Economics 2 Professor Christina Romer Spring 2020 Professor David - PDF document

Economics 2 Professor Christina Romer Spring 2020 Professor David Romer LECTURE 7 COMPETITIVE FIRMS IN THE LONG RUN FEBRUARY 11, 2020 I. A L ITTLE M ORE ON S HORT -R UN P ROFIT -M AXIMIZATION 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 C. The two-way interaction between individual firms and the market II. A VERAGE T OTAL C OST AND S HORT -R UN P ROFITS A. Average total cost (atc) B. Graphing atc C. atc, price, and profits D. Three possible profit scenarios III. L ONG -R UN P ROFIT M AXIMIZATION 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 IV. E XAMPLES A. A fall in demand 1. The immediate effect of the fall in demand 2. Profits and entry/exit 3. The new long-run equilibrium B. A decrease in cost 1. The immediate effect of the fall in demand 2. Profits and entry/exit 3. The new long-run equilibrium C. Discussion 1. Who enters or exits? 2. The invisible hand

Economics 2 Christina Romer Spring 2020 David Romer L ECTURE 7 Competitive Firms in the Long Run February 11, 2020

Announcements • Problem Set 2 is being handed out. • It is due at the beginning of lecture next Tuesday (Feb. 18). • The ground rules are the same as on Problem Set 1. • Optional problem set work session: Thursday, Feb. 13 th , 4–6 p.m., 648 Evans Hall. • Problem Set 1 is being returned in section this week.

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.

Announcements • Beware of the phone-eating seats in this classroom! • Campus Lost and Found is in the basement of Sproul Hall.

I. A L ITTLE M ORE ON S HORT -R UN P ROFIT -M AXIMIZATION

The Profit-Maximizing Level of Output for a Perfectly Competitive Firm P mc mr (= P MARKET ) q 1 q A competitive firm produces up to the point where P = mc.

Two Interpretations of a Firm’s Supply Curve P mc mr (= P MARKET ) q 1 q • 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”).

Two Interpretations of the Market Supply Curve • The sum of individual firms’ supply curves (“horizontal” interpretation). • The industry’s marginal cost curve (“vertical” interpretation).

The Two-Way Interaction of Individual Firms and the Market – Example: A Fall in an Input Price Market Individual Firm P P S 1 mc 1 mc 2 S 2 mr 1 P 1 P 2 mr 2 D 1 q 1 q 2 q Q 1 Q Q 2

II. A VERAGE T OTAL C OST AND S HORT -R UN P ROFITS

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

Marginal Cost and Average Total Cost Cost (in $) mc atc q The mc and atc curves cross at the lowest point of the atc curve.

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 on whether P − atc is positive, negative, or zero.

Aside: “Average Revenue” • If we want, we can define Total Revenue Average Revenue = Quantity • But, since total revenue is price times quantity (P q), average revenue is just price (P q/q = P). • •

Revenues, Costs, and Profits P mc atc f e P 1 mr • • atc 1 • • d c a b • • q q 1 Revenues: Rectangle abef. Costs: abcd. Profits: cdef.

Negative Economic Profits Market Individual Firm P P S mc atc atc 1 P 1 mr D q q 1 Q P 1 < atc at q 1 .

Positive Economic Profits Market Individual Firm P P mc S atc P 1 mr atc 1 D q q 1 Q P 1 > atc at q 1 .

Zero Economic Profits Market Individual Firm P P S mc atc P 1 mr atc 1 D q q 1 Q P 1 = atc at q 1 .

III. L ONG -R UN P ROFIT - MAXIMIZATION

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.

Long-Run Equilibrium Market Individual Firm P P S mc atc P 1 mr D q q 1 Q

IV. E XAMPLES

Fall in Demand (Starting in Long-Run Equilibrium) Short-Run Effects Market Individual Firm P P mc 1 atc 1 S 1 P 1 mr 1 P 2 mr 2 D 1 D 2 q q 2 q 1 Q 2 Q 1 Q

Fall in Demand (Starting in Long-Run Equilibrium) Long-Run Effects Market Individual Firm P P S 3 mc 1 atc 1 S 1 P 1,3 mr 1,3 P 2 mr 2 D 1 D 2 q q 2 q 1,3 Q 2 Q 1 Q Q 3

Fall in Marginal Cost (Starting in LR Equilibrium) Short-Run Effects Market Individual Firm P P S 1 mc 1 atc 1 S 2 mc 2 atc 2 P 1 mr 1 P 2 mr 2 D q 1 q 2 Q 2 Q Q 1 q

Fall in Marginal Cost (Starting in LR Equilibrium) Long-Run Effects Market Individual Firm P P S 1 mc 1 atc 1 S 2 mc 2 atc 2 S 3 P 1 mr 1 P 2 mr 2 P 3 mr 3 D q 1,3 q 2 Q 2 Q Q 1 Q 3 q

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.

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.