Today  LR industry supply –Constant cost –Increasing cost  Implications of LR equilibrium  Market efficiency in perfect competition

Industry Supply in the Long Run The Key to understanding the long run is firm entry and exit.

Case 1: Constant Cost Industry  Assumes that firms’ costs are independent of the size of the market. Expanding or contracting demand yields the same price in the long run. –Firms’ cost curves do not shift as industry output changes.  Leads to a horizontal long-run industry supply curve.

Initial LR Equilibrium qQ D PPTypical FirmIndustry or Market Thought experiment: What happens to the industry LR equilibrium as market demand expands? MC ATC SRS P Q q LRATC

SR Response to Increase in Demand qQ D PPTypical FirmIndustry or Market SR: price rises. Firms earn profits. Why isn’t this a new LR equilibrium? MC ATC SRS P Q q LRATC D’ Q’ q’

LR Response to Increase in Demand qQ D PPTypical FirmIndustry or Market LR: Firms enter until no more profits can be made. Given our assumption, that is when price falls to its original level. Second LR equilibrium. MC ATC SRS P Q” q” LRATC D’ SRS’ Q q’

LR Industry Response to an Increase in Demand  Assuming that firms’ costs do not depend on the size of the industry, and  Beginning in LR equilibrium and increasing demand: – in the SR, price rises, firms’ profits and outputs rise. –In the LR, price returns to original level, firms earn zero profits, each firm makes same q as before, but market output is higher.

LR Response to Increase in Demand qQ D PPTypical FirmIndustry or Market Case 1: Horizontal Long-Run Supply Curve MC ATC P Q” q LRATC D’ Q LRS

Significance of Result  For these industries, growing demand (ceteris paribus) will not result in higher (or lower) prices. –Remember LRS is not predicting how prices change over time.  For these industries, there is a constant opportunity cost of producing this good.

Case 2: Increasing Cost Industry  Assumes rising opportunity cost as an industry (or market) expands, causing firms’ costs to rise. –Ex: market for milk & price of dairy land  Results in an upward-sloping long-run industry supply curve

Case 2 & LR Industry Supply qQ D PPTypical FirmIndustry or Market Case 2: Upward-sloping Long-Run Supply Curve P Q1Q1 LRATC(Q 0 ) D Q0Q0 LRS LRATC (Q 1 ) SRS SRS’

Significance of Case 2  Growing demand for milk forces up the price of milk.  Less productive land is converted to dairy farming.  Opportunity cost of producing milk rises.  Price of milk rises in the long run, even though there are more milk farms.  ***Result comes from the underlying scarcity of dairy land.***

Profits for New Dairy Farms  Consider the dairy farms that have opened because of higher milk prices.  Do they make profits, losses, or break even in the long run? How do you know?

Profits for Old Dairy Farms.  Consider the dairy farms that were in business prior to the increase in demand.  Will they make profits, losses, or break even in the new long run equilibrium? –What about dairy farmers who rent their land? –What about dairy farmers who buy land that has always been used for dairy farming? –What about dairy farmers who already owned dairy farms?

Economic Efficiency

Definition  Economic Efficiency: When goods are produced in the least costly manner and distributed to those who value them most.  Requires: –Productive Efficiency –Allocative Efficiency

Productive Efficiency  There is no way to re-direct production among firms to increase total output.

Perfect Comp and Productive Efficiency  In LR firms produce at lowest possible LRAC. –There is no way to cut costs by changing plant size.  Since all firms take the same price, all firms have same MC (why?) –There is no way to re-direct production to other firms and get lower marginal costs.  Productive efficiency holds.

Allocative Efficiency  Goods are consumed by those who most value them.  There is no alternative comb. of goods that could be produced that would increase society’s well-being.

Measuring Allocative Efficiency  The sum of consumers’ surplus and producers’ surplus.

2 Recall: Consumers’ Surplus  The difference between what a consumer is willing to pay & what he does pay. D $/unit units A B

Producers’ Surplus-SR perspective  The difference between the amount of revenue the firm earns and the minimum amount necessary to get the firm to produce that quantity of the good in the short run.  Revenue - total variable costs.

2 Producers’ Surplus-Market  Selling 4  Total revenue = B + C.  TVC for all firms is represented by the area under the SRS curve (why?) = C  B = producers’ surplus D $/unit units B SRS C

2 Allocative Efficiency  A + B = The sum of consumers’ and producers’ surplus.  Vertical distance between D and S is the difference between value to consumer and MC to producer.  What Q maximizes CS+PS? D $/unit units B SRS C A

Allocative Efficiency & Perfect Competition  Perfectly competitive markets provide the allocatively efficient quantity of a good.

Perfect Comp and Econ Efficiency  Conclusion: Perfectly competitive markets are economically efficient!  This is one reason why we use them as a benchmark for our study of other market structures.

Coming Up:  Prepare for second midterm exam.

Group Work  Profits for Coal Mines  Allocative Efficiency and the excise tax.

Coal Mining  Assume the coal mining industry is perfectly competitive.  Consider two mines: –Alpha mine has rich, easily accessible deposits. –Beta mine has less desirable deposits. Its marginal cost of producing coal is everywhere twice as high as for Alpha.

Profits for Alpha & Beta Mines  Assume the price of coal is high enough that Beta mine is actively mining coal.  Will Beta mine make economic profits, economic losses or break even in the long run?  Suppose the total coal deposits in the two mines are equal. What can you say about the likely price of Alpha mine compared to Beta mine?

Profits for Alpha & Beta Mines, Cont’d.  Will the two mines have the same fixed costs?  Will Alpha mine make economic profits, economic losses or break even in the long run? How do you know?

Bonus—Excise Taxes and Allocative Efficiency  Assume the market for wheat shown in the next slide is perfectly competitive.  Shade in the sum of consumers’ and producers’ surpluses for the competitive market equilibrium.

Wheat Bushels of wheat Price/Gal.  Identify the market equilibrium price and quantity.  Shade in the CS + PS. D S

Excise Tax  Add an excise tax of $0.50 per bushel to this market as in the next slide.  What happens to market price and quantity?  Shade in CS + PS in light of the tax.  Compare your answer to before the tax. Is it allocatively efficient to tax this industry?

0.50 Excise tax on wheat-50¢ Bushels of wheat Price/Gal.  Price paid by elevator is $1.25  Price kept by farmer is $0.75.  What is quantity?  How is CS + PS affected? D S S’