1. Lecture 10: The Theory of Competitive Supply
Readings: Chapter 12

2. The Theory of Competitive Supply
Q: What does the firm’s technology and costs have to do with supply decisions?
We earlier discussed how the firm maximizes profits by adopting strategies in which the MR of an activity equals the MC.
We now have to explore the firm’s revenue side to understand its decision-making.

3. The Theory of Competitive Supply
Q: We know how to derive the firm’s cost curves. What does the firm’s revenue curve look like?
The firm’s total revenue curve will depend on the nature of competition (or market structure). We begin by assuming that firms face Perfect Competition. Next lecture we will explore various forms of Imperfect Competition.

4. The Theory of Competitive Supply
Q: What characterizes a perfect competition?
There are several characteristics:
Many small firms.
Homogeneous product.
Entry into the industry is easy.
All firm’s view the market price as being something over which they have no control over – firms are price takers.
Example: Wheat farmer

5. The Theory of Competitive Supply
Q: What does the revenue curve of a firm in a perfectly competitive industry look like?
Because the firm is small and a price taker:
The firm can sell as much as it produces without altering the market price. Therefore, demand is perfectly elastic at the market p.
The firm’s total revenue is simply: TR = pq

6. Figure 11.1a,b Demand, Price, and Revenue in Perfect Competition25
AR = MR
Swanky’s
demand
curve S 50 50 25 9 D 20 Q 10 20 Q
(a) Industry
(b) Firm
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7. Figure 11. 1c. Demand, Price, and Revenue in Perfect
Figure 11.1c Demand, Price, and Revenue in Perfect Competition: Swanky’s Total Revenue TR
TR = pq
500
225 9 20 Q
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 235

8. The Theory of Competitive Supply
For a firm in a competitive industry we have derived:
Its short and long-run cost curves
Its total revenue curve
Q: If a firm in a perfectly competitive firm is profit maximizing, what is its best quantity strategy?
Profits will be maximized if the firm chooses to produce where the TR and TC curves are at the maximum distance

9. The Firm’s Output Decision
At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.
At intermediate output levels, the firm makes an economic profit.

10. The Firm’s Output Decision
At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns.
The firm maximizes its economic profit when it produces 9 sweaters a day.

11. The Theory of Competitive Supply
Q: Suppose the manager of the firm wants to maximize profits, but does not know the full TR and TC curves. What is her best strategy?
The manager knows enough to follow the following rules:
if MR > MC, firm ­ ↑Q to ­ ↑ profit
if MR < MC, firm ¯ Q to ­ ↑ profit
If MR = MC, then profits are being maximized and the manager should stop.

12. The Theory of Competitive Supply
Q: Is it not true that modern university educated managers, accountants, and engineers are able to draw the TR and TC curves for the firm, and so immediately find the optimal strategy?
No! Professional managers do not have the information needed to immediately find the optimal strategy.
Q: What is a smart manager to do?
Focus on the marginal costs and revenue!

13. The Firm’s Output Decision
If MR > MC, economic profit increases if output increases.
If MR < MC, economic profit decreases if output increases.
If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

14. The Theory of Competitive Supply
Q: Will this strategy always provide the firm with economic profits?
No. If prices are low or costs are high, this strategy may fail to provide a positive profit, but it is still the best strategy as it minimizes losses.
Q:How is the firm’s strategy related to its profits?
Adding the ATC curve to the picture makes it possible to measure the profits (or losses) from a strategy choice.

15. Figure 11. 4a. Three Possible Profit Outcomes
Figure 11.4a Three Possible Profit Outcomes in the Short Run: Economic Profit P MC
ATC
25.00
AR = MR
Economic profit
20.33 9 Q
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Textbook p. 239

16. Figure 11. 4b. Three Possible Profit Outcomes
Figure 11.4b Three Possible Profit Outcomes in the Short Run: Normal Profit P MC
Break-even
point
ATC
20.00
AR = MR 8 Q
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Textbook p. 239

17. Figure 11. 4c. Three Possible Profit Outcomes
Figure 11.4c Three Possible Profit Outcomes in the Short Run: Economic Loss P MC
ATC
20.14
Economic loss
17.00
AR = MR 7 Q
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Textbook p. 239

18. The Theory of Competitive Supply
As the preceding diagrams make clear, there are three possible short-run outcomes:
P > ATC ® economic profits
P = ATC ® zero economic profits (break-even point at minimum ATC; firm just earning normal profits)
P < ATC ® economic losses (firm earning less than normal profits)
continued

19. The Theory of Competitive Supply
Q: What does a firm do if it faces economic losses?
For firm suffering economic losses
if P > AVC, firm continues to produce
if P < AVC, firm temporarily shuts down
shutdown point at minimum AVC
Important Implication ® Perfectly competitive firm's supply curve is MC curve above minimum AVC

20. Figure 11. 5a. Swanky’s Supply Curve: Marginal Cost
Figure 11.5a Swanky’s Supply Curve: Marginal Cost and Average Variable Cost P MC 10 31
MR2 9 25
MR1 7
MR0 17
Shutdown
point s
AVC Q
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Textbook p. 240

21. Figure 11.5b Swanky’s Supply Curve31 25 s 17 7 9 10 Q
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Textbook p. 240

22. The Theory of Competitive Supply
Q: If the firm’s short run supply curve is the MC curve above the AVC curve, what is the industry supply curve?
Short-run industry supply curve is horizontal sum of individual firm supply curves
Example: In the next slide it is assumed that there are 10 firms with identical costs in the competitive industry.

23. Deriving Industry SupplyMC 25
25.00
ATC
AVC
20.00 20
Normal
profit 17
17.00 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
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24. The Theory of Competitive Supply
Equilibrium market price and quantity determined by industry demand and supply curves
In short run, perfectly competitive firms can make economic profit, normal profit (zero economic profit), or suffer economic loss
In short run, number of firms and plant size fixed

25. Figure 11.7 Short-Run EquilibriumP P S MC 25
25.00
ATC 20
20.00
Econ.
loss
Normal
profit 17
17.00 D 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 242

26. Figure 11.7 Short-Run EquilibriumP P S MC
Econ. profit 25
25.00
ATC
Normal
profit 17 D 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
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Textbook p. 242

27. The Theory of Competitive Supply
Q: What happens industry over the long-run?
Economic profits/losses are signals for firms to enter/exit industry ® reallocation of resources
economic profits ® new entry ® rightward shift industry S ® P¯ ® profits¯
economic losses ® existing firms exit ® leftward shift industry S ® ­ P↑ ® losses¯
Long-Run Equilibrium when economic profits = 0
continued

28. Figure 11.8 Entry and Exit P 17 9 SB 20 8 SO SA 30 23 D 10 6 7 10 Q6 7 10 Q
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29. Economic Losses cause firms to exit, which causes supply to decrease (shift in).MC 25
25.00
ATC 20
20.00
Econ.
loss
Normal
profit 17
17.00 D 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 242

30. Economic Profit attracts entry, which causes supply to increase (shift out)MC 25
25.00
ATC 17 D 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 242

31. The Theory of Competitive Supply
In long-run competitive equilibrium
MR = P = MC; firms maximize short-run profits
P = minimum ATC; economic profits are zero; no incentive for firms to enter or exit
P = minimum LRAC; optimum plant size; no incentive for firm to change plant size

32. Figure 11.9 Plant Size and Long-Run Equilibrium
MCo
SRAC0
MC1
LRAC
SRAC1 25 6
MR0
Short-run
profit-maximizing
point 20 8
MR1 m
Long-run
competitive
equilibrium Q
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 245

33. The Theory of Competitive Supply
Q: What happens when changing tastes reduce demand?
demand shifts left ® P ¯
Firms to move down their MC curve and supply less (q ¯) reducing the amount sold in the market (Q ¯).
The lower price also creates losses ® over time, firms exit causing industry supply to decline (shift left)® ­ P
In the long run, enough firms exit so remaining firms earn normal profit (zero economic profit).
continued

34. Impact of a permanent decline in demandS' P P D D' S MC 25
25.00
ATC 20
20.00
Econ.
loss
Normal
profit 17
17.00 7 8 9 Q 7 8 9 Q
(a) Industry
(b) Firm
Copyright © 1997 Addison-Wesley Publishers Ltd.
Textbook p. 242

35. The Theory of Competitive Supply
Q: What happens when technology improves?
firm’s MC and ATC shift down
shift in MC causes Supply to shift down by the same amount as the MC curves shifted down.
Price falls, but costs fall further so that the firm earns economic profits.
Profits attract entry which causes price to fall further, industry output rises, while firm output falls.
continued

36. Impact of a permanent improvement in production technologyS MC 25
ATC 20 17 70 80 90 Q 7 8 9 Q
(a) Industry
(b) Firm
Copyright © 1997 Addison-Wesley Publishers Ltd.
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37. The Theory of Competitive Supply
We have seen how over the long-run the short-run supply relationship can shift because of entry and exit by firms, and because of investment in new plant.
Q: Is there a long-run supply curve that takes into account entry, exit and investment?
Yes, and the shape of this long-run relationship will depend on whether there are external economies or diseconomies of scale.
continued

38. The Theory of Competitive Supply
Q: What are external economies and external diseconomies of scale?
external economies of scale: are factors beyond control of firm that lower costs as industry output ­
external diseconomies of scale: are factors beyond control of firm that raise costs as industry output ­

39. The Theory of Competitive Supply
Q: Example of external diseconomy of scale?
David Ricardo pointed out that as wheat production expanded, more land would have to be pushed into cultivation. This causes the demand for land to rise, which in turn increases the price of land. As land is an important input into wheat production, the average and marginal cost of wheat would rise as output increased.
Implication: The long-run supply curve for wheat would be upward sloping.

40. P 30 23 D 10 6 7 10 Q Short Run Supply Long Run Supply6 7 10 Q
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41. The Theory of Competitive Supply
Q: Example of external economy of scale?
An important cost of business is the cost of manufactured factor inputs. As an industry grows, more and more specialized firms providing these inputs begin to appear. If this creates greater competition, the costs of manufactured inputs can fall driving average and marginal costs down.
Implication: The long-run supply curve for such an industry would be downward sloping.

42. P D Q Short Run Supply Long Run SupplyQ
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43. The Theory of Competitive Supply
Summing Up
Long-run industry supply curve shows how industry quantity supplied varies as market price varies after all possible adjustments, including changes in plant size and number of firms
Shape of long-run industry supply curve depends on the existence of external economies or diseconomies
continued

44. The Theory of Competitive Supply
Long-run industry supply curve is
horizontal for constant cost industry
upward sloping for increasing cost industry with external diseconomies
downward sloping for decreasing cost industry with external economies
continued

45. The Theory of Competitive Supply
Q: What is missing from our theory of supply?
How firms make supply decisions in industries with imperfect competition.
Q: Despite the weakness of the present theory is it useful in attempting to understand and predict supply?
Yes. While very few markets are perfectly competitive, there is often sufficient competition so that the perfectly competitive model can provide a first approximation of behaviour.