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.
The Theory of Competitive Supply
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.
The Theory of Competitive Supply
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
The Theory of Competitive Supply
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
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Swanky’s demandcurve
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Figure 11.1c Demand, Price, and Revenue in Perfect Competition: Swanky’s Total Revenue
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The Theory of Competitive Supply
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.
The Firm’s Output Decision
The Theory of Competitive Supply
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.
The Theory of Competitive Supply
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.
The Firm’s Output Decision
The Theory of Competitive Supply
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
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25.00 AR = MR
ATC
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Economic profit
Figure 11.4b Three Possible Profit Outcomes in the Short Run: Normal Profit
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MC
P
20.00 AR = MR
ATCBreak-evenpoint
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20.14Economic loss
Figure 11.4c Three Possible Profit Outcomes in the Short Run: Economic Loss
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The Theory of Competitive Supply
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
The Theory of Competitive Supply
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
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Figure 11.5b Swanky’s Supply Curve
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The Theory of Competitive Supply
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
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The Theory of Competitive Supply
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
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Econ. loss
Figure 11.7 Short-Run Equilibrium
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Econ. profit
Normal profit
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The Theory of Competitive Supply
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
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Economic Losses cause firms to exit, which causes supply to decrease (shift in).
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Econ. loss
Economic Profit attracts entry, which causes supply to increase (shift out)
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The Theory of Competitive Supply
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
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Long-runcompetitiveequilibrium
The Theory of Competitive Supply
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
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Econ. loss
The Theory of Competitive Supply
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
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The Theory of Competitive Supply
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
The Theory of Competitive Supply
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
The Theory of Competitive Supply
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.
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The Theory of Competitive Supply
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.
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The Theory of Competitive Supply
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
The Theory of Competitive Supply
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
The Theory of Competitive Supply
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.
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