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Ch 9 – Besanko

I. competitive market - a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

A) Four characteristics of a perfectly competitive market 

a. Fragmented market: Many buyers and sellers so all are Price takers

b. Undifferentiated products: Identical goods no matter who produces them.

c. Perfect information about prices – perfect info on prices and quality.

d. Equal access to resources: Free entry and exit in the long run. 

B) Implications for the operation f competitive markets:

1. All participants are price takers.

2. Law of one price: transactions between buyers and sellers occur at a single market price.

3. Free entry

C) Examples of near perfect competition:

1. Commodities markets – wheat, copper, etc.

2. Market for Roses

3. Catfish farming

-highly fragmented (>1000 in U.S. alone)

-perfect info on prices – monthly reports of catfish prices

-undifferentiated product – catfish from one farm is a perfect substitute for catfish from another

-Free entry – low costs of entry, MES is 80-100 ponds, well-understood technology

II. Profit maximization by a Price taking firm

A. NOTES:

1. All firms (even in non competitive markets) maximize profits where MR = MC.

2. In prefect competition, MR=P because of horizontal demand curve; so perfectly competitive firms max profit where P = MC.

3. profit π = TR(Q) – TC(Q)

4. profit π = q x (P – AC)

B. Economic profit, not accounting profit, is the relevant profit for firm decision-making

Economic costs include both explicit and implicit costs. Typical implicit costs are: 1) foregone income, i.e. the opportunity cost of the owner’s time, and 2) foregon interest, i.e. the opportunity cost of capital.

EVA (economic value added) – a widely used measure of economic profit = accounting profit – minimum return on invested capital demanded by the firm’s investors. A positive EVA means that the company delivered a return on invested capital greater than that demanded by its investors.

EX: 9.1. The annual accounting statement of revenues and costs for a local flower shop shows the following:

Revenues $250,000Supplies $25,000Employee Salaries $170,000

If the owners of the firm closed its operations, they could rent out the land for $100,000. They would then avoid incurring any of the expenses for employees and supplies. Calculate the shop’s accounting profit and its economic profit. Would the owners be better off operating the shop or shutting it down? Explain.

The accounting costs are Supplies $25,000Employee Salaries $170,000 Total Accounting Cost$195,000Accounting profit = Revenue – Accounting Cost = $250,000 -

$195,000 = $55,000

The economic costs areSupplies $25,000Employee Salaries $170,000Opportunity cost of land $100,000 Total Economic Cost $295,000Economic profit = Revenue – Economic Cost = $250,000 -

$295,000 = - $45,000

The negative economic profit indicates that the owners would be better off by $45,000 if they shut down the shop and rent out the land.

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C. Profit maximization in Perfect Competition

1. chooses q to max profit given the market price

2. maximizes profit π when both of the following conditions hold:

a. P = MC

b. MC is increasing

NOTE:

There are two places where P=MC, one is a profit min and one is a profit max.

At the maximum, MC will be increasing.

A P.C. firm faces a horizontal demand curve at the market price, P.

D. Short – Run

1. At least one input (such as plant size) is fixed.

2. Number of firms in the industry is fixed – no entry or exit

E. SR Costs for P.C. firm

(output sensitive costs)

(unavoidable cost even if Q=0)

(avoidable only when Q = 0)

Ex: Rose-growing firm. If the firm produces 0 output, it can stop using pesticide and fertilizer, which are variable costs. The long-term lease on the land is a sunk fixed cost if the land cannot be sublet to another farmer for another use. The costs of heating the greenhouses is a nonsunk fixed cost – it does not depend on output if Q>0 but it can be avoided when the firm shuts down and Q=0.

F. SR supply curve for P.C. firm when all fixed costs are sunk

TFC = NSFC +SFC

Now NSFC = 0.

So TFC = SFC → the relationship from principles about total costs: STC = TFC + TVC.

Dividing by Q, we get the usual average relationship from principles: SAC = AFC + AVC

Firm’s SR supply = MC above minimum AVC. (shutdown)

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As long as the firm covers its AVC, it should continue to operate in the SR at a loss. As long as P>AVC, the firm reduces its loss by continuing to operate. If the firm shuts down and Q=0, then the loss=TFC. If the firm operates at P>AVC, it can reduce the loss by TFC – q x (P – AVC). See graph below...

Ex: This is why restaurants remain open at lunchtime when there are few customers. As long as the TR from customers > TVC (the cost of the chef and waitress to produce meals), then the restaurant should stay open at lunch.

Ex: 9.8 Dave’s Fresh Catfish is a northern Mississippi farm that operates in the perfectly competitive catfish farming industry. Dave’s short-run total cost curve is

STC (Q)=400+2Q+0.5Q 2, where Q is the number of catfish harvest per month. The

corresponding short-run marginal cost curve is SMC (Q)=2+Q . All of the fixed costs

are sunk.

(a) What is the equation for the average variable cost ( AVC )?

(b) What is the minimum level of average variable costs?(c) What is Dave’s short-run supply curve?

(a) TVC=2Q+0.5 Q2so AVC=TVC /Q=2+0.5Q .

(b) The minimum level of AVC occurs at the Q where SMC=AVC , or

2+Q=2+0.5 Q , or Q=0 . The minimum level of AVC is thus 2.

(c) Since all fixed costs are sunk, the firm will not produce if the price is below the minimum

level of AVC ., or 2. For prices above 2, the quantity supplied is found by equating

price to marginal cost, or 2+Q=P , which implies Q=P−2 . Thus, the firm’s

short-run supply curve is

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s (P)=0, if P<2

.s (P)=P –2 if P2

G. SR supply with sunk and nonsunk fixed costs

TFC = SFC + NSFC

The only difference in the analysis is that we need to treat NSFC like a variable cost. So the relevant curve = ANSC (average nonsunk costs) where

ANSC = AVC + NSFC/Q

Note: NSFC = Average or per unit NSFC.

Minimum ANSFC occurs where ANSFC = SMC.

Minimum ANSFC is now the shutdown point.

Summary:

1. All fixed costs are sunk → shutdown if P < AVC.

2. Some FC are sunk and some not sunk → shutdown if P < ANSC.

3. All FC are nonsunk → shutdown if P < SAC.

EX: Ex: 9.11. Newsprint (the paper used for newspapers) is produced in a perfectly competitive market. Each identical firm has a total variable cost TVC(Q) = 40Q + 0.5Q2, with an associated marginal cost curve SMC(Q) = 40 + Q. A firm’s fixed cost is entirely nonsunk and equal to 50.

a) Calculate the price below which the firm will not produce any output in the short run.

b) Assume that there are 12 identical firms in this industry. Currently, the market demand for newsprint is D(P) = 360 − 2P, where D(P) is the quantity consumed in the market when the price is P. What is the short-run equilibrium price?

a) The firm will not produce any output when the price falls below the point where SMC =

ANSC, i.e. the minimum of the ANSC curve. Therefore QQQ +=++ 405.040/50

This implies Q = 10. The corresponding price, below which the firms will not produce, is equal to MC(10) = ANSC(10) = 50.

b) Each firm will produce according to the relation, P = MC, or QP += 40

. This means

that each firm’s supply curve is 40−= PQ

if P > 50 and zero if P < 50. Therefore market

supply equals )40(12 −P and in equilibrium this must equal market demand,

P2360 −.

Therefore the equilibrium price is P = 60. At this price, each firm produces 20 units of output.

F. SR Market Supply Curve

IN SR only , Horizontally sum the individual supply curves for each firm to derive the market supply.

The market supply curve tells us the MC of producing the last unit supplied in the market. This is because each producer expands production until the MC=P for the last unit produced.

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NOTE: This horizontal summation method only works for SR market supply curves because the number of firms is fixed in the SR.

Also, horizontal summation is only valid if we assume that input prices remain constant as market output varies (this might be true if the amount of the input, say unskilled L in the

industry is a small fraction of the total amount of unskilled L).

In an increasing cost industry, costs will rise if output expands causing the MC curves to rise for each firm. This causes the SR market supply curve to be less responsive to a change in price.

G. SR Competitive Equilibrium

Recall that market price is set by the industry S and D curves. The industry D curve is downward sloping, but the demand curve that the firm sees is horizontal because it is a Price taker.

The more inelastic the SR supply curve, the more market price will fluctuate in the short run.

In the graph below, demand increases. In the SR, price rises to P2 (the intersection of the new D curve and the original SR supply curve S1). Firms are making positive profits in the SR.

In the LR, positive profits will cause other firms to enter the market and SR supply will shift out to S2. The free entry will bring LR profit back to 0, and in a constant cost industry, LR price will return to its original level, P1.

EX: Supertankers have an inelastic SR supply which causes a boom-bust behaviour in price dependent on the world price of oil.

LONG RUN – Perfect Competition

All costs are Nonsunk.

Firms will enter or exit industry until LR profit = 0.

In the LR equilibrium,

1. P* = LMC(Q*)

Ea. Firm selects an output to max profit (P=MC) and selects a plant size to minimize the cost of producing that output.

2. LR economic profit = 0

P* = SAC(Q*)

P* = LRAC(Q*)

If there is only one output level that minimizes LRAC, then we can say that the firm produces at the MES where P = minLRAC.

No pos or neg profit. So P = AC and profit is 0.

3. Market Demand = Market Supply

D(P*)= n*Q (n* firms with identical costs producing market quantity Q)

No entry or exit of firms in the industry.

4. Graph of LR equilibrium

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So P*=LMC = SMC = SAC = SMC.

A. LR Supply Curve.

1. Firm’s LR supply curve

Q = 0 at P < min LRAC

Q>0 at P = LMC above minimum LRAC

2. LR Market Supply Curve

a. Cannot horizontally sum across individual firm supply curves because there is entry and exit in the LR. There is no fixed set of firm supply curves.

b. LR may be upward, downward, or horizontally sloped depending on whether the firm is operating in an increasing, decreasing, or constant cost industry, respectively.

Constant cost industry – horizontal LR supply.

Input prices don’t change as industry output increases.

Cost curves of incumbent producers do not change in LR.

Industry’s use of teh input is a small fraction of the world market for the input.

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Increasing Cost Industry – upward sloping LR supply

Input prices increase in LR as LR output expands in industry.

Firm’s SR costs curves shift up in the LR.

Usually occurs industries with highly skilled or specialized labour. (Aerospace industry)

Also occurs industries with scarce resource inputs, like those that use rare earth metals.

Decreasing Cost industry – downward sloping LR supply

Input prices decrease as ouput expands.

SR Cost curves for firm fall in LR.

Usu in industries where the input comes from an industry with economies of scale.

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EX: Market for Ethanol is an increasing cost industry

Price of corn (input) increases when demand for ethanol increases because corn is used in other industries, such as feed, and arable land for producing corn can is in relatively fixed supply though farmers can switch from soybeans to corn production.

LESSON from Perfect Competition

If you make economic profit in the SR, you need to anticipate entry and LR profits of 0. If you can restrict entry by obtaining a patent or locating your business in an exclusive area, then you can maintain positive profit in The LR. “If anyone can do it, you can’t make money at it.”

Economic Rent

A= $105,000 (rose firm’s WTP for a master grower)

B = 70,000 (best alternative income in tulip industry)

Then econ rent = 105,000-70,000 = 35,000.

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NNOTE: that bidding for an expensive master grower raises AC only not MC.

Economic Rent is not the same as Economic profit.

The master grower who is extraordinarily productive will capture all of the economic rent from the firm if firms compete for the master grower and bid up the salary.

Like market for free agents in baseball. This is why extraordinary player make very high incomes. They capture their economic rent.

Producer Surplus