ECO 365 – Intermediate Microeconomics

1. ECO 365 – Intermediate Microeconomics Lecture Notes

2. Firm Supply in Competitive Markets • Market Environment: ways firms interact in making pricing and output decisions. • Possibilities: (1) Perfect Competition (2) Monopoly (3) Oligopoly (4) Imperfect Competition (monopolistic) • In P.C. p=fixed for the producer • Why? => small firms, identical products, large number of firms • Examples

3. P S • Firms are price takers at market prices D market Don’t usually worry about p < p* since these firms are typically smaller and can’t produce much O OR P df P* P* D market y y

4. The firm’s problem is to max  = py - c(y) • Is this a long run or a short run problem? • ∆R = p ∆ y + ∆ p y => ∆R/ ∆y = p = MR • But p = MR • Why? • ∆C/ ∆ y = MC • Choose to produce where MR=MC • Why does this make sense?

5. P mc • Exceptions to the Rule • A= point of  minimization • Why? • MC downward sloping => increasing y, decreasing mc => • Decreasing C MR=>  increases as y increases • B= point of  maximization B A Df P* Y

6. (1) any movement from A increases  • (2) any movement from B decreases  • Idea of second order conditions • What does that mean? • First order conditions : MR=MC • Second order condtions: slope of MC > 0 • Or slope of MC > Slope of MR = o • => B is the correct point

7. 2nd Exception—Shut Down • Short-Run: if shut down => lose fixed costs (F) • When is this better than operating? •  = -F if y =0 •  = py – Cv (y) – F if y>0 • So if –F > py – Cv(y) – F => shutdown or • Cv(y) > py • Or Cv(y)/(y) > p or p < AVC => shutdown • Similarly in the Long Run:  = 0 if shutdown •  = py – C(y) or p < AC

8. AC p • A= Short Run shut down point • B = Long Run shut down point AVC B A Y

9. $ MC LRAC A y • A = LR shut-down point • Short Run Supply = portion of MC • Above point A in 1st graph • Also LR Supply = portion of LRMC above LRAC • loss minimization

10. p Profit (graphically) MC AC AVC P* Df y • Also Inverse Supply • 2 Choices: • Ps = S (y) • y= S (P) y*

11. Profit = the shaded area in the graph • =p*y* - AC(y*) y* • TR TC • Since AC(y*) = TC(y*)/y* • Now more carefully define producer surplus. • Recall: p Producer surplus S P* y* Y

12. p p P* MC MC AC AC Y y* Y y* P* AVC AVC • Producer Surplus = the shaded area in the graph • Why are the two graphs equivalent?

13. Why is Producer’s Surplus relevant if profit matters? • In SR must be true that ∆PS=∆ • Why? Fixed costs don’t change as y changes in SR • L-R Supply Curve • S-R Supply Curve = MC above AVC • Where MR=MC P= MC (y, k) – k is fixed • L-R Supply Curve = same with K variable • => where MR = MC • P = MC (y, k(y)) • K is optimal

14. Lmc • In L-R  > 0 or Py – C(y) > 0 • Or p > c(y)/y or P > ATC $ LR Supply Constant Returns to Scale L atc $ L atc = Lmc Cmin y What is LR Supply? y

15. Relationship between long-run and short-run supply curve for a given firm is given by: SSR p SLR Y1 Y

16. Why would SLR be more elastic (more responsive to price changes)? • Can change both K & L optimally in the L-R => • Increase y at lower cost beyond y1 in the LR • Note: (Producer Surplus)LR = LR since all inputs are variable.

17. p p • In the short-run, firms can be found with 3 different situations where y > 0. MC MC AC AC AVC AVC P* P* Df Df y y 1) π > 0, y > 0 2) π = 0, y > 0 y* y*

18. p • What is the short-run industry supply? • S = Σ Si (P) = Σ MCi for all i firms. • Recall that firm short-run supply = firm’s MC curve above AVC. MC AC 3) π < 0, y > 0; why is y>0? AVC P* y Df y*

19. Long-Run Equilibrium in Perfect Competition • No fixed inputs. • Free entry and exit. • Consider firms of type 3 above ( π < 0 but p > AVC) who still produce in short-run. What happens? • No fixed costs => observe exit in the market and π rises to zero. • Consider firms of type 1 above (π > 0). What happens? • The positive π serves as a signal to other firms to enter => π falls to zero. • The long equilibrium occurs where π equals 0. • What does this look like, assuming all firms have the same costs?

20. p • Notice that y* must occur where LRAC is at its minimum. Why? • Also p* = C(y*) => π = 0. MC LRAC=AVC P* y Df y*

21. What does LR industry supply curve look like if firms are large relative to the market? • Assume that all firms are the same => industry supply in SR = Σ MCi = nMC; where i=n (i.e., n = the the total number of firms. • Suppose that there are 4 possible firms then get: S1 p S2 S3 S4 P* D1 Y

22. Notice that equilibrium p and y is given by the lowest possible price where p1 ≥ p* and y* is at that intersection. • Thus, if D = D1 then p = p1 and Y = Y1 • If D = D2 the p = p1 and Y = Y2 S1 D2 D1 Y2 p S2 S3 Y1 S4 P1 P* Y

23. With large plants then long-run supply looks like: S1 p S2 S3 S4 • P* = the minimum LRAC. • The above is with only 4 firms total. P* Y

24. What if firms are all very small with respect to the market? p SLR = min LRAC P* Y

25. Taxes • The graph below shows the SLR both before and after a tax is imposed. p SLR before tax SLR after tax P*+ tax tax P* Y

26. Where is the equilibrium? • For that must have Demand and SSR SSR SSR p SLR before tax P1 SLR after tax P*+ tax tax D P* • Short-run Equilibrium is at P1 therefore, both firms and consumers pay tax. • Long-run Equilibrium is at P* + tax therefore only consumers pay tax in long-run. Y

27. Before assumed that costs were constant with entry. • Is that a reasonable assumption? p p SLR = min LRAC SLR = min LRAC P* P* Increasing costs with entry Decreasing costs with entry Y Y

28. Economic Rent • Suppose that we look at the rent earned by a highly paid sports or entertainment individual. • Do D and S still determine price? • Yes. S p P* D Y

29. D and S still determine price but what economic rent is the player getting? • That is, due to a talent restriction, there is no free entry for the players. • Can profit be driven to zero under these conditions? • Suppose fixed supply of Peyton Manning and his opportunity cost = $100,000 but his MP in football = $10 m. • Profits are driven to zero just for the firm producing the product (i.e., NFL team). • The economic rent is the payment for the fixed factor(s) = total fixed costs. • What is rent seeking behavior?

30. What affects the size of the rent? • Depends upon the fixed supply for the talent market (Peyton Manning) and the no-talent market (me). S S p p P* D D Talent Market NoTalent Market Y Y

31. Final notes on Perfect Competion • Assume that we generally having an increasing cost industry with an upward sloping long-run industry supply. • This leads to an equilibrium that is allocatively efficient. • One that maximizes net surplus (i.e., MSB = MSC or no deadweight losses). p S=MSC P* D=MSB Y Y*