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SUPPLY AND PRICING IN COMPETITIVE MARKETS n n n Principles of Microeconomic Theory, ECO SUPPLY AND PRICING IN COMPETITIVE MARKETS n n n Principles of Microeconomic Theory, ECO 284 John Eastwood CBA 247 523 -7353 e-mail address: John. [email protected] edu 1

SCP Paradigm Structure ® Conduct ® Performance of an industry. n Economists classify industries SCP Paradigm Structure ® Conduct ® Performance of an industry. n Economists classify industries into four broad categories: n – – Pure Competition Monopolistic Competition Oligopoly Monopoly 2

The Theory of Pure Competition n Assumptions: Many Sellers and Buyers Identical Products Easy The Theory of Pure Competition n Assumptions: Many Sellers and Buyers Identical Products Easy Entry and Exit (in the Long Run) “Perfect Competition” Assumes Perfect Information and Mobility. 3

The Purely Competitive Firm As The Purely Competitive Firm As "Price Taker" n “Price takers are buyers or sellers who are so small relative to a market that the effects of their transactions are inconsequential for market prices. ” page 193, Byrns & Stone. 4

The Demand Curve in Pure Competition n The demand curve for the product of The Demand Curve in Pure Competition n The demand curve for the product of a purely competitive firm is perfectly elastic (horizontal). 5

The Marginal Revenue Curve in Pure Competition MR is the change in TR from The Marginal Revenue Curve in Pure Competition MR is the change in TR from a one unit change in quantity, q. l If the firm sells one more unit, its TR increases by P. l Price and MR are equal (in Pure Comp) l 6

Price Equals Average Revenue, equals TR divided by quantity, q. n If the firm Price Equals Average Revenue, equals TR divided by quantity, q. n If the firm sells all of its output at the same price (P), then P = AR. n 7

PURE COMPETITION IN THE SHORT RUN n Profit Maximization – – n Using TR PURE COMPETITION IN THE SHORT RUN n Profit Maximization – – n Using TR & TC. Using MR & MC. If a firm is losing money, should it continue to produce? – – Minimizing losses Shut-down point 8

Profit Maximization Firms will attempt to earn the greatest possible profit. n Profit equals Profit Maximization Firms will attempt to earn the greatest possible profit. n Profit equals Total Revenue minus Total Cost: p = TR - TC n 9

The Profit Maximization Rule: Produce where MR = MC. There is only one output The Profit Maximization Rule: Produce where MR = MC. There is only one output level at which the MC curve cuts the MR curve from below. n This output level will maximize profits or minimize losses (unless P < AVC). n Profit = P(q) - ATC(q) = (P - ATC) q n 10

When P ³ ATC, it pays to produce. n The firm will maximize its When P ³ ATC, it pays to produce. n The firm will maximize its profits by producing the quantity that equates MR and MC. – – P > ATC. The firm will earn a positive economic profit (TR > TC). P = ATC. The firm will earn its opportunity cost (TR = TC), a zero economic profit. 11

When P < ATC it may pay to produce in the short run. AVC When P < ATC it may pay to produce in the short run. AVC < P < ATC. The firm can pay all its variable costs, plus part of its fixed costs. Thus it can minimize losses by producing where MR = MC in the SR. n P < AVC. The firm should shut-down in the SR. Its losses will equal its fixed costs. n n In the long run it will either need to reduce its costs or exit the industry. 12

The Firm’s Short-Run Supply The firm produces (in SR) if P ³ AVC, but The Firm’s Short-Run Supply The firm produces (in SR) if P ³ AVC, but shuts down if P< AVC. n In Pure Competition, P = MR. n The firm will produce the quantity where P = MR = MC. n It follows that the MC curve above the minimum point of AVC is the SR supply curve of the firm. n 13

Short-Run Industry Supply. . . equals the horizontal sum of the shortrun supply curves Short-Run Industry Supply. . . equals the horizontal sum of the shortrun supply curves of all the firms in the industry. n Long-run Industry Supply is more elastic than SR or Market-Period Supply. n 14

PURE COMPETITION IN THE LONG RUN n How Profits Direct Resource Allocation – – PURE COMPETITION IN THE LONG RUN n How Profits Direct Resource Allocation – – Economic Profits Attract New Firms. Economic Losses Cause Firms to Exit. Long-Run Equilibrium for the Firm n Long-Run Industry Supply n Economic Efficiency n 15

Economic Profits Attract New Firms Assume that P = MC > ATC in SR Economic Profits Attract New Firms Assume that P = MC > ATC in SR equil. n For simplicity, assume that resource prices and technology are fixed in LR, all firms face the same costs. n TR > TC implies that new firms will enter. Short-Run Industry Supply shifts to the right; market price falls. “Old” firms decrease their q as price falls. n 16

Losses May Cause Firms to Exit Assume that P = MC < ATC in Losses May Cause Firms to Exit Assume that P = MC < ATC in SR equil. n Again assume that resource prices and technology are fixed in LR, all firms face the same costs. n TR < TC implies that some firms will exit. Short-Run Industry Supply shifts to the left; market price rises. Survivors increase their q as price rises. n 17

Characteristics of Long-Run Equilibrium: P = minimum short-run ATC. Each firm in the industry Characteristics of Long-Run Equilibrium: P = minimum short-run ATC. Each firm in the industry is earning a "normal profit. " There is no incentive for new firms to enter or for existing firms to exit. n P = minimum long-run ATC. The firm has no incentive to change the size of its plant or the scale of its operations. Technical Efficiency is achieved. n 18

Industry Adjustment to an Increase in Demand The Long-Run Industry Supply Curve (a horizontal Industry Adjustment to an Increase in Demand The Long-Run Industry Supply Curve (a horizontal sum of long-run MC). n As demand increases, market price will increase. Existing firms will expand output (moving along their short-run supply curves) and earn positive economic profits in the short run. n 19

Industry Adjustment to an Increase in Demand (LR) In the long run, new firms Industry Adjustment to an Increase in Demand (LR) In the long run, new firms will enter, shifting the short run industry supply curve to the right. n Market price will decrease as a result, but how much? n A single firm is too small to affect factor prices, but when an industry expands, resource prices may change. n 20

Slope of the Long-Run Industry Supply Curve (LS) n If identical firms use general Slope of the Long-Run Industry Supply Curve (LS) n If identical firms use general inputs, such as unskilled labor, that can be attracted from a vast ocean of other uses without affecting the prices of those general inputs, we get the case known as a Constant-Cost Industry, which implies a flat LS. 21

Increasing-Cost Industries If an industry uses specialized resources, LS must slope upward. n To Increasing-Cost Industries If an industry uses specialized resources, LS must slope upward. n To produce more, the industry must either employ less suitable inputs, or pay higher prices to hire specialized inputs away from other industries. n 22

Decreasing Cost Industries n The entry of new firms causes falling input prices. Falling Decreasing Cost Industries n The entry of new firms causes falling input prices. Falling factor prices shift the cost curves downward, and the short-run industry supply curve shifts to the right. 23

Decreasing Cost -- LS has a negative slope Eventually, the falling product price catches Decreasing Cost -- LS has a negative slope Eventually, the falling product price catches up with the decreasing costs, profits are squeezed out, and entry ceases. n The new long-run equilibrium occurs at a lower product price because lower resource prices have shifted the cost curves down. n 24

What might cause Decreasing Costs? Economic development n IRS in supply industries n Gains What might cause Decreasing Costs? Economic development n IRS in supply industries n Gains in Process Technology n 25

External v. Internal Economies These economies associated with expanding industry output are external to External v. Internal Economies These economies associated with expanding industry output are external to the firm. No single firm can affect resource prices. n Economies of scale are internal to the firm - its long-run average costs decline as it expands the scale of its operations. n 26

Competitive Markets are Efficient n n n Technical (or Productive) Efficiency requires minimizing the Competitive Markets are Efficient n n n Technical (or Productive) Efficiency requires minimizing the opportunity cost of producing a given level of output. Allocative Efficiency requires national output mirrors what people want and are willing and able to buy. Distributive Efficiency requires that specific goods be used by the people who value them relatively the most. 27

Pareto Efficiency n n Pareto Efficiency occurs when no possible reorganization of production can Pareto Efficiency n n Pareto Efficiency occurs when no possible reorganization of production can make anyone better off without making someone else worse off. Under conditions of Pareto Efficiency, one person's utility can be increased only by lowering someone else's utility. Pareto Efficiency combines the notions of Technical, Allocative, and Distributive eff. 28

In Short- and Long-Run Equilibrium, P = MC n n When price equals marginal In Short- and Long-Run Equilibrium, P = MC n n When price equals marginal cost, the last unit produced cost an amount equal to what the last buyer was willing to pay. Under certain conditions, this achieves efficiency in both allocation and distribution. In the absence of external benefits and costs, Marginal Social Benefits = Marginal Social Costs. With economy-wide PC, resources earn their opportunity costs. 29

A Simple Competitive Economy n Assumptions: – All individuals are identical farmers (ability and A Simple Competitive Economy n Assumptions: – All individuals are identical farmers (ability and taste). – As people increase their work and leisure hours are curtailed, each additional hour of work becomes increasingly tiresome. – Each extra unit of food consumed brings diminished marginal utility, MU, which we will measure in dollars (maximum willingness-to-pay, WTP). – Because food production takes place on fixed plots of land, by the law of diminishing returns, each extra minute of work brings less and less extra food. 30

Equilibrium n n n Add the identical marginal cost (MC) curves of our identical Equilibrium n n n Add the identical marginal cost (MC) curves of our identical farmers to get the upward sloping industry supply curve. Add the identical demand (MU) curves of our identical consumers to get the downward sloping industry demand curve. The intersection of demand supply is competitive equilibrium. A careful analysis of this competitive equilibrium will show that it achieves Pareto Efficiency: 31

Output Mirrors People’s Demands P = MU. Consumers choose food purchases up to the Output Mirrors People’s Demands P = MU. Consumers choose food purchases up to the amount P = MU. n Each person is gaining P dollars of satisfaction from the last unit of food consumed. n 32

Allocative Efficiency, P = MC Each farmer supplies labor up to the point where Allocative Efficiency, P = MC Each farmer supplies labor up to the point where the price of food exactly equals the MC of the last unit of food supplied. n The price here is the satisfaction lost by working that last bit of time needed to grow that last unit of food. n 33

MU = P = MC n MU = MC. This means that the satisfaction MU = P = MC n MU = MC. This means that the satisfaction gained from the last unit of food consumed exactly equals the satisfaction lost from the labor required to produce that last unit of food. 34

Consumer & Producer Surplus A brief review: n Economic surplus is the excess of Consumer & Producer Surplus A brief review: n Economic surplus is the excess of utility over costs of production. It is equal to consumer surplus (excess of consumer utility over price paid) plus producer surplus (excess of producer revenues over cost). n 35

Efficiency and Surplus Pareto Efficiency requires production of the maximum amount of economic surplus Efficiency and Surplus Pareto Efficiency requires production of the maximum amount of economic surplus out of society’s resources. n Competitive equilibrium maximizes the economic surplus. n If the economy operates at any point other than the competitive equilibrium point, it will be inefficient. n 36

Equilibrium With Many Markets Can a Purely Competitive economy be efficient if it contains Equilibrium With Many Markets Can a Purely Competitive economy be efficient if it contains millions of firms, hundreds of millions of people, and countless commodities? n The answer is yes, if certain conditions hold. n 37

Conditions: 1. A Purely Competitive Economy: All markets must be purely competitive. Buyers and Conditions: 1. A Purely Competitive Economy: All markets must be purely competitive. Buyers and sellers must be well informed, Markets must exist for all outputs. 2. No Externalities. 38

A System of Purely Competitive Markets n For those industries where there are many A System of Purely Competitive Markets n For those industries where there are many reasonably informed consumers, many mutually competing producers, and negligible externalities, a system of purely competitive markets will produce the maximum economic surplus. 39

Consumer Sovereignty n Competitive markets synthesize – – n the willingness of people possessing Consumer Sovereignty n Competitive markets synthesize – – n the willingness of people possessing dollar votes to pay for goods (demand) with the marginal costs of those goods (supply). Under ideal conditions, competitive markets achieve Pareto Efficiency, in which no person’s utility may be raised without lowering that of another. 40

Model v. Real World n We cannot say that laissez-faire competition results in the Model v. Real World n We cannot say that laissez-faire competition results in the greatest happiness of the greatest number of people. – – – Imperfect competition is common. Externalities are pervasive. People are not equally endowed with purchasing power. 41

Efficiency Vs. Equity A society does not live on efficiency alone. Philosophers and others Efficiency Vs. Equity A society does not live on efficiency alone. Philosophers and others ask, "Efficiency for what? And for whom? " n A society may decide to lessen efficiency to improve equity. n 42

Economies of Scale and the End of Pure Competition. Suppose that a firm in Economies of Scale and the End of Pure Competition. Suppose that a firm in pure competition faces falling long-run marginal and average costs. MC cuts the P = MR line from above. The firm can increase its profit by expanding output. n Further, it will find its advantage growing as it gets larger. n 45

IRS Leads to Imperfect Competition One or a few firms will expand their output IRS Leads to Imperfect Competition One or a few firms will expand their output to the point where they supply a significant share of the industry's total output. n The industry then becomes imperfectly competitive. n Many studies have found IRS in a wide range of non-agricultural industries. n 46