Week 8 Lecture Notes ECMA04 2012

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Department
Economics for Management Studies
Course
MGEA02H3
Professor
Michael Krashinsky
Semester
Fall

Description
Week 8 Lecture Notes ECMA04 2012 8/1 FIRST SEVEN PAGES ARE REVIEW Review what happens in long run in perfect competition: Case 1: If negative profits, assume EXIT Case 2: If positive profits, assume ENTRY Reminder ! Profits are economic profits So if π > 0, that is, if economic profits are positive, the firm is covering all of its costs, making a reasonable return on capital and getting reasonable compensation for the efforts (time) of the entrepreneur PLUS ... getting something extra (the economic profits) Let’s do case 2 (positive profits) first. Positive profits makes this a very attractive industry for entrepreneurs looking to make money Buried behind this is the implicit assumption that there are entrepreneurs hunting for exactly these kinds of opportunities. So π > 0 leads these entrepreneurs to ENTER the industry as new firms 8/2 But as we saw, more firms → shifts supply curve to the right So ENTRY → SUPPLY SHIFTS RIGHT → PRICE FALLS → PROFITS FALL Diagram: NOTE : This continues until the entry stops But entry continues as long as π > 0 So entry continues until profits are driven down to zero. 8/3 Now let’s look at case 1 (negative profits). Negative profits makes this a very unattractive industry for entrepreneurs, because they are not earning a decent return on their efforts. Again: Reminder ! Profits are economic profits So if π < 0, that is, if economic profits are negative but the firm is operating in the short run, then the firm is covering all of its variable costs, BUT the firm is not making a reasonable return on capital and is not getting reasonable compensation for the efforts (time) of the entrepreneur As soon as they can (that is, in the long run when they can get rid of their capital), entrepreneurs leave the industry to look for better opportunities elsewhere. So π < 0 leads these entrepreneurs to EXIT the industry. But as we saw, fewer firms  shifts supply curve to the left So EXIT → SUPPLY SHIFTS LEFT → PRICE RISES → PROFITS RISE 8/4 Diagram: NOTE : This continues until the exit stops But exit continues as long as π < 0 So entry continues until profits are driven up to zero. 8/5 So, in both cases, profits are driven to zero Where are profits zero ?? Remember:  = TR − TC = Pq − (AC)q = q(P − AC) So profits are zero where P = AC We are in the long run, so this means that P must be driven to the minimum point on the LAC Diagram: 8/6 Let’s review the logic: P > min LAC → π > 0 → entry → P , π P < min LAC → π < 0 → exit → P , π In each case, end up at P = min LAC and π = 0 OK, stop for a minute - why would firms be “satisfied” in long run to earn zero profits??? Remember that zero profits are zero economic profits, which correspond to positive accounting profits. This is the level of profits which provide an acceptable return on corporate capital. So shareholder are “satisfied” - that is, not overjoyed, but not so angry that they storm in and fire the managers !!! 8/7 So, to do “long run problems”, we must know the minimum point of the LAC. How do we find that? For this course, we will have to be given it. This can occur in several ways: 1. We tell you the minimum point, both the value of q and the minimum LAC at that q. 2. We use a “trick” and tell you that the short run average cost curve touches the LAC at the minimum (that is, the SAC, which you will be given, and the LAC share the same minimum point, so that the minimum of the SAC is the minimum of the LAC) NOTE - We assume that costs do not change as firms enter or exit called “constant costs” 8/8 Review of ENTRY and EXIT as an INVISIBLE HAND MECHANISM to shift resources around the economy. If consumers want more: Demand increases, price rises in short run, positive profits In long run, entrepreneurs respond to lure of profits Shift resources into this sector by opening new firms Production responds automatically to additional demand At the end, prices return to minimum LAC Diagram: 8/9 If consumers want less: Demand decreases, price falls in short run, negative profits In long run, entrepreneurs respond to losses Shift resources out of this sector by closing firms Production responds automatically to fall in demand At the end, prices return to minimum LAC Diagram: 8/10 Diagram of short run and long run supply (redo change in demand): 8/11 Try another problem in Long Run: Demand: P = 100 − .001Q In long run, given that min LAC occurs at q = 20, LAC = $40 We know that P = $40 q = 20 π = 0 Solve for Q and N: Q = 60,000, N = 3000 Now suppose that in LR there is technological change that reduces min LAC so that it occurs at q = 40, LAC = $30 P = 30, Q = 70,000,
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