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Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

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Page 1: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Today

LR industry supply Constant cost, increasing cost, and decreasing cost industries

Market efficiency in perfect competition

Page 2: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Industry Supply in the Long Run

Three Cases

Page 3: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 1: Constant Cost Industry

Assumes that firms’ costs are independent of the size of the market. Expanding or contracting demand yields the same price in the long run. Firms’ cost curves do not shift as industry

output changes.

Leads to a horizontal long-run industry supply curve.

Page 4: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Initial LR Equilibrium

q Q

D

PP Typical Firm Industry or Market

Thought experiment: What happens to the industry LR equilibrium as market demand expands?

MC

ATC

SRS

P

Qq

LRATC

Page 5: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

SR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

SR: price rises. Firms earn profits. Why isn’t this a new LR equilibrium?

MC

ATC

SRS

P

Qq

LRATC

D

Q’

Page 6: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

LR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

LR: Firms enter until no more profits can be made. Given our assumption, that is when price falls original level. Second LR equilibrium.

MC

ATC

SRS

P

Q”q

LRATC

D

SRS’

Q

0

1

20

1

2

Page 7: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

LR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

LR: Firms enter until no more profits can be made. For case 1, that is when price falls original level. Second LR equilibrium.

MC

ATC

SRS

P

Q”q

LRATC

D

SRS’

Q

Page 8: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

LR Industry Response to an Increase in Demand

Assuming that firms’ costs do not depend on the size of the industry, and Beginning in LR equilibrium and increasing demand: in the SR, price rises, firms’ profits and outputs

rise. In the LR, price returns to original level, firms

earn zero profits, each firm makes same q as before, but market output is higher.

Page 9: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

LR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

Case 1: Horizontal Long-Run Supply Curve

MC

ATC

P

Q”q

LRATC

D

Q

LRS

Page 10: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Significance of Result

For these industries, growing demand will not result in higher (or lower) prices. (Ceterus Paribus)

Remember LRS is not predicting prices over time.

Page 11: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 2: Increasing Cost Industry

Assumes factor prices rise as industry (or market) output expands, causing firms’ costs to rise. Ex: market for milk & price of dairy land

Results in an upward-sloping long-run industry supply curve

Page 12: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 2 & LR Industry Supply

q Q

D

PP Typical Firm Industry or Market

Case 2: Upward-sloping Long-Run Supply Curve

P

Q1

LRATC(Q0)

D

Q0

LRSLRATC (Q1)SRS

Page 13: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Significance of Case 2

Growing demand for milk forces up the prices of dairy land.

Cost of producing milk rises.

Price of milk rises in the long run, even though there are more milk farms.

***Result comes from the underlying scarcity of dairy land.***

Page 14: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 3: Decreasing Cost Industry

Assumes costs fall as industry (or market) output expands.

Results in an downward-sloping long-run industry supply curve

Page 15: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Ex: Software Production

It’s less costly to produce software as the industry grows because of a larger pool of possible programmers in the same area Don’t need to relocate programmers to your

area, cheaper. Programmers informally spread new ideas,

reducing costs.

The price of software falls as the industry expands.

Page 16: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Economic Efficiency

Page 17: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Definition

Economic Efficiency: When goods are produced in the least costly manner and distributed to those who value them most.

Requires: Productive Efficiency Allocative Efficiency

Page 18: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Productive Efficiency

There is no way to re-direct production among firms to increase total output.

Page 19: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Perfect Comp and Productive Efficiency

In LR firms produce at lowest possible LRAC. There is no way to cut costs by changing plant

size.

Since all firms take the same price, all firms have same MC (why?) There is no way to re-direct production to other

firms and get lower marginal costs.

Productive efficiency holds.

Page 20: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Allocative Efficiency

Goods are consumed by those who most value them.

There is no alternative comb. of goods that could be produced that would increase society’s well-being.

Page 21: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Measuring Allocative Efficiency

The sum of consumers’ surplus and producers’ surplus.

Page 22: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

2

Recall: Consumers’ Surplus

The difference between what a consumer is willing to pay & what he does pay.

D

1 2 3 4 5 6 7

6

4

8

$/unit

units

A

B

Page 23: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Producers’ Surplus-SR perspective

The difference between the amount of revenue the firm earns and the minimum amount necessary to get the firm to produce that quantity of the good in the short run.

Revenue - total variable costs.

Page 24: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

2

Producers’ Surplus-Market

Selling 4 units @$6/unit.

Total revenue = B + C.

TVC for all firms is represented by the area under the SRS curve (why?) = C

B = producers’ surplusD

1 2 3 4 5 6 7

6

4

8

$/unit

units

B

SRS

C

Page 25: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

2

Allocative Efficiency

A + B = The sum of consumers’ and producers’ surplus.Vertical distance between D and S is the difference between value to consumer and MC to producer.What Q maximizes CS+PS?

D

1 2 3 4 5 6 7

6

4

8

$/unit

units

B

SRS

C

A

Page 26: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Allocative Efficiency & Perfect Competition

Perfectly competitive markets provide the allocatively efficient quantity of a good.

Page 27: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Perfect Comp and Econ Efficiency

Conclusion: Perfectly competitive markets are economically efficient!

This is one reason why we use them as a benchmark for our study of other market structures.

Page 28: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Coming Up:

Begin Monopoly

Second midterm exam is 1 week from today! We will use Monday’s class to review for the

exam. Bring your copy of the study guide.

Page 29: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Group Work

Thought problem on perfect competition.

Graph of Case 3: Downward-sloping LR industry supply.

Page 30: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Profits and Perfect Competition

Assume dairy production is a perfectly competitive, increasing cost industry (case 2 in our notes).

Suppose demand for dairy products is growing.

Some farmers have really good land for grazing, others have land that is rather poor.

Page 31: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Questions about Dairy Example

Which farmer earns the most profits? Explain in full.

Hint: Don’t forget, this is a perfectly competitive industry.

Hint: Don’t forget opportunity costs.

Page 32: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 3 & LR Industry Supply

On the following graph, derive the LR Industry supply curve. Assume that firms’ costs decrease as the industry grows.

Page 33: Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Case 3 & LR Industry Supply

q Q

D

PP Typical Firm Industry or Market

Case 3: Downward-sloping Long-Run Supply Curve

P

LRATC(Q0)

D’

Q0

SRS