MBA201a: Entry, Exit & Equilibrium

Professor WolframMBA201a - Fall 2009 Page 1 Basic definitions & principles (I) In the short run (SR), –for an individual firm, many costs are sunk, and –for an entire industry, the number of firms is fixed. In the long run (LR), –everything is variable: production process within a firm and the number of firms.

Professor WolframMBA201a - Fall 2009 Page 2 Basic definitions & principles (II) Profit maximization implies the following decision rules: –In the short run: Produce at the quantity level where MR=MC *, so long as your revenues cover your variable costs. Otherwise, exit. –In the long run: Enter markets or expand capacity as long as your incremental revenues will cover your incremental total costs. Stay in the market as long as you continue to cover your total costs. Exit if you can no longer cover your total costs. * Remember that MR=P for a price-taking firm (aka a firm in a perfectly competitive industry).

Professor WolframMBA201a - Fall 2009 Page 3 LR vs. SR example: Recall the t-shirt factory To produce T-shirts: Lease one machine at $20 / week. Machine requires one worker. The machine, operated by the worker, produces one T-shirt per hour. Worker is paid $1/hour on weekdays (up to 40 hours), $2/hour on Saturdays (up to 8 hours), $3 on Sundays (up to 8 hours).

Professor WolframMBA201a - Fall 2009 Page 4 T-shirt factory cost curves Cost ($) ATC MC 48 T-shirts

Professor WolframMBA201a - Fall 2009 Page 5 T-shirt factory cost curves Cost ($) ATC MC 48 T-shirts AVC

Professor WolframMBA201a - Fall 2009 Page 6 Short versus long run It’s Monday morning. The weekly machine lease has been paid. p=$1.3. Should the factory shut down? It’s Friday afternoon. Should it pay for next week’s lease?

Professor WolframMBA201a - Fall 2009 Page 7 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D1D1

Professor WolframMBA201a - Fall 2009 Page 8 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 In industries with low MC/high fixed costs, market pressures may produce prices that are highly volatile. MC/ AVC

Professor WolframMBA201a - Fall 2009 Page 9 Entry/expansion & exit ATC Cost MC market price Say you: observe the market price, know your costs would look something like the curves on the graph. Would you want to get into this industry? Q

Professor WolframMBA201a - Fall 2009 Page 10 Entry/expansion & exit Cost ATC MC market price Say you: observe the market price, know your costs would look something like the curves on the graph. Would you want to get into this industry? Q

Professor WolframMBA201a - Fall 2009 Page 11 Entry/expansion & exit Cost ($) ATC MC market price Say you: observe the market price, know your costs would look something like the curves on the graph. Would you want to get into this industry? Would you want to stay in the industry if you were already in it? Q

Professor WolframMBA201a - Fall 2009 Page 12 Constructing the industry supply curve Recall that the industry supply curve is the sum of individual firm’s supply curves: P P P Q Q Q Firm AFirm BIndustry

Professor WolframMBA201a - Fall 2009 Page 13 Entry and the industry supply curve Imagine that a firm identical to Firm A enters the industry P P P Q Q Q 2xFirm AFirm BIndustry Supply Curve with Firm A & Firm B Supply Curve with 2 Firm A’s & Firm B

Professor WolframMBA201a - Fall 2009 Page 14 Entry and the market equilibrium price Entry shifts the supply curve to the right. As a result, the market equilibrium price goes down. P Q P before entry P after entry

Professor WolframMBA201a - Fall 2009 Page 15 When does entry stop? P Q P1P1 P2P2 Cost MC ATC Q

Professor WolframMBA201a - Fall 2009 Page 16 Which firms stay and which firms exit? If several firms have access to the same technology as Firm A, what will happen to Firm B? P P P Q Q Q 2xFirm AFirm BIndustry D

Professor WolframMBA201a - Fall 2009 Page 17 How much do the remaining firms produce? P P P Q Q Q 2xFirm A3 rd Firm AIndustry D Supply Curve with 2 Firm A’s Supply Curve with 3 Firm A’s

Professor WolframMBA201a - Fall 2009 Page 18 The third firm A’s entry decision P Q Profits at P = 140

Professor WolframMBA201a - Fall 2009 Page 19 The third firm A’s entry decision P Q Profits at P = 120

Professor WolframMBA201a - Fall 2009 Page 20 Long run competitive equilibrium Industry P Q D Supply Curve with 3 Firm A’s = Long run competitive equilibrium supply curve; 17 firms, each producing 10 units each at price = 100.

Professor WolframMBA201a - Fall 2009 Page 21 Long run competitive equilibrium In a long-run competitive equilibrium: –All of the existing firms are maximizing their short-run profits. –None of the existing firms want to either exit or expand output. –No new firms want to enter. –All existing firms earn zero economic profits. –The market price equals the minimum of the long-run average cost curve (P=min(LRAC)). –All consumers who want to buy the product at this price are able to.

Professor WolframMBA201a - Fall 2009 Page 22 Can an industry with a monopoly be in a LR equilibrium? Cost MC ATC D

Professor WolframMBA201a - Fall 2009 Page 23 Takeaways –Firms have more control over their costs in the long run. –A firm should stay in business in the short run as long as it is making some contribution towards its fixed costs (i.e. P>AVC). –The following dynamics contribute to the long-run competitive equilibrium: Firms entering markets where there are opportunities to make profits. Firms exiting markets where they can no longer cover their total costs, even if they’re making profit maximizing price/output decisions. –In a long-run competitive equilibrium: p=min(LRAC), all firms earn zero economic profits.