Steven Landsburg, University of Rochester Chapter 7 Competition Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Application, 6th edition2 Introduction Brotherhood for the Respect, Elevation, and Advancement of Dishwashers Impact of achieving goal –SR life better for dishwashers –LR wages of dishwashers decrease by full amount of tips Why wages bid down by full amount of tips Who benefits from tipping Tools for analyzing competitive industry

Landsburg, Price Theory and Application, 6th edition3 Competitive Firm Sell any quantity it wants at the going market price –Classic example farm Serve a small part of market –Horizontal demand curve Products are interchangeable Buyers can easily buy from another producer

Landsburg, Price Theory and Application, 6th edition4 Revenue TR = P X Q MR ≡ P MR curve is flat –MR curve coincides with demand curve

Landsburg, Price Theory and Application, 6th edition5 Firm’s Supply Decision Produce good until MR = MC Competitive firm produces a quantity where P = MC –Note: P ≡ MR Supply curve –MC and supply are inverse functions –Supply curve looks like upward sloping portion of MC curve as long as MC curve upward sloping –SR and LR supply curves exist for the firm

Landsburg, Price Theory and Application, 6th edition6 Shutdowns and Exits Does the producer want to produce the good? Two distinctions –Shutdown: firm stops producing the good but still pays fixed costs –Exit: firm leaves the industry entirely and no longer faces any costs In SR, can shutdown but not exit –Firms remains operational if P > AVC In LR, can exit

Landsburg, Price Theory and Application, 6th edition7 Short-Run Supply Curve SR supply curve identical to part of SRMC curve that lies above AVC curve –Firm shutdown otherwise Upward slope due to average and marginal cost U-shape –Diminishing marginal returns to variable factors of production Elasticity of supply –Percent change in quantity supplied resulting from a 1% change in price

Landsburg, Price Theory and Application, 6th edition8 Competitive Industry in the SR All firms in industry competitive Defining the SR –Period of time in which no firm can enter or exit the industry Number of firms cannot change –LR is a period of time in which any firm that wants to can enter or leave the industry Industry’s SR supply curve –Sum together SR supply curves of individual firms within the industry –More elastic than individual supply curves

Landsburg, Price Theory and Application, 6th edition9 Supply, Demand, and Equilibrium Each firm operates where supply equals demand Industrywide supply equals industrywide demand –Industry equilibrium consequence of optimizing behavior on part of individuals and firms

Landsburg, Price Theory and Application, 6th edition10 Competitive Equilibrium Firms produces where supply (or MC) curve crosses horizontal line at market going price Increase in FC –Price and quantity remain unchanged Increase in VC –Raises firms MC curve –Causes some firms to shutdown –Higher market equilibrium price –Firm’s output could go up or down Increase in industry demand –Higher market equilibrium price –Increase in firm’s output

Landsburg, Price Theory and Application, 6th edition11 Industry’s Costs Sum of total cost of all individual firms To minimize cost of all firms, use equimarginal principle –Insure that MC same for all producers in industry –Automatic because all firms have same price

Landsburg, Price Theory and Application, 6th edition12 Competitive Firm in the LR Some fixed cost in SR become variable cost in the LR Firms can enter and exit in the LR

Landsburg, Price Theory and Application, 6th edition13 LRMC and Supply Operate where P = LRMC If firm remains in industry, LR supply curve identical to LRMC curve Firm remains as long as earn positive profit

Landsburg, Price Theory and Application, 6th edition14 Profit and the Exit Decision Profit = TR – TC –Costs includes all foregone opportunities SR versus LR supply response –LR supply curve more elastic than SR supply curve –Firm shuts down if price of output falls below average variable cost –Firm exits if price of output falls below average cost

Landsburg, Price Theory and Application, 6th edition15 Competitive Industry in the LR Firms that wish to enter or exit the market can do so in the LR Link between entry and exit and industry’s LR supply curve LR competitive equilibrium

Landsburg, Price Theory and Application, 6th edition16 Zero Profit Condition Laverne and Shirley –Economic versus accounting profit –Newspaper carrier versus lemonade stand All firms earn zero economic profit in the LR –All firms equally efficient –Firms produce at the lowest possible average cost

Landsburg, Price Theory and Application, 6th edition17 Industry’s LR Supply Curve All firms identical –Industry supply curve flat at the break-even price Break-even price and the LR supply –Break-even price (P = AC) at which a seller earns zero profit Changes if anything changes costs –P > AC, firm earns positive profit Remains in industry –P < AC, firm earns negative profit Leaves industry –LR supply curve identical with part of firm’s LRMC curve that lies above its LRAC curve

Landsburg, Price Theory and Application, 6th edition18 Flat LR Supply Curve Flatness based on entry and exit P < AC, all firms exit P > AC, unlimited number of firms enter LR zero profit equilibrium almost never reached –Demand and cost curves shift so often that entry and exit never settles down –Approximation to the truth

Landsburg, Price Theory and Application, 6th edition19 Equilibrium LR same as SR between firm and industry –Market price determined by intersection of industrywide demand and supply –Firms face flat demand curves at market price Analysis of changes to equilibrium –Changes in FC –Changes in VC –Changes in demand

Landsburg, Price Theory and Application, 6th edition20 Application: Government as a Supplier In SR, government policy to build and operate apartment complex increasing housing LR supply curve does not shift –Determined by break-even price –Number of privately owned apartments withdrawn from the market equals number of apartments built by government

Landsburg, Price Theory and Application, 6th edition21 Relaxing the Assumptions Assumption 1: All firms are identical, have identical cost curves –True in industries that do not require unusual skills Assumption 2: Cost curves do not change as industry expands or contracts –True in industries not large enough to affect input prices Without these assumptions, all firms do not have the same break-even price

Landsburg, Price Theory and Application, 6th edition22 Relaxing the Assumptions Continued Constant cost industry –Satisfies assumptions Increasing cost industry –Break-even price for new entrants increases as industry expands –Assumption 1 violated: Less-efficient firms –Assumption 2 violated: Factor-price effect –LR industry supply curve slopes upward Decreasing cost industry –Break-even price for new entrants decreases as industry expands –LR industry supply curve slopes downward

Landsburg, Price Theory and Application, 6th edition23 Applications Removing a rent control A tax on motel rooms Tipping the busboy

Landsburg, Price Theory and Application, 6th edition24 Using the Competitive Model Fundamentals of competitive analysis –Industry versus firm demand and supply –SR versus LR –Entry and exit decisions

Landsburg, Price Theory and Application, 6th edition25 EXHIBIT 7.4Marginal Cost and Supply

Landsburg, Price Theory and Application, 6th edition26 EXHIBIT 7.7The Competitive Firm’s Supply Responses

Landsburg, Price Theory and Application, 6th edition27 EXHIBIT 7.8The Competitive Firm’s Short-Run Supply Curve

Landsburg, Price Theory and Application, 6th edition28 EXHIBIT 7.9The Industry Supply Curve

Landsburg, Price Theory and Application, 6th edition29 EXHIBIT 7.11The Competitive Industry and the Competitive Firm

Landsburg, Price Theory and Application, 6th edition30 EXHIBIT 7.12A Rise in Marginal Costs

Landsburg, Price Theory and Application, 6th edition31 EXHIBIT 7.13A Change in Demand

Landsburg, Price Theory and Application, 6th edition32 EXHIBIT 7.14The Competitive Firm’s Long-Run Supply Curve

Landsburg, Price Theory and Application, 6th edition33 EXHIBIT 7.16Computing the Break-even Price

Landsburg, Price Theory and Application, 6th edition34 EXHIBIT 7.19A Rise in Fixed Costs

Landsburg, Price Theory and Application, 6th edition35 EXHIBIT 7.20A Rise in Variable Costs

Landsburg, Price Theory and Application, 6th edition36 EXHIBIT 7.21 A Rise in Demand

Landsburg, Price Theory and Application, 6th edition37 EXHIBIT 7.24 An Increase in Costs in an Increasing- Cost Industry

Landsburg, Price Theory and Application, 6th edition38 EXHIBIT 7.25A Change in Demand