MICROECONOMICS�

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Production

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The Firm’s Problem

• Recall the Consumer Optimization Problem:
• Maximize utility subject to budget constraint
• The producer’s (firm’s) problem is more complicated:
• Maximize profit
• The choice variables are output and prices (for non-competitive firms)
• Subject to 3 types of constraints:
• Production technology
• Market demand
• Market structure (competitive/monopoly/oligopoly)

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Production Technology

• A production technology is a process by which inputs are converted into output.
• Ex: labor, a computer, a projector, electricity, and software are being combined to produce this lecture.
• Inputs in production (factors of production)
• Land
• Labor
• Capital
• Entrepreneurship
• The production technology will be represented by a production function:
• Y = F(x₁,x₂,x₃,…,x_n), where x₁,…,x_n measure the quantity of each factor of production used, and Y is the quantity of output
• We will focus on two factors of production: capital (K) and labor (L)
• Y = F(K,L)
• Technologically efficient production

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Production Functions

• Examples:
• Cobb-Douglas: Y = K^αL^β
• Perfect complements: Y = min{K,L}
• Perfect substitutes: Y = K+L
• Note: different combinations of capital and labor can result in the same level of output
• Ex: Suppose that there are 200 econ students taking Micro this semester
• The econ department can use 1 big classroom with 100 seats (K=100), and then it would need to offer two sections, i.e. 2 professors will be needed (L=2)
• OR, the department can use a small classroom with 40 seats (K=40), but then it would need to teach 5 sections, i.e. 5 professors (L=5)
• F(100,2) = F(40,5) = 200
• Isoquant: the set of all input bundles that yield the same output level y
• Same as indifference curve, but applied to production functions�

Cobb-Douglas Isoquants

L

K

Perfect Complements in Production

L

K

4

8

14

2

4

7

K = 2L

Marginal Products

MPL and the production function

Y

output

L

labor

MPL

As more labor is added, MPL falls

Example: Diminishing Marginal Products

and

Both marginal products are diminishing.

Cobb-Douglas:

Marginal Rate of Technical Substitution

Marginal Rate of Technical Substitution

L

K

Y=100

The slope is the rate at which labor must be given up as capital’s level is increased so as not to change the output level. The slope of an isoquant is its marginal rate of technical substitution.

Returns to scale

Initially Y₁ = F (K₁ , L₁ )

Scale all inputs by the same factor z:

K₂ = zK₁ and L₂ = zL₁

(e.g., if z = 1.2, then all inputs are increased by 20%)

What happens to output, Y₂ = F (K₂, L₂ )?

• If Y₂ = zY₁ => constant returns to scale
• If Y₂ > zY₁ => increasing returns to scale
• If Y₂ < zY₁ => decreasing returns to scale

Returns to scale

Formally: starting with F(K,L) = Y

• If F(zK,zL) = zY => constant returns to scale
• If F(zK,zL) > zY => increasing returns to scale
• If F(zK,zL) < zY => decreasing returns to scale

Returns to scale: Example 1

constant returns to scale for any z > 0

Returns to scale: Example 2

increasing returns to scale for any �z > 1

Firms and Their Production Decisions�

The Short Run versus the Long Run

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short run Period of time in which quantities of capital production factor cannot be changed. It requires new investment. It is assumed that capital is fixed in short run.

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long run Amount of time needed to make all production inputs variable

Production with One Variable Input (Labor)

Average and Marginal Products

average product Output per unit of a particular input.

marginal product Additional output produced as an input is increased by one unit.

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Average product of labor

Output/labor input = Y/L

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Marginal product of labor

Change in output/change in labor input = ∆Y/ ∆ L

The Relationship Between Average and Marginal Product Curves

• When the marginal product is greater than average product, average product must be increasing.
• When the marginal product is less than average product, average product must be decreasing.
• When the marginal and average products are equal, average product is at a maximum.

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The Slopes of the Product Curve

PRODUCTION WITH ONE VARIABLE INPUT

The total product curve in (a) shows the output produced for different amounts of labor input.

The average and marginal products in (b) can be obtained (using the data in Table) from the total product curve.

At point A in (a), the marginal product is 20 because the tangent to the total product curve has a slope of 20.

At point B in (a) the average product of labor is 20, which is the slope of the line from the origin to B.

The average product of labor at point C in (a) is given by the slope of the line 0C.

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The Slopes of the Product Curve

PRODUCTION WITH ONE VARIABLE INPUT

To the left of point E in (b), the marginal product is above the average product and the average is increasing; to the right of E, the marginal product is below the average product and the average is decreasing.

As a result, E represents the point at which the average and marginal products are equal, when the average product reaches its maximum.

At D, when total output is maximized, the slope of the tangent to the total product curve is 0, as is the marginal product.

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The Firm’s Problem

• Profit Function:
• Y = quantity of output produced
• P = price of output
• Total Revenue: TR = PY
• L = number of workers hired
• W = nominal wage paid to each worker
• WL = Total Labor Income (total wages paid to all workers)
• K = number of units of capital rented
• R = nominal rental rate on capital
• Total Capital Income = RK (total rent paid for all capital)
• We are assuming that capital is owned by third party individuals and rented to firms
• In the real world an individual buys corporate stock; the firm uses the invested money to buy capital; the stock holder now receives dividend (rent)
• Whether (1) the individual loans money to the firm and the firm uses it to buy the capital and pays dividend OR (2) the individual buys the capital first and then rents the capital it to the firm is immaterial – the two cases are equivalent for the purposes of the model�

Firm Profits in General

• Economic Profit (Π) = Total Revenue – Total Cost
• Π = PY – WL – RK
• Assumption: the goal of the firm is to maximize profits
• Exogenous Variables:
• Factor Prices W and R
• We are assuming that the markets for the factors of production (L and K) are competitive and the firm takes those prices as given
• Choice Variables:
• L and K
• Y, but recall that Y=F(K,L)
• How about P?
• If the market for the firm’s output Y is competitive then P is exogenous (the firm is a price-taker)
• If the firm is a monopolist, then P is a choice variable
• If the firm is part of an oligopoly, then P is a choice variable, but there will be additional constraints imposed by the choices made by other firms

Profit Maximization by a Competitive Firm

Profit Maximization by a Competitive Firm

Profit Maximization and Returns to Scale

• It turns out that the profit maximization above only makes sense if firms have Constant or Decreasing Returns to Scale
• Suppose that the production function exhibits Increasing Returns to Scale: F(zK,zL) > zF(K,L)
• Then what happens to profits when we scale K and L by the same factor z?
• Π(K,L) = PF(K,L) – WL – RK
• Π(zK,zL) = PF(zK,zL) – W(zL) – R(zK) > zPF(K,L) – zWL – zRK = z Π(K,L)
• So if a competitive firm makes positive profits, then by scaling K and L by the same factor z profits would scale up even faster
• Ex: doubling K and L will more than double Π
• So it would be optimal for the firm to grow as large as possible (K* and L* are infinity)
• But if the firm grows arbitrarily large, then how can it still be a competitive firm?
• Increasing Returns to scale are inconsistent with profit maximization in competitive markets�

Profit Maximization and Returns to Scale

• The same “problem” occurs with Constant Returns to Scale
• Suppose that the production function exhibits Constant Returns to Scale: F(zK,zL) = zF(K,L)
• Then what happens to profits when we scale K and L by the same factor z?
• Π(K,L) = PF(K,L) – WL – RK
• Π(zK,zL) = PF(zK,zL) – W(zL) – R(zK) = zPF(K,L) – zWL – zRK = z Π(K,L)
• Ex: doubling K and L will double Π
• So it seems that once again it would be optimal for the firm to grow as large as possible (K* and L* are infinity)
• Unless maximized Π = 0 to begin with
• This turns out to be the case with CRS�

Profit Maximization and CRS

The Firm’s Problem

• Maximize Π = PY – WL – RK
• Where Y = F(K,L)
• Instead of maximizing profits directly consider the following two-step procedure:
• Step 1: For any given level of output Y find the cheapest way to produce it
• Call the resulting minimized cost of production C(Y)
• Step 2: Maximize Π = PY – C(Y) with respect to Y (and P in the case of monopoly/oligopoly)
• Note: This method is equivalent to maximizing profits directly
• Advantages:
• Allows us to separate the marketing (price and quantity) decision from the production technology decision
• Step 1 depends only on the production technology; it is independent of the market structure
• Having the cost function C(Y) will allow us to understand better the profit maximizing behavior in step 2
• The in chapter 7:
• Derive the minimized cost function C(Y)
• Analyze its properties

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The Nature of Cost

• Recall:
• Explicit costs – arise from transactions in which the firm purchases inputs or the services of inputs from other parties (accounting costs)
• Implicit costs – costs associated with the use of the firm’s own resources and reflect the fact that these resources could be employed elsewhere

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• Opportunity cost reflects both explicit and implicit costs (economic cost).

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Measures of Short-Run Cost

• Total fixed cost (TFC) – the cost incurred by the firm that does not depend on how much output it produces
• Total variable cost (TVC) – the cost incurred by the firm that depends on how much output it produces

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Fixed versus Sunk Costs

• Fixed cost – input cost that is invariant to the output level selected by the firm; relevant cost even when output is zero
• Sunk cost – Expenditure that has been made and cannot be recovered.

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Because a sunk cost cannot be recovered, it should not influence the firm’s decisions.

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For example, consider the purchase of specialized equipment for a plant. Suppose the equipment can be used to do only what it was originally designed for and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost. Because it has no alternative use, its opportunity cost is zero. Thus it should not be included as part of the firm’s economic costs.

It is important to understand the characteristics of production costs and to be able to identify which costs are fixed, which are variable, and which are sunk.

Computers (Lenovo, Dell, etc): mostly variable costs

Software: mostly sunk costs

Pizzas: mostly fixed costs

SUNK, FIXED, AND VARIABL E COSTS: COMPUTERS, SOFTWARE, AND PIZZAS

Fixed Costs and Variable Costs

Shutting Down

Shutting down doesn’t necessarily mean going out of business.

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By reducing the output of a factory to zero, the company could eliminate the costs of raw materials and much of the labor. The only way to eliminate fixed costs would be to close the doors, turn off the electricity, and perhaps even sell off or scrap the machinery.

Fixed or Variable?

How do we know which costs are fixed and which are variable?

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Over a very short time horizon—say, a few months—most costs are fixed. Over such a short period, a firm is usually obligated to pay for contracted shipments of materials.

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Over a very long-time horizon—say, ten years—nearly all costs are variable. Workers and managers can be laid off (or employment can be reduced by attrition), and much of the machinery can be sold off or not replaced as it becomes obsolete and is scrapped.

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From Total Product to Total Variable Cost

Cost

Q

TC(Q) = TVC + TFC

TVC(Q)

FC

0

DIMINISHING MARGINAL RETURNS AND MARGINAL COST

Diminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases.

As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

Five Other Measures of Short-Run Cost

• Total cost (TC) – the sum of total fixed and total variable cost at each output level

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• Marginal cost (MC) – the change in total cost that results from a one-unit change in output

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• Average fixed cost (AFC) – total fixed cost divided by the amount of output

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• Average variable cost (AVC) – total variable cost divided by the amount of output

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• Average total cost (ATC) – total cost divided by the output

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• Marginal and Average Cost

TA FIRM’S COSTS

Average Costs

$/output unit

AFC(y)

y

0

AFC(y) → 0 as y → ∞

$/output unit

y

AVC(y)

MC(y)

ATC(y)

Marginal Cost-Average Cost Relationships

• When marginal cost is below average (total or variable) cost, average cost will decline.

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• When marginal cost is above average cost, average cost rises.

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• When average cost is at a minimum, marginal cost is equal to average cost.

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COST IN THE SHORT RUN

The Shapes of the Cost Curves

In (a) total cost TC is the vertical sum of fixed cost FC and variable cost VC.

In (b) average total cost ATC is the sum of average variable cost AVC and average fixed cost AFC.

Marginal cost MC crosses the average variable cost and average total cost curves at their minimum points.

COST IN THE SHORT RUN

The Shapes of the Cost Curves

The Average-Marginal Relationship

Consider the line drawn from origin to point A in (a). The slope of the line measures average variable cost (a total cost of $175 divided by an output of 7, or a cost per unit of $25).

Because the slope of the VC curve is the marginal cost , the tangent to the VC curve at A is the marginal cost of production when output is 7. At A, this marginal cost of $25 is equal to the average variable cost of $25 because average variable cost is minimized at this output.

LONG-RUN COST OF PRODUCTION

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Cost Minimization

• For any given level of output Y’, what is the cheapest way to produce it?
• i.e. what is the cheapest combination of capital and labor that yield output Y’
• Minimize WL + RK (total cost of production)
• Subject to F(K,L) = Y’
• Choice variables: K and L
• NB! We are solving this conditional on a given level of output Y’, so we will treat Y as an exogenous variable

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Isoquant

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• Recall:
• Isoquant: the set of all input bundles (K,L) that yield the same output level Y
• So our constraint is just one of the isoquants of the production function

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Isoquants

L

K

Isocost

Isocost Lines

RK + WL ≡ c’

RK + WL ≡ c”

c’ < c”

K

L

Slope = -R/W.

Cost Minimization

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• Minimize WL + RK
• Subject to Y’ = F(K,L)

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• Or:
• Given an isoquant Y’ = F(K,L), find the bundle (K*,L*) on it that lies on the lowest possible isocost line

K

L

All input bundles yielding Y’ units�of output. Which is the cheapest?

F(K,L) ≡ Y’

K

L

All input bundles yielding Y’ units�of output. Which is the cheapest?

F(K,L) ≡ Y’

K

L

All input bundles yielding Y’ units�of output. Which is the cheapest?

F(K,L) ≡ Y’

K

L

All input bundles yielding Y’ units�of output. Which is the cheapest?

F(K,L) ≡ Y’

K*

L*

K

L

F(K,L) ≡ Y’

K*

L*

At an interior cost-minimizing input bundle:�(a) F(K,L) ≡ Y’ and�(b) slope of isocost = slope of isoquant; i.e.

Cost Minimization

• The solution to the cost-minimization problem is a function of Y:
• K*(Y,R,W)
• L*(Y,R,W)

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• These are known as the Conditional Demand Curves for capital and labor

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Minimized Cost Function

• Having found K*(Y,R,W) and L*(Y,R,W) we can find the value of minimized costs:

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• C(Y,R,W) = RK* + WL*

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• We will typically plug in specific values for W and R and consider the minimized cost only as a function of output : C(Y)

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Cost in the Long Run

INPUT SUBSTITUTION WHEN AN INPUT PRICE CHANGES

Facing an isocost curve C₁, the firm produces output q₁ at point A using L₁ units of labor and K₁ units of capital.

When the price of labor increases, the isocost curves become steeper.

Output q₁ is now produced at point B on isocost curve C₂ by using L₂ units of labor and K₂ units of capital.

$/output unit

y

AVC(y)

MC(y)

ATC(y)

Average Variable Costs

• AVC is:
• upward sloping in the case of DRS
• Flat (horizontal) in the case of CRS
• Downward sloping in the case of IRS
• We argued that it is common for firms to have:
• IRS when they are small (y very low)
• DRS when they become large (y very high)
• CRS in between
• So it is most common that the AVC is U-shaped

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Economies of Scale and Diseconomies of Scale

• Economies of scale – a situation in which a firm can increase its output more than proportionally to its total input cost
• Reflects increasing returns to scale

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• Diseconomies of scale – a situation in which a firm’s output increases less than proportionally to its total input cost
• Reflects decreasing returns to scale

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The Long Run and Short Run Revisited

Summary:

• Long-run average cost curve (LAC): the lowest average cost attainable when all inputs are variable

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• Each point on the LAC is associated with a different short-run scale of operation that the firm could choose.

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Short- and Long-Run Average Cost Curves

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The Assumptions of Perfect Competition

• Large numbers of buyers and sellers
• Each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price
• Price taker Firm that has no influence over market price and thus takes the price as given
• Free entry and exit
• Free entry (or exit) Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry. Firms (suppliers) can easily enter or exit a market.
• Product Homogeneity
• When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business.
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price above that of its competitors without losing all of its sales.

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• Perfect information

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Profit Maximization

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• Recall the profit function: Π = TR(y) – TC(y)
• TC(y) = C(y) +FC , where C(y) is the minimized cost function
• TR(y) = Py
• P is a constant
• MR = P
• The only choice variable is output
• First Order Condition: MR=MC
• Implies that the supply curve is the same as the MC curve

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Short-Run Profit Maximization �

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• Profit is maximized at the output level where MR=MC.

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• If MR>MC, profits would increase if output were increased.
• If MR<MC, profits would increase if output were decreased.
• MR=P

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The Firm’s Supply Decision

P^e = MR

Q^f*

ATC

P^e

Profit = (P^e - ATC) × Q^f*

Should this Firm Sustain Short Run Losses or Shut Down?

ATC

P^e = MR

Q^f*

ATC

P^e

Profit = (P^e - ATC) × Q^f* < 0

Operating at a Loss in the Short-Run

• If ATC>P at the output-level where
• MC=MR =P=> profit is negative

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• Two choices:
• Temporarily shut-down
• Permanently go-out-of-business

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• Question: Which choice will yield smaller loss?

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Shutdown Decision Rule

Decision rule:

• A firm should shutdown when P < min AVC.
• Continue operating as long as P ≥ min AVC.

Firm’s Short-Run Supply Curve: MC Above Min AVC

Q^f*

P ^{min AVC}

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A Competitive Firm’s Short-Run Supply Curve

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Short-Run Market Supply Curve

• The market supply curve is the summation of each individual firm’s supply at each price.

Firm 1

Firm 2

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Market

Q

Q

Q

P

P

P

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Short-Run Industry Equilibrium

Market demand

Short-run industry�supply

p_s^e

Y_s^e

Y

Short-run equilibrium price clears the�market and is taken as given by each firm.

y₁

y₂

y₃

ATC

ATC

ATC

MC

MC

MC

y₁^*

y₂^*

y₃^*

p_s^e

Firm 1

Firm 2

Firm 3

y₁

y₂

y₃

ATC

ATC

ATC

MC

MC

MC

y₁^*

y₂^*

y₃^*

p_s^e

Firm 1

Firm 2

Firm 3

Firm 1 wishes�to remain in�the industry.

Firm 2 wishes�to exit from�the industry.

Firm 3 is�indifferent.

Π₁ > 0

Π₂ < 0

Π₃ = 0

Long-Run Industry Supply

• In the long-run every firm now in the industry is free to exit and firms now outside the industry are free to enter.
• The industry’s long-run supply function must account for entry and exit as well as for the supply choices of firms that choose to be in the industry.
• How is this done?

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

Suppose the industry initially contains�only two firms.

Mkt.�Supply

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Then the market-clearing price is p₂.

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

y₂*

Then the market-clearing price is p₂.�Each firm produces y₂* units of output.

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

y₂*

Π > 0

Each firm makes a positive economic�profit, inducing entry by another firm.

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Market supply shifts outwards.

y₂*

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Market supply shifts outwards.�Market price falls.

y₂*

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm produces less.

y₃*

p₃

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm produces less.�Each firm’s economic profit is reduced.

y₃*

p₃

Π > 0

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm’s economic profit is positive.�Will another firm enter?

y₃*

p₃

Π > 0

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Market supply would shift outwards again.

y₃*

p₃

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Market supply would shift outwards again.�Market price would fall again.

y₃*

p₃

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again.

y₄*

p₄

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again. Each�firm’s economic profit would be negative.

y₄*

Π < 0

p₄

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again. Each�firm’s economic profit would be negative.�So the fourth firm would not enter.

y₄*

Π < 0

p₄

Long-Run Industry Supply

• The long-run number of firms in the industry is the largest number for which the market price is at least as large as min ATC(y).

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• In the case of Perfect Competition each firm is really small and the number of firms is large, so P=min ATC(y)
• This implies that in a perfectly competitive market profits are zero

S(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p’

y*

p’

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A long-run competitive equilibrium occurs when three conditions hold:

1. All firms in the industry are maximizing profit.
2. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit.
3. The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers.

Output Response to a Change in Input Prices

Question: What is the impact of a change in input price, holding product price constant?

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1) ATC and MC will shift

2) Firm will adjust output until MC=MR

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How a Firm Responds to Input Prices Changes

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The Long-Run Industry Supply Curve

• The long-run relationship between price and industry output

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• It depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts

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The Long-Run Industry Supply Curve

• Constant-cost industry: an industry in which
• expansion of output does not bid up input prices
• long-run average production cost per unit remains unchanged, and
• the long-run industry supply curve is horizontal

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• Increasing-cost industry: an industry in which
• expansion of output leads to higher long-run average production costs
• the long-run industry supply curve slopes upward

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• Decreasing-cost industry: an industry in which
• the long-run industry supply curve slopes downward

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CONSTANT-, INCREASING-, AND DECREASING-COST INDUSTRIES: COFFEE, OIL, AND AUTOMOBILES

You have been introduced to industries that have constant, increasing, and decreasing long-run costs.

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The supply of coffee is extremely elastic in the long run. The reason is that land for growing coffee is widely available and the costs of planting and caring for trees remains constant as the volume grows. Thus, coffee is a constant-cost industry.

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The oil industry is an increasing cost industry because there is a limited availability of easily accessible, large-volume oil fields.

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Finally, a decreasing-cost industry. In the automobile industry, certain cost advantages arise because inputs can be acquired more cheaply as the volume of production increases.

The Industry’s Long-Run Supply Curve

Constant-Cost Industry

constant-cost industry Industry whose long-run supply curve is horizontal.

LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY

In (b), the long-run supply curve in a constant-cost industry is a horizontal line S_L. When demand increases, initially causing a price rise, the firm initially increases its output from q₁ to q₂, as shown in (a). But the entry of new firms causes a shift to the right in industry supply. Because input prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point B in (b)).

The long-run supply curve for a constant-cost industry is, therefore, a horizontal line at a price that is equal to the long-run minimum average cost of production.

The Industry’s Long-Run Supply Curve

Increasing-Cost Industry

increasing-cost industry Industry whose long-run supply curve is upward sloping.

LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY

In (b), the long-run supply curve in an increasing-cost industry is an upward-sloping curve S_L. When demand increases, initially causing a price rise, the firms increase their output from q₁ to q₂ in (a). In that case, the entry of new firms causes a shift to the right in supply from S₁ to S₂.

Because input prices increase as a result, the new long-run equilibrium occurs at a higher price than the initial equilibrium.

In an increasing-cost industry, the long-run industry supply curve is upward sloping.