1. CHAPTER 14 Perfectly Competitive Markets: Short-Run Analysis

2. Objective Analyze the firm’s output decision in a perfectly competitive market in the short run (sr) Analyze the market effects of different policies

3. Properties of Perfectly Competitive markets Large number of firms Large number of buyers Free entry and exit Homogenous product Perfect information This implies: No market power Firms take the market price as given

4. Competitive Markets in the SR Short run One input – fixed Number of firms – fixed The firm faces a horizontal demand or price line P=MR=AR Profit-maximizing quantity? 4

5. Cost and demand for a competitive firm 5 Price, Cost In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost. MC ATC AVC Quantity 0 e b q3q3 p1p1 p 1 =MR 1 =AR 1 d q”q’ q ’+1 c

6. Shut down or stay in business What should the firm do if the market price does not cover its average cost? Shut down? Shut down if Profit if in business <Profit if shut down TR-VC-FC < 0-FC TR<VC The firm should shut down if the revenue is less than the variable cost of production since fixed costs are sunk costs. Simplify further and divide both sides by Q: TR/Q < VC/Q Therefore, the firm shuts down if P < AVC

7. The Shut Down Price 7 Price, Cost The shut down price is at the min of the AVC curve MC ATC AVC Quantity 0 e b a d q” p0p0 Shut down price p’ 0 produce nothing p3p3 Produce q 3 at a profit p1p1 Produce q’’ at a loss q3q3

8. Cost and demand for a competitive firm 8 Price, Cost In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost. Thus, at a price of p 1, the firm produces a quantity of q” but at a price of p’ 1 the firm produces nothing MC ATC AVC Quantity 0 e b p3p3 p 3 =MR 3 =AR 3 q3q3 a p1p1 p 1 =MR 1 =AR 1 d q”q’ q ’+1 q’ 0 p2p2 p 2 =MR 2 =AR 2 p0p0 p 0 =MR 0 =AR 0 q0q0 p’ 0 p’ 0 =MR’ 0 =AR’ 0 c

9. A Competitive Firm’s Supply Supply function How much of a good One firm - willing to sell Given any market price Other factors constant Supply function Marginal cost curve Above - lowest point on AVC curve 9

10. A short-run supply curve for a competitive firm 10 Price, Cost At prices below p 0, the firm produces nothing because these prices are less than the average variable cost. At prices above p 0, the supply curve is identical to the marginal cost curve Quantity 0 P 0 Shut down price q0q0 S

11. Competitive Markets in the Short Run Market supply function (aggregate supply function) How much of a good All of firms supply Any given market price Horizontally add supply curves All of firms in the industry Aggregate short-run marginal cost Supply each unit 11

12. Market Supply 12 The market supply curve is the horizontal sum of the marginal cost curves of all of the firms in the industry Quantity 0 Price p1p1 p2p2 p3p3 p4p4 p’ 2 FIRM 1 Quantity 0 Price FIRM 2 Quantity 0 Price FIRM 3 Quantity 0 Price MARKET SUPPLY q11q11 q 1 2’ q14q14 q 2 2’ q24q24 q34q34 q11q11 q 1 4 +q 2 4 +q 3 4 q 1 2’ +q 2 2’ A B

13. Competitive Markets in the Short Run Short-run equilibrium Price-quantity combination Prevail - perfectly competitive market Short run (1) Firms – no change (quantity supplied) (2) Consumers – no change (quantity demanded) (3) Aggregate supply = Aggregate demand 13

14. Equilibrium 14 Price The equilibrium price of p e and quantity of q e equate the aggregate supply and aggregate demand in the market. Quantity 0 Market Supply Market Demand pepe p1p1 p2p2 q2sq2s q2dq2d q1dq1d q1sq1s qeqe

15. The SR equilibrium in competitive market 15 The short-run equilibrium for a competitive industry is consistent with positive profits. Price FIRM 1 Price FIRM 2 Price FIRM 3 Quantity 0 Price Quantity 0 0 0 MC q1eq1e ATC π1π1 q2eq2e π2π2 q3eq3e q e =q 1 e +q 2 e +q 3 e S D pepe pepe

16. Policy Analysis in the Short Run Comparative static analysis Examine market equilibrium Before and after policy change Effect on market price and quantity Compare 2 static equilibria 16

17. The market for illegal drugs 17 Price An increase in the probability that a drug dealer will be caught shifts the supply curve to the left, from S 1 to S 2, raises the equilibrium price from p a to p b, and lowers the equilibrium quantity from q a to q b. Quantity 0 D S1S1 qaqa papa a S2S2 qbqb pbpb b

18. The decision about whom to prosecute 18 Price A policy of prosecuting illegal drug dealers shifts the supply curve from S 1 to S 2 and the equilibrium from point a to point c. Quantity 0 D1D1 S1S1 qaqa papa a S2S2 qcqc pcpc c A policy of prosecuting illegal drug users shifts the demand curve from D 1 to D 2 and the equilibrium from point a to point b. D2D2 b qbqb pbpb

19. The incidence of a tax and elasticity of demand 19 When demand is perfectly inelastic, the incidence of a tax of α per unit falls entirely on the consumer Price Quantity 0 0 0 Price S1S1 S2S2 qaqa D (a)(b)(c) a b papa p a+α α S1S1 S2S2 D papa When demand is perfectly elastic, the incidence of the tax falls entirely on the producer S1S1 D S2S2 a b papa qaqa pbpb qbqb c d When elasticity is intermediate between 0 and -∞, the incidence of the tax falls partly on the consumer and partly on the producer

20. The labor market and the minimum wage 20 Price The establishment of a minimum wage of w min raises the equilibrium wage paid to employed workers from w a to w min and lowers the number of employed workers from q a to q min. Quantity 0 D1D1 S1S1 qaqa wawa a w min q min

21. Government-subsidized wages 21 Price A government subsidy of the wages of teenage workers shifts the demand curve for labor from D 1 to D 2, raises the equilibrium wage from w a to w b, and raises the number of workers employed from qa to q b. Quantity 0 D1D1 S1S1 D2D2 D3D3 wawa qaqa wbwb qbqb

22. Figure 14.11 Subsidizing youth employment 22 Wage A subsidy leads to higher wages and more young employees Labor 0 D S b D’ qaqa q min w min wawa a e c d wvwv