ECON 110 Introductory Microeconomics

1
ECON 110Introductory Microeconomics

• Lecture 12
• Fall, 2009
• William Chow

2
Decision in the SR

• A perfect competitive firm will want to decide
  on
• To produce or not to produce
• If affirmative, what amount to produce
• To answers the first question, the first will
  consider whether it should shut down. This is
  determined by the following rule When price (P)
  lt minimum AVC, it shuts down.
• If P gt min AVC, it will produce and the amount of
  output it chooses to produce will be determined
  by the level where MR MC is achieved.

3
Decision in the SR

• Intuition of the 1st rule
• The shutdown point is the output and price at
  which the firm just covers its total variable
  cost. (P min AVC)
• This point is where average variable cost is at
  its minimum.
• It is also the point at which the marginal cost
  curve crosses the average variable cost curve.
  (MC min AVC)
• At the shutdown point, the firm is indifferent
  between producing and shutting down temporarily.
  It incurs a loss equal to total fixed cost from
  either action.

4
(No Transcript)
5
The Firms Short-Run Supply Curve

• A perfectly competitive firms short-run supply
  curve shows how the firms profit-maximizing
  output varies as the market price varies, other
  things remaining the same.
• Because the firm produces the output at which
  marginal cost equals marginal revenue, and
  because marginal revenue equals price, the firms
  supply curve is linked to its marginal cost
  curve.
• But there is a price ( min AVC) below which the
  firm produces nothing and shuts down temporarily.

6
The Markets Short-Run Supply Curve

• The short-run industry supply curve shows the
  quantity supplied by the industry at each price
  when the plant size of each firm and the number
  of firms remain constant.
• The quantity supplied by the industry at any
  given price is the sum of the quantities supplied
  by all the firms in the industry at that price.
• At a price equal to minimum average variable
  costthe shutdown pricethe industry supply curve
  is perfectly elastic because some firms will
  produce the shutdown quantity and others will
  produce zero.

7
The Markets Short-Run Equilibrium
8
The Industrys Short-Run Equilibrium

• The market equilibrium is determined by the
  intersection of the market demand and market
  supply.
• The P so determined will be taken as given by all
  firms.
• The Q so determined will be split between all
  firms.

9
Short Run Equilibrium for the Firm

• In short-run equilibrium, a firm may
• earn an economic profit, (AR gt ATC)
• earn normal profit, (AR ATC) or
• incur an economic loss (AVC lt AR lt ATC)
• Which of these states exists determines the
  further decisions the firm makes in the long run.
• In the long run, the firm may
• Enter or exit an industry
• Change its plant size

10
Long Run Adjustment

• Entry Exit
• New firms enter an industry in which existing
  firms earn an economic profit.
• Firms exit an industry in which they incur an
  economic loss.
• Change in Plant Size
• Firms change their plant size whenever doing so
  is profitable.
• If average total cost exceeds the minimum
  long-run average cost, firms change their plant
  size to lower costs and increase profits.

11
Entry and Exit

• As new firms enter an industry, industry supply
  increases.
• The industry supply curve shifts rightward.
• The price falls, the quantity increases, and the
  economic profit of each firm decreases.

12
Entry and Exit

• As firms exit an industry, industry supply
  decreases.
• The industry supply curve shifts leftward.
• The price rises, the quantity decreases, and the
  economic profit of each firm increases.

13
Changes in Plant Size

• The firm earns zero economic profit with the
  current plant size.
• But if the LRAC curve is sloping downward at the
  current output, the firm can increase profit by
  expanding the plant size.

14
Changes in Plant Size

• As the plant size increases, short-run supply
  increases, the price falls, and economic profit
  decreases.

15
Changes in Plant Size

• Long-run equilibrium occurs when the firm is
  producing at the minimum long-run average cost
  and earning zero economic profit.

16
Long-Run Equilibrium

• Long-run equilibrium occurs in a competitive
  industry when
• Economic profit is zero, so firms neither enter
  nor exit the industry.
• Long-run average cost is at its minimum, so firms
  dont change their plant size.

17
A Change in Demand

• A decrease in demand shifts the demand curve
  leftward. The price falls and the quantity
  decreases.
• The fall in price puts the price below each
  firms minimum average total cost and firms incur
  an economic loss.

18
A Change in Demand

• Economic losses induce exit, which decreases
  short-run supply and shifts the short-run
  industry supply curve leftward.
• As industry supply decreases, the price rises and
  the market quantity continues to decrease.

19
A Change in Demand

• With a rising price, each firm that remains in
  the industry increases production in a movement
  along the firms marginal cost curve (short-run
  supply curve).

20
A Change in Demand

• A new long-run equilibrium occurs when the price
  has risen to equal minimum average total cost so
  that firms do not incur economic losses, and
  firms no longer leave the industry.
• The main difference between the initial and new
  long-run equilibrium is the number of firms in
  the industry.
• In the new equilibrium, a smaller number of firms
  produce the equilibrium quantity.

21
A Change in Demand

• A permanent increase in demand has the opposite
  effects to those just described.
• An increase in demand shifts the demand curve
  rightward. The price rises and the quantity
  increases.
• Economic profit induces entry, which increases
  short-run supply and shifts the short-run
  industry supply curve rightward.
• As industry supply increases, the price falls and
  the market quantity continues to increase.

22
A Change in Demand

• With a falling price, each firm decreases
  production in a movement along the firms
  marginal cost curve (short-run supply curve).
• A new long-run equilibrium occurs when the price
  has fallen to equal minimum average total cost so
  that firms do not earn economic profits, and
  firms no longer enter the industry.
• The main difference between the initial and new
  long-run equilibrium is the number of firms in
  the industry
• In the new equilibrium, a larger number of firms
  produce the equilibrium quantity.

23
A Change in Demand

• The change in the long-run equilibrium price
  following a permanent change in demand depends on
  external economies and external diseconomies.
• External economies are factors beyond the control
  of an individual firm that lower the firms costs
  as the industry output increases.
• External diseconomies are factors beyond the
  control of a firm that raise the firms costs as
  industry output increases.
• In the absence of external economies or external
  diseconomies, a firms costs remain constant as
  industry output changes.

24
Long-run Market Supply Curve

• The long-run industry supply curve shows how the
  quantity supplied by an industry varies as the
  market price varies after all the possible
  adjustments have been made, including changes in
  plant size and the number of firms in the
  industry.

25
Long-run Market Supply Curve

• In the absence of external economies or external
  diseconomies, the price remains constant when
  demand increases.

26
Long-run Market Supply Curve

• When external diseconomies are present, the price
  rises when demand increases.

27
Long-run Market Supply Curve

• When external economies are present, the price
  falls when demand increases.

28
Technological Change

• New technologies are constantly discovered that
  lower costs.
• A new technology enables firms to produce at a
  lower average cost and lower marginal cost
  firms cost curves shift downward.
• Firms that adopt the new technology earn an
  economic profit.
• New-technology firms enter and old-technology
  firms either exit or adopt the new technology.

29
Technological Change

• Industry supply increases and the industry supply
  curve shifts rightward.
• The price falls and the quantity increases.
• Eventually, a new long-run equilibrium emerges in
  which all the firms use the new technology, the
  price has fallen to the minimum average total
  cost, and each firm earns normal profit.

30
Competition and Efficiency

• Resources are used efficiently when no one can be
  made better off without making someone else worse
  off.
• This situation arises when marginal benefit
  equals marginal cost.
• If a consumer makes his choice rationally, he
  ends up allocating his budget over bundles
  implied by the consumer equilibrium. He is on his
  demand curve (MB) and is consuming efficiently.
• If a perfect competitive firm produces
  efficiently, MRMC and it is on its supply curve
  (MC).

31
Competition and Efficiency

• Along the demand curve D MB the consumer is
  efficient.
• Along the supply curve S MC the producer is
  efficient.
• If the quantity produced were Q, marginal
  benefit would equal marginal cost at P.
• This outcome is efficient.

32
Competition and Efficiency

• The quantity Q and price P are the competitive
  equilibrium values.
• So competitive equilibrium is efficient.
• The consumer gains the consumer surplus, and the
  producer gains the producer surplus.

33
Practical Considerations

• Examples? The textbook offers a few. Examples in
  HK?
• Actually it is difficult to find a perfect
  example. Is the foreign exchange market perfectly
  competitive?
• It has a lot of buyers and sellers
• the product (foreign currency) is an identical
  product US1 from HSBC is the same as US1 from
  BOC
• but there is barrier to entry not everyone can
  sell foreign currency, unless one has a license
  to do so.

34
Practical Considerations

• Most important of all, the price (the exchange
  rate) is not unique the price quoted by HSBC
  could be different from that by BOC.
• Another example Selling of Newspapers (not
  publishing). Again, many buyers and sellers
  newspaper stands, convenience stores, etc
• A SCMP you bought in Central is same as that you
  bought in Mongkok.
• Same price (unless very special circumstances)
  regardless of where you bought it.
• But then, again, there is an informal barrier
  to entry you have to deal with the triad before
  you can really operate.

35
How competitive is competitive?

• Two measures of market concentration in common
  use are
• The four-firm concentration ratio
• The HerfindahlHirschman index (HHI)
• The four-firm concentration ratio is the
  percentage of the total industry sales accounted
  for by the four largest firms in the industry.
• The HerfindahlHirschman index (HHI) is the sum
  of the squared market shares of the 50 largest
  firms in the industry.

36
How competitive is competitive?

• The larger the measure of market concentration,
  the less competition that exists in the industry.
• The U.S. Justice Department uses the HHI to
  classify markets
• A market with an HHI of less than 1,000 is
  regarded as highly competitive
• A market with an HHI between 1,000 and 1,800 is
  regarded as moderately competitive
• A market with an HHI greater than 1,800 is
  uncompetitive