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
Demand
Supply
Supply
(Topic 1)
(Topic 2)
(Topic 3) (Topic 4)
(Topic 5 = Structure and efficiency)
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.
Robin Naylor, Department of Economics, Warwick
3
Topic 3 : Lecture 16Perfect 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:
Robin Naylor, Department of Economics, Warwick
4
Topic 3 : Lecture 16Perfect competition
Consider the individual firm i:
x
p
pc pc = d
The firm is a price-taker at the market price. Demand is perfectly elastic.
Robin Naylor, Department of Economics, Warwick
5
Topic 3 : Lecture 16Perfect competition
x
p
pc
Recall that:
.dp
MR p XdX
pc = 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.
Robin Naylor, Department of Economics, Warwick
6
Topic 3 Lecture 16
p SMC
SAVC
xWhat is the firm’s chosen output level?
SATC
pc = d = mr pc
This diagram is the same as that in Lecture 15 Slide 2, except that we now have d=mr=p as perfectly elastic.
Robin Naylor, Department of Economics, Warwick
7
Topic 3 Lecture 16
p
SAVC
xSuppose market price rises: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?
SATC
pc = d = mr pc
SMC
Robin Naylor, Department of Economics, Warwick
8
Topic 3 Lecture 16
p
SAVC
xSuppose market price falls: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?
SATC
pc = d = mr pc
SMC
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
pc = d = mr pc
Robin Naylor, Department of Economics, Warwick
10
Topic 3 : Lecture 16Perfect competition
Now consider the long run and also where market price comes from:
x
pc
pc = d = mr
p S
D
X
Market price is where market supply meets market demand.
Market demand is exogenous.
What determines market supply?
p
Xc
The market price determines the demand curve faced by the individual firm.
And hence also mr.
Robin Naylor, Department of Economics, Warwick
11
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p S
D
X
Can you say where this market supply curve, S, comes from?
p
Xc
lmc = s lac
Here we add the firm’s cost curves (and hence its supply curve): for the long run.
Robin Naylor, Department of Economics, Warwick
12
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p
D
X
p
Xc = nx*
lmc = s lac
x*
1
n
i iS lmc
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’.
Robin Naylor, Department of Economics, Warwick
13
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p
D
X
p
Xc = nx*
lmc = s lac
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*
1
n
i iS lmc
Suppose there is an (exogenous) increase in the level of market demand.
Robin Naylor, Department of Economics, Warwick
14
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmc = s lac
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*
1
n
i iS lmc
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?
Robin Naylor, Department of Economics, Warwick
15
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmc = s lac
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*
1
n
i iS lmc
D
New firms will enter the industry (why?). How do we show this in the diagram?
Robin Naylor, Department of Economics, Warwick
16
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmc = s lac
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?)
1
n
i iS lmc
Xc = (n+E)x*
Robin Naylor, Department of Economics, Warwick
17
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmc = s lac
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.
1
n
i iS lmc
Xc = (n+E)x*
Robin Naylor, Department of Economics, Warwick
18
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmc = s lac
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.
1
n
i iS lmc
Xc = (n+E)x*
LRSS
Robin Naylor, Department of Economics, Warwick
19
Topic 3 : Lecture 16Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc
lmci = s lac
xi
D
1
n
i iS lmc
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.
Robin Naylor, Department of Economics, Warwick
20
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc
lac
D
New firms enter: the number is now n+E. Could this be the new equilibrium?
1
n
i iS lmc
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?
lmci = s
xi
ab
Robin Naylor, Department of Economics, Warwick
21
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmci,j = s laci
x*
D
Point ‘b’ will be an equilibrium if . . . ? And so the LRSS is where?
1
n
i iS lmc
Xc = (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?
ab
lacj
Robin Naylor, Department of Economics, Warwick
22
Topic 3 : Lecture 16
1
n E
i iS lmc
Perfect competition
x
pc pc = d = mr
p
D’
X
p
Xc = nx*
lmci,j = s laci
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)?
1
n
i iS lmc
Xc = (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?
ab
lacj
Robin Naylor, Department of Economics, Warwick
Topic 2: Lecture 16
23
Now read B&B 4th 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).