Today LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition

Industry Supply in the Long Run Three Cases

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’

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 original level. Second LR equilibrium. MC ATC SRS P Q” q LRATC D SRS’ Q

LR Response to Increase in Demand qQ D PPTypical FirmIndustry or Market LR: Firms enter until no more profits can be made. For case 1, that is when price falls original level. Second LR equilibrium. MC ATC SRS P Q” q LRATC D SRS’ 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 will not result in higher (or lower) prices. (Ceterus Paribus) Remember LRS is not predicting prices over time.

Case 2: Increasing Cost Industry Assumes factor prices rise as industry (or market) output 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

Significance of Case 2 Growing demand for milk forces up the prices of dairy land. 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.***

Case 3: Decreasing Cost Industry Assumes costs fall as industry (or market) output expands. Results in an downward-sloping long-run industry supply curve

Ex: Software Production It’s less costly to produce software as the industry grows because of a larger pool of possible programmers in the same area Don’t need to relocate programmers to your area, cheaper. Programmers informally spread new ideas, reducing costs. The price of software falls as the industry expands.

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: Begin Monopoly Second midterm exam is 1 week from today! We will use Monday’s class to review for the exam. Bring your copy of the study guide.

Group Work Thought problem on perfect competition. Graph of Case 3: Downward-sloping LR industry supply.

Profits and Perfect Competition Assume dairy production is a perfectly competitive, increasing cost industry (case 2 in our notes). Suppose demand for dairy products is growing. Some farmers have really good land for grazing, others have land that is rather poor.

Questions about Dairy Example Which farmer earns the most profits? Explain in full. Hint: Don’t forget, this is a perfectly competitive industry. Hint: Don’t forget opportunity costs.

Case 3 & LR Industry Supply On the following graph, derive the LR Industry supply curve. Assume that firms’ costs decrease as the industry grows.

Case 3 & LR Industry Supply qQ D PPTypical FirmIndustry or Market Case 3: Downward-sloping Long-Run Supply Curve P LRATC(Q 0 ) D’ Q0Q0 SRS