Download The Role of Profit

Equilibrium, Profits, and
Adjustment in a Competitive
Market
Chapter 8
J. F. O’Connor
Major Questions
• How do profits guide resource allocation in
a market system?
• How does a change in price affect profit?
• What are the two functions of price?
• How does profit seeking by firms lead to a
socially efficient outcome?
Industry Equilibrium
• Short-run
• Industry is in equilibrium if:
– Each firm is maximizing profit
– For the market, quantity supplied equals
quantity demanded.
• Consider our example of the glass bottle
making industry. We need to look at both
the typical firm and the market.
Typical Firm
•
•
•
•
Price of output $45
Profit maximum at output of 500
Compute economic profit two ways:
Profit = Total Revenue – Total Variable Cost –
Fixed Cost
• Profit = [ Price – Average Total Cost]*Quantity
•
• Economic profit 5(45-29) = 80
P r o f it M a x im iz a t io n
P ric e o f o u t p u t $ 4 5 , L a b o r $ 1 0 p e r h o u r
80
70
60
M C
$ / u n it
50
M R = P ric e
40
A TC
30
20
10
0
0
100
200
300
400
O u t p u t o f B o t t le s
500
600
700
The Market
• Demand is given to the industry. It is shown
in the next slide.
• The industry has 200 producers, identical to
the typical firm. Industry supply is 200
times the supply of our typical firm.
• Equilibrium price is $45 and quantity is
100,000.
The Market for Glass Bottles
90
80
70
Demand
Supply
$/hundred
60
50
40
30
20
10
0
70
80
90
100
110
Thousands
120
130
140
Equilibrium in the Short Run
• Quantity demanded is equal to quantity
supplied
• Each firm is maximizing profit
• Is this equilibrium going to continue over
the long run? NO because the firms in the
industry are enjoying positive economic
profit. This will attract new firms. Let us see
what happens if 75 new firms enter.
TheMarket for GlassBottles
Effect of newentrants
80
70
Demand
60
Supply
$/hundred
50
S2
40
30
20
10
0
50
60
70
80
90
100
Thousands
110
120
130
140
The Effect of Entrants
• Entry of new firms shifts supply curve to
the right. Equilibrium price falls to $35.
• Typical firm now finds that 400 units of out
maximizes profit.
• Economic profit is still positive, (3526.25)400
• More firms will enter until profit is zero!
The Market for Glass Bottles
Long-run equilibrium
80
70
Demand
60
Supply
$/hundred
50
S2
40
30
S3
20
10
0
50
60
70
80
90
100
Thousands
110
120
130
140
Industry Long-run Equilibrium
• Entry continues until economic profit is
zero, that is when price is $25.
• Equilibrium is 120 thousand. There are 400
firms, each producing 300 units.
• Each is maximizing profit (P=MC) and its
economic profit is zero.
P r o f it M a x im iz a t io n
P ric e o f o u t p u t $ 2 5 , L a b o r $ 1 0 p e r h o u r
80
70
$ / u n it
60
M C
50
40
A TC
30
M R = P ric e
20
10
0
0
100
200
300
400
O u t p u t o f B o t t le s
500
600
700
Profits in the Adjustment Process
• Started with an industry where economic
profits were being made. This attracted new
firms and, as a result, price decreased and
the output of existing firms decreased. This
continued until economic profit was zero.
Price was then equal to minimum average
total cost. (See graph)
• Positive profits attract resources;
negative profits repel resources.
• Why were there positive profits to begin
with? Could have been caused by an
increase in demand or a reduction in costs,
due to a decline in input prices or a
technological advance.
• Given that the industry is in long-run
equilibrium. What would be the adjustment
if the demand decreased by 30 thousand?
TheMarketforGlassBottles
Decreaseindemandof 30K
80
70
Demand
60
$/hundred
50
40
30
Supply
20
10
0
50
60
70
80
90
100
Thousands
110
120
130
140
The Adjustment Process
• Price falls to about $19. The typical firm reduces
its output to about 240 and finds that it is
experiencing economic losses because $19 is less
than its average total cost.
• Firms start to leave the industry. This moves the
supply curve to the left. This continues until
economic losses are eliminated, namely, when
price increases to $25
• Each firm produces 300 units and there are 300
firms.
P r o f it M a x im iz a t io n
P ric e o f o u t p u t $ 1 9 , L a b o r $ 1 0 p e r h o u r
80
70
$ / u n it
60
M C
50
40
A TC
30
M R = P ric e
20
10
0
0
100
200
300
400
O u t p u t o f B o t t le s
500
600
700
TheMarketforGlassBottles
Decreaseindemandof 30K
80
70
Demand
60
$/hundred
50
D2
40
S2
30
Supply
20
10
0
50
60
70
80
90
100
Thousands
110
120
130
140
Prices and Profits
• Price rations existing supplies and causes
them to go to the buyers who value them
most highly.
• Price through its effect on profit guides the
allocation of resources to the production of
goods that are in demand. Its movement
signals to firms whether to increase or
decrease production.
Equilibrium
• When a market is in equilibrium, then there
are no additional opportunities in that
market for individuals to gain. Remember,
if a market is not in equilibrium, then there
are opportunities for gain open to the
participants. Suppose that there is excess
demand. Then, there are buyers whose
reservation prices exceed those of sellers,
and trade will be mutually beneficial. A
market in equilibrium has exhausted such
opportunities.
Social Efficiency (Optimum)
• A socially efficient (optimal) outcome is one
where it is not possible to improve the wellbeing of one person without making someone
else worse off.
• Is the equilibrium in a perfectly competitive
market system a socially efficient (optimal)
outcome? Yes, under certain circumstances.
Which are?
The Invisible Hand
• Remember that the demand curve gives he
marginal benefit of the good for the
consumer and the supply curve gives the
marginal (opportunity) cost of producing
the good.
• The key is that the marginal benefit for each
consumer is the same as that for society and
that the marginal cost for each producer is
the same as that for society.