1. Robin Naylor, Department of Economics, Warwick 1 Topic 3 Product Markets: Lecture 16 The circular flow model Agent: Households Market: Goods/Services Market: Inputs Agent: Firms Demand Supply (Topic 1) (Topic 2) (Topic 3) (Topic 4) (Topic 5 = Structure and efficiency)

2. Robin Naylor, Department of Economics, Warwick 2 Topic 3 : Lecture 16 Markets differ by nature/extent of competition. So far, we have assumed (at least implicitly) that there is just one firm in the market, confronting the entire market demand: a monopolist. Now consider the extreme opposite case of ‘perfect competition’ – then we’ll look at perhaps more realistic intermediate cases.

3. Robin Naylor, Department of Economics, Warwick 3 Topic 3 : Lecture 16 Perfect competition All (the very many) firms are assumed identical and will set the same price (each is a price-taker) because: a firm cannot charge more than the competitive market price (assuming homogeneous goods and perfect information) a firm cannot charge less than the market price (free entry means that all firms will just break even at the market price) each firm is so ‘small’ it does not affect market price. Hence:

4. Robin Naylor, Department of Economics, Warwick 4 Topic 3 : Lecture 16 Perfect competition Consider the individual firm i: x p pcpc p c = d The firm is a price-taker at the market price. Demand is perfectly elastic.

5. Robin Naylor, Department of Economics, Warwick 5 Topic 3 : Lecture 16 Perfect competition x p pcpc p c = d = mr Because the firm does not have to reduce price to sell an extra unit (because it is so ‘small’), the marginal revenue is equal to price. Hence, p = d = mr.

6. Robin Naylor, Department of Economics, Warwick 6 Topic 3 Lecture 16 p SMC SAVC x What is the firm’s chosen output level? SATC p c = d = mrpcpc This diagram is the same as that in Lecture 15 Slide 2, except that we now have d=mr=p as perfectly elastic.

7. Robin Naylor, Department of Economics, Warwick 7 Topic 3 Lecture 16 p SAVC x Suppose market price rises: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve? SATC p c = d = mr pcpc SMC

8. Robin Naylor, Department of Economics, Warwick 8 Topic 3 Lecture 16 p SAVC x Suppose market price falls: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve? SATC p c = d = mr pcpc SMC

9. Robin Naylor, Department of Economics, Warwick 9 Topic 3 Lecture 16 p SMC = s SAVC x Suppose market price falls further: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve? SATC p c = d = mrpcpc

10. Robin Naylor, Department of Economics, Warwick 10 Topic 3 : Lecture 16 Perfect competition Now consider the long run and also where market price comes from: x pcpc p c = d = mr pS D X Market price is where market supply meets market demand. Market demand is exogenous. What determines market supply? p XcXc The market price determines the demand curve faced by the individual firm. And hence also mr.

11. Robin Naylor, Department of Economics, Warwick 11 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr pS D X Can you say where this market supply curve, S, comes from? p XcXc lmc = slac Here we add the firm’s cost curves (and hence its supply curve): for the long run.

12. Robin Naylor, Department of Economics, Warwick 12 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D X p X c = nx* lmc = slac x* This is the long-run industry supply curve for a fixed number of firms, n. This industry is in equilibrium: why? Define and Explain Recall that we are assuming that all firms are identical. So this is the ‘representative firm’.

13. Robin Naylor, Department of Economics, Warwick 13 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D X p X c = nx* lmc = slac We now want to derive the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* Suppose there is an (exogenous) increase in the level of market demand.

14. Robin Naylor, Department of Economics, Warwick 14 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc = slac We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* D The initial effect is that market price will rise so that supply by the n firms is equal to demand. Each firm is producing increased output. What can you say about profits? And industry equilibrium?

15. Robin Naylor, Department of Economics, Warwick 15 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc = slac We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* D New firms will enter the industry (why?). How do we show this in the diagram?

16. Robin Naylor, Department of Economics, Warwick 16 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc = slac We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* D New firms enter the industry. Where does this process take us? (What are we assuming about new firms and about industry costs?) X c = (n+E)x*

17. Robin Naylor, Department of Economics, Warwick 17 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc = slac We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* D So, in the new equilibrium following the increase in demand: market output is higher; price is unchanged; each of the original firms has returned to its original actions, there are more firms. X c = (n+E)x*

18. Robin Naylor, Department of Economics, Warwick 18 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc = slac We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand. x* D What does the long-run industry supply curve look like? It is perfectly elastic. Essentially, this is because new firms can enter the market without needing the market price to remain higher than at the initial equilibrium. X c = (n+E)x* LRSS

19. Robin Naylor, Department of Economics, Warwick 19 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p XcXc lmc i = slac xixi D What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents? Originally, there is a marginal firm, i, which just breaks even. Then demand shifts and each of the original n firms raises output. So firm i now makes a supernormal profit. Then what happens? We are assuming that firms are not equally efficient. So this is the ‘marginal firm,’ initially.

20. Robin Naylor, Department of Economics, Warwick 20 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p XcXc lac D New firms enter: the number is now n+E. Could this be the new equilibrium? LRSS?? What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents? lmc i = s xixi a b

21. Robin Naylor, Department of Economics, Warwick 21 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc i,j = s lac i x* D Point ‘b’ will be an equilibrium if... ? And so the LRSS is where? X c = (n+E)x* LRSS?? What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents? a b lac j

22. Robin Naylor, Department of Economics, Warwick 22 Topic 3 : Lecture 16 Perfect competition x pcpc p c = d = mr p D’ X p X c = nx* lmc i,j = s lac i x* D Point ‘b’ will be an equilibrium if... ? And so the LRSS is where? And the intuition? What else would make the long-run industry supply curve upward-sloping (imperfectly elastic)? X c = (n+E)x* LRSS?? What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents? a b lac j

23. Robin Naylor, Department of Economics, Warwick Topic 2: Lecture 16 23 Now read B&B 4 th Ed., pp. 328-341, 345-352, 353-366. Note that in B&B (eg p. 337) a distinction is drawn between 2 types of short-run fixed cost: Sunk Fixed Costs and Non-sunk Fixed Costs. I’m not making that distinction in lectures as, for simplicity, I’m assuming that all Fixed Costs are Sunk (i.e., unavoidable even if output is zero).