SLIDE 1 Economics 2 Professor Christina Romer Spring 2020 Professor David Romer LECTURE 7 COMPETITIVE FIRMS IN THE LONG RUN FEBRUARY 11, 2020 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
- 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
- IV. EXAMPLES
- 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
SLIDE 2 LECTURE 7 Competitive Firms in the Long Run
February 11, 2020
Economics 2 Christina Romer Spring 2020 David Romer
SLIDE 3 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. 13th, 4–6 p.m., 648 Evans Hall.
- 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.
SLIDE 5 Announcements
- Beware of the phone-eating seats in this
classroom!
- Campus Lost and Found is in the basement of
Sproul Hall.
SLIDE 6
I. A LITTLE MORE ON SHORT-RUN PROFIT-MAXIMIZATION
SLIDE 7
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 8 Two Interpretations of a Firm’s Supply Curve
- 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”).
mc q P mr (= PMARKET) q1
SLIDE 9 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 10
The Two-Way Interaction of Individual Firms and the Market – Example: A Fall in an Input Price
q P
Individual Firm
mr1 mc1 q1 mc2 mr2 q2 Q1 S1 Q
Market
D1 P1 P P2 Q2 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 The mc and atc curves cross at the lowest point of the atc curve. atc mc
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 Aside: “Average Revenue”
- If we want, we can define
Average Revenue =
- But, since total revenue is price times quantity
(P q), average revenue is just price (P q/q = P). Total Revenue Quantity
SLIDE 16 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 17
Negative Economic Profits
q
P1 < atc at q1.
Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc atc1
SLIDE 18
Positive Economic Profits
q
P1 > atc at q1.
Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc atc1
SLIDE 19
Zero Economic Profits
q
P1 = atc at q1.
Q
Market
D S P1 P P
Individual Firm
mr mc q1 atc atc1
SLIDE 20
- III. LONG-RUN PROFIT-MAXIMIZATION
SLIDE 21 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 22
Long-Run Equilibrium
q P
Individual Firm
mr mc q1 atc Q
Market
D S P1 P
SLIDE 24
Fall in Demand (Starting in Long-Run Equilibrium) Short-Run Effects
q mr1 P
Individual Firm
q1 atc1 mc1 mr2 q2 D2 P2 Q
Market
D1 S1 P1 P Q2 Q1
SLIDE 25
Fall in Demand (Starting in Long-Run Equilibrium) Long-Run Effects
q mc1 P
Individual Firm
q1,3 atc1 mr1,3 mr2 q2 D2 Q2 Q1 S3 Q
Market
D1 S1 P1,3 P P2 Q3
SLIDE 26
Fall in Marginal Cost (Starting in LR Equilibrium) Short-Run Effects
q mr2 atc2 mc2 P
Individual Firm
mr1 mc1 q1 atc1 q2 Q2 P2 Q1 Q
Market
D S1 P1 P S2
SLIDE 27
Fall in Marginal Cost (Starting in LR Equilibrium) Long-Run Effects
q mr2 atc2 mc2 P
Individual Firm
mr1 mc1 q1,3 atc1 q2 mr3 Q2 P2 Q1 Q
Market
D S1 P1 P S2 P3 S3 Q3
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.
