MBA201a: Entry, Exit & Equilibrium

1. MBA201a: Entry, Exit & Equilibrium

2. Basic definitions & principles (I) • In the short run (SR), • for an individual firm, many costs are sunk, and • for an entire industry, the number of firms is fixed. • In the long run (LR), • everything is variable: production process within a firm and the number of firms. MBA201a - Fall 2009

3. Basic definitions & principles (II) • Profit maximization implies the following decision rules: • In the short run: • Produce at the quantity level where MR=MC*, so long as your revenues cover your variable costs. • Otherwise, exit. • In the long run: • Enter markets or expand capacity as long as your incremental revenues will cover your incremental total costs. • Stay in the market as long as you continue to cover your total costs. • Exit if you can no longer cover your total costs. * Remember that MR=P for a price-taking firm (aka a firm in a perfectly competitive industry). MBA201a - Fall 2009

4. LR vs. SR example: Recall the t-shirt factory • To produce T-shirts: • Lease one machine at $20 / week. • Machine requires one worker. • The machine, operated by the worker, produces one T-shirt per hour. • Worker is paid $1/hour on weekdays (up to 40 hours), $2/hour on Saturdays (up to 8 hours), $3 on Sundays (up to 8 hours). MBA201a - Fall 2009

5. T-shirt factory cost curves Cost ($) MC 3 2 ATC 1.5 1 48 T-shirts 10 20 30 40 50 MBA201a - Fall 2009

6. T-shirt factory cost curves Cost ($) MC 3 2 ATC 1.5 AVC 1 48 T-shirts 10 20 30 40 50 MBA201a - Fall 2009

7. Short versus long run • It’s Monday morning. The weekly machine lease has been paid. p=$1.3. Should the factory shut down? • It’s Friday afternoon. Should it pay for next week’s lease? MBA201a - Fall 2009

8. SR pricing & LR profitability Cost AC p2 MC/AVC p1 D1 qcap MBA201a - Fall 2009

9. SR pricing & LR profitability Cost AC p2 MC/AVC p1 qcap In industries with low MC/high fixed costs, market pressures may produce prices that are highly volatile. MBA201a - Fall 2009

10. Cost MC market price Entry/expansion & exit • Say you: • observe the market price, • know your costs would look something like the curves on the graph. • Would you want to get into this industry? ATC Q MBA201a - Fall 2009

11. Entry/expansion & exit Cost • Say you: • observe the market price, • know your costs would look something like the curves on the graph. • Would you want to get into this industry? MC ATC market price Q MBA201a - Fall 2009

12. market price Entry/expansion & exit Cost ($) • Say you: • observe the market price, • know your costs would look something like the curves on the graph. • Would you want to get into this industry? • Would you want to stay in the industry if you were already in it? MC ATC Q MBA201a - Fall 2009

13. Constructing the industry supply curve Recall that the industry supply curve is the sum of individual firm’s supply curves: Firm A Firm B Industry P P P 180 100 Q Q Q 10 100 30 10 100 130 MBA201a - Fall 2009

14. Entry and the industry supply curve Imagine that a firm identical to Firm A enters the industry. 2xFirm A Firm B Industry P P P Supply Curve with Firm A & Firm B 180 100 Supply Curve with 2 Firm A’s & Firm B Q Q Q 10 100 30 10 20 100 130 200 MBA201a - Fall 2009

15. Entry and the market equilibrium price P Entry shifts the supply curve to the right. As a result, the market equilibrium price goes down. Pbeforeentry Pafterentry Q MBA201a - Fall 2009

16. When does entry stop? P Cost MC P1 P2 ATC Q Q MBA201a - Fall 2009

17. Which firms stay and which firms exit? If several firms have access to the same technology as Firm A, what will happen to Firm B? 2xFirm A Firm B Industry P P P 180 100 D Q Q Q 10 100 30 10 20 100 130 200 MBA201a - Fall 2009

18. How much do the remaining firms produce? 2xFirm A 3rd Firm A Industry P P P Supply Curve with 2 Firm A’s 140 100 D Supply Curve with 3 Firm A’s Q Q Q 10 80 10 10 160 MBA201a - Fall 2009

19. The third firm A’s entry decision P Profits at P = 140 140 100 Q 10 80 MBA201a - Fall 2009

20. The third firm A’s entry decision P Profits at P = 120 120 100 Q 10 55 MBA201a - Fall 2009

21. Long run competitive equilibrium Industry P Supply Curve with 3 Firm A’s 100 D Q 10 160 170 = Long run competitive equilibrium supply curve; 17 firms, each producing 10 units each at price = 100. MBA201a - Fall 2009

22. Long run competitive equilibrium • In a long-run competitive equilibrium: • All of the existing firms are maximizing their short-run profits. • None of the existing firms want to either exit or expand output. • No new firms want to enter. • All existing firms earn zero economic profits. • The market price equals the minimum of the long-run average cost curve (P=min(LRAC)). • All consumers who want to buy the product at this price are able to. MBA201a - Fall 2009

23. Can an industry with a monopoly be in a LR equilibrium? Cost MC ATC D MBA201a - Fall 2009

24. Takeaways • Firms have more control over their costs in the long run. • A firm should stay in business in the short run as long as it is making some contribution towards its fixed costs (i.e. P>AVC). • The following dynamics contribute to the long-run competitive equilibrium: • Firms entering markets where there are opportunities to make profits. • Firms exiting markets where they can no longer cover their total costs, even if they’re making profit maximizing price/output decisions. • In a long-run competitive equilibrium: p=min(LRAC), all firms earn zero economic profits. MBA201a - Fall 2009