1. CDAE 254 - Class 24 Nov. 15 Last class: 7. Profit maximization and supply Today: 7. Profit maximization and supply 8. Perfectly competitive markets Class exercise Quiz 7 (take-home) Next class: 8. Perfectly competitive markets Important dates: Problem set 6: due today Final exam: 3:30-6:30pm, Tuesday, Dec. 11

2. 7. Profit maximization and supply 7.1. Goals of a firm 7.2. Profit maximization 7.3. Marginal revenue and demand 7.4. Marginal revenue curve 7.5. Alternatives to profit maximization 7.6. Short-run supply 7.7. Applications

3. 7.6. Short-run supply by a price-taking firm (1) Profit maximizing decision: MC = MR = P (2) The firm’s supply (3) Shutdown decision: STC = SFC + SVC If TR < SVC, the company should shut down SAC = SAFC + SAVC i.e., If the price is less than the short-run average variable cost (SAVC), the firm will shut down the production. (4) The firm’s supply curve: SMC above the SAVC

4. 7.6. Short-run supply by a price-taking firm (5) Practice questions according to the graph on the handout (a) Where is the firm’s supply curve (b) What is the break-even production level (c) What is the shutdown price level? (d) What is the total profit at the shutdown price? (e) What is the total profit when P=38? ( f ) What is the total fixed cost?

5. Application: Steel trap U.S. steel firms were very slow in leaving the market Youngstown Sheet & Tube and U.S. Steel Corporation at Youngstown did not close until the late 1970s The next big firm closed in 1982 Steel firms continued to operate aging, inefficient, and unprofitable plants

6. Application: Steel trap Huge cost to close a steel firm: pay to dismantle mill and terminate contracts union contracts: – pay to workers after the firm is closed – supplemental unemployment benefits – payments to cover additional future pensions and insurance – generally, union members eligible for pensions when age + years of service = 75 – workers laid off due to plant closings are eligible for a pension when age + years of service = 70

7. Application: Steel trap The estimated costs to close a steel firm in the U.S.: $650 million ($415 million labor related or $37,000 per laid-off worker) in 1979 Have increased at least 45% since then

8. Application: Steel trap Because they avoided shutting down since 1970s, U.S. steel mills sold some products at prices below AC or even AVC For example: In 1986: – AVC of hot-rolled sheets per ton = $305 – AC = $406 – price = $273

9. Application: Steel trap International trade and policy: -- New import tax on steel products in Feb. 2002 -- Reactions from steel exporters -- Debate under WTO

10. 8. Perfect competitive markets 8.1. Basic concepts 8.2. Supply in the very short run 8.3. Short-run supply 8.4. Short-run price determination 8.5. Shifts in supply and demand curves 8.6. Long-run supply 8.7. Applications

11. 8.1. Basic concepts (1) An overview of an economy (2) Market structures -- Perfectly competitive market -- Monopoly -- Oligopoly (3) Supply response: The change in quantity of output in response to a change in demand conditions. (4) Very short run, short run, and long run

12. 8.2. Supply in the very short run (1) A graphical analysis (Fig. 8.1) (2) Market equilibrium (3) Impact of a shift in demand (4) Impact of trade, inventories, and government interventions

13. 8.3. Short-run supply (1) Short-run: The number of firm is fixed but the existing firms can change their output levels in response to changes in the market. (2) Supply curve: Relationship between market price and quantity supplied. (3) Short-run supply curve of an individual firm: SMC above the SAVC (Ch. 7). (4) Short-run supply curve in a market (Fig. 8.2) For example, there are only two firms in a market: q a = - 2 + 0.5P, q b = -6 + 1 P (5) Notations

14. 8.3. Short-run supply (6) Short-run elasticity of supply (a) Recall our general definition of elasticity Elasticity of Y with respect to X = (b) Short-run supply elasticity =

15. 8.3. Short-run supply (6) Short-run elasticity of supply (c) Estimation of supply elasticities: -- From two observations For example: the supply in the market increased from 100 to 120 units when the price increased from $2.0 to $2.6. What is the supply elasticity? -- From a supply function: For example: Q = -10 + 0.6P, what is the supply elasticity when P = 40?

16. 8.4. Short-run price determination (Fig. 8.3) (1) Supply and demand in a market (2) Market equilibrium (3) An example (4) Effect of an increase in market demand