The output decision for a competitive firm: To maximize profit, produce the output level for which: MR = MC (that is, p = MC) . . . unless p < AVC. In that case, shut-down (produce zero output) for the short-run. If AVC < p < ATC, continue to produce in short-run, but exit in long-run if market conditions don’t improve. These rules describe the supply curve of the firm -- showing how output varies as price varies.

Start with conventional cost curves. Add AVC (which tends to be “U-shaped” also). AVC MC ATC ($/widget) (widgets/day) For prices (like p1) that are < min AVC, . . . profit-max output is zero. For prices (like p2, p3) that are > min AVC, p2 p3 q3 q2 min AVC p1 . . . profit-max output is determined by p = MC. q1= 0 “Connecting the dots” gives us the short-run supply curve for the competitive firm.

Drawing the short-run supply curve for a competitive firm. For prices below min AVC, profit-max output is zero. ($/widget) MC ATC AVC (widgets/day) min AVC One “branch” of supply curve coincides with vertical axis. At prices above min AVC, firm supplies positive output. Second “branch” of supply curve traces MC. Firm’s short-run supply slopes up . . . because MC slopes up . . . because of diminishing MP.

Now that we’ve derived the short-run supply curve for a competitive firm, the next step is to investigate equilibrium for the industry . . . . . . in the short-run, and in the long-run. Recall: Short-run: Employment level of fixed factors (“factory”) cannot be adjusted. Long-run: “Fixed” factors become variable. Existing firms can expand or “downsize” their plants. But we also assume that new firms can enter, . . . . . . and existing firms can exit.

In this analysis (to keep things simple In this analysis (to keep things simple!), we’ll ignore the possibility of firms expanding or downsizing . . . . . . and focus instead on effects of entry and exit. So, in the short-run: Fixed number of identical firms. (same technology, same cost curves). In the long-run: Depending on market conditions (Is this a “profitable industry?”), some new firms (identical to existing ones) might enter . . . . . . or some existing firms might exit.

Going from firm supply to industry supply: ($/widget) AVC MC (widgets/day) ($/widget) Supply p2 q2 Q2=100 x q2 p1 q1 Q1=100 x q1 Let’s say there are 100 firms in industry. When price = p1, firm supply = q1 . . . and industry supply = 100 x q1 When price = p2, firm supply = q2 . . . and industry supply = 100 x q2 Industry supply is horizontal sum of 100 copies of firm supply (MC).

Short-run equilibrium for the competitive industry. ($/widget) ATC MC Representative firm (1 of 100 identical) (widgets/ day) Supply Demand p1 q1 Q1 = 100 x q1 Industry supply is the horizontal sum of firm supplies. Supply and demand determine equilibrium price; p1, let’s call it. Facing price p1, each firm maximizes profit by producing q1. Industry output is 100 x q1; Q1, let’s call it. In this short-run equilibrium, each firm makes positive profit.

Remember, this is positive economic profit. Each firm is more-than-covering opportunity costs . . . . . . including opportunity costs of owners’ inputs (labor, financial capital, etc.) In other words, owners’ resources are earning a higher return in this industry than they would in next-best alternative use. Positive profit attracts more investment to the industry. Entry of new firms occurs in long-run.

Entry of new firms and its effect on equilibrium: ($/widget) MC Representative firm (1 of 100 identical) p1 q1 Industry S1 Demand Q1 = 100 x q1 ATC S2 The short-run (positive profit) equilibrium from the previous slide. (Industry supply now denoted “S1.”) Let’s say that positive profit attracts 5 new firms (to start). Industry supply shifts to the right: S1  S2.

Entry of new firms and its effect on equilibrium: ($/widget) MC Representative firm (1 of 100 identical) Industry Demand S2 ATC Industry supply shifts further to the right with additional entry. p2 Price falls to p2. Q2 = 105 x q2 Industry supplies Q2 (a little more than before). Firms still earn positive profit . . . q2 Each firm produces q2 (a little less than before). so there’s still incentive for entry.

Long-run equilibrium: ($/widget) MC Representative firm (1 of 100 identical) Industry Demand ATC S3 p* Price: p* = min ATC. Q* = 108 x q* Industry output: Q* = 108 x q*. q* Each firm produces q*. Entry incentive is eliminated (long-run equilibrium reached) when firms earn zero profit. (Let’s say this takes entry of 3 more firms; bringing total to 108.)

Things to notice about long-run equilibrium: Firms operate at the “efficient scale” (the quantity of output that minimizes ATC) . . . . . . and price equals minimum ATC. This means that profit is zero. (Very important to distinguish between “accounting profit” and “economic profit.”) We get this result because of “free entry and exit” of firms.

We can use what we’ve learned to investigate the response of a competitive industry to a demand shift. When demand increases (for example) . . . . . . how do price, firm output, and industry output respond . . . . . . in the short-run? . . . in the long-run?

Let’s start with a long-run (zero-profit) equilibrium: ($/wdgt) Rep. firm (wdgts/ day) Industry MC ATC S1 D1 p1 Q1 D2 Then demand increases to D2. Price increases to p2. p2 Q2 Industry quantity increases to Q2. Each firm makes positive profit! q2 Each firm increases output to q2. In the short-run (with number of firms fixed), equil. moves up S1.

Positive profit is an incentive for entry of new firms. q2 ($/wdgt) Rep. firm (wdgts/ day) Industry MC ATC S1 D1 D2 q1 p1 Q1 p2 Q2 As entry occurs, supply curve shifts right. This brings price back down some, reducing profit of rep. firm. Entry continues until original price is restored.

Positive profit is an incentive for entry of new firms. ($/wdgt) Rep. firm (wdgts/ day) Industry MC ATC S1 D1 D2 q1 p1 Q1 p2 q2 Q2 S2 Q3 industry quantity = Q3 (there are more firms than before) Entry continues until original price is restored. In new long-run (zero profit) equilibrium: price = p1 and firm quantity = q1 (just like at the beginning)

Recap: Response to demand increase. ($/wdgt) Rep. firm ($/wdgt) Industry MC S1 S2 D1 D2 p2 ATC p1 (wdgts/ day) (wdgts/ day) q1 q2 Q1 Q2 Q3 Short-run response.

Recap: Response to demand increase. ($/wdgt) Rep. firm ($/wdgt) Industry MC S1 S2 D1 D2 p2 ATC . . . gives long-run supply curve. SLR p1 (wdgts/ day) (wdgts/ day) q1 q2 Q1 Q2 Q3 Long-run response. Connecting original LR equilibrium . . . . . . and new LR equilibrium . . .

An exercise to test your understanding of the dynamics of competitive industries: Start with a long-run (zero profit) equilibrium. Assume that demand decreases. (Hint: This time, the mechanism for long-run change will be exit, not entry.)