CDAE 254 - Class 26 Nov 30

Last class: 7. Profit maximization and supply

8. Perfectly competitive markets

Today:8. Perfectly competitive markets9. Applying the competitive models

Next class:9. Applying the competitive modelsQuiz 8 (Chapters 7 and 8)Quiz 9 (optional and take home, due Thursday, Dec. 7 )

Readings:Chapter 8 and Chapter 9

CDAE 254 - Class 26 Nov 30

Important dates:Problem set 7 due Tuesday, Dec. 5 Problems 7.1, 7.2., 7.3 and 7.8 from the textbook

Final exam: 3:30 – 6:30pm, Friday, Dec. 15

7. Profit maximization and supply 7.1. Goals of a firm

7.2. Profit maximization 7.3. Marginal revenue and demand 7.4. Marginal revenue curve 7.5. Alternatives to profit maximization 7.6. Short-run supply 7.7. Applications

7.6. Short-run supply by a price-taking firm

(1) Profit maximizing decision: MC = MR = P (2) The firm’s supply (3) Shutdown decision:

STC = SFC + SVCIf TR < SVC, the company should shut down SAC = SAFC + SAVCi.e., If the price is less than the short-run average variable cost (SAVC), the firm will shut down the production.(4) The firm’s supply curve: SMC above the SAVC

7.6. Short-run supply by a price-taking firm

(5) Practice questions according to handout graph (a) Where is the firm’s supply curve

(b) What are the break-even price & output (c) What is the shutdown price level? (d) What is the total profit at the shutdown price? (e) What is the total profit when P= 100? ( f ) What is the total short run fixed cost (SFC)?

Application: Steel trap

U.S. steel firms were very slow in leaving the market• Youngstown Sheet & Tube and U.S. Steel Corporation at

Youngstown did not close until the late 1970s • The next big firm closed in 1982• Steel firms continued to operate aging, inefficient, and

unprofitable plants

Application: Steel trap

Huge cost to close a steel firm:• pay to dismantle mill and terminate contracts • union contracts:

– pay to workers after the firm is closed – supplemental unemployment benefits– payments to cover additional future pensions and insurance– generally, union members eligible for pensions when age + years

of service = 75– workers laid off due to plant closings are eligible for a pension

when age + years of service = 70

Application: Steel trap

The estimated costs to close a steel firm in the U.S.:• $650 million ($415 million labor related or $37,000

per laid-off worker) in 1979• Have increased at least 45% since then

Application: Steel trap

• Because they avoided shutting down since 1970s, U.S. steel mills sold some products at prices below AC or AVC

• For example:In 1986:– AVC of hot-rolled sheets per ton = $305– AC = $406– price = $273

Application: Steel trap

International trade and policy:-- New import tax on steel products in Feb. 2002

-- Reactions from steel exporters -- Debate under WTO

8. Perfect competition 8.1. Basic concepts

8.2. Supply in the very short run 8.3. Short-run supply 8.4. Short-run price determination 8.5. Shifts in supply and demand curves 8.6. Long-run supply 8.7. Applications

8.3. Short-run supply (1) Short-run: The number of firm is fixed but the

existing firms can change their output levels in response to changes in the market.

(2) Supply curve: Relationship between market price and quantity supplied.

(3) Short-run supply curve of an individual firm:SMC above the SAVC (Ch. 7).

(4) Short-run supply curve in a market (Fig. 8.2)(5) Notations

8.3. Short-run supply (6) Short-run elasticity of supply

(a) Recall our general definition of elasticity

Elasticity of Y with respect to X

=

(b) Short-run supply elasticity

=

Xin change Percentage

Yin change Percentage

Pin change Percentage

Qin change Percentage s

8.3. Short-run supply (6) Short-run elasticity of supply

(c) Estimation of supply elasticities: -- From two observations -- From a supply equation

8.4. Short-run price determination (Fig. 8.3) (1) Supply and demand in a market

(2) Market equilibrium(3) An example(4) Effect of an increase in market demand

Class Exercise Suppose a market has 100 identical producers and each producer has

the following supply function:q = - 2 + 0.5 P

(a) Graph the supply curve for one firm and then graph the supply curve for the market(b) Calculate the supply elasticity for the market when P=12

If the demand function for the market is Q = 1000 – 30 P, (c) Derive the market equilibrium P* and Q*(d) Calculate the demand and supply elasticities at the market equilibrium price and quantity

8.5. Long run supply (1) Constant cost market

(2) Increasing cost market(3) Decreasing cost market (4) Examples

p, $ per unit

150

LRAC

LRMC

(a) Firm

q, Hundred metric tons of oil per year

10

S1

0

p, $ per unit (b) Market

Q , Hundred metric tons of oil per year

Long-run market supply10

0

Long-Run Market Supply in a Constant-cost Market

Long-Run Market Supply in an Increasing-Cost Market

p, $ per unit

q1 q2 Q1 = n1q1 Q2 = n2q2q, Units per year Q, Units per year

p1

p2

e2

e1

E2

S

E1

p, $ per unit

(a) Firm (b) Market

AC2

MC 2

MC1

AC1

Long-Run Market Supply in an Decreasing-Cost Market

p, $ per unit

q1 q2 Q1 = n1 q1 Q2 = n2 q2q, Units per year Q, Units per year

p1

p2

e2

e1

E2

S

E1

p, $ per unit

(a) Firm (b) Market

AC2

MC2MC1

AC1

LR supply: examples

• downward-sloping LR supply curves: prepared feeds, aircraft, construction equipment, computers, TVs, DVD players, etc.

• upward-sloping LR supply curves: tires, drugs, paints, glass, etc.

• flat LR supply curves: plumbing and heating products, floor coverings, etc.

• on average across all industries: LR supply curves have only slight upward slope

Upward-Sloping Long-Run Supply Curve for Cotton in the world market

0.71

Price, $ per kg

0 1 2 3

Iran

United States

Nicaragua, Turkey

BrazilAustralia

Argentina

Pakistan

4 5 6 6.8

Cotton, billion kg per year

1.081.15

1.27

1.43

1.56

1.71 S

9. Applying the competitive model 9.1. Consumer and producer surplus

9.2. Impact of price interventions 9.3. Tax incidence analysis 9.4. Trade restrictions 9.5. Applications

9.1. Consumer and producer surplus (1) Consumer surplus (review)

-- Definition (interpretation) -- How to calculate it at a particular price? -- How to calculate the change in consumer surplus due to a tax or a change in price?

9.1. Consumer and producer surplus (2) What is producer surplus?

Example: A firm with a supply functionqs = -10 + P

--------------------------------------------------------------------------- Minimum price to Cumulative

P qs supply the last unit “revenue” -------------------------------------------------------------------------- < 10 0 = 11 1 11 11 = 12 2 12 23 = 13 3 13 36 = 14 4 14 50

9.1. Consumer and producer surplus (2) What is producer surplus? Example: A firm with a supply functionqs = -10 + P Cumulative “revenue” from 4 units = $50 Total actual revenue from 4 units = 4 x 14 = $56 The difference = 56 - 50 = $6 (producer surplus)

Producer surplus: The extra value producers get for a good in excess of the opportunity costs of producing the good.

9.1. Consumer and producer surplus (3) Economic efficiency (Fig. 9.1.)

The sum of producer surplus and consumer surplus is at the maximum when the market is at equilibrium.

(4) How to estimate consumer & producer surplus? e.g., QD = 10 - P and QS = 0.5 P - 2

At the equilibrium: Q* = 2 and P* = 8 Consumer surplus = 0.5 x 2 x 2 = 2 Producer surplus = 0.5 x 4 x 2 = 4

What will be the change in CS and PS if Q is restricted to be 1.5 units by a quota?

If the government wants to reduce Q to 1.5 units by a sales tax, what should be the tax rate per unit?

9.2. Impact of price interventions (1) Price interventions: (2) Impacts of a price ceiling

-- If the ceiling price is above the equ. price -- If the ceiling price is below the equ. price

QuantityPriceConsumer surplusProducer surplusEfficiency

-- Examples:

9.2. Impact of price interventions (3) Impacts of a price floor

-- If the floor price is below the equilibrium price -- If the floor price is above the equ. price

QuantityPriceConsumer surplusProducer surplusEfficiency

-- Examples