SLIDE 1 Economics 2 Professor Christina Romer Spring 2019 Professor David Romer LECTURE 7 COMPETITIVE FIRMS IN THE LONG RUN FEBRUARY 12, 2019 I. A LITTLE MORE ON SHORT-RUN PROFIT-MAXIMIZATION
- A. The condition for short-run profit-maximization
- B. The “horizontal” and “vertical” interpretations of supply curves
- 1. An individual firm’s supply curve
- 2. The industry’s supply curve (and why it’s the industry’s marginal cost curve)
- C. The two-way interaction between individual firms and the market
- II. AVERAGE TOTAL COST AND SHORT-RUN PROFITS
- A. Average total cost (atc)
- B. Graphing atc
- C. atc, price, and profits
- D. Three possible profit scenarios
- III. LONG-RUN PROFIT MAXIMIZATION
- A. Short-run profits as a signal for entry or exit
- B. The impact of entry or exit on the industry supply curve
- C. Long-run equilibrium
- D. Example: A fall in demand
- 1. The immediate effect of the fall in demand
- 2. Profits and entry/ exit
- 3. The new long-run equilibrium
- E. Example: A decrease in cost
- 1. The immediate effect of the fall in demand
- 2. Profits and entry/ exit
- 3. The new long-run equilibrium
- IV. SOME IMPLICATIONS OF LONG-RUN PROFIT-MAXIMIZATION
- A. The long-run industry supply curve
- B. Who enters or exits?
- C. The invisible hand
SLIDE 2 LECTURE 7 Competitive Firms in the Long Run
February 12, 2019
Economics 2 Christina Romer Spring 2019 David Romer
SLIDE 3 Announcements
- Problem Set 2 is being handed out.
- It is due at the beginning of lecture next
Tuesday (Feb. 19).
- The ground rules are the same as on Problem
Set 1.
- Optional problem set work session:
Thursday, 5:00–7:00, in 648 Evans.
- Problem Set 1 is being returned in section this
week.
SLIDE 4 Announcements
- Journal article reading for Thursday (by Edward
Glaeser and Erzo Luttmer):
- Read only the assigned pages.
- Don’t stress over every word or parts you
don’t understand.
- Read for approach and findings; think about
relevance for the consequences of not letting prices adjust.
- Office hours tomorrow are 1:15–3:00.
SLIDE 5
I. A LITTLE MORE ON SHORT-RUN PROFIT-MAXIMIZATION
SLIDE 6
q P mc mr (= PMARKET) q1
The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
A competitive firm produces up to the point where P = mc.
SLIDE 7 q P
Two Interpretations of a Firm’s Supply Curve
s,mc
- It shows the quantity the firm supplies as a function of price
(“horizontal interpretation”).
- It shows the firm’s marginal cost as a function of quantity
(“vertical interpretation”). q1 P1,mc1
SLIDE 8 Two Interpretations of the Market Supply Curve
- The sum of individual firms’ supply curves
(“horizontal” interpretation).
- The industry’s marginal cost curve (“vertical”
interpretation).
SLIDE 9 Q P
The Industry Supply Curve Is the Industry Marginal Cost Curve
S (= MC)
- At P1, each firm produces until mci = P1.
- The total amount produced is the point on the supply curve (Q1).
- So: When the industry is producing Q1, each firm’s m.c. is P1.
- So: P1 is the marginal cost of producing 1 more unit when the
industry is producing Q1. Q1 P1
SLIDE 10
The Two-Way Interaction of Individual Firms and the Market – Example: A Fall in an Input Price
q Q
Market
D1 P1 P P
Individual Firm
mr1 mc1 q1 Q1 mc2 mr2 P2 Q2 q2 S1 S2
SLIDE 11
- II. AVERAGE TOTAL COST AND SHORT-RUN PROFITS
SLIDE 12 Average Total Cost
- Recall:
- Costs are measured as opportunity costs.
- Fixed costs: Costs that do not vary with how
much is produced.
- Variable costs: Costs that do vary with how
much is produced.
- Total cost: The sum of fixed and variable costs.
- Average Total Cost = Total Cost
Quantity
SLIDE 13
Marginal Cost and Average Total Cost
Cost (in $) q mc The mc and atc curves cross at the lowest point of the atc curve. atc
SLIDE 14 atc, Price, and Profits
- Recall:
- Profits = Total Revenue – Total Cost
- Now:
- Total Revenue = P q
- Total Cost = atc q
- So: Profits = (P q) − (atc q)
= (P − atc) q
- So: Profits are positive, negative, or zero depending
- n whether P − atc is positive, negative, or zero.
SLIDE 15 q P mc q1
Revenues, Costs, and Profits
Revenues: Rectangle abef. Costs: abcd. Profits: cdef.
P1 atc1
b c d e f atc mr
SLIDE 16
Negative Economic Profits
q Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc
P1 < atc at q1.
atc1
SLIDE 17
Positive Economic Profits
q Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc
P1 > atc at q1.
atc1
SLIDE 18
Zero Economic Profits
q Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc
P1 = atc at q1.
atc1
SLIDE 19
- III. LONG-RUN PROFIT-MAXIMIZATION
SLIDE 20 The Signals Sent by Profits
- If there are negative profits: Some firms will reduce
the scale of their operations, or exit.
- If there are positive profits: Some firms will expand
the scale of their operations, or new firms will enter.
- Exit moves the industry supply curve to the
left; entry moves it to the right.
- If there are zero profits: There are no forces
tending to cause either contraction or expansion of the industry. In this situation, the industry is in long-run equilibrium.
SLIDE 21
Long-Run Equilibrium
q Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc
SLIDE 22
Fall in Demand (Starting in Long-Run Equilibrium) – Short-Run Effects
q Q
Market
D1 S1 P1 P P
Individual Firm
q1 atc1 D2 P2 mr1 mc1 mr2 q2 Q2 Q1
SLIDE 23
Fall in Demand (Starting in Long-Run Equilibrium) – Long-Run Effects
q Q
Market
D1 S1 P1,3 P P
Individual Firm
q1,3 atc1 D2 P2 mr1,3 mc1 mr2 q2 S3 Q2 Q1 Q3
SLIDE 24
Fall in Marginal Cost (Starting in Long-Run Equilibrium) – Short-Run Effects
q Q
Market
D S1 P1 P P
Individual Firm
mr1 mc1 q1 atc1 atc2 mc2 S2 P2 q2 mr2 Q2 Q1
SLIDE 25
Fall in Marginal Cost (Starting in Long-Run Equilibrium) – Long-Run Effects
q Q
Market
D S1 P1 P P
Individual Firm
mr1 mc1 q1,3 atc1 atc2 mc2 S2 P2 q2 mr2 P3 S3 mr3 Q2 Q1 Q3
SLIDE 26
- IV. SOME IMPLICATIONS OF LONG-RUN
PROFIT MAXIMIZATION
SLIDE 27
The Long-Run Industry Supply Curve
q Q
Market
PLR P P
Individual Firm
SLR q1 atc
The long-run industry supply curve is perfectly elastic at the minimum of atc.
mc
SLIDE 28 Entry and Exit
- “Exit” can take the form of firms reducing their
scale or of firms leaving the industry altogether.
- Likewise, “entry” can take the form of existing
firms increasing their scale or of new firms coming into the industry.
SLIDE 29 The Invisible Hand
- In a market economy, profits provide signals that
move resources across industries to where they are most valued.
- These movements occur without any centralized
planning or direction.
- A corollary: In a well-functioning market economy,
there are always some industries that are expanding and some that are contracting.
- This helps explain why barriers to entry usually
make economists nervous.
