Equilibrium, Profits, and Adjustment in a Competitive Market Chapter 8 J. F. O’Connor

Major Questions How do profits guide resource allocation in a market system? How does a change in price affect profit? What are the two functions of price? How does profit seeking by firms lead to a socially efficient outcome?

Industry Equilibrium Short-run Industry is in equilibrium if: – Each firm is maximizing profit – For the market, quantity supplied equals quantity demanded. Consider our example of the glass bottle making industry. We need to look at both the typical firm and the market.

Typical Firm Price of output $45 Profit maximum at output of 500 Compute economic profit two ways: Profit = Total Revenue – Total Variable Cost – Fixed Cost Profit = [ Price – Average Total Cost]*Quantity Economic profit 5(45-29) = 80

The Market Demand is given to the industry. It is shown in the next slide. The industry has 200 producers, identical to the typical firm. Industry supply is 200 times the supply of our typical firm. Equilibrium price is $45 and quantity is 100,000.

Equilibrium in the Short Run Quantity demanded is equal to quantity supplied Each firm is maximizing profit Is this equilibrium going to continue over the long run? NO because the firms in the industry are enjoying positive economic profit. This will attract new firms. Let us see what happens if 75 new firms enter.

The Effect of Entrants Entry of new firms shifts supply curve to the right. Equilibrium price falls to $35. Typical firm now finds that 400 units of out maximizes profit. Economic profit is still positive, ( )400 More firms will enter until profit is zero!

Industry Long-run Equilibrium Entry continues until economic profit is zero, that is when price is $25. Equilibrium is 120 thousand. There are 400 firms, each producing 300 units. Each is maximizing profit (P=MC) and its economic profit is zero.

Profits in the Adjustment Process Started with an industry where economic profits were being made. This attracted new firms and, as a result, price decreased and the output of existing firms decreased. This continued until economic profit was zero. Price was then equal to minimum average total cost. (See graph) Positive profits attract resources; negative profits repel resources.

Why were there positive profits to begin with? Could have been caused by an increase in demand or a reduction in costs, due to a decline in input prices or a technological advance. Given that the industry is in long-run equilibrium. What would be the adjustment if the demand decreased by 30 thousand?

The Adjustment Process Price falls to about $19. The typical firm reduces its output to about 240 and finds that it is experiencing economic losses because $19 is less than its average total cost. Firms start to leave the industry. This moves the supply curve to the left. This continues until economic losses are eliminated, namely, when price increases to $25 Each firm produces 300 units and there are 300 firms.

Prices and Profits Price rations existing supplies and causes them to go to the buyers who value them most highly. Price through its effect on profit guides the allocation of resources to the production of goods that are in demand. Its movement signals to firms whether to increase or decrease production.

Equilibrium When a market is in equilibrium, then there are no additional opportunities in that market for individuals to gain. Remember, if a market is not in equilibrium, then there are opportunities for gain open to the participants. Suppose that there is excess demand. Then, there are buyers whose reservation prices exceed those of sellers, and trade will be mutually beneficial. A market in equilibrium has exhausted such opportunities.

Social Efficiency (Optimum) A socially efficient (optimal) outcome is one where it is not possible to improve the well- being of one person without making someone else worse off. Is the equilibrium in a perfectly competitive market system a socially efficient (optimal) outcome? Yes, under certain circumstances. Which are?

The Invisible Hand Remember that the demand curve gives he marginal benefit of the good for the consumer and the supply curve gives the marginal (opportunity) cost of producing the good. The key is that the marginal benefit for each consumer is the same as that for society and that the marginal cost for each producer is the same as that for society.