Chapter 14

1. Chapter 14 Perfectly Competitive Markets: Short-Run Analysis

2. Objective • Analyze the firm’s output decision in a perfectly competitive market in the short run (sr) • Analyze the market effects of different policies

3. Properties of Perfectly Competitive markets • Large number of firms • Large number of buyers • Free entry and exit • Homogenous product • Perfect information • This implies: • No market power • Firms take the market price as given

4. Competitive Markets in the SR • Short run • One input – fixed • Number of firms – fixed • The firm faces a horizontal demand or price line • P=MR=AR • Profit-maximizing quantity?

5. Cost and demand for a competitive firm Price, Cost e d b MC ATC c AVC p1=MR1=AR1 p1 Quantity 0 q’+1 q3 q” q’ In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost.

6. Shut down or stay in business What should the firm do if the market price does not cover its average cost? Shut down? • Shut down if Profit if in business <Profit if shut down TR-VC-FC < 0-FC TR<VC The firm should shut down if the revenue is less than the variable cost of production since fixed costs are sunk costs. Simplify further and divide both sides by Q: TR/Q < VC/Q Therefore, the firm shuts down if P < AVC

7. The Shut Down Price Price, Cost a e d b MC ATC AVC • Produce q3at a profit Shut down price Produce q’’ at a loss p1 p0 p3 p’0 produce nothing Quantity 0 q” q3 The shut down price is at the min of the AVC curve

8. Cost and demand for a competitive firm Price, Cost a e d b MC ATC c AVC p3=MR3=AR3 p1=MR1=AR1 p0=MR0=AR0 p2=MR2=AR2 p2 p0 p1 p3 p’0 p’0=MR’0=AR’0 Quantity 0 q’+1 q” q3 q’0 q’ q0 In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost. Thus, at a price of p1, the firm produces a quantity of q” but at a price of p’1 the firm produces nothing

9. A Competitive Firm’s Supply • Supply function • How much of a good • One firm - willing to sell • Given any market price • Other factors constant • Supply function • Marginal cost curve • Above - lowest point on AVC curve

10. A short-run supply curve for a competitive firm Price, Cost S P0 Shut down price Quantity 0 q0 At prices below p0, the firm produces nothing because these prices are less than the average variable cost. At prices above p0, the supply curve is identical to the marginal cost curve

11. Competitive Markets in the Short Run • Market supply function (aggregate supply function) • How much of a good • All of firms supply • Any given market price • Horizontally add supply curves • All of firms in the industry • Aggregate short-run marginal cost • Supply each unit

12. Market Supply Price Price Price Price FIRM 3 FIRM 2 FIRM 1 MARKET SUPPLY B p4 p3 A p’2 p2 p1 0 0 0 0 q11 q11 q14+q24+q34 q14 q24 q34 q12’ q22’ q12’ +q22’ Quantity Quantity Quantity Quantity The market supply curve is the horizontal sum of the marginal cost curves of all of the firms in the industry

13. Competitive Markets in the Short Run • Short-run equilibrium • Price-quantity combination • Prevail - perfectly competitive market • Short run • (1) Firms – no change (quantity supplied) • (2) Consumers – no change (quantity demanded) • (3) Aggregate supply = Aggregate demand

14. Equilibrium Price Market Supply p1 pe p2 Market Demand 0 Quantity q2s q1d qe q2d q1s The equilibrium price of pe and quantity of qe equate the aggregate supply and aggregate demand in the market.

15. The SR equilibrium in competitive market Price Price Price Price FIRM 1 FIRM 2 FIRM 3 ATC ATC ATC S MC MC MC π2 π1 pe pe D 0 0 0 0 qe=q1e+q2e+q3e q1e q2e q3e Quantity Quantity Quantity Quantity The short-run equilibrium for a competitive industry is consistent with positive profits.

16. Policy Analysis in the Short Run • Comparative static analysis • Examine market equilibrium • Before and after policy change • Effect on market price and quantity • Compare 2 static equilibria

17. The market for illegal drugs b Price a S1 An increase in the probability that a drug dealer will be caught shifts the supply curve to the left, from S1 to S2, raises the equilibrium price from pa to pb, and lowers the equilibrium quantity from qa to qb. S2 pb pa D Quantity 0 qa qb

18. The decision about whom to prosecute b c Price a A policy of prosecuting illegal drug dealers shifts the supply curve from S1 to S2 and the equilibrium from point a to point c. S1 S2 pc pa pb A policy of prosecuting illegal drug users shifts the demand curve from D1 to D2 and the equilibrium from point a to point b. D2 D1 0 Quantity qa qb qc

19. The incidence of a tax and elasticity of demand Price Price Price (a) (b) (c) b b d c a a D S2 S1 pa+α S1 S2 S2 α pb pa pa S1 D pa D qa qa qb 0 0 0 Quantity Quantity Quantity When demand is perfectly inelastic, the incidence of a tax of α per unit falls entirely on the consumer When demand is perfectly elastic, the incidence of the tax falls entirely on the producer When elasticity is intermediate between 0 and -∞, the incidence of the tax falls partly on the consumer and partly on the producer

20. The labor market and the minimum wage Price a S1 The establishment of a minimum wage of wmin raises the equilibrium wage paid to employed workers from wa to wmin and lowers the number of employed workers from qa to qmin . wmin wa D1 Quantity 0 qa qmin

21. Government-subsidized wages Price S1 A government subsidy of the wages of teenage workers shifts the demand curve for labor from D1 to D2, raises the equilibrium wage from wa to wb, and raises the number of workers employed from qa to qb. wb wa D1 D2 D3 Quantity 0 qb qa

22. Figure 14.11 Wage • Subsidizing youth employment S d c wv wmin A subsidy leads to higher wages and more young employees a wa b e D D’ Labor 0 qa qmin