THE FIRM AND THE
MARKET
Competition
EC2A0
Frank Cowell
EC2A0 2022/3: Competition
Overview
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From the firm to the industry and market
 Use firm’s market behaviour
• profit maximisers
• price takers
• individual supply curve
 Industry as a collection of firms
• aggregation over a given collection
• market outcome with known demand
 Dynamics of the collection
• profit as a mechanism
• long-run equilibrium
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Market supply
 Supply curve firm 1 follows MC
 Supply curve firm 2 follows MC
 Horizontal line: a given price
 Sum individual firms’ supply of output
 Repeat…
 Market supply curve is locus of these points
p
p
p
•
•
q1
low-cost firm 1
 Text: Section 3.2
q1+q2
q2
high-cost firm 2
both firms
MiniProb
What assumptions are
implicit in this process?
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Market equilibrium
 Reuse the derived supply curve
 Introduce a market demand curve
p
 Equilibrium at intersection
demand
supply
 Equilibrium price p*
p*
q
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Three worries about aggregating firms
 What if supply is discontinuous?
• individual supply curves usually are discontinuous
• no equilibrium?
• see next slide
 What if one firm’s activities affect another firm’s costs?
• externality
 How many firms in the industry?
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Market supply (2)
 Below p' neither firm is in the market
 Between p' and p'' only firm 1 is in the market
 Above p'' both firms are in the market
p
p
p
•
•
p"
p"
p'
p'
q1
low-cost
firm
•
•
•
q2
high-cost
firm
q1+q2
both firms
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Where is the market equilibrium?
 Try p′ (demand exceeds supply )
 Try p″′ (supply exceeds demand)
p
demand
 Try p″ ??
supply
 There is no equilibrium at p"
p′″
p"
p′
q
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Market supply (3)
 (top) 2 identical firms with discontinuous S
 (bottom) Sum to get aggregate supply curve
p
p
 Text: Section 3.3
p'
 the discontinuity in
supply is still clear
p'
q1
4
8
12 16
q2
4
8
12 16
p
•
p'
q1 + q2
8
16
24
32
 to analyse the effect of
numbers, let’s rescale the
bottom diagram
MiniProb
Write down a cost function
consistent with either firm’s
supply curve
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Numbers and average supply
 Rescale to get average supply of the firms
 Compare with S for just one firm
 Repeat to get average S of 4 firms
 …average S of 8 firms
p
p'
 … of 16 firms
•••••••••••••••
average(qf)
4
8
12
16
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The limiting case
The limit: continuous “averaged” supply curve
Put in average demand to find equilibrium
Purple blobs: market eqm at average qf = 13
p
Purple circles: Firms’ outputs in equilibrium
average
demand
average
supply
p'
average(qf)
4
8
12
16
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Industry supply: negative externality
 Each firm’s S-curve (MC) shifted by the other’s output
 The result of simple
ΣMC at each output level
 Industry supply allowing for interaction
p
p
S1 (q2=5)
p
S
S2 (q1=5)
MC1+MC2
S1 (q2=1)
S2 (q1=1)
q1
firm 1 alone
MC1+MC2
q2
firm 2 alone
q1+ q2
both firms
 Text: Section 3.4
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Market Supply – summary
 Nonconcave production function: discontinuous supply?
• discontinuous supply functions: no equilibrium?
 If there are lots of firms then we may have a solution
• average behaviour may appear to be conventional
 Externalities affect properties of response function
• Negative: supply less responsive than “sum-of-MC”
• Positive: supply more responsive than “sum-of-MC”
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Market equilibrium
 How to find equilibrium number of firms?
 Get this from firms’ optimising rules
•
•
 determines output of any active firm
 determines number of firms
price = marginal cost
price ≥ average cost
 Entry mechanism:
•
•
if p − C/q gap is large then another firm could enter
applying this iteratively determines the size of the industry
(0) Assume that first firm makes a positive profit
(1) Is pq – C < set-up costs of a new firm?
• …if YES then stop. We’ve got the eqm # of firms
• …otherwise continue:
(2) Number of firms goes up by 1
(3) Industry output goes up
(4) p falls (D-curve) & firms adjust output (firm S-curve)
(5) Back to step (1)
MiniProb
Why does YES in step (1)
mean that we’ve reached
the eqm number?
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Firm equilibrium with entry
 AC (purple) and MC (red)
 Use MC to get supply curve
price
marginal
cost
p
p
p
p
Π1
p
qN
q4q3qq21
average
cost
 Use price to find output
 Π1: profits in temporary equilibrium
 Allow new firms to enter: price falls
 In the limit entry
 Price-taking
ensures
profits are
temporary
competed
away
equilibrium
 p = C/q
234
 nf = 1
output of
 nf = N
firm
 Text: Section 3.5
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Firm and competitive market: Takeaway points
 Market supply
• price taking gives simple aggregation rule
 Potential difficulty
• individual supply curves discontinuous: a problem for equilibrium?
• large-numbers argument may help
 Externality
• interactions affect supply curve
 Size of the industry:
• determined by a simple “entry” model
• use the “price ≥ AC” rule
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