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Chapter 7
Competition
Steven Landsburg,
University of Rochester
Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.
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
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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
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Revenue
• TR = P X Q
• MR ≡ P
• MR curve is flat
– MR curve coincides with demand curve
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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
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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
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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
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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
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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
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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
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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
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Competitive Firm in the LR
• Some fixed cost in SR become variable
cost in the LR
• Firms can enter and exit in the LR
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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
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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
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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
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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
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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
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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 and cost curves shift so often that
entry and exit never settles down
– Approximation to the truth
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Equilibrium
• LR same as SR between firm and industry
– Market price determined by intersection of
industrywide demand and supply
– Firms face flat demand curves at market price
• Analysis of changes to equilibrium
– Changes in FC
– Changes in VC
– Changes in demand
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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
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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
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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
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Applications
• Removing a rent control
• A tax on motel rooms
• Tipping the busboy
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Using the Competitive Model
• Fundamentals of competitive analysis
– Industry versus firm demand and supply
– SR versus LR
– Entry and exit decisions
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EXHIBIT 7.4
Marginal Cost and Supply
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EXHIBIT 7.7
The Competitive Firm’s Supply
Responses
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EXHIBIT 7.8
The Competitive Firm’s Short-Run
Supply Curve
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EXHIBIT 7.9
The Industry Supply Curve
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EXHIBIT 7.11 The Competitive Industry and the
Competitive Firm
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EXHIBIT 7.12 A Rise in Marginal Costs
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EXHIBIT 7.13 A Change in Demand
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EXHIBIT 7.14 The Competitive Firm’s Long-Run
Supply Curve
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EXHIBIT 7.16 Computing the Break-even Price
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EXHIBIT 7.19 A Rise in Fixed Costs
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EXHIBIT 7.20 A Rise in Variable Costs
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EXHIBIT 7.21
A Rise in
Demand
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EXHIBIT 7.24
An Increase
in Costs
in an
IncreasingCost
Industry
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EXHIBIT 7.25 A Change in Demand
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