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University of Queensland Lecture 6 Semester 2 2013 Introductory Microeconomics Law of Supply and Diminishing Returns
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Lecture 6
ECON1010
Introductory Microeconomics
David Ricardo (1772-1823):The Law of Diminishing Returns
• “On the Principles of Political Economy and Taxation”;
• “Essay on the Influence of a Low Price of Corn on the Profits of Stock”;
AVC
Q
ATC
The Law of Supply Revisited
MC
The Law of Supply Revisited
Output rule: Firms choose the level of production such that MC=P (PROFIT MAXIMIZATION);
Short-run Shutdown rule: firms shutdown operations if P<AVC;
Profitability and long-run analysis.
Questions
Total Cost = 25 x 6 = 150
Profit = 250 – 150 = 100
Q
ATC
Profitability
P =10
MC
Q = 25
ATC=6
ATC
MC
p
q
p
Q
p*
Individual Market
D
S
q* Q*
Individual Seller/ Market S and D
Long Run Perfect Competition
Short-run Competition:• Individual Seller –vs- Market Supply; (Infinitely) Many
sellers (price takers)
• Individual Buyer –vs- Market Demand - (Infinitely) Many buyers (price takers)
• Homogeneous good
Long Run competition:• No barriers to entry/exit for firms• There may be fixed costs of production, but no barriers in terms of
information, technology/knowledge adoption, or costs associated with entry or exit
The function of price in the long-run
Short-run Competition:• If price is at its equilibrium then we have market
clearing;
• Price has a rationing function (distribute a scarce good among potential claimants);
Long Run competition:• If price is at its equilibrium then there are no profits to
be made;
• In this case the price has an allocative function (it directs resources towards sectors with higher profitability!)
Example: 10 Sellers, each with supply q = 2p
Market supply:
Q = 10(2p) = 20p
Sum of individual supply curves.
Where does each individual supply curve comefrom?
Individual seller vs the Market
p
Q
Market
S= 20p
P=4
Individual seller: q = 2p
p
Q
D
q = 2p
q = 8
P=4
P=10
Example: 20 buyers, each with demand q = 10 – p
Market demand:
Q = 20(10 - p) = 200 – 20p
Sum of individual demand curves.
Where does each individual demand curve comefrom?
Individual buyer vs the Market
p
Q
Market
D
120 200
P=4
P=10
Individual buyer: q = 10 - p
p
q
S
q = 10-p
q = 6
P=4
P=10
Short run equilibrium and profits
There are 3 possible cases:
1. P>ATC: positive profits;
2. P=ATC: zero profits;
3. P<ATC: negative profits;
ATC
MC
p
q
p
Q
p*
Individual Firm Market
D
S
q* Q*
Case 1: Profit is positive since P > ATC
ATC
ATC
MC
p
q
p
Q
Individual Firm Market
D
S
q* Q*
p*=ATC
Case 2: Profit is zero since P = ATC
ATC
MC
p
q
p
Q
Individual Firm Market
D
S
q* Q*
ATC
p*
Case 3: Profit is negative since P < ATC
Questions
Long Run Perfect Competition
1. Firms can change all inputs (also fixed assets). All costs are variable costs.
2. Free entry and exit of firms (at no cost).
3. All firms can copy technology freely (they all use the same technology).
Implications:
All firms will use the same cost minimising technology, and economic profits will be driven to zero.
A Long run competitive equilibrium (LRCE) is a competitive
Equilibrium where firm’s profit is zero (P = ATC).
Long Run Competitive Equilibrium with U-Shaped ATCThe quantity supplied is chosen such that:
1. P=MC (Profit maximization, firm’s motivation);
2. P=ATC (Zero profit, long-run market outcome);
1 and 2 together imply that each seller chooses q such that: MC=ATC;
In other words they produce the quantity which minimizes ATC! This is optimal in aggregate (though firms would like to make positive profits and seek for it explicitly)
Adam Smith invisible hand
The invisible hand is the metaphor used to describe the self-regulating behaviour of competitive markets.
Even if individual seek for surplus maximization (profits) for their own good, the outcome of the market will benefit society.
This is true even if the individuals have no benevolent intentions (i.e. their aim is to maximize their individual suprlus, not the surplus of society).
Describing a Long Run Competitive Equilibrium:
AC
MCp
q
p
Q
p*
Individual SellerMarket
D
S
q* Q*
How firms respond to profits and losses?
For example, assume a demand shift due to population growth.
What happens to the long run equilibrium and to the firm profits?
Demand curve shifts out due to Population Growth
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
DN
Short run effects
In the short run a shift of the demand curve (with a fixed supply curve) will increase the short run equilibrium price and quantity.
This will create positive profits for the firms!
Short run effects: P↑ , q ↑,Q ↑, profit ↑
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
DN
pN
qN QN
Long Run Effects
• The positive profits are a strong incentive for new firms to enter the market (information, entry costs, technology/knowledge).
• This will shift the market supply curve to the right (out) while the number of supplier on the market increases.
• Profit will fall back to zero.
Long Run Effects
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
DN
SN
QN
New long run competitive equilibrium
• Profits are zero;
• Supply satisfy the new demand;
• PRICE IS THE SAME! (ATC=P) WHY?
• All changes are absorbed into a quantity effect (rising consumption);
IMPLICATION: the long run supply curve is perfectly elastic!
Long run supply curve is perfectly elastic
p
Q
Market
D
S
Q*
DN
QN
P=ATC
How firms respond to profits and losses?
For example, assume a demand shift due to a reduction in the price of a substitute.
What happens to the long run equilibrium and to the firms profits?
Demand curve shifts to the left due to cross-price elasticity
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
D
Demand curve shifts left due to cross-price elasticity
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
D
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
D
S
Demand curve shifts to the left due to cross-price elasticity
Long run supply curve is perfectly elastic
p
Q
Market
D
S
Q*
DN
QN
P=ATC
How firms respond to profits and losses?
For example, assume that a new technology reduces the average cost of production at the firm level.
What happens to the long run equilibrium and to the firms profits?
Change in costs
AC
MCp
q
p
Q
p*
One SellerMarket
D
S
q* Q*
D
Change in costs
AC
MCp
q
p
Q
p*
One SellerMarket
S
q* Q*
D
Change in costs
AC
MCp
q
p
Q
p*
One SellerMarket
S
q* Q*
D
Long run supply curve is perfectly elastic: the cost saving benefit of technology improvement is passed to the consumers!!!
p
Q
Market
D
S
Q* QN
P*=ATC
P=ATC S
Long Run Summary
In the long run (with free entry), the supply curve for the market is perfectly elastic.
Long run response to an increase in demand is to have new entrants. However, each new entrant produces the “q” where ATC = MC.
In the long run burden of tax falls on Buyers only (perfectly elastic supply)
Cost reducing innovations are passed onto the consumers as well.
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