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Chapter 7 Competition Steven Landsburg, University of Rochester Copyright © 2005 by Thomson South-Western, 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 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 – 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 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 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 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 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 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, 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 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 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 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 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 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 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 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 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 < 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 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 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 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 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 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 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 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 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, 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 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 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 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 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, 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 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 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 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 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 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 EXHIBIT 7. 25 A Change in Demand Landsburg, Price Theory and Application, 6 th edition 38