MGEA02H3 Lecture Notes - Demand Curve, Perfect Competition, Market Power

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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
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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.
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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
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