Chapter 7 Competition Steven Landsburg University of Rochester

Chapter 7 Competition Steven Landsburg, University of Rochester Copyright © 2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved. Landsburg, Price Theory and Application, 6 th edition

Introduction • Brotherhood for the Respect, Elevation, and Advancement of Dishwashers • Impact of achieving goal – SR life better for dishwashers – LR wages of dishwashers decrease by full amount of tips • Why wages bid down by full amount of tips • Who benefits from tipping • Tools for analyzing competitive industry Landsburg, Price Theory and Application, 6 th edition 2

Competitive Firm • Sell any quantity it wants at the going market price – Classic example farm • Serve a small part of market – Horizontal demand curve • Products are interchangeable • Buyers can easily buy from another producer Landsburg, Price Theory and Application, 6 th edition 3

Revenue • TR = P X Q • MR ≡ P • MR curve is flat – MR curve coincides with demand curve Landsburg, Price Theory and Application, 6 th edition 4

Firm’s Supply Decision • Produce good until MR = MC • Competitive firm produces a quantity where P = MC – Note: P ≡ MR • Supply curve – MC and supply are inverse functions – Supply curve looks like upward sloping portion of MC curve as long as MC curve upward sloping – SR and LR supply curves exist for the firm Landsburg, Price Theory and Application, 6 th edition 5

Shutdowns and Exits • Does the producer want to produce the good? • Two distinctions – Shutdown: firm stops producing the good but still pays fixed costs – Exit: firm leaves the industry entirely and no longer faces any costs • In SR, can shutdown but not exit – Firms remains operational if P > AVC • In LR, can exit Landsburg, Price Theory and Application, 6 th edition 6

Short-Run Supply Curve • SR supply curve identical to part of SRMC curve that lies above AVC curve – Firm shutdown otherwise • Upward slope due to average and marginal cost U-shape – Diminishing marginal returns to variable factors of production • Elasticity of supply – Percent change in quantity supplied resulting from a 1% change in price Landsburg, Price Theory and Application, 6 th edition 7

Competitive Industry in the SR • All firms in industry competitive • Defining the SR – Period of time in which no firm can enter or exit the industry • Number of firms cannot change – LR is a period of time in which any firm that wants to can enter or leave the industry • Industry’s SR supply curve – Sum together SR supply curves of individual firms within the industry – More elastic than individual supply curves Landsburg, Price Theory and Application, 6 th edition 8

Supply, Demand, and Equilibrium • Each firm operates where supply equals demand • Industrywide supply equals industrywide demand – Industry equilibrium consequence of optimizing behavior on part of individuals and firms Landsburg, Price Theory and Application, 6 th edition 9

Competitive Equilibrium • Firms produces where supply (or MC) curve crosses horizontal line at market going price • Increase in FC – Price and quantity remain unchanged • Increase in VC – – Raises firms MC curve Causes some firms to shutdown Higher market equilibrium price Firm’s output could go up or down • Increase in industry demand – Higher market equilibrium price – Increase in firm’s output Landsburg, Price Theory and Application, 6 th edition 10

Industry’s Costs • Sum of total cost of all individual firms • To minimize cost of all firms, use equimarginal principle – Insure that MC same for all producers in industry – Automatic because all firms have same price Landsburg, Price Theory and Application, 6 th edition 11

Competitive Firm in the LR • Some fixed cost in SR become variable cost in the LR • Firms can enter and exit in the LR Landsburg, Price Theory and Application, 6 th edition 12

LRMC and Supply • Operate where P = LRMC • If firm remains in industry, LR supply curve identical to LRMC curve • Firm remains as long as earn positive profit Landsburg, Price Theory and Application, 6 th edition 13

Profit and the Exit Decision • Profit = TR – TC – Costs includes all foregone opportunities • SR versus LR supply response – LR supply curve more elastic than SR supply curve – Firm shuts down if price of output falls below average variable cost – Firm exits if price of output falls below average cost Landsburg, Price Theory and Application, 6 th edition 14

Competitive Industry in the LR • Firms that wish to enter or exit the market can do so in the LR • Link between entry and exit and industry’s LR supply curve • LR competitive equilibrium Landsburg, Price Theory and Application, 6 th edition 15

Zero Profit Condition • Laverne and Shirley – Economic versus accounting profit – Newspaper carrier versus lemonade stand • All firms earn zero economic profit in the LR – All firms equally efficient – Firms produce at the lowest possible average cost Landsburg, Price Theory and Application, 6 th edition 16

Industry’s LR Supply Curve • All firms identical – Industry supply curve flat at the break-even price • Break-even price and the LR supply – Break-even price (P = AC) at which a seller earns zero profit • Changes if anything changes costs – P > AC, firm earns positive profit • Remains in industry – P < AC, firm earns negative profit • Leaves industry – LR supply curve identical with part of firm’s LRMC curve that lies above its LRAC curve Landsburg, Price Theory and Application, 6 th edition 17

Flat LR Supply Curve • • Flatness based on entry and exit P < AC, all firms exit P > AC, unlimited number of firms enter LR zero profit equilibrium almost never reached – Demand cost curves shift so often that entry and exit never settles down – Approximation to the truth Landsburg, Price Theory and Application, 6 th edition 18

Equilibrium • LR same as SR between firm and industry – Market price determined by intersection of industrywide demand supply – Firms face flat demand curves at market price • Analysis of changes to equilibrium – Changes in FC – Changes in VC – Changes in demand Landsburg, Price Theory and Application, 6 th edition 19

Application: Government as a Supplier • In SR, government policy to build and operate apartment complex increasing housing • LR supply curve does not shift – Determined by break-even price – Number of privately owned apartments withdrawn from the market equals number of apartments built by government Landsburg, Price Theory and Application, 6 th edition 20

Relaxing the Assumptions • Assumption 1: All firms are identical, have identical cost curves – True in industries that do not require unusual skills • Assumption 2: Cost curves do not change as industry expands or contracts – True in industries not large enough to affect input prices • Without these assumptions, all firms do not have the same break-even price Landsburg, Price Theory and Application, 6 th edition 21

Relaxing the Assumptions Continued • Constant cost industry – Satisfies assumptions • Increasing cost industry – Break-even price for new entrants increases as industry expands – Assumption 1 violated: Less-efficient firms – Assumption 2 violated: Factor-price effect – LR industry supply curve slopes upward • Decreasing cost industry – Break-even price for new entrants decreases as industry expands – LR industry supply curve slopes downward Landsburg, Price Theory and Application, 6 th edition 22

Applications • Removing a rent control • A tax on motel rooms • Tipping the busboy Landsburg, Price Theory and Application, 6 th edition 23

Using the Competitive Model • Fundamentals of competitive analysis – Industry versus firm demand supply – SR versus LR – Entry and exit decisions Landsburg, Price Theory and Application, 6 th edition 24

EXHIBIT 7. 4 Marginal Cost and Supply Landsburg, Price Theory and Application, 6 th edition 25

EXHIBIT 7. 7 The Competitive Firm’s Supply Responses Landsburg, Price Theory and Application, 6 th edition 26

EXHIBIT 7. 8 The Competitive Firm’s Short-Run Supply Curve Landsburg, Price Theory and Application, 6 th edition 27

EXHIBIT 7. 9 The Industry Supply Curve Landsburg, Price Theory and Application, 6 th edition 28

EXHIBIT 7. 11 The Competitive Industry and the Competitive Firm Landsburg, Price Theory and Application, 6 th edition 29

EXHIBIT 7. 12 A Rise in Marginal Costs Landsburg, Price Theory and Application, 6 th edition 30

EXHIBIT 7. 13 A Change in Demand Landsburg, Price Theory and Application, 6 th edition 31

EXHIBIT 7. 14 The Competitive Firm’s Long-Run Supply Curve Landsburg, Price Theory and Application, 6 th edition 32

EXHIBIT 7. 16 Computing the Break-even Price Landsburg, Price Theory and Application, 6 th edition 33

EXHIBIT 7. 19 A Rise in Fixed Costs Landsburg, Price Theory and Application, 6 th edition 34

EXHIBIT 7. 20 A Rise in Variable Costs Landsburg, Price Theory and Application, 6 th edition 35

EXHIBIT 7. 21 A Rise in Demand Landsburg, Price Theory and Application, 6 th edition 36

EXHIBIT 7. 24 An Increase in Costs in an Increasing. Cost Industry Landsburg, Price Theory and Application, 6 th edition 37

EXHIBIT 7. 25 A Change in Demand Landsburg, Price Theory and Application, 6 th edition 38