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Yasin Janjua

Eco205 Chapter 9 – Perfect Competition in a Single Market 12th January 2013 Timing of a Supply Response When determining equilibrium prices it is important to consider the time frame in which there is a supply response. Supply response - The change in quantity of output supplied in response to a change in demand conditions. Market period - A short period of time during which quantity supplied is fixed. In the very short run, there can be no supply response—quantity supplied is absolutely fixed. In the short run, existing firms may change the quantity they are supplying but no new firms can enter the market. In the long run, firms can further change the quantity supplied and completely new firms may enter a market; this produces a very flexible supply response Pricing in the Very Short Run In the very short run or market period, there is no supply response. The goods are already ‘‘in’’ the marketplace and must be sold for whatever the market will bear. In this situation, price acts only to ration demand. The price will adjust to clear the market of the quantity that must be sold. Equilibrium price - The price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good Shifts in Demand: Price as a Rationing Device In order to ration the available quantity among all demanders, the price would have to rise to P2. At that new price, demand would again be reduced to Q* (by a movement along D0 in a northwesterly direction as the price rises). The price rise would restore equilibrium to the market Applicability of the Very Short-Run Model It is usually presumed that a rise in price prompts producers to bring additional quantity into the market Note: increases in quantity supplied in response to higher prices need not come only from increased production In a world in which some goods are durable current owners of these goods may supply them in increasing amounts to the market as price rises Short Run Supply In analysis of the short run, the number of firms in an industry is fixed. However, the firms currently operating in the market are able to adjust the quantity they are producing in response to changing prices. Because there are a large number of firms each producing the same good, each firm will act as a price taker. That is, each firm’s short-run supply curve is simply the positively sloped section of its short-run marginal cost curve above the shutdown price. Using this model to record individual firms’ supply decisions, we can add up all of these decisions into a single market supply curve. Construction of a Short-Run Supply Curve The quantity of a good that is supplied to the market during a period is the sum of the quantities supplied by each of the existing firms. Because each firm faces the same market price in deciding how much to produce, the total supplied to the market also depends on this price. This relationship between market price and quantity supplied is called a short-run market supply curve. Because each firm operates on a positively sloped segment of its own marginal cost curve, the market supply curve will also have a positive slope Short-Run Price Determination Functions of the Equilibrium Price First, this price acts as a signal to producers about how much should be produced. In order to maximize profits, firms produce that output level for which marginal costs are equal to P1 A second function of the price is to ration demand. Given the market price of P1, utility-maximizing consumers decide how much of their limited incomes to spend on that particular good Effect of an Increase in Market Demand The rise in price in the short run has served two functions. First, as shown in our analysis of the very short run, it has acted to ration demand. Whereas at P1 a typical individual demanded q1, now at P2 only q2 is demanded. The rise in price has also acted as a signal to the typical firm to increase production. An increase in market price acts as an inducement to increase production. Firms are willing to increase production (and to incur higher marginal costs) because price has risen. If market price had not been permitted to rise firms would not have increased their outputs. At the new price P2, the typical firm has also increased its profits Shifts In Supply And Demand Curves Reasons for a Shift in a Demand or Supply Curve figure 9.1 page 310 In the case of inelastic demand, a price change does not have very much effect on the quantity that people choose to buy. Firms’ short-run supply responses can be described along the same lines. If an increase in price causes firms to supply significantly more output, we say that the supply curve is ‘‘elastic’’ Short-run elasticity of supply - The percentage change in quantity supplied in the short run in response to a 1 percent change in price Shifts in Supply Curves and the Importance of the Shape of the Demand Curve The demand curve is relatively price elastic; that is, a change in price substantially affects the quantity demanded. For this case, a shift in the supply curve from S to S0 causes equilibrium prices to rise only moderately (from P to P0), whereas quantity is reduced sharply (fromQtoQ0). Rather than being ‘‘passed on’’ in higher prices, the increase in the firms’ input costs is met primarily by a decrease in quantity produced (a movement down each firm’s marginal cost curve) with only a slight increase in price Shifts in Demand Curves and the Importance of the Shape of the Supply Curve The short-run supply curve for the good in question is relatively inelastic. As quantity expands, firms’ marginal costs rise rapidly, giving the supply curve its steep slope. In this situation, a shift outward in the market demand curve causes prices to increase substantially. Yet, the quantity supplied increases only slightly. The increase in demand (and in Q) has caused firms to move up their steeply sloped marginal cost curves. The accompanying large increase in price serves to ration demand. There is little response in terms of quantity supplied. A relatively elastic short-run supply curve - this kind of curve would occur for an industry in which marginal costs do not rise steeply in response to output increases. For this case, an increase in demand produces a substantial increase in Q. However, because of the nature of the supply curve, this increase is not met by great cost increases. Consequently, price rises only moderately. The Long Run In perfectly competitive markets, supply responses are more flexible in the long run than in the short run for two reasons. First, firms’ long-run cost curves reflect the greater input flexibility that firms have in the long run. Diminishing returns and the associated sharp increases in marginal costs are not such a significant issue in the long run. Second, the long run allows firms to enter and exit a market in response to profit opportunities Equilibrium Conditions A perfectly competitive market is in long-run equilibrium when no firm has an incentive to change its behavior. Such equilibrium has two components: Firms must be content with their output choices (maximizing profits), and they must be content to stay in the market. Profit Maximization Because each firm is a price taker, profit maximization requires that the firm produce where price is equal to (long-run) marginal cost. Entry and Exit The perfectly competitive model assumes that such entry and exit entail no special costs. Consequently, new firms are lured into any market in which (economic) profits are positive because they can earn more there than they can in other markets. Similarly, firms leave a market when profits are negative. In this case, firms can earn more elsewhere than in a market where they are not covering all opportunity costs. If profits are positive, the entry of new firms causes the short-run market supply curve to shift outward because more firms are now producing than were in the market previously. Such a shift causes market price (and market profits) to fall. The process continues until no firm contemplating entering the market would be able to earn an economic profit.3 At that point, entry by new firms ceases and the number of firms has reached equilibrium. When the firms in a market suffer short-run losses, some firms choose to leave, causing the supply curve to shift to the left. Market price then rises, eliminating losses for those firms remaining in the marketplace Long-Run Equilibrium Because all firms are identical, the equilibrium long-run position requires every firm to earn exactly zero economic profits. Profit maximization is a goal of firms. Firms would obviously prefer to have large profits. The long-run operations of competitive markets, however, force all firms to accept a level of zero economic profits (P ¼ AC) because of the willingness of firms to enter and exit. Although the firms in a perfectly competitive industry may earn either positive or negative profits in the short run, in the long run only zero profits prevail. That is, firms’ owners earn only normal returns on their investments Long-Run Supply: The Constant Cost Case Constant cost case - A market in which entry or exit has no effect on the cost curves of firms A Shift In Demand Curve In the long run, these profits attract new firms into the market. Because of the constant cost assumption, this entry of new firms has no effect on input prices. New firms continue to enter the market until price is forced down to the levels at which there are again no economic profits being made. The entry of new firms therefore shifts the short-run supply curve to S0, where the equilibrium price (P1) is reestablished. At this new long-run equilibrium, the price-quantity combination P1, Q3 prevails in the market. The typical firm again produces at output level q1, although now there are more firms than there were in the initial situation Long Run Supply Curve For a constant cost industry of identical firms, the long-run supply curve is a horizontal line at the low point of the firms’ long-run average total cost curves. The fact that price cannot depart from P1 in the long r
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