INTERMEDIATE MICROECONOMICS AND ITS APPLICATION

INTERMEDIATE MICROECONOMICS AND ITS APPLICATION
Chapter 8 Perfect Competition Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida

Timing of a Supply Response
A supply response is the change in quantity of output in response to a change in demand conditions. The pattern of equilibrium prices will be different depending upon the time period In the very short run, quantity is fixed so there is no supply response Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Timing of a Supply Response
In the short run existing firms may change the quantity they are supplying, but no firms enter or exit the market. In the long run firms can further change the quantity supplied and new firms may enter the market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Pricing in the Very Short Run
The market period (very short run) is a short period of time during which quantity supplied is fixed. In this period, price acts to ration demand as it adjusts to clear the market. This situation is illustrated in Figure 8.1 where supply is fixed at Q*. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.1: Pricing in the Very Short Run
Price S P1 D Quantity per week Q* Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Pricing in the Very Short Run
When demand is represented by the curve D, P1 is the equilibrium price. The equilibrium price is the price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shifts in Demand: Price as a Rationing Device
If demand were to increase, as illustrated by the new demand curve D’ in Figure 8.1, P1 is no longer the equilibrium price since the quantity demanded exceeds the quantity supplied. The new equilibrium price is now P2 where price has rationed the good to those who value it the most. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.1: Pricing in the Very Short Run
Price S P2 P1 D’ D Quantity per week Q* Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

APPLICATION 8.1: Auctions for Financial Assets
A common type is “ascending bid” where the auctioneer calls out progressively higher bids until only one person remains. He or she wins the item. Treasury bills are sold at a discount so that the buyer earns interest as they mature in either 13 or 26 weeks when the buyer receives the face value. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Treasury bills are mainly sold to 38 primary dealers who submit sealed bids stating how many bills the dealer wants to purchase and what price he/she will pay. The bills are first sold to the highest bidder, then the next highest, and so on until all the bills are sold. Some dealers may not buy any bills. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Two criticisms of this approach are: The highest bidder is subject to the “winner’s curse” of having purchased the bills at an uneconomically high bid. This may cause bids to be lower than would be under alternative methods of bidding. One large bidder may attempt to corner the market obtaining a monopoly position in the resale market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The U.S. Treasury has experimented with a “second best” auction where the highest bidder wins but pays the price of the second highest bidder. It is claimed that the “second best” auction gets rid of the “winner’s curse.” Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Corporate shares can be bought and sold at auctions by specialists on the exchange floor. An example of this is the New York Stock Exchange. Others are traded using a network of computer bidding. The National Securities Dealers Automated Quotation (NASDAQ) is an example of this. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

A recent study suggests that the NASDAQ market was rigged. In support of the claim, it was argued that there was an unusual lack of “odd-eight” (1/8, - 7/8) bids for major stocks. It was suggested that the lack of such bids meant the dealers were making more profits on the bid-ask spreads than justified. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Applicability of the Very Short-Run Model
This model may only apply where the goods are very perishable. It is usually assumed that a rise in price will prompt producers to bring additional quantity to the market. This can result from greater production, or, if the goods are durable, from existing stock held by producers. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Short-Run Supply In the short-run the number of firms is fixed as no firms are able to enter or leave the market. However, existing firms can adjust their quantity in response to price changes. Because of the large number of firms, each firm is treated as a price taker. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Construction of a Short-Run Supply Curve
The quantity that is supplied is the sum of the quantities supplied by each firm. The short-run market supply curve is the relationship between market price and quantity supplied of a good in the short run. In Figure 8.2 it is assumed that there are only two firms, A and B. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.2: Short-Run Market Supply Curve
Price Price SA Price P Output Output Quantity per week q A 1 (a) Firm A (b) Firm B (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Construction of a Short-Run Supply Curve
Both firm A’s and firm B’s short-run supply curves (their marginal cost curves) are shown in Figure 8.2(a) and Figure 8.2(b) respectively. The market supply curve is the horizontal sum of the two firms are every price. In Figure 8.2(c), Q1 equals the sum of q1A and q1B. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Short-Run Price Determination
Figure 8.3 (b) shows the market equilibrium where the market demand curve D and the short-run supply curve S intersect at a price of P1 and quantity Q1. This equilibrium would persist since what firms supply at P1 is exactly what people want to buy at that price. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run
SMC Price Price S Price SAC P1 D d q1 q2 Q1 Q2 Quantity per week q1 q2 q1 ‘ Output Quantity (a) Typical Firm (b) The Market (c) Typical Person Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run
SMC Price Price S Price SAC P2 D’ P1 d’ D d q1 q2 Q1 Q2 Quantity per week q1 q2 q1 ‘ Output Quantity (a) Typical Firm (b) The Market (c) Typical Person Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Functions of the Equilibrium Price
The price serves as a signal to producers about how much should be produced. To maximize profit, firms will produce the output level for which marginal costs equal P1. This yields an aggregate production of Q1. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Functions of the Equilibrium Price
Given the price, utility maximizing individuals will decide how much of their limited incomes to spend At price P1 the total quantity demanded is Q1. No other price brings about the balance of quantity demanded and quantity supplied. These situations are depicted in Figure 8.3 (a) and (b) for the typical firm and individual, respectively. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Effect of an Increase in Market Demand
If the typical person’s demand for the good increases from d to d’, the entire market demand curve will shift to D’ as shown in figure 8.3. The new equilibrium is P2, Q2 where a new balance between demand and supply is established. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Effect of an Increase in Market Demand
The increase in demand resulted in a higher equilibrium price, P2 and a greater equilibrium quantity, Q2. P2 has rationed the typical person’s demand so that only q2 is demanded rather than the q’1 that would have been demanded at P1. P2 also signals the typical firm to increase production from q1 to q2. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shifts in Demand Curves
Demand will increase, shift outward, because Income increases The price of a substitute rises The price of a complement falls Preferences for the good increase Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shifts in Demand Curves
Demand will decrease, shift inward, because Income falls The price of a substitute falls The price of a complement rises Preferences for the good diminish Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shifts in Supply Curves
Supply will increase, shift outward, because Input prices fall Technology improves Supply will decrease, shift inward, because Input prices rise Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Table 8.1: Reasons for a Shift in a Demand or Supply Curve
Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Short-Run Supply Elasticity
The short-run elasticity of supply is the percentage change in quantity supplied in the short run in response to a 1 percent change in price. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Short-Run Supply Elasticity
If a 1percent increase in price causes firms to increase quantity supplied by more than 1 percent, supply is elastic. If a 1 percent increase in price causes firms to increase quantity supplied by less than 1 percent, supply is inelastic. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shits in Supply Curves and the Importance of the Shape of the Demand Curve
The effect of a shift in supply upon equilibrium levels of P and Q depends upon the shape of the demand curve. If demand is elastic, as in Figure 8.4 (a), a decrease in supply has a small effect on price but a relatively large effect on quantity. If demand is inelastic, as in Figure 8.4 (b), the decrease in supply has a greater effect on price than on quantity. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve
Price Price S S D P P D Quantity per week Q Q Quantity per week (a) Elastic Demand (b) Inelastic Demand Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve
Price Price S’ S S P’ P’ D P P D Q’ Quantity per week Q’ Q Q Quantity per week (a) Elastic Demand (b) Inelastic Demand Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shifts in Demand Curves and the Importance of the Shape of the Supply Curve
The effect of a shift in demand upon equilibrium levels of P and Q depends upon the shape of the supply curve. If supply is inelastic, as in Figure 8.5 (a), the effect on price is much greater than on quantity. If the supply curve is elastic, as in Figure 8.5 (b), the effect on price is relatively smaller than the effect on quantity. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve
Price Price S P’ P P D D Quantity per week Q Quantity per week Q (a) Inelastic Supply (b) Elastic Supply Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve
Price Price S P’ P’ P P D’ D’ D D Quantity per week Q Q’ Quantity per week Q Q’ (a) Inelastic Supply (b) Elastic Supply Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil
Ethanol has potentially desirable properties as a fuel for automobiles or additive to gasoline that may reduce air pollution. Several governments have adopted subsides to producers of ethanol. One way to show the effect of a subsidy is to treat it as a shift in the short-run supply curve as shown in Figure 1. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price
($/gallon) S1 P1 D Q1 Quantity (million gallons) Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price
($/gallon) S1 S2 P1 P2 Subsidy D Q1 Q2 Quantity (million gallons) Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The subsidy shifts out the supply curve (by about 54 cents-a-gallon in the U.S.) which results in a quantity demanded increase from Q1 to Q2. The total cost of the subsidy depends upon the per-gallon amount and on the amount of the increase in quantity demanded. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

In the U.S. it is made from corn, and the subsidy is primarily found in Iowa where many major corn producers are located. In Brazil it is made from sugar cane and was heavily subsidized until Economic liberalization in the 1990s. Due to political pressure from producers, the subsidy is again being proposed. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

A Numerical Illustration
Suppose the quantity of cassette tapes demanded per week (Q) depends on the price of the tapes (P) per equation 8.2, Suppose short-run supply is given by equation 8.3. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Figure 8.6 shows the graph for these equations. Since the supply curve intersects the vertical axis at P = 2, this is the shutdown price. The equilibrium price is $6 with people demanding 4 tapes which equals the amount supplied by the firms. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.6: Demand and Supply Curves for Cassette Tapes
Price S 10 6 2 D 4 10 Tapes per week Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

If the demand increased as reflected in equation 8.4, the former equilibrium price and quantity would no longer hold. As shown in Figure 8.6, the new equilibrium price is $7 where the quantity demanded and supplied of tapes is 5. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.6: Demand and Supply Curves for Cassette Tapes
Price $12 S 10 7 6 5 2 D’ D 3 4 5 6 10 12 Tapes per week Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Table 8.2 shows the two cases. After the increase in demand, there is an excess demand for tapes at the old equilibrium price of $6. The increase in price from $6 to $7 restores equilibrium in the market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

TABLE 8.2: Supply and Demand Equilibrium in the Market for Cassette Tapes
New equilibrium Initial equilibrium Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Long Run Long run supply responses are much more flexible than in the short run. Long-run cost curves reflect greater input flexibility. Firms can enter and exit the market in response to profit opportunities. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Equilibrium Conditions
In a perfectly competitive equilibrium, no firm has an incentive to change its behavior. Firms must be choosing the profit maximizing level of output. Firms must be content to stay in or out of the market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Profit Maximization It is assumed that the goal of each firm is to maximize profits. Since each firm is a price taker, this implies that each firm product where price equals long-run marginal cost. This equilibrium condition, P = MC determines the firm’s output choice and its choice of inputs that minimize their long-run costs. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Entry and Exit The perfectly competitive model assumes that firms entail no special costs when they exit and enter the market. Firms will be enticed to enter the market when economic profits are positive. Firms will leave the market when economic profits are negative. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Entry and Exit Entry will cause the short-run market supply curve to shift outward causing the market price to fall. This will continue until positive economic profits are no longer available. Exit causes the short-run market supply curve to shift inward causing the market price to increase, eliminating the economic losses. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Equilibrium For purposes of this chapter, it is assumed that all firms producing a particular good have identical cost curves. Thus, in the long-run equilibrium all firms earn zero economic profits. Firms will produce at minimum average total costs where P = MC and P = AC. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Equilibrium P = MC results from the assumption that firm’s are profit maximizers. P = AC results because market forces cause long run economic profits to equal zero. In the long run, firm owners will only earn normal returns on their investments. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Supply: The Constant Cost Case
The constant cost case is a market in which entry or exit has no effect on the cost curves of firms. Figure 8.7 demonstrates long-run equilibrium for the constant cost case. Figure 8.7 (b) shows that market where the market demand and supply curves are D and S, respectively, and equilibrium price is P1. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.7: Long-Run Equilibrium for a Perfectly Competitive Constant Market: Cost Case
Price Price SMC MC S AC P1 D q1 Output Q1 Quantity per week (a) Typical Firm (b) Total Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Supply: The Constant Cost Case
The typical firm will produce output level q1 which results in Q1 in the market. The typical firm is maximizing profits since price is equal to long-run marginal cost. The typical firm is earning zero economic profits since price equals long-run average total costs. There is no incentive for exit or entry. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

A Shift in Demand If demand increases to D’, the short-run price will increase to P2. A typical firm will maximize profits by producing q2 which will result in short-run economic profits (P2 > AC). Positive economic profits cause new firms to enter the market until economic profits again equal zero. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

A Shift in Demand Since costs do no increase with entry, the typical firm’s costs curves do not change. The supply curve shifts to S’ where the equilibrium price returns to P1 and the typical firm produces q1 again. The new long-run equilibrium output will be Q3 with more firms in the market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Supply Curve Regardless of the shift in demand, market forces will cause the equilibrium price to return to P1 in the long-run. The long-run supply curve is horizontal at the low point of the firms long-run average total cost curves. This long-run supply curve is labeled LS in Figure 8.7 (b). Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Shape of the Long-Run Supply Curve: The Increasing Cost Case
The increasing cost case is a market in which the entry of firms increases firms’ costs. New firms may increase demand for scarce inputs driving up their prices. New firms may impose external costs in the form of air or water pollution. New firms may place strains on public facilities increasing costs for all firms in the market. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.8: Increasing Costs Result in a Positively Sloped Long-Run Supply Curve
Price Price SMC Price S MC SMC D AC MC P2 AC P3 P3 P1 P1 2 q1 q2 Output q3 Output Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Price D’ Price SMC Price S MC SMC D AC P2 MC P2 AC P1 P1 2 q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Price D’ Price SMC Price S S’ MC SMC D AC LS P2 MC P2 AC P3 P3 P1 P1 2 q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Increasing Cost Case
This case is shown in Figure 8.8, where the initial equilibrium price is P1 with the typical firm producing q1 with total output Q1. Economic profits are zero. The increase in demand to D’, with short-run supply curve S, causes equilibrium price to increase to P2 with the typical firm producing q2 resulting in positive profits. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Increasing Cost Case
The positive profits entice firms to enter which drives up costs. The typical firm’s new cost curves are shown in Figure 8.8 (b). The new long-run equilibrium price is P3 with market output Q3. The long-run supply curve, LS, is positively sloped because of the increasing costs. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Long-Run Supply Elasticity
The long-run elasticity of supply is the percentage change in quantity supplied in the long run in response to a 1 percent change in price. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Decreasing Cost Case
The decreasing cost case is a market in which the entry of firms decreases firms’ costs. Entry may produce a larger pool of trained labor which reduces the costs of hiring. Entry may provide a “critical mass” of industrialization that permits the development of more efficient transportation, communications, and financial networks. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The initial equilibrium is shown as P1, Q1 in Figure 8.9 (c). The increase in demand from D to D’ results in the short-run equilibrium, P2, Q2 where the typical firm is earning positive economic profits. Entry drives down costs for the typical firm, as shown in Figure 8.9 (b). Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 8.9: Decreasing Costs Result in a Negatively Sloped Long-Run Supply Curve
Price S Price Price SMC D P2 MC AC SMC MC P1 AC P1 2 q1 Output Output Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Price D’ S Price Price SMC D P2 MC P2 AC SMC MC P1 AC P1 2 q1 q2 Output Output Q2 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Price D’ S Price Price SMC D P2 MC P2 S’ AC SMC MC P1 AC P1 2 P3 P3 LS q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Entry continues until short-run economic profits are eliminated. The new long-run equilibrium is P3, Q3 as shown in Figure 8.9 (c). The long-run supply curve is downward sloping due to the decreasing costs as labeled LS in Figure 8.9 (c). Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

APPLICATION 8.4: Network Externalities
Network externalities occur when additional users cause network costs to decline. Subject to Metcalfe’s Law which states that the number of interconnections possible in a given communications network expands with the square of the number of subscribers in the network. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

These cause negatively sloped long-run supply curves. This can cause lower consumer prices when demand expands. Industries subject to network externalities include telecommunications, computer software, and the Internet. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Telecommunications Most of the gains in developed countries have been realized, but remain for less developed. Computer Software As adoption grows, lower learning costs for users. These benefits may explain why software companies are not too concerned with pirating. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Internet Since anything that can be encoded in digital format can be shared over the network, benefits for specialized groups can also be realized. This, along with the improved storage capacity of computers, makes it possible to provide specific types of services that where cost prohibitive before the Internet. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Infant Industries Initially the cost of production of a new product may be very high. As the pool of skilled workers grows, costs may decline. It is often argued that these “infant” industries must be protected from lower-cost foreign competition until they reach the lower cost portion of their supply curves. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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