change in q*
At q*, where AC(v,w,q*(v,w,p))  MC(v,w,q*(v,w,p))
the change in AC = the change in MC, that is:
AC AC q* MC MC q*



w q* w
w
q* w
AC
And at q* where AC=MC,
0
q *
AC MC

q* w
w , ,  0, depending on AC , ,  MC

MC
w
w
w
q *
If AC rises more than MC, q* will rise and vice versa.
Supply and Demand
• Basis is the competitive model
– Usually, competitive market in the short run.
– Sometimes used to depict competitive market in the
long run with increasing cost industry assumption.
• Treatment
– Algebra (to get equilibrium)
– Calculus (comparative statics)
• Demand shifters
• Supply shifters
• Sales and Excise taxes
As in Intermediate Micro
• Inverse Demand: P = 1,500 - .5Qd
• Inverse Supply: P = 600 + Qs
• Solution is Q = 600, P = 1,200
P
S
1,500
1,200
D
600
600
3,000
Q
Sales Tax, Comparative Statics
• Intermediate
– Add Sales Tax = $150
•
•
•
•
Inverse Demand: P = 1500 - tax - .5Qd
Inverse Supply: P = 600 + Qs
Solution is Q = 500, P = 1100 (consumer cost = P + t = $1250)
Just by comparing outcomes,
dP*
dQ *
dt
P
 0,
dt
0
S
Market
Price
PD=1,250
P*=1,100
D
Dt
500
Q
Excise Tax, Comparative Statics
• Intermediate
– Add Excise Tax = $150
•
•
•
•
Market
Price
Inverse Demand: P = 1500 - .5Qd
Inverse Supply: P = 600 + tax + Qs
Solution is Q = 500, P = 1250 (producer keeps = P – t = $1100)
Just by comparing outcomes, dP*  0, dQ *  0
dt
P
St
S
P*=1,250
PS=1,100
D
500
Q
dt
Linear Supply and Demand, Equilibrium
• General linear functions specified
– Inverse Demand: P = a – bQd
(a > 0, b > 0)
– Inverse Supply: P = c + dQs (c > 0, d > 0)
– Equilibrium condition: Qs = Qd (and Ps = Pd)
• Reduced form solution (only in terms of a, b, c, d)
ad  bc
P* 
bd
ac
Q* 
bd
P
a
slope = d
S
P*
slope = -b
D
c
Q*
Q
Shifts in Supply or Demand,
Comparative Statics
• Solution
P
ad  bc
ac
P* 
, Q* 
bd
bd
• Comparative Statics
dP*
d

 0,
da b  d
dP* d  c  a

 0,
2
db b  d
a
slope = d
S
P*
slope = -b
D
c
dQ *
1

0
da b  d
dQ *  c  a

0
2
db b  d
dP*
b
1
So long dQ *

 0, as a>c

0
dc b  d
dc b  d
dP*  a  c 
dQ *  c  a

 0,

0
2
2
dd b  d
dd b  d
Q*
Note, “b” rising
means demand
must be getting
steeper.
Q
Sales Tax
• Market Model (sales tax)
– Inverse Demand: P = a - t – bQd (a > 0, b > 0)
– Inverse Supply: P = c + dQs (c > 0, d > 0)
– Equilibrium condition: Qs = Qd
• Reduced form solution (only in terms of a, b, c, d, t)
ad  td  bc
P 
bd
atc
*
Qt 
bd
PD*  Pt*  t
*
t
P
a
S
a-t
PD*
P*
P t*
D
c
Dt
Qt* Q*
Q
Sales Tax, Comparative Statics
• Solution
ad  td  bc
atc
*
P 
, Qt 
, PD*  Pt*  t
bd
bd
*
t
• Comparative Statics
dP*
d

0
dt b  d
dQ *
1

0
dt b  d
dPD*
d
d



 1  0  as  1 
 0
dt b  d
bd


P
a
S
a-t
PD*
P*
P t*
D
c
Dt
Qt* Q*
Q
Supply and Demand with General
Form Equations
• All we assume is:
dQ d
D(P;a)  Q d ,
 0 and "a" is a parameter that shifts demand
dP
dQ s
S(P;b)  Q s ,
 0 and "b" is a parameter that shifts supply
dp
• And that at equilibrium (Q*, P*):
D(P*;a)  Q*, or D(P*;a)  Q*  0
S(P*;b)  Q*, or S(P*;b)  Q*  0
• First assume only a is changing and then only b.
Comparative Statics of a Demand Shift
• Start with
FD = D(P*, a) – Q* = 0
FS = S(P*) – Q* = 0
(see 8.41 in
Chiang)
• Substitute in:
P*=P*(a), and Q*=Q*(a)
• To get
FD = D(P*(a), a) – Q* (a)= 0
FS = S(P*(a)) – Q*(a) = 0
(see 8.40 in Chiang),
Implicit function
theorem tells us
equations P* and Q*
must exist to solve
these equations
simultaneously.
• Take the total derivative with respect to a:
D
P*
S
P*
dP* D dQ *


0
da a da
dP* dQ *

0
da da
Demand Shifting
• From above
Slope of
demand curve
so dQd/dP
D
P*
S
P*
Slope of
supply curve
dQs/dP
• Matrix Notation
 D
 P*

 S
 P*
dP* dQ *
D


da da
a
dP* dQ *

0
da da
Change in
equilibrium price
when a changes
*
  dP 
1 
 D 

 
da



 a

*
dQ   0 


1 

  da  
Change in demand when a
changes
(Holding P constant, how
does Qd change with a).
Change in equilibrium
quantity when a
changes
Demand Shifting and Change in P*
• Cramer’s Rule
D

1
a
D
0
1
Da
dP*

a




S

D
D
da
SP*  DP*


1
P* P*
P*
>0
S

1
P*
• If a is income and the good is normal, then
Da > 0 and equilibrium price will rise with a.
• If a is price of a complimentary good, then
Da < 0 and equilibrium price will fall with a.
Demand Shifting and Change in Q*
• Cramer’s Rule
D
D

*
P
a
S
D S
0
*
*
DaSP*
dQ * P*

a

P




S

D
D
da
SP*  DP*


1
P* P*
P*
S
1
*
P
>0
• If a is income and the good is normal, then Da > 0
and equilibrium quantity will rise with a.
• If a is price of a complimentary good, then Da < 0
and equilibrium price will fall with a.
Supply Shifting
• Start with
FD = D(P*) – Q* = 0
FS = S(P*, b) – Q* = 0
(see 8.41 in
Chiang)
• Substitute in:
P*=P*(b), and Q*=Q*(b)
• To get
FD = D(P*(b)) – Q* (b)= 0
FS = S(P*(b), b) – Q*(b) = 0
(see 8.40 in Chiang),
Implicit function
theorem tells us
equations P* and Q*
must exist to solve
these equations
simultaneously.
• Take the total derivative with respect to b:
D
P*
S
P*
dP* dQ *

0
db db
dP* S dQ *
 
0
db b db
Supply Shifting
• From above
Slope of
demand curve
so dQd/dP
Slope of
supply curve
so dQs/dP
• Matrix Notation
 D
 P*

 S
 P*
D
P*
S
P*
*
*
dP dQ

0
db db
dP* dQ *
S


db db
b
Change in equilibrium
quantity when b
changes
Change in
equilibrium price
when b changes
*
  dP 
1 
 0 

db   





S
*
 
dQ



1 
  db   b 
Change in supply when b
changes (holding P
constant, how does Qs
change with a).
Supply Shifting and the Change in P*
• Cramer’s Rule
0
1
S
S


1

Sb
dP*

b

b




S

D
D
db
DP*  SP*


1
P* P*
P*
<0
S
1
*
P
• If b is technology, then Sb > 0 and equilibrium
price will fall with b.
• If b is wages, then Sb < 0 and equilibrium price
will rise with b.
Supply Shifting and the Change in P*
• Cramer’s Rule
D
0
*
P
S
S
D S


*
DP*Sb
DP*Sb
dQ * P*

b

P

b





S

D
D
db
SP*  DP* DP*  SP*


1
P* P*
P*
S
1
*
P
<0
• If b is technology, then Sb > 0 and equilibrium
quantity will rise with b.
• If b is wages, then Sb < 0 and equilibrium
quantity will fall with b.
Results in Elasticities
• We can convert our analysis to elasticities
Da
dP a
a
P,a   

da P SP  DP P
1
(Da )  a
D,a
(Da )  a
Q
Q
P,a 
 

1
(SP  DP )  P
Q S ,P  Q d ,P
SP  P  DP  P
Q
Q
Q


P,b
Sb
dP b
b

 

db P SP  DP P
1
(Sb )  b
S,b
(Sb )  b Q
Q
P,b 
 

(SP  DP )  P 1
Q S ,P  Qd ,P
SP  P  DP  P
Q
Q
Q


Effect of a 1% increase in income on
demand for a normal good
• Assume D,M = .5, S,p = .75, D,p = -1.25
D,M
.5
P,M 

 .25
Q S ,P  QD ,P .75  1.25
.5% increase in
demand 
.25% inc. in
price
1% increase in income
 .5% inc. in demand
P
.5%
S
.25%
D’
D
.1875%
.25 increase in price .1875%
inc. in quantity:
%ΔQs/%ΔP =.75
%ΔQs/.25 =.75
%ΔQs =.1875
Q
Effect of a 1% increase in wages
• Assume S,w = -.60, Qs,p = .80, Qd,p = -.70
P,w 
.6% decrease in
supply  .40%
inc. in price
S,w
Q s ,P  Q d ,P
P
.60

 .40
.80  .70

1% increase in income
for a .6% dec. in
supply
S’
.6%
S
.40%
.40% increase in price .28% dec. in quantity:
%ΔQd/%ΔP =-.70
%ΔQd/.40 =-.70
%ΔQs =-.28
D
-.28%
Q
Supply and Demand (Sales Tax)
• Start with
FD = D(P*+t) – Q* = 0
FS = S(P*) – Q* = 0
P* is the market price, but
the buyer pays PD = P*+t
• Substitute in:
P*=P*(t), and Q*=Q*(t)
• To get
FD = D(P*(t) + t) – Q*(t)= 0
FS = S(P*(t)) – Q*(t) = 0
• Take the total derivative with respect to t:
 dQ *
D  dP*
D dP* dQ *
D

1


0






P*  dt
P* dt
dt
P*
 dt
S dP* dQ *

0
*
P dt
dt
Supply and Demand (Sales Tax)
• From above
D
P*
S
P*
dP* dQ *
D

 *
dt
dt
P
dP* dQ *

0
dt
dt
• Matrix Notation
 D
 P*

 S
 P*
*
  dP 
1 
 D 

 *
dt



 P

*
dQ   0 


1 

  dt  
Change in P* when t rises
D
1
*
P
D
*
DP*
0
1
dP*

P



0 ,
S D S *  D *
D
dt
P
P
 *
1
*
*
P
P P
P
S
dP
1
*
dt
P
dt
P
dP
Q
DP*
D
dP*
dt

  
0
dt SP*  DP*  P   S  D
 
Q
PD  P*  t

Original Tax
S
D
*
 
S
dPD dP
D
D

1 
1 
 S D
0
dt
dt
 S  D
 S  D  S  D  S  D
*
D
Q
Change in Q* when t rises
 D
 P*

 S
 P*
*
  dP 
1 
 D 

 *
dt

   *   P
dQ   0 


1 

  dt  
D
D
 *
*
P
P
S
D S
0
*
*
dQ * P*

P

P


S D

D
dt
 *
1
*
*
P P
P
S
1
*
P
P
Q

 P
Q
P
Original Tax

 D  S
0

 S  D

S
D
dQ *
dt
Supply and Demand (Excise)
• Start with
FD = D(P*) – Q* = 0
FS = S(P*-t) – Q* = 0
P* is the market price, but
the supplier keeps Ps = P*-t
• Substitute in:
P*=P*(t), and Q*=Q*(t)
• To get
FD = D(P*(t)) – Q*(t)= 0
FS = S(P*(t) - t) – Q*(t) = 0
• Take the total derivative with respect to t:
D dP* dQ *

0
*
P dt
dt
 dQ *
S  dP*
S dP* S dQ *
 1 
0 *
 *
0
* 
P  dt
P dt P
dt
 dt
Supply and Demand (Excise Tax)
D
P*
S
P*
dP* dQ *

0
dt
dt
dP* S dQ *


0
dt P* dt
• Matrix Notation
 D
 P*

 S
 P*
*
  dP 
1 
 0 

dt   





S
dQ *   * 


1 
  dt   P 
Change in P* when t rises
0
S
dP* P*

D
dt
P*
S
P*
1
1
1

S
P*
S D
 *
*
P P

0 P
SP*  DP*
1
P
Q
SP*
dP*


dt SP*  DP*  P

Q
PS  P*  t
SP*
S
dP*
dt
dt


S
0


  S  D

dPS
dt
 S  D
S
S
dPS dP*
D
0


1 
1 

 S  D  S  D  S  D
 S  D
dt
dt
D
Original Tax
Q
Change in Q* when t rises
D
P*
S
P*
dP* dQ *

0
dt
dt
dP* S dQ *
 *
0
dt P
dt
D
0
*
P
S
S
D S
*
*
*
*
*
dQ

P

P

P

P


S D
D
dt
 *
1
*
*
P P
P
S
1
*
P
S
P
dt
D
P
Q

 P
Q

 DS
0

 S  D

dQ *
dt
Original Tax
Q
And Finally
Note that for Sales tax, P*=PS and for excise tax, P*= PD
For either tax, the ratio of change in the demander price to
the supplier price is as follows:
S
dPD
dt  S  D   S
dPS
D
D
dt S  D
If   3 and   1, the price to
Absolute value of both sides to get:
demanders will rise 3x more than
S
dPD
dt  S
dPS
D
dt
D
the price for suppliers will fall.
That is, for a $4 tax, demanders will
see prices rise $3 and sellers will see
their price fall $1.
If S  D , suppliers see the bigger change in price
If S  D , demanders see the bigger change in price
Increasing Cost Industries and
Decreasing Cost Industries
• What happens when the market expands or
contracts.
– For constant cost industries, expansion and
contraction of the market does not affect v and w so
the break-even price remains constant.
– For increasing cost industries:
• Factor price effect: w, or v rise with Qe
• Less efficient firm’s effect
– For decreasing cost industries:
• Factor price effect: w, or v fall with Qe
Short Run
• Assume we start here.
SMC
$
$
ATC
SRS
AVC
PBE
D
q
Q
Increasing Cost Industry:
Factor Price effect
• Demand Increases
SMC
$
$
ATC
SRS
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Factor Price effect
• Firms increase production in the short run
SMC
$
$
ATC
SRS
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Factor Price effect
• If it is w that rises with an increased demand for
labor, MC will rise with expansion.
SMC
$
$
ATC
SRS’
SRS
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Factor Price effect
• Profits > 0, so firms still enter, but profit returns
to zero before the price falls to its previous level.
SMC
$
$
ATC
SRS’’
SRS’
SRS
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Factor Price effect
• Profits > 0, so firms still enter, but profit returns
to zero before the price falls to its previous level.
SMC
$
$
ATC
SRS’
SRS
SRS’’
LRS
AVC
PBE’
PBE
D’
D
q
Q
SR or LR effects
• Often, costs are assumed stable in SR, but
increase only in the long run.
• Same result, easier math.
Increasing Cost Industry:
Differential Productivity Effect
• Firms increase production in the short run
SMC
$
$
ATC
SRS
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Differential Productivity Effect
• New firms are less efficient, so entry stops
before price returns to original level
SMC
$
$
SRS’
SRS
ATC
AVC
PBE
D’
D
q
Q
Increasing Cost Industry:
Differential Productivity Effect
• New firms are less efficient, so entry stops
before price returns to original level
SMC
$
$
SRS’
SRS
ATC
AVC
LRS
PBE
D’
D
q
Q
Why differential in efficiency?
• Better (lower cost) location? Rent should rise
to compensate.
• Better managers at some firms? Wages should
rise to equilibrate costs.
• Smarter entrepreneur? Should have higher
opportunity cost.
• More fertile land (Ricardo’s original example)
Decreasing Cost Industry
• As a market expands, economies of scale in
production of inputs causes input prices to fall.
• As the market expands, inputs prices fall and
when firms enter, the price falls below its initial
level before P = PBE.
• Reverse of factor price effect.
• As demand for micro computers rose in the
1980s-90s, chip factories got bigger and prices fell
(technological advances exacerbated the issue,
but that is separate).
Producer Surplus
• Remember the short run
SMC
$
$
ATC
SRS
AVC
PBE
PS=π+FC
D
q
Q
Long Run Producer Surplus
• Long Run producer surplus is long run π
• Zero producer surplus if constant cost industry.
SMC
$
$
SRS
ATC
AVC
LRS
PBE
D
q
Q
Producer Surplus
• In an increasing cost industry, depends on the
source of the upward sloping LRS curve.
SMC
$
$
SRS
ATC
AVC
LRS
PBE
D
q
Q
Producer Surplus
• Factor price effect, the rising price needed to increase
supply of the input provides a surplus to lower cost
suppliers
$
$
Factor Market
Output Market
S
LRS
D
D
q
• However, individual firms have LR π=0 and PS=0.
Q
Producer Surplus
• Differential Productivity Effect: if some firms
have a cost advantage, the firm that owns the
source will benefit in the long run.
$
$
SMC
Output Market
S
ATC
LRS
PBE
D
q
Q
Long Run Producer Surplus
• Farmer with the best land will earn an
increasing producer surplus (long run profit).
– The excess future stream of long run profits will
be capitalized into the market price (value) of the
land.
excess annual profit
extra land value =
i
• Actors and Athletes who are really good earn
a long run profit because there is no
substitute. But now we are starting to talk
about market power.