© Pilot Publishing Company Ltd Chapter 9 Price-taking Model

© Pilot Publishing Company Ltd Market Conditions of a Price-taking Market Demand and Revenue Curves of a Price-taker Equilibrium of a Wealth-Maximizing Firm Short Run Model Long Run Model Efficiency and Price-taking Market Appendix I Appendix II Appendix III Contents:

© Pilot Publishing Company Ltd Advanced Material 9.1 Advanced Material 9.2 Advanced Material 9.2 Contents:

© Pilot Publishing Company Ltd Market

© Pilot Publishing Company Ltd What is a market? A market ( ) is a system governed by a set of rules or customs under which a well-defined good is exchanged.

© Pilot Publishing Company Ltd Price-taking markets A price-taker: is a participant who cannot affect the market price has to take (accept) whatever price that the market determines. To a price-taker, the market is a price-taking market or a perfectly competitive market.

© Pilot Publishing Company Ltd A price-searcher : is a participant who can affect the market price has to search for the wealth-maximizing price. Price-searching markets To a price-searcher, the market is a price-searching market or an imperfectly competitive market

© Pilot Publishing Company Ltd Conditions of a Price-Taking Market

© Pilot Publishing Company Ltd Conditions of a price-taking market 1. Large/Small number of sellers 3. Perfect/Imperfect information 2. Homogeneous/Heterogeneous goods 4. Free/Restricted entry and exit Large Homogeneous Perfect Free

© Pilot Publishing Company Ltd Violation of conditions The market with only one seller is a _________. The market dominated by a few large sellers is an __________. The market with a large number of small sellers but selling heterogeneous goods or having imperfect information is a ______________________. monopoly oligopoly monopolistic competition (Options: monopolistic competition / oligopoly / monopoly)

© Pilot Publishing Company Ltd Demand and Revenue Curves of a Price-taker

© Pilot Publishing Company Ltd q $ 0 d The demand curve faced by a price-taker is ___________ at the prevailing market price. Demand curve A price-taker cannot influence the market price. The price is a constant irrespective of its quantity supplied. What is the shape of its demand curve? horizontal (Options: vertical / horizontal)

© Pilot Publishing Company Ltd Q9.2: As the demand curve faced by a price-taker is horizontal, the market demand curve, which is the horizontal sum of all individual demand curves, must also be horizontal. Discuss.

© Pilot Publishing Company Ltd q $ 0 = d Its MR curve and AR curve are __________ at the prevailing market price. MR = AR MR and AR curve A price-taker cannot influence the market price. What will be the shape of its MR curve & AR curve? They coincide with the demand curve. (Options: vertical / horizontal) horizontal

© Pilot Publishing Company Ltd Equilibrium of a Wealth-maximizing Firm

© Pilot Publishing Company Ltd MC MR q $ 0 Loss Gain q* q Output below q: MR < MC Loss incurred Derivation: Output between qand q*: MR > MC Wealth in producing them Output beyond q*: MR < MC Wealth in producing them Loss

© Pilot Publishing Company Ltd MR = MC MC MR q $ 0 Loss Gain q* q Wealth-maximizing output Equilibrium conditions 3. In the short run, AR AVC and in the long run, AR LRAC 2. MC curve cuts MR curve from below Loss

© Pilot Publishing Company Ltd Q9.3: (a) At q*, MR = MC. The marginal gain is zero. Explain why it is wealth-maximizing. (b) At q, MR = MC. Explain why it is not wealth- maximizing. (c) In the short run, if ATC > AR > AVC, explain why the output is still worth to be produced.

© Pilot Publishing Company Ltd Short-run Model

© Pilot Publishing Company Ltd Wealth-maximizing output level at a price below AVC The loss if suspend production = TFC = AFC^ x q^ = (ATC^ - AVC^) x q^ D^= MR^=AR^ q $ 0 MC ATC AVC ATC^ AVC^ P^ q^ Suspend production

© Pilot Publishing Company Ltd Wealth-maximizing output level at a price equal to AVC Produce at q 0 The loss if produce at q 0 = TFC = AFC 0 x q 0 = (ATC 0 - AVC 0 ) x q 0 ATC 0 P 0 = AVC 0 q0q0 d 0 = MR 0 = AR 0 q $ 0 MC ATC AVC

© Pilot Publishing Company Ltd q $ 0 d 1 = MR 1 =AR 1 MC ATC AVC ATC 1 AVC 1 q1q1 P1P1 Wealth-maximizing output level at a price above AVC but below ATC Produce at q 1 The loss if produce at q 1 < TFC

© Pilot Publishing Company Ltd q $ 0 d 2 = MR 2 = AR 2 MC ATC AVC ATC 2 AVC 2 q2q2 P2P2 The net receipt if produce at q 2 Produce at q 2 Wealth-maximizing output level at a price above ATC

© Pilot Publishing Company Ltd q $ 0 ATC AVC q0q0 P0P0 Short run supply curve of a price-taker For P < min. AVC, Qs = 0 units. The supply curve coincides with the y-axis. Supply Curve For P > min. AVC, the supply curve coincides with the MC curve.

© Pilot Publishing Company Ltd P qaqa 0 sasa q a1 P1P1 Firm a Short run market supply curve of a price-taking industry … P Q0 S Q1Q1 Market P1P1 + P qbqb 0 sbsb q b1 Firm b P1P1 …

© Pilot Publishing Company Ltd Determination of the equilibrium price $ Q0 S D P* Q* The equilibrium price is determined by the intersection point of the market demand and the market supply curves.

© Pilot Publishing Company Ltd Long-run Model

© Pilot Publishing Company Ltd MR=AR $ P q 0 LRMC LRAC Long run adjustment 1. Producing at the output where MR equates LRMC MR = LRMC q LRMC curve cuts MR curve from below AR LRAC

© Pilot Publishing Company Ltd At q (MR = LRMC) AR > LRAC Positive net receipt New firms enter S & P q $ 0 MR=AR P q LRMC LRAC 2. Entry and exit until zero net receipt and production at the optimum scale are attained Positive Net Receipt

© Pilot Publishing Company Ltd At q (MR = LRMC) AR < LRAC Negative net receipt Some firms leave. S & P P q $ 0 MR=AR q LRMC LRAC Negative Net Receipt

© Pilot Publishing Company Ltd At q* (MR = LRMC), AR* = LRAC* Zero net receipt No entry nor exit Long run equilibrium q $ 0 MR*=AR* P* LRMC LRAC * q*

© Pilot Publishing Company Ltd Long run market supply curve In the long-run equilibrium, P always equates the minimum LRAC.

© Pilot Publishing Company Ltd Long run market supply curve The long-run market supply curve (relating P to Q) is actually relating the minimum LRAC to Q.

© Pilot Publishing Company Ltd Long run market supply curve three kinds of long-run market supply curves can be derived: According to the relationship between LRAC and Q, 1. constant-cost 2. decreasing-cost 3. increasing-cost

© Pilot Publishing Company Ltd q $ 0 S2: Constant-cost industry S3: Decreasing-cost industry S1: Increasing-cost industry Long-run market supply curve

© Pilot Publishing Company Ltd Q P 0 D LRAC P* QdQd qsqs Number of firms in a price-taking market Number of identical firms in the industry = Q d /q s Number of identical firms in the industry = Q d /q s

© Pilot Publishing Company Ltd Q9.6: After an increase in market demand, predict what would happen to a price-taking industry in both the short run and the long run – number of firms, price, quantity supplied and net receipt.

© Pilot Publishing Company Ltd Efficiency & Price-taking Market

© Pilot Publishing Company Ltd Pareto efficiency Pareto optimality or efficiency is attained if it is impossible to reallocate resources to make an individual gain (better off) without making other individuals lose (worse off)

© Pilot Publishing Company Ltd Pareto efficiency Inefficiency occurs if it is possible to reallocate resources to make an individual gain (better off) without making other individuals lose (worse off).

© Pilot Publishing Company Ltd Allocation of resources involves three basic economic problems: 1. what to produce? 2. how to produce? 3. for whom to produce?

© Pilot Publishing Company Ltd Correspondingly, three efficiency conditions are defined: 1. production efficiency 2. consumption efficiency 3. allocative efficiency

© Pilot Publishing Company Ltd Production efficiency Production efficiency is attained when – defining the criterion of how to produce then, it will be impossible to raise the output of any good without reducing the outputs of others. goods are produced at the minimum cost.

© Pilot Publishing Company Ltd Conditions of production efficiency (production at the minimum cost): All firms use cost-minimizing production methods to produce. MCs of all firms producing the same good are equal. Why?

© Pilot Publishing Company Ltd Consumption efficiency Consumption efficiency is attained when – defining the criterion of for whom to produce goods are consumed by individuals with the highest MUV. then, it will be impossible to raise TUV of any individual without reducing TUVs of others.

© Pilot Publishing Company Ltd MUVs of all individuals consuming the same goods are equal. Conditions of consumption efficiency (consumption by individuals with the highest MUV): Why?

© Pilot Publishing Company Ltd Allocative efficiency Allocative efficiency is attained when – defining the criterion of what to produce resources are allocated to their highest-valued uses. then, it will be impossible to raise the TUV of all the commodities produced.

© Pilot Publishing Company Ltd Conditions to achieve allocative efficiency (allocated to the highest-valued uses): MUV of each good is equal to its MC Why?

© Pilot Publishing Company Ltd Situation in a price-taking industry: To maximize wealth, firms produce the output at which MC = MR = P. As they face the same price, MCs of all firms producing the same good are equal. Production efficiency is achieved. To maximize wealth, firms have to minimize cost. So they must use the cost-minimizing production methods in their production. Behaviours of producers

© Pilot Publishing Company Ltd Consumption efficiency is also achieved. To maximize utility, individuals consume the amount at which MUV = P. Situation in price-taking industry: As individuals face the same market price, MUVs of all individuals consuming the same good are equal. Behaviours of consumers

© Pilot Publishing Company Ltd Allocative efficiency is achieved. Individuals consume the quantities where MUV = P. Situation in price-taking industry: Allocation of resources Firms produce the quantities where MC = P. As they face the same market price, MUV = P = MC.

© Pilot Publishing Company Ltd In price-taking markets, resource allocation is efficient. This is achieved without any government intervention nor guidance from visible hands. Individuals & firms make their own decisions according to the market price (the invisible hand) adjusted under the market mechanism. Situation in price-taking industry: Conclusion:

© Pilot Publishing Company Ltd Appendix I: Perfect competition is a misleading term (as if other markets are less competitive) 2. Price-taking is a more appropriate term 1. Under scarcity & maximization severe competition exists in all kinds of markets e.g., monopoly --- compete for the monopoly right, against potential entrants, against takeover, with producers of substitutes, factor suppliers and consumers, etc. since individual sellers cannot affect the price.

© Pilot Publishing Company Ltd Appendix II: Supply A. Quantity supplied and supply Quantity supplied is the amount that a supplier is willing and able to sell at a certain price within a certain period of time. at different prices, the supplier is willing to sell different quantities.

© Pilot Publishing Company Ltd Appendix II: Supply A. Quantity supplied and supply Supply describes the relationship between the price and the quantity supplied of a good. if expressed in the form of a table --- supply ________ if expressed in the form of a curve --- supply _______ schedule curve

© Pilot Publishing Company Ltd S(= MC) Q P 0 1. Price of a variable factor Q P 0 S(= MC) MC S Price of variable factor MC S

© Pilot Publishing Company Ltd State of technology S(= MC) Q P 0 Technology improvement S MC

© Pilot Publishing Company Ltd Tax S(= MC) MC S q P 0 S(= MC) Imposition of a sales tax

© Pilot Publishing Company Ltd Subsidy S(= MC) MC S q P 0 S(= MC) Imposition of a subsidy

© Pilot Publishing Company Ltd Price expectation S(= MC) S q P 0 Supplier expect the future price Present supply Why?

© Pilot Publishing Company Ltd Weather and climate S(= MC) S q P 0 Bad weather e.g. a typhoon S of vegetables

© Pilot Publishing Company Ltd Price of related goods (joint supply) P x2 X2X2 PYPY Y 0 Pork chop PxPx X 0 P x1 X1X1 Pork SxSx S Y1 S Y2 Why?

© Pilot Publishing Company Ltd PxPx X 0 SxSx P x1 X1X1 PYPY Y 0 S Y1 P x2 X2X2 S Y2 8. Price of related goods (competitive supply) Fruits Vegetables Why?

© Pilot Publishing Company Ltd Price elasticity of supply ( p E s ) A. What is elasticity of supply? is a measure of the responsiveness of the quantity supplied of a good to a change in its price. Appendix III: Elasticity of Supply

© Pilot Publishing Company Ltd According to the size of elasticity Perfectly inelasticEs = 0%Δin quantity supplied of X = 0 InelasticEs < 1 %Δin X < % in P Unitarily elasticEs = 1 %Δin X = % in P ElasticEs > 1 %Δin X > % in P Perfectly elasticEs = infinity%Δin X = infinity

© Pilot Publishing Company Ltd B.Classification of price elasticities of supply Point elasticity of supply Arc elasticity of supply 1. According to the formula adopted in calculation applied when the % Δ is very small applied when the % Δ is not very small

© Pilot Publishing Company Ltd Δ XΔ X ΔPxΔPx P P1P1 O X1X1 X A B C Tangent at point A S Point elasticity of supply--- non-linear supply curve p E s at point A: Graphical measure: Mathematical measure:

© Pilot Publishing Company Ltd SP P1P1 O X1X1 X A B C Δ X ΔPxΔPx Point elasticity of supply --- linear supply curve Mathematical measure: p E s at point A: Graphical measure:

© Pilot Publishing Company Ltd Q9.8: The supply of new residential flats is inelastic. List all possible reasons.

© Pilot Publishing Company Ltd Determinants of elasticity of supply 1. Flexibility of production 2. Time for adjustment 3. Ease of entry and exit 4. Size of stock 5. Ease of storage Production method Mobility of factors Production time required

© Pilot Publishing Company Ltd $ q 0 TC TR TFC Short run Advanced Material 9.1 Equilibrium by TR curve and TC curve Largest net receipt Slope = MC Slope = MR Notice: At q*, MR = MC where the distance between TR & TC (= net receipt) is the largest. Notice: At q*, MR = MC where the distance between TR & TC (= net receipt) is the largest. q* Wealth-maximizing output

© Pilot Publishing Company Ltd Long run $ q 0 TR Equilibrium by TR and TC curves Wealth-maximizing output q* MC 2 MC* MC 1 MR q1q1 q2q2 At q 1, MR>MC 1, production raises net receipt. At q 2, MR<MC 2, production reduces net receipt. At q*, MR=MC*, net receipt is the largest. The largest net receipt

© Pilot Publishing Company Ltd Original net receipt Advanced Material 9.2 Marginal firms and infra-marginal firms LRAC (under competition, factor incomes of superior factors rise and absorb the original net receipt) q0q0 $ q0 LRMC LRAC P 1. Absorption of net receipts by superior factors An established firm with superior factors

© Pilot Publishing Company Ltd Classification of firms according to their responses to a fall in price _____________________ are firms that do not have superior factors and they leave the industry even if the market price falls by a very small amount. ______________________ are firms that have superior factors and they leave the industry only if the market price falls drastically. (Options: Marginal firms / Infra-marginal firms) Marginal firms Infra-marginal firms

© Pilot Publishing Company Ltd When price falls, some firms instead of all will leave 1. If resources are ________________, marginal firms would be the first to leave. 2. If resources are _______________, which firm will leave first is by random selection. (Options: homogeneous / heterogeneous) heterogeneous homogeneous Price some firms leave supply price until it reaches the mini. LRAC remaining firms can stay 4. The first firm to leave

© Pilot Publishing Company Ltd Correcting Misconceptions: 1. The market demand curve faced by a price- taking industry is horizontal. 2. The short-run supply curve of a price-taker is its MC curve. 3. The equilibrium condition of a wealth- maximizing firm is TR = TC.

© Pilot Publishing Company Ltd If a firm earns zero net receipt (profit), it is not worth to produce. 5. As infra-marginal firms have superior factors and lower production costs, they have positive net receipts even in the long run. 6. When market price falls, all existing firms suffer losses and they will leave the industry. Correcting Misconceptions:

© Pilot Publishing Company Ltd After the imposition of a lump-sum tax, a price-taker will cut its output both in the short run and the long run. 8. Efficiency is attained if it is impossible to reallocate resources to make an individual gain. Correcting Misconceptions:

© Pilot Publishing Company Ltd Survival Kit in Exam Question 9.1 : Explain why the equilibrium of a price-taking industry is efficient. Use a demand-supply diagram to explain.