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Today. LR industry supply Constant cost, increasing cost, and decreasing cost industries Market efficiency in perfect competition. Industry Supply in the Long Run. Three Cases. Case 1: Constant Cost Industry.
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Today • LR industry supply • Constant cost, • increasing cost, and • decreasing cost industries • Market efficiency in perfect competition
Industry Supply in the Long Run Three Cases
Case 1: Constant Cost Industry • Assumes that firms’ costs are independent of the size of the market. Expanding or contracting demand yields the same price in the long run. • Firms’ cost curves do not shift as industry output changes. • Leads to a horizontal long-run industry supply curve.
Initial LR Equilibrium P Typical Firm P Industry or Market SRS MC ATC LRATC P D q Q q Q Thought experiment: What happens to the industry LR equilibrium as market demand expands?
SR Response to Increase in Demand P Typical Firm P Industry or Market SRS MC ATC LRATC P D D q Q q Q Q’ SR: price rises. Firms earn profits. Why isn’t this a new LR equilibrium?
LR Response to Increase in Demand P Typical Firm P Industry or Market SRS MC ATC SRS’ 1 1 LRATC 2 0 0 P 2 D D q Q q Q Q” LR: Firms enter until no more profits can be made. Given our assumption, that is when price falls original level. Second LR equilibrium.
LR Response to Increase in Demand P Typical Firm P Industry or Market SRS MC ATC SRS’ LRATC P D D q Q q Q Q” LR: Firms enter until no more profits can be made. For case 1, that is when price falls original level. Second LR equilibrium.
LR Industry Response to an Increase in Demand • Assuming that firms’ costs do not depend on the size of the industry, and • Beginning in LR equilibrium and increasing demand: • in the SR, price rises, firms’ profits and outputs rise. • In the LR, price returns to original level, firms earn zero profits, each firm makes same q as before, but market output is higher.
LR Response to Increase in Demand P Typical Firm P Industry or Market MC ATC LRATC LRS P D D q Q q Q Q” Case 1: Horizontal Long-Run Supply Curve
Significance of Result • For these industries, growing demand will not result in higher (or lower) prices. (Ceterus Paribus) • Remember LRS is not predicting prices over time.
Case 2: Increasing Cost Industry • Assumes factor prices rise as industry (or market) output expands, causing firms’ costs to rise. • Ex: market for milk & price of dairy land • Results in an upward-sloping long-run industry supply curve
Case 2 & LR Industry Supply P Typical Firm P Industry or Market SRS LRATC (Q1) LRS LRATC(Q0) P D D q Q Q0 Q1 Case 2: Upward-sloping Long-Run Supply Curve
Significance of Case 2 • Growing demand for milk forces up the prices of dairy land. • Cost of producing milk rises. • Price of milk rises in the long run, even though there are more milk farms. • ***Result comes from the underlying scarcity of dairy land.***
Case 3: Decreasing Cost Industry • Assumes costs fall as industry (or market) output expands. • Results in an downward-sloping long-run industry supply curve
Ex: Software Production • It’s less costly to produce software as the industry grows because of a larger pool of possible programmers in the same area • Don’t need to relocate programmers to your area, cheaper. • Programmers informally spread new ideas, reducing costs. • The price of software falls as the industry expands.
Definition • Economic Efficiency: When goods are produced in the least costly manner and distributed to those who value them most. • Requires: • Productive Efficiency • Allocative Efficiency
Productive Efficiency • There is no way to re-direct production among firms to increase total output.
Perfect Comp and Productive Efficiency • In LR firms produce at lowest possible LRAC. • There is no way to cut costs by changing plant size. • Since all firms take the same price, all firms have same MC (why?) • There is no way to re-direct production to other firms and get lower marginal costs. • Productive efficiency holds.
Allocative Efficiency • Goods are consumed by those who most value them. • There is no alternative comb. of goods that could be produced that would increase society’s well-being.
Measuring Allocative Efficiency • The sum of consumers’ surplus and producers’ surplus.
Recall: Consumers’ Surplus • The difference between what a consumer is willing to pay & what he does pay. $/unit 8 A 6 B 4 D 2 units 1 3 4 5 2 6 7
Producers’ Surplus-SR perspective • The difference between the amount of revenue the firm earns and the minimum amount necessary to get the firm to produce that quantity of the good in the short run. • Revenue - total variable costs.
Producers’ Surplus-Market • Selling 4 units @$6/unit. • Total revenue = B + C. • TVC for all firms is represented by the area under the SRS curve (why?) = C • B = producers’ surplus $/unit SRS 8 6 B 4 C D 2 units 1 3 4 5 2 6 7
Allocative Efficiency • A + B = The sum of consumers’ and producers’ surplus. • Vertical distance between D and S is the difference between value to consumer and MC to producer. • What Q maximizes CS+PS? $/unit SRS 8 A 6 B 4 C D 2 units 1 3 4 5 2 6 7
Allocative Efficiency & Perfect Competition • Perfectly competitive markets provide the allocatively efficient quantity of a good.
Perfect Comp and Econ Efficiency • Conclusion: Perfectly competitive markets are economically efficient! • This is one reason why we use them as a benchmark for our study of other market structures.
Coming Up: • Begin Monopoly • Second midterm exam is 1 week from today! • We will use Monday’s class to review for the exam. Bring your copy of the study guide.
Group Work • Thought problem on perfect competition. • Graph of Case 3: Downward-sloping LR industry supply.
Profits and Perfect Competition • Assume dairy production is a perfectly competitive, increasing cost industry (case 2 in our notes). • Suppose demand for dairy products is growing. • Some farmers have really good land for grazing, others have land that is rather poor.
Questions about Dairy Example • Which farmer earns the most profits? Explain in full. • Hint: Don’t forget, this is a perfectly competitive industry. • Hint: Don’t forget opportunity costs.
Case 3 & LR Industry Supply • On the following graph, derive the LR Industry supply curve. Assume that firms’ costs decrease as the industry grows.
Case 3 & LR Industry Supply P Typical Firm P Industry or Market SRS LRATC(Q0) P D D’ q Q Q0 Case 3: Downward-sloping Long-Run Supply Curve