1. MBA201a: Entry, Exit & Equilibrium

2. 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.

3. 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).

4. 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).

5. Professor WolframMBA201a - Fall 2009 Page 4 T-shirt factory cost curves Cost ($) ATC 10 3 1 20304050 1.5 2 MC 48 T-shirts

6. Professor WolframMBA201a - Fall 2009 Page 5 T-shirt factory cost curves Cost ($) ATC 10 3 1 20304050 1.5 2 MC 48 T-shirts AVC

7. 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? –Not this week (short run). Lease is a sunk cost. Keep factory open for any p above min(AVC) = $1. It’s Friday afternoon. Should it pay for next week’s lease? –No, shut down if p=$1.3. (In fact, shut down for any p below $1.5.) General result: you typically have more control over costs in the long run than in the short run.

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

9. Professor WolframMBA201a - Fall 2009 Page 8 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D2D2

10. Professor WolframMBA201a - Fall 2009 Page 9 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D2D2

11. Professor WolframMBA201a - Fall 2009 Page 10 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D2D2

12. Professor WolframMBA201a - Fall 2009 Page 11 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D3D3

13. Professor WolframMBA201a - Fall 2009 Page 12 SR pricing & LR profitability Cost AC q cap p1p1 p2p2 MC/ AVC D3D3

14. Mojave, California Professor WolframMBA201a - Fall 2009 Page 13

15. Professor WolframMBA201a - Fall 2009 Page 14

16. Professor WolframMBA201a - Fall 2009 Page 15 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

17. Professor WolframMBA201a - Fall 2009 Page 16 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

18. Professor WolframMBA201a - Fall 2009 Page 17 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

19. Professor WolframMBA201a - Fall 2009 Page 18 Entry/expansion & exit Cost ($) ATC MC market price Q 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?

20. Professor WolframMBA201a - Fall 2009 Page 19 Constructing the industry supply curve Recall that the industry supply curve is the sum of individual firms’ supply curves: 180 100 10 100 30 10 100 130 P P P Q Q Q Firm AFirm BIndustry

21. Professor WolframMBA201a - Fall 2009 Page 20 Entry and the industry supply curve Imagine that a firm identical to Firm A enters the industry. 180 100 10 100 30 10 20 100 130 200 P P P Q Q Q 2xFirm AFirm BIndustry Supply Curve with Firm A & Firm B Supply Curve with 2 Firm As & Firm B

22. Professor WolframMBA201a - Fall 2009 Page 21 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

23. Professor WolframMBA201a - Fall 2009 Page 22 When does entry stop? P Q P1P1 P2P2 Cost MC ATC Q

24. Professor WolframMBA201a - Fall 2009 Page 23 When does entry stop? P Q P2P2 P3P3 Cost MC ATC Q

25. Professor WolframMBA201a - Fall 2009 Page 24 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? 180 100 10 100 30 10 20 100 130 200 P P P Q Q Q 2xFirm AFirm BIndustry D

26. Professor WolframMBA201a - Fall 2009 Page 25 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? 180 100 10 100 30 10 20 100 130 200 P P P Q Q Q 2xFirm AFirm BIndustry D

27. Professor WolframMBA201a - Fall 2009 Page 26 How much do the remaining firms produce? 140 100 10 80 10 10 160 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

28. Professor WolframMBA201a - Fall 2009 Page 27 The third firm A’s entry decision 140 100 10 80 P Q Profits at P = 140

29. Professor WolframMBA201a - Fall 2009 Page 28 The third firm A’s entry decision 120 100 10 55 P Q Profits at P = 120

30. Professor WolframMBA201a - Fall 2009 Page 29 Long run competitive equilibrium 100 10 160 170 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.

31. Professor WolframMBA201a - Fall 2009 Page 30 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.

32. Professor WolframMBA201a - Fall 2009 Page 31 Can an industry with a monopoly be in a LR equilibrium? Cost MC ATC D

33. Professor WolframMBA201a - Fall 2009 Page 32 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.