Download Lecture 12 - UBC Blogs

Economics 101
Principles of microeconomics
Output and Costs
2 0 1 6 FA L L T E R M
LEC T UR E 1 2
CHA PT ER 1 2
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Content
Define perfect competition
Explain how a firm makes its output decision
Explain how price and output are determined in perfect competition
Explain why firms enter and leave a market
Predict the effects of technological change in a competitive market
Explain why perfect competition is efficient
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What is perfect competition?
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What Is Perfect Competition?
Perfect competition is a market that consists of many small firms
each producing a similar good for sale and profit
Four Conditions of Perfectly Competition Market
1. All firms sell the same standard product
◦ Switching is easy
2. Lots of buyers and sellers all buy or sell only a fraction of
the quantity exchanged.
3. Firm find it easy to exit & enter market - Productive
resources are mobile..
4. Buyers and sellers are well informed re: cost and quality
(full information)
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What Is Perfect Competition?
How Perfect Competition Arises
 The firm’s minimum efficient scale is small relative to market
demand, so there is room for many firms in the market.
 Each firm is perceived to produce a good or service that has
no unique characteristics, so consumers don’t care which
firm’s good they buy.
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What Is Perfect Competition?
And perfectly competitive firms are price takers
Why?
◦ Firm has no influence over the price at which it sells its product
◦ Firms sells only a fraction of the market output
◦ Firm can sell as much output as it wishes Each firm’s output is
a perfect substitute for the output of the other firms, so the
demand for each firm’s output is perfectly elastic.
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Is the Sushi market perfect competition???
Does it meet these 4 conditions?
What are some barriers to entry and exit?
Sushi to You
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What Is Perfect Competition?
Perfect competition & Economic Profit and Revenue
◦ Goal - maximize economic profit
◦ equals total revenue minus total cost.
◦ cost includes opportunity cost of production
◦ Firm’s
◦ total revenue equals P  Q.
◦ marginal revenue is the change in total revenue that results
from a one-unit increase in the quantity sold.
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What Is Perfect Competition?
◦ Part (a) Total Market
◦ demand and supply - price for
the firm as a price taker comes
from this P*
What Is Perfect Competition?
Given the firm faces a price
of $25 /sweater, the firm
sells 9 sweaters and makes
total revenue of $225.
◦ See TR curve
What Is Perfect Competition?
Where do we get the Demand
curve of the firm?
◦ Demand Curve for the Firm –
also known as the MR
What Is Perfect Competition?
Demand for Sweaters in the Market
versus Firm
The demand for a firm’s product is
perfectly elastic because one firm’s
sweater is a perfect substitute for the
sweater of another firm.
The market demand is not perfectly
elastic because a sweater is a substitute
for some other good.
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What Is Perfect Competition?
The Firm’s Decisions
◦ A perfectly competitive firm’s goal is to make maximum
economic profit, given the constraints it faces.
◦ So the firm must decide:
◦ 1. How to produce at minimum cost
◦ 2. What quantity to produce
◦ 3. Whether to enter or exit a market
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Output Decision
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The Firm’s Output Decision
◦ A perfectly competitive firm chooses the output that
maximizes its economic profit.
◦ How?
1. Use firm’s total revenue and total cost curves.
2. Use MC = MR and supply decision
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The Firm’s
Output Decision
1. Use firm’s total revenue and total
cost curves.
◦ At low output levels, the firm incurs
an economic loss—it can’t cover its
fixed costs.
◦ At intermediate output levels, the
firm makes an economic profit.
◦ At high output levels, the firm again
incurs an economic loss—now the
firm faces steeply rising costs
because of diminishing returns.
◦ Profit - 9 sweaters a day.
The Firm’s Output Decision
2. Marginal Analysis and Supply
Decision
◦ If MR > MC, economic profit
increases if output increases.
◦ If MR < MC, economic profit
decreases if output increases.
◦ If MR = MC, economic profit
decreases if output changes in either
direction, so economic profit is
maximized.
The Firm’s Output Decision
Where do we get the MR value?
Consider definition of MR
◦ Revenue or $$ gained from selling one extra unit
Consider definition of Price
◦ Revenue or $$ gained from selling one extra unit
◦ And where does price come from when you are a price takers?
Where do we get the MC value?
◦ MC = Change in TC/Change in Q
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Output Decisions & Shutdown Rule
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The Firm’s Output Decision
The Shut-Down Rule – P = AVC
Perfectly competitive firms should always produce where
P = MC, with one exception:
when revenue falls below variable costs shut down:
◦ When P falls below the minimum of the AVC curve- Why?
◦ Don’t even cover VC then no contribution to FC so not worth
it.
◦ Operate as long as you can contribute something to FC
The Shut-Down Rule – P = AVC
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The Firm’s Output Decision
The Shut-Down Rule when P = AVC & Loss Comparisons
◦ Economic loss
= TFC + TVC  TR
= TFC + (AVC  P) x Q
◦ If the firm shuts down, Q is 0 and the firm still has to pay its
TFC.
◦ So the firm incurs an economic loss equal to TFC.
◦ This economic loss is the largest that the firm must bear.
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The Firm’s Output Decision
The Shutdown Point
◦ Shutdown point is the price and quantity at which it is
indifferent between producing the profit-maximizing quantity
and shutting down.
◦ The shutdown point is at minimum AVC.
◦ This point is the same point at which the MC curve crosses
the AVC curve.
◦ At the shutdown point, the firm is indifferent between
producing and shutting down temporarily.
◦ At the shutdown point, the firm incurs a loss equal to total
fixed cost (TFC).
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The Firm’s Output Decision
The Shut-Down Rule
Graphically
◦ Minimum AVC is $17 a
sweater.
◦ At $17 a sweater, the profitmaximizing output is 7
sweaters a day.
◦ The firm incurs a loss equal to
the red rectangle.
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The Firm’s Output Decision
The Shut-Down Rule
Graphically
◦ If the price of a sweater is
between $17 and $20.14, …
◦ the firm produces the
quantity at which marginal
cost equals price.
◦ The firm covers all its variable
cost and some
of its fixed cost.
◦ It incurs a loss that is less than
TFC.
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The Firm’s Output Decision
The Shut-Down Rule
Graphically
As a result of this idea.. the MC
curve is the supply curve above
minimum AVC .. As we will not
supply anything if P < AVC as
noted above.. We need to get at
least that price = AVC or we will
choose not to produce anything
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Average total cost
0.50
If Price per bottle =
$0.32 from the
market ;
0.40
Marginal cost
Profits per bottle=
$0.32 - $0.28 = $0.04
 TC = 0.28c
 Where is the 28
cents from?
 Shutdown?
$/bottl
e
0.32
0.30
Total profit = $0.04 x 400 = $16.00
0.28
Minimum
average total
cost
0.20
Average variable
cost
0.10
0
100
Minimum
average variable
cost
200
300
Output (bottles/day)
400
500
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Firm’s Individual Supply Curve
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The Firm’s Supply Curve
The Firm’s Supply Curve
◦ A perfectly competitive firm’s supply curve shows how the
firm’s profit-maximizing output varies as the market price
varies, other things remaining the same.
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The Firm’s Supply Curve
LAW: Producers offer more of a
product when the prices rises.
Why?
The perfectly competitive firm’s
supply curve run is really the ..
◦ Marginal cost curve (i.e.
when price is above average
variable cost)
◦ At every point along a market
supply curve is really what it
would cost producers to
expand production by one
unit
So if deciding based upon P=MC
then
If P increases the firm compares P
to MC and if then > increase
output.
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The Firm’s Supply
Curve
How is the firm’s supply curve is
constructed?
◦ If price equals minimum AVC, $17 a
sweater, the firm is indifferent
between producing nothing and
producing at the shutdown point, T.
The Firm’s Supply Curve
◦ If the price is $25 a sweater, the firm
produces 9 sweaters
a day, the quantity at which
P = MC.
◦ If the price is $31 a sweater, the firm
produces 10 sweaters a day, the
quantity at which
P = MC.
◦ The blue curve in part (b) traces the
firm’s short-run supply curve.
Output, Price, and Profit
in the Short Run
TEXT P 278 -280
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Output, Price, and Profit
in the Short Run
Market Supply in the Short Run
◦ The short-run market supply
curve shows the quantity
supplied by all firms in the
market at each price points
◦ At the shutdown price ($17),
some firms will produce the
shutdown quantity (7
sweaters) and others will
produce zero.
◦ At this price, the market
supply curve is horizontal.
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Output, Price, and Profit
in the Short Run
Short-Run Market
Equilibrium
◦ Short-run market supply
and market demand
determine the market price
and output.
◦ Given D1 then P* = ??
And then each firm in the
industry takes this price as
given and compares that to
their individual cost curves
and decides the Q.
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Output, Price, and Profit
in the Short Run
If there is a Change in Demand
◦ An increase in demand brings
a rightward shift of the market
demand curve: The price rises
and the quantity increases.
◦ A decrease in demand brings a
leftward shift of the market
demand curve: The price falls
and the quantity decreases.
◦ That is the price for the price
takers!
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Output, Price, and Profit
in the Short Run
Decision Making & Profits/Losses Determination in the Short
Run
◦ Firms make the decision MR = MC to get profit max Q
◦ Then they produce
◦ Do they always make economic profit? For this we need to
use the TR = TC an solve for profit
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Output, Price, and Profit
in the Short Run
Mkt price equals average total
cost
◦ firm makes zero economic
profit (breaks even).
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Output, Price, and Profit
in the Short Run
Mkt Price exceeds average total
cost
◦ firm makes a positive
economic profit.
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Output, Price, and Profit
in the Short Run
◦ Mkt price is less than average
total cost
◦ firm incurs an economic
loss—economic profit is
negative.
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Long Run: Output, Price, Profit , Exit
& Entry
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Output, Price, and Profit
in the Long Run
◦ In short-run equilibrium, a firm might make an economic
profit, break even, or incur an economic loss.
◦ In long-run equilibrium, firms break even because firms can
enter or exit the market.
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Output, Price, and Profit
in the Long Run
Entry and Exit
◦ New firms enter an industry in which existing firms make an
economic profit.
◦ Firms exit an industry in which they incur an economic loss.
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Output, Price, and Profit
in the Long Run
◦ A Closer Look at Entry
◦ When the market price is $25 a sweater, firms in the market are making
economic profit.
Output, Price, and Profit
in the Long Run
◦ New firms have an incentive to enter the market.
◦ When they do, the market supply increases and the market
price falls.
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Output, Price, and Profit
in the Long Run
◦ Firms enter as long as firms are making economic profits.
◦ In the long run, the market price falls until firms are making
zero economic profit.
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Output, Price, and Profit
in the Long Run
◦ A Closer Look at Exit
◦ When the market price is $17 a sweater, firms in the market are incurring
economic loss.
Output, Price, and Profit
in the Long Run
◦ Firms have an incentive to exit the market.
◦ When they do, the market supply decreases and the market
price rises.
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Output, Price, and Profit
in the Long Run
◦ Firms exit as long as firms are incurring economic losses.
◦ In the long run, the price continues to rise until firms make
zero economic profit.
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Changes in Demand & Supply due to
technology changes in Long Run
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Changes in Demand as Technology
Advances
An Increase in Demand
◦ An increase in demand shifts the market demand curve
rightward.
◦ The price rises and the quantity increases.
◦ Starting from long-run equilibrium, firms make economic
profits.
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Changes in Demand as
Technology Advances
◦ The market demand curve shifts rightward, the market price rises, and
each firm increases the quantity it produces.
Changes in Demand as Technology
Advances
◦ The market price is now above the firm’s minimum average
total cost, so firms make economic profit.
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Changes in Demand as Technology
Advances
◦ Economic profit induces some firms to enter the market, which
increases the market supply and the price starts to fall.
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Changes in Demand as Technology
Advances
◦ As the price falls, the quantity produced by all firms starts to
decrease and each firm’s economic profit starts to fall.
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Changes in Demand as Technology
Advances
◦ Eventually, enough firms have entered for the supply and increased
demand to be in balance and firms make zero economic profit. Firms
no longer enter the market.
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Changes in Demand as Technology
Advances
◦ main difference between the initial and new long-run equilibrium is the
number of firms in the market. More firms produce the equilibrium
quantity.
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Changes in Demand as Technology
Advances
◦ A decrease in demand - opposite effects
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Changes in Supply as Technology
Advances
Starting from a long-run equilibrium, when a new technology
becomes available that lowers production costs, the first firms to
use it make economic profit.
But as more firms begin to use the new technology, market
supply increases and the price falls.
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Changes in Supply as Technology
Advances
Part (a) shows the market.
Part (b) shows a firm using the original old technology.
Firms are making zero economic profit.
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Changes in Demand and Supply as
Technology Advances
When a new technology becomes available, the ATC and MC
curves shift downward.
Firms that use the new technology make economic profit.
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Changes in Demand and Supply as
Technology Advances
◦ Economic profit induces some new-technology firms to enter
the market.
◦ The market supply increases and the price starts to fall.
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Changes in Demand and Supply as
Technology Advances
◦ With the lower price, old-technology firms incur economic losses.
◦ Some exit the market; others switch to the new technology.
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Changes in Demand and Supply as
Technology Advances
◦ Eventually all firms are using new technology.
◦ The market supply has increased and firms are making zero
economic profit.
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Competition & Efficiency
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Competition and Efficiency
Efficient Use of Resources
◦ Resources are used efficiently when no one can be made
better off without making someone else worse off.
◦ This situation arises when marginal social benefit equals
marginal social cost.
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Competition and Efficiency
Choices, Equilibrium, and Efficiency
◦ We can describe an efficient use of resources in terms of the
choices of consumers and firms coordinated in market
equilibrium.
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Competition and Efficiency
◦ Equilibrium and Efficiency
◦ In competitive equilibrium, resources are used efficiently—the
quantity demanded equals the quantity supplied, so marginal
social benefit equals marginal social cost.
◦ The gain from trade for consumers is measured by consumer
surplus.
◦ The gain from trade for producers is measured by producer
surplus.
◦ Total gains from trade equal total surplus.
◦ In long-run equilibrium total surplus is maximized.
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Competition and Efficiency
◦ Efficiency in the Sweater
Market
◦ Figure 12.12(a) shows the
market.
◦ Along the market demand
curve D = MSB, consumers
are efficient.
◦ Along the market supply
curve S = MSC, producers
are efficient.
Competition and Efficiency
At the market equilibrium,
marginal social benefit equals
marginal social cost.
Resources are allocated
efficiently.
Total surplus is maximized.
Competition and Efficiency
◦ Campus Sweaters makes
zero economic profit.
◦ Each firm in the market has
the plant that enables it to
produce at the lowest
possible average total cost.
◦ Consumers are as well off as
possible because the good
cannot be produced at a
lower cost and the price
equals that least possible
cost.
Questions
 Define profit, profit-maximizing firms and factors of
production.
 Define perfectly competitive firm and perfectly competitive
markets.
 Understand implication of price-taking for firm’s demand
curve.
 Identify difference between short run and long run time
frame.
 Define production function, variable factor of production, and
fixed factor of production.
 Define marginal product and average product.
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Questions
Explain how economic profits/losses motivate firm behaviour.
 Exit and entry in LR
 Demand and Supply Changes in LR
 SR profit decision/shutdown
 Perfect comp
◦ What are some barriers to entry and exit?
◦ Are all markets competitive?
◦ When is a market highly competitive?
◦ Are there any perfect competition markets?
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End of slides
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