Steven Landsburg, University of Rochester Chapter 7 Competition Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights

Steven Landsburg,

University of Rochester

Chapter 7Competition

Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Application, 6th edition 2

Introduction

• Brotherhood for the Respect, Elevation, and Advancement of Dishwashers

• Impact of achieving goal– SR life better for dishwashers– LR wages of dishwashers decrease by full

amount of tips

• Why wages bid down by full amount of tips• Who benefits from tipping• Tools for analyzing competitive industry


Competitive Firm

• Sell any quantity it wants at the going market price– Classic example farm

• Serve a small part of market– Horizontal demand curve

• Products are interchangeable

• Buyers can easily buy from another producer


Revenue

• TR = P X Q

• MR ≡ P

• MR curve is flat– MR curve coincides with demand curve


Firm’s Supply Decision

• Produce good until MR = MC• Competitive firm produces a quantity where P =

MC– Note: P ≡ MR

• Supply curve– MC and supply are inverse functions– Supply curve looks like upward sloping portion of MC

curve as long as MC curve upward sloping– SR and LR supply curves exist for the firm


Shutdowns and Exits

• Does the producer want to produce the good?• Two distinctions

– Shutdown: firm stops producing the good but still pays fixed costs

– Exit: firm leaves the industry entirely and no longer faces any costs

• In SR, can shutdown but not exit– Firms remains operational if P > AVC

• In LR, can exit


Short-Run Supply Curve

• SR supply curve identical to part of SRMC curve that lies above AVC curve– Firm shutdown otherwise

• Upward slope due to average and marginal cost U-shape– Diminishing marginal returns to variable factors of

production

• Elasticity of supply– Percent change in quantity supplied resulting from a

1% change in price


Competitive Industry in the SR

• All firms in industry competitive• Defining the SR

– Period of time in which no firm can enter or exit the industry

• Number of firms cannot change

– LR is a period of time in which any firm that wants to can enter or leave the industry

• Industry’s SR supply curve– Sum together SR supply curves of individual firms

within the industry– More elastic than individual supply curves


Supply, Demand, and Equilibrium

• Each firm operates where supply equals demand

• Industrywide supply equals industrywide demand– Industry equilibrium consequence of

optimizing behavior on part of individuals and firms


Competitive Equilibrium

• Firms produces where supply (or MC) curve crosses horizontal line at market going price

• Increase in FC– Price and quantity remain unchanged

• Increase in VC– Raises firms MC curve– Causes some firms to shutdown– Higher market equilibrium price– Firm’s output could go up or down

• Increase in industry demand– Higher market equilibrium price– Increase in firm’s output


Industry’s Costs

• Sum of total cost of all individual firms

• To minimize cost of all firms, use equimarginal principle– Insure that MC same for all producers in

industry– Automatic because all firms have same price


Competitive Firm in the LR

• Some fixed cost in SR become variable cost in the LR

• Firms can enter and exit in the LR


LRMC and Supply

• Operate where P = LRMC

• If firm remains in industry, LR supply curve identical to LRMC curve

• Firm remains as long as earn positive profit


Profit and the Exit Decision

• Profit = TR – TC– Costs includes all foregone opportunities

• SR versus LR supply response– LR supply curve more elastic than SR supply

curve– Firm shuts down if price of output falls below

average variable cost– Firm exits if price of output falls below

average cost


Competitive Industry in the LR

• Firms that wish to enter or exit the market can do so in the LR

• Link between entry and exit and industry’s LR supply curve

• LR competitive equilibrium


Zero Profit Condition

• Laverne and Shirley– Economic versus accounting profit– Newspaper carrier versus lemonade stand

• All firms earn zero economic profit in the LR– All firms equally efficient– Firms produce at the lowest possible average

cost


Industry’s LR Supply Curve

• All firms identical– Industry supply curve flat at the break-even price

• Break-even price and the LR supply– Break-even price (P = AC) at which a seller earns

zero profit• Changes if anything changes costs

– P > AC, firm earns positive profit• Remains in industry

– P < AC, firm earns negative profit• Leaves industry

– LR supply curve identical with part of firm’s LRMC curve that lies above its LRAC curve


Flat LR Supply Curve

• Flatness based on entry and exit

• P < AC, all firms exit

• P > AC, unlimited number of firms enter

• LR zero profit equilibrium almost never reached– Demand and cost curves shift so often that

entry and exit never settles down– Approximation to the truth


Equilibrium

• LR same as SR between firm and industry– Market price determined by intersection of

industrywide demand and supply– Firms face flat demand curves at market price

• Analysis of changes to equilibrium– Changes in FC– Changes in VC– Changes in demand


Application: Government as a Supplier

• In SR, government policy to build and operate apartment complex increasing housing

• LR supply curve does not shift– Determined by break-even price– Number of privately owned apartments

withdrawn from the market equals number of apartments built by government


Relaxing the Assumptions

• Assumption 1: All firms are identical, have identical cost curves– True in industries that do not require unusual skills

• Assumption 2: Cost curves do not change as industry expands or contracts– True in industries not large enough to affect input

prices

• Without these assumptions, all firms do not have the same break-even price


Relaxing the Assumptions Continued

• Constant cost industry– Satisfies assumptions

• Increasing cost industry– Break-even price for new entrants increases as

industry expands– Assumption 1 violated: Less-efficient firms– Assumption 2 violated: Factor-price effect– LR industry supply curve slopes upward

• Decreasing cost industry– Break-even price for new entrants decreases as

industry expands– LR industry supply curve slopes downward


Applications

• Removing a rent control

• A tax on motel rooms

• Tipping the busboy


Using the Competitive Model

• Fundamentals of competitive analysis– Industry versus firm demand and supply– SR versus LR– Entry and exit decisions


EXHIBIT 7.4 Marginal Cost and Supply


EXHIBIT 7.7 The Competitive Firm’s Supply Responses


EXHIBIT 7.8 The Competitive Firm’s Short-Run Supply Curve


EXHIBIT 7.9 The Industry Supply Curve


EXHIBIT 7.11 The Competitive Industry and the Competitive Firm


EXHIBIT 7.12 A Rise in Marginal Costs


EXHIBIT 7.13 A Change in Demand


EXHIBIT 7.14 The Competitive Firm’s Long-Run Supply Curve


EXHIBIT 7.16 Computing the Break-even Price


EXHIBIT 7.19 A Rise in Fixed Costs


EXHIBIT 7.20 A Rise in Variable Costs


EXHIBIT 7.21A Rise in Demand


EXHIBIT 7.24An Increase in Costs in an Increasing-Cost Industry


EXHIBIT 7.25 A Change in Demand

Documents

Steven Landsburg, University of Rochester Chapter 7 Competition Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights