Download We`ve been talking about how an individual firm

Perfect Competition
Market Supply
Relating the Individual Firm to the Market
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We’ve been talking about how an individual firm responds to a market price to maximize its output. Well, that still
leaves the question unanswered, how is the market price determined? What we’re going to do in this lesson is put
together the supply and demand stuff that we did early in the course, with all the stuff about cost curves that we’ve
been doing in the recent lessons. I remember when I took this course I found this stuff eventually became very
confusing. We have all these cost curves floating around, and all of them have different names and how does that
relate to supply and demand? Here’s a lecture where we stop for a moment and start to put a lot of things together.
Now, I hope you’re not confused, at this point, about the different cost curves, what they mean and how they’re
labeled. If you are, you can go back and review some of the earlier lessons. I’m going to do a quick review before we
actually begin the supply and demand analysis here.
The question we’re going to be answering here is how does the market influence the individual firm, and how does the
individual firm, in turn, along with a bunch of other individual firms influence and actually make up the market? So,
let’s look then at these two diagrams side by side, I put them side by side because they are measuring the same
thing, price and costs on the vertical axis. Over on the right, I have the situation for an individual firm. Over on the
left, I have the situation for the market. Now, the individual firm is defined by its marginal cost curve, its average
variable cost curve, and its average total cost curve. This is what the individual firm looks like in the short run. Now,
all right, a few quick review points. Remember, first of all the short run refers to the period where the firm cannot
change its fixed inputs, it has a factory, conveyor belts, tools, all that stuff that’s fixed. All these curves refer to what
the firm can do if it modifies only its variable inputs, if it changes only the amount of labor that it hires. The marginal
cost curve is eventually upward sloping because labor productivity begins to fall because of congestion of the fixed
inputs. The average variable cost tells you the labor cost per unit. If the price isn’t higher than the minimum average
variable cost, then the firm cannot profitably produce in the short run. The firm will minimize its losses by shutting
down. The average total cost curve tells you the total cost per unit produced. If the price is below average total cost,
the firm is making a loss in the short run. If the price is above the average total cost, the firm is making an economic
profit in the short run. So these curves summarize the technology and the input prices of the firm to tell you how much
it costs to produce the given amount of output. Once we put a price into this picture, we can tell you how much the
firm will be producing and how much profit the firm may be making.
Over here we have the situation for the market. The market supply curve is simply the sum of the short run supply
curves of the individual firm. Take a moment and ask yourself, what is the short run supply curve for an individual
firm? Where do we get it? The answer is the short run supply curve for an individual firm is just the firms marginal
cost curve above the shut down point, above the point of minimum average variable cost. So, if we add together all
those short run supply curves the way we did in the last lesson, we get this blue curve, the short run supply curve for
the market. Now, here’s the market demand curve that’s determined by the behavior of consumers. If you put the
short run supply curve together with the demand curve for the market, you can find the point of equilibrium. The point
of equilibrium is the price at which the quantity supplied in the short run is equal to the quantity demanded. If the
quantity supplied and the quantity demanded are not equal, the price will adjust. Remember the bidding mechanism?
The price will rise if there is a shortage and the price will fall if there’s a surplus until finally, we reach the equilibrium
price, the price at which quantity supplied and quantity demanded are equal.
Now, let’s look at this for a moment. We know that the supply curve represents the sum of a bunch of small firm’s
supply curves, the supply curve of a bunch of competitive firms in a short run. That’s where we got this blue curve.
We’re given that this is the summary of the behavior of all of these firms, given that this summarizes the behavior of all
of the firms in the market. We know that the equilibrium price is going to be right here where the curves cross, that is,
the equilibrium price will be, we’ll call this P*, and the quantity that will be produced in the market will be Q*. This is
exactly what we did early in the course when we played with supply and demand curves. Now, how does an
individual firm respond to this particular price? That is, what is our little firm doing here when its playing its own part in
the market? Well, what it’s doing is this: take the price that’s set, follow it over to the individual firm’s marginal cost
curve and put a dot there. This is the output that our firm will be producing in the short run, the output is, we’ll call this
Y*, the profit maximizing response of this firm to a market price of P*.
So, the first thing is how much output is our firm producing? And the answer is, where price equals marginal cost and
the marginal cost curve, or course, being upward sloping at that point.
Perfect Competition
Market Supply
Relating the Individual Firm to the Market
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The second question is how much profit is our firm making at that point? How much profit? Well, remember the trick
for calculating that. Take the price, go over to the curve and look at how much of its revenue the firm is spending on
its various inputs. If we take Y* and go up to average variable cost curve and over to the axis, we can see that the firm
is spending this chunk of its revenue on labor, and if we go up to the average total cost, we can see that the firm is
spending this chunk of its revenue, the top portion of this box, on the fixed inputs. Add them together and it looks like,
at this particular price, price being equal to average total cost, our firm is just breaking even, it is making zero
economic profits. Now, remind yourself, zero economic profits doesn’t mean that you don’t want to be in business.
Zero economic profits mean that the firm is just able to cover the opportunity cost of all of its inputs, labor, capital, etc.,
everything including the value of the manager’s time. Everything that’s relevant here, all of those costs are included in
these cost curves, and so, if the firm is covering its total costs, it is in fact covering all of the opportunity costs of all the
inputs that it’s using.
Well, in the case, the firm would be completely satisfied and happy about producing. Let’s suppose now that there’s a
change in the market, we’re starting with a situation that is kind of nice and stable, the firm is breaking even, its
covering its cost, its making zero extra profit, zero economic profit, and the market is in equilibrium. Let’s suppose
now that this firm is producing television sets like before, and let’s suppose that the demand for television sets
increases because it’s summer and the Olympics are going to be broadcast and a lot of people run out to buy a new
television set. Well, how would we show that in this picture? How would we show an increase in the demand for
television sets because of the Olympics? The answer is the demand curve would shift outward representing an
increase in the quantity of televisions demanded at every price. So, our demand curve would shift outward, showing a
change in the market. Let me go ahead and draw that new demand curve, it would look something like this, and I’ll
put my label up here just to try to keep my graph uncluttered, D prime, represents the new demand because of the
change in the economy, people want televisions to watch sports. Well, given that the demand curve has shifted
*
outwards, we have now got a situation of dis-equilibrium. At he price of P , say $300 per television set, the quantity
demanded exceeds the quantity supplied, that is, here’s the quantity supplied. All those firms trying to make a profit,
producing where price equals marginal cost, they are not able to keep up with the quantity demanded, we have an
excess demand at the old price. Therefore, the bidding mechanism pushes up the price of television sets, and as it
pushes up the price of television sets, we get to a new equilibrium point. Now, we’ve done this before, this is just
review. What happens as the price of television sets rises, is this: some buyers decide that they will put off the
purchase of the television set, they will go watch the Olympics with a friend, and sellers produce more television sets.
We move up along the market supply curve until we reach the new equilibrium point. The equilibrium point in this
case has a higher price per television sets, P* prime, and it has a larger quantity of television sets actually produced
and traded, and I can label this Q* prime, an increase in the quantity. What we’re interested in this particular lesson is
going behind this picture, looking in more detail at how the supply actually ends up changing. How does the quantity
supplied actually increase in response to the higher price? In order to see how the quantity supply actually changes,
in order to put this movement under a microscope, we’re going to go over and look at the behavior of an individual
firm.
As the price rises to P* prime, if we take that price on over into our individual firm’s diagram we see that that individual
firm now facing a higher price, we’ll respond by producing a larger quantity of output. Why is that? Why does the firm
choose to produce a larger quantity of output when the price goes up? The answer is that at that higher price, the firm
can now afford to cover a higher marginal cost. Before, this firm’s marginal cost might have been equal to $300, in
fact, price equals marginal cost, but if the price of televisions goes up to $400 a television, this firm can now afford to
hire some extra workers and turn out more televisions. Maybe these extra workers are brought in by being hired at
the going wage, certainly, but the point I want to make is, why weren’t those workers hired before? Why weren’t those
extra workers hired before? Why weren’t those extra televisions produced before? The answer is at a price of $300
per television set, the firm can only afford to hire so many workers, those extra television sets here are going to cost
the firm up to $400 to produce because labor productivity is diminishing, if you crowd more workers into your factory
and make them work with a given set of tools, and a given factory space, eventually that productivity starts to decline
as you push more workers in, but if the price of televisions goes up, then it’s profitable for you to bring the workers in
even though the productivity is falling. That’s the thing you need to know, the firm responds to the higher price by
hiring more workers even though the worker’s productivity is diminishing at the margin, even though the cost of
producing televisions is rising with a higher price for televisions, this firm now finds it profitable to hire those workers
Perfect Competition
Market Supply
Relating the Individual Firm to the Market
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anyway. It wouldn’t have hired them when the price was $300, but it will hire them when the price is $400 per
television set.
All right, so given that the firm now finds it optimal to hire more workers, given that it’s now profit maximizing to
produce more television sets, what happens to the firm’s profits? The answer is this: before the firm was making zero
economic profit, now when it’s producing more televisions at a higher price, the firm is actually going to be making
some economic profits. See here, that the average variable cost when they’re producing this larger quantity of
television sets is right here. This is what it’s going to cost per television set to pay your workers. If you look at the
difference between average variable cost and average total cost, this is the average fixed cost. This is what your
having to pay to cover your overhead per television produced. So, if we wanted to draw our little parfait, again, we
would find this chunk of the revenue goes to workers and this chunk of the revenue goes to the fixed costs. Well, that
leaves us with a nice little chunk here on top. If we go over to the average total cost curve, we find that it only takes
this bottom rectangle to cover the cost of production. All of this revenue on top is economic profit because of the
increased demand for television sets, the firms that are producing television sets will find that in the short runs, they
are able to earn an economic profit equal to the amount of this area. The higher price for television sets leads them to
produce more television sets, and because the total cost of production is less than the total revenue they earn, the
firm is making an economic profit in the short run. So, I could label this π, remember π stands for profit, π is greater
than zero, the firm is making a positive economic profit.
Will this situation last? Will this situation last? Well, it will last in the short run, but in the long run what will happen
and we’ll be talking about the long run very shortly. In the long run what will happen is new firms will enter this
market. Hey, look, this profit is sitting there like a bunch of raw meat on the surface of shark infested waters, and the
sharks are going to start to gather until there’s a great crowd of them all fighting over the meat and the meat is gone.
So what you have here in an economy is: you’ve got this chunk of raw meat, this chunk of tasty raw meat of economic
profit that draws in the sharks, and not to say that sharks are bad and not to say that sharks aren’t doing what they do
when they go after the raw meat. It’s what companies do when they see an opportunity for extra profit, they enter,
and what happens when new companies start up in this market to enter? The short run supply curve begins to shift
outwards, and when it shifts outwards, the price of the product falls and eventually the firms will be pushed back into
the situation where there are no extra profits to be made. There is no economic profit; everybody just covers their
opportunity cost. This is what happens in a competitive market in the long run.
I want to summarize with this question, how do we adjust from this original price quantity equilibrium to this new one?
What happened behind the scene that gave us the increase in quantity supplied after the demand shifted outwards?
We can see in this individual firm’s diagram that an individual firm responded by increasing its output. An individual
firm moved along its marginal cost curve as the price rose allowing it to cover the increasing marginal costs
associated with expanding its output. Put simply, when the price rose, this firm could afford to hire more workers even
though those extra workers were less productive and marginal cost was rising. But that’s only one part of the picture;
that’s all we can see here in this little diagram that I’ve drawn. Something that you can see here, we looked at more
carefully in the last lesson. What’s another reason why the quantity supply is increasing in the short run? It’s not just
that firms are moving along the marginal cost curve, but what else is happening in the short run that’s increasing the
quantity supplied as we move along this blue curve? What else is happening in the short run? The answer is in the
short run. Firms that were previously shut down are starting up again. Some firms were not able to cover their
variable costs, some firms had average variable cost curves that had minimum points up here in this region and they
were shut down before when the price was $300 per television. When the price goes up to $400, some firms that
were previously shut down, now resume operation and they add their output to the market total. So when you move
along the short run supply curve, two things are happening: individual firms are expanding their output and firms that
were previously shut down are resuming production. That’s the short run adjustment process, you can see some of it
in this picture, but some of it you can’t because we are only looking at one firm.
Anytime the demand curve shifts, there will be this kind of adjustment. An outward shift in the demand curve will
increase economic profits for firms in the short run; an inward shift in the demand curve will lead to perhaps economic
losses or a reduction in economic profit in the short run. However, in the long run, the supply curve itself will shift as
firms enter or leave the market in response to changing conditions. We are going to be going to the long run next.