The Theory of Competitive Supply Lecture 10: The Theory of Competitive Supply Readings: Chapter 12.

Lecture 10: The Theory of The Theory of Competitive SupplyCompetitive Supply

Readings: Chapter 12

The Theory of Competitive Supply

Q: What does the firm’s technology and costs have

to do with supply decisions?

We earlier discussed how the firm maximizes

profits by adopting strategies in which the MR of

an activity equals the MC.

We now have to explore the firm’s revenue side

to understand its decision-making.


Q: We know how to derive the firm’s cost curves.

What does the firm’s revenue curve look like?

The firm’s total revenue curve will depend on the

nature of competition (or market structure). We

begin by assuming that firms face Perfect

Competition. Next lecture we will explore

various forms of Imperfect Competition.


Q: What characterizes a perfect competition?

There are several characteristics:

Many small firms.

Homogeneous product.

Entry into the industry is easy.

All firm’s view the market price as being something over which they have no control over – firms are price takers.

Example: Wheat farmer


Q: What does the revenue curve of a firm in a

perfectly competitive industry look like?

Because the firm is small and a price taker:

The firm can sell as much as it produces

without altering the market price. Therefore,

demand is perfectly elastic at the market p.

The firm’s total revenue is simply: TR = pq

Figure 11.1a,b Demand, Price, and Revenue in Perfect Competition

Textbook p. 235

0

50

P

Q

D

20

25

9

S 50

P

25 AR = MR

Swanky’s demandcurve

0 Q10 20

(a) Industry (b) Firm

Copyright © 1997 Addison-Wesley Publishers Ltd.

Figure 11.1c Demand, Price, and Revenue in Perfect Competition: Swanky’s Total Revenue

Textbook p. 235

0

500

TR

Q

TR = pq

225

9 20



For a firm in a competitive industry we have

derived:

Its short and long-run cost curves

Its total revenue curve

Q: If a firm in a perfectly competitive firm is profit

maximizing, what is its best quantity strategy?

Profits will be maximized if the firm chooses to

produce where the TR and TC curves are at the

maximum distance

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.

The Firm’s Output Decision

At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns.

The firm maximizes its

economic profit when it

produces 9 sweaters a

day.



Q: Suppose the manager of the firm wants to

maximize profits, but does not know the full TR

and TC curves. What is her best strategy?

The manager knows enough to follow the

following rules:

if MR > MC, firm ↑Q to ↑ profit

if MR < MC, firm Q to ↑ profit

If MR = MC, then profits are being

maximized and the manager should stop.


Q: Is it not true that modern university educated

managers, accountants, and engineers are able

to draw the TR and TC curves for the firm, and

so immediately find the optimal strategy?

No! Professional managers do not have the

information needed to immediately find the

optimal strategy.

Q: What is a smart manager to do?

Focus on the marginal costs and revenue!

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.



Q: Will this strategy always provide the firm with

economic profits?

No. If prices are low or costs are high, this

strategy may fail to provide a positive profit, but

it is still the best strategy as it minimizes losses.

Q:How is the firm’s strategy related to its profits?

Adding the ATC curve to the picture makes it

possible to measure the profits (or losses) from

a strategy choice.

20.33

Figure 11.4a Three Possible Profit Outcomes in the Short Run: Economic Profit

Textbook p. 239

Q90

MCP

25.00 AR = MR

ATC


Economic profit

Figure 11.4b Three Possible Profit Outcomes in the Short Run: Normal Profit

Textbook p. 239

80

MC

P

20.00 AR = MR

ATCBreak-evenpoint


Q

20.14Economic loss

Figure 11.4c Three Possible Profit Outcomes in the Short Run: Economic Loss

Textbook p. 239

7

MC

AR = MR

ATC


Q0

P

17.00


As the preceding diagrams make clear, there

are three possible short-run outcomes:

P > ATC economic profits

P = ATC zero economic profits (break-

even point at minimum ATC; firm just

earning normal profits)

P < ATC economic losses

(firm earning less than normal profits)

continued


Q: What does a firm do if it faces economic losses?

For firm suffering economic losses

if P > AVC, firm continues to produce

if P < AVC, firm temporarily shuts down

shutdown point at minimum AVC

Important Implication Perfectly competitive

firm's supply curve is MC curve above minimum

AVC

Figure 11.5a Swanky’s Supply Curve: Marginal Cost and Average Variable Cost

Textbook p. 240

MC

Q0

P

AVC

7

MR017

Shutdownpoint

s

Copyright © 1997 Addison-Wesley Publishers Ltd.9

25 MR1

10

31 MR2

Figure 11.5b Swanky’s Supply Curve

Textbook p. 240Q0

P

7

17

Copyright © 1997 Addison-Wesley Publishers Ltd.9

25

10

31

S

s


Q: If the firm’s short run supply curve is the MC curve

above the AVC curve, what is the industry supply

curve?

Short-run industry supply curve is horizontal sum

of individual firm supply curves

Example: In the next slide it is assumed that there

are 10 firms with identical costs in the competitive

industry.

Deriving Industry Supply

Textbook p. 242Copyright © 1997 Addison-Wesley Publishers Ltd.

0 Q70 80 90

P

25

S

2017

0 7 8 9

P

25.00

20.0017.00

ATC

Normal profit

Q

MC



Equilibrium market price and quantity

determined by industry demand and supply

curves

In short run, perfectly competitive firms can

make economic profit, normal profit (zero

economic profit), or suffer economic loss

In short run, number of firms and plant size fixed

Figure 11.7 Short-Run Equilibrium


0 Q70 80 90

P

25

S

2017

0 7 8 9

P

25.00

20.0017.00

ATC

Normal profit

Q

MC


Econ. loss

Figure 11.7 Short-Run Equilibrium


0 Q70 80 90

P

25

S

17

0 7 8 9

P

25.00 ATC

Econ. profit

Normal profit

Q

MC



Q: What happens industry over the long-run?

Economic profits/losses are signals for firms to

enter/exit industry reallocation of resources

economic profits new entry rightward

shift industry S P profits

economic losses existing firms exit

leftward shift industry S P↑ losses

Long-Run Equilibrium when economic profits = 0

continued

Figure 11.8 Entry and Exit

Textbook p. 243

0

P

30

Q76 10

10

23

SA

D


20

8

SO

17

9

SB

Economic Losses cause firms to exit, which causes supply to decrease (shift in).


0 Q70 80 90

P

25

S

2017

0 7 8 9

P

25.00

20.0017.00

ATC

Normal profit

Q

MC


Econ. loss

Economic Profit attracts entry, which causes supply to increase (shift out)


0 Q70 80 90

P

25

S

17

0 7 8 9

25.00 ATC

Q

MC



In long-run competitive equilibrium

MR = P = MC;

firms maximize short-run profits

P = minimum ATC;

economic profits are zero;

no incentive for firms to enter or exit

P = minimum LRAC;

optimum plant size;

no incentive for firm to change plant size

Figure 11.9 Plant Size and Long-Run Equilibrium

Textbook p. 245

0

P

Q

SRAC1

SRAC0

MCo

MC1LRAC


25

6

MR0

Short-run profit-maximizingpoint

20

8

MR1m

Long-runcompetitiveequilibrium


Q: What happens when changing tastes reduce demand?

demand shifts left P Firms to move down their MC curve and

supply less (q ) reducing the amount sold in the market (Q ).

The lower price also creates losses over time, firms exit causing industry supply to decline (shift left) P

In the long run, enough firms exit so remaining firms earn normal profit (zero economic profit).

continued

Impact of a permanent decline in demand


0 Q7 8 9

P

25

S

2017

0 7 8 9

P

25.00

20.0017.00

ATC

Normal profit

Q

MC


Econ. loss


Q: What happens when technology improves?

firm’s MC and ATC shift down shift in MC causes Supply to shift down by

the same amount as the MC curves shifted down.

Price falls, but costs fall further so that the firm earns economic profits.

Profits attract entry which causes price to fall further, industry output rises, while firm output falls.

continued

Impact of a permanent improvement in production technology


0 Q70 80 90

P

25

S

2017

0 7 8 9

P

ATC

Q

MC



We have seen how over the long-run the short-

run supply relationship can shift because of

entry and exit by firms, and because of

investment in new plant.

Q: Is there a long-run supply curve that takes into

account entry, exit and investment?

Yes, and the shape of this long-run relationship

will depend on whether there are external

economies or diseconomies of scale.

continued


Q: What are external economies and external

diseconomies of scale?

external economies of scale: are factors

beyond control of firm that lower costs as

industry output

external diseconomies of scale: are factors

beyond control of firm that raise costs as

industry output


Q: Example of external diseconomy of scale?

David Ricardo pointed out that as wheat production expanded, more land would have to be pushed into cultivation. This causes the demand for land to rise, which in turn increases the price of land. As land is an important input into wheat production, the average and marginal cost of wheat would rise as output increased.

Implication: The long-run supply curve for wheat would be upward sloping.

Textbook p. 243

0

P

30

Q76 10

10

23

D



Q: Example of external economy of scale?

An important cost of business is the cost of manufactured factor inputs. As an industry grows, more and more specialized firms providing these inputs begin to appear. If this creates greater competition, the costs of manufactured inputs can fall driving average and marginal costs down.

Implication: The long-run supply curve for such an industry would be downward sloping.

Textbook p. 243

0

P

Q

D



Summing Up

Long-run industry supply curve shows how

industry quantity supplied varies as market

price varies after all possible adjustments,

including changes in plant size and number

of firms

Shape of long-run industry supply curve

depends on the existence of external

economies or diseconomies

continued


Long-run industry supply curve is

horizontal for constant cost industry

upward sloping for increasing cost industry

with external diseconomies

downward sloping for decreasing cost

industry with external economies

continued


Q: What is missing from our theory of supply?

How firms make supply decisions in industries with imperfect competition.

Q: Despite the weakness of the present theory is it useful in attempting to understand and predict supply?

Yes. While very few markets are perfectly competitive, there is often sufficient competition so that the perfectly competitive model can provide a first approximation of behaviour.

The Theory of Competitive Supply Lecture 10: The Theory of Competitive Supply Readings: Chapter 12.

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