Economics 2 Professor Christina Romer Spring 2020 Professor David Romer

LECTURE 7

COMPETITIVE FIRMS IN THE LONG RUN

FEBRUARY 11, 2020

I. A LITTLE MORE ON SHORT-RUN PROFIT-MAXIMIZATION

A. The condition for short-run profit-maximization

B. The “horizontal” and “vertical” interpretations of supply curves 1. An individual firm’s supply curve 2. The industry’s supply curve

C. The two-way interaction between individual firms and the market

II. AVERAGE TOTAL COST AND SHORT-RUN PROFITS

A. Average total cost (atc)

B. Graphing atc

C. atc, price, and profits

D. Three possible profit scenarios

III. LONG-RUN PROFIT MAXIMIZATION

A. Short-run profits as a signal for entry or exit

B. The impact of entry or exit on the industry supply curve C. Long-run equilibrium

IV. EXAMPLES

A. A fall in demand 1. The immediate effect of the fall in demand 2. Profits and entry/exit 3. The new long-run equilibrium

B. A decrease in cost 1. The immediate effect of the fall in demand 2. Profits and entry/exit 3. The new long-run equilibrium

C. Discussion 1. Who enters or exits? 2. The invisible hand

LECTURE 7Competitive Firms in the Long Run

February 11, 2020

Economics 2 Christina RomerSpring 2020 David Romer

Announcements

• Problem Set 2 is being handed out.• It is due at the beginning of lecture next

Tuesday (Feb. 18).• The ground rules are the same as on Problem

Set 1.• Optional problem set work session:

Thursday, Feb. 13th, 4–6 p.m., 648 Evans Hall.

• Problem Set 1 is being returned in section this week.

Announcements

• Journal article reading for Thursday (by Edward Glaeser and Erzo Luttmer):

• Read only the assigned pages.

• Don’t stress over every word or parts you don’t understand.

• Read for approach and findings; think about relevance for the consequences of not letting prices adjust.

Announcements

• Beware of the phone-eating seats in this classroom!

• Campus Lost and Found is in the basement of Sproul Hall.

I. A LITTLE MORE ON SHORT-RUN

PROFIT-MAXIMIZATION

q

P

mc

mr (= PMARKET)

q1

The Profit-Maximizing Level of Output for a Perfectly Competitive Firm

A competitive firm produces up to the point where P = mc.

Two Interpretations of a Firm’s Supply Curve

• It shows the quantity the firm supplies as a function of price (“horizontal interpretation”).

• It shows the firm’s marginal cost as a function of quantity (“vertical interpretation”).

mc

q

P

mr (= PMARKET)

q1

Two Interpretations of the Market Supply Curve

• The sum of individual firms’ supply curves (“horizontal” interpretation).

• The industry’s marginal cost curve (“vertical” interpretation).

The Two-Way Interaction of Individual Firms and the Market – Example: A Fall in an Input Price

q

P

Individual Firm

mr1

mc1

q1

mc2

mr2

q2Q1

S1

Q

Market

D1

P1

P

P2

Q2

S2

II. AVERAGE TOTAL COST AND SHORT-RUN PROFITS

Average Total Cost

• Recall:

• Costs are measured as opportunity costs.

• Fixed costs: Costs that do not vary with how much is produced.

• Variable costs: Costs that do vary with how much is produced.

• Total cost: The sum of fixed and variable costs.

• Average Total Cost = Total CostQuantity

Marginal Cost and Average Total Cost

Cost (in $)

qThe mc and atc curves cross at the lowest point of the atc curve.

atc

mc

atc, Price, and Profits

• Recall:

• Profits = Total Revenue – Total Cost

• Now:

• Total Revenue = P q• Total Cost = atc q

• So: Profits = (P q) − (atc q)= (P − atc) q

• So: Profits are positive, negative, or zero depending on whether P − atc is positive, negative, or zero.

•

•

• •

•

Aside: “Average Revenue”

• If we want, we can define

Average Revenue =

• But, since total revenue is price times quantity (P q), average revenue is just price (P q/q = P).

Total RevenueQuantity

• •

q

P

mc

q1

Revenues, Costs, and Profits

Revenues: Rectangle abef. Costs: abcd. Profits: cdef.

P1atc1

• •

•• •

•

a b

c d

e f

atc

mr

Negative Economic Profits

q

P1 < atc at q1.

Q

Market

D

S

P1

P P

Individual Firm

mr

mc

q1

atc

atc1

Positive Economic Profits

q

P1 > atc at q1.

Q

Market

D

S

P1

P P

Individual Firm

mr

mc

q1

atc

atc1

Zero Economic Profits

q

P1 = atc at q1.

Q

Market

D

S

P1

P P

Individual Firm

mr

mc

q1

atc

atc1

III. LONG-RUN PROFIT-MAXIMIZATION

The Signals Sent by Profits

• If there are negative profits: Some firms will reduce the scale of their operations, or exit.

• If there are positive profits: Some firms will expand the scale of their operations, or new firms will enter.

• Exit moves the industry supply curve to the left; entry moves it to the right.

• If there are zero profits: There are no forces tending to cause either contraction or expansion of the industry. In this situation, the industry is in long-run equilibrium.

Long-Run Equilibrium

q

P

Individual Firm

mr

mc

q1

atc

Q

Market

D

S

P1

P

IV. EXAMPLES

Fall in Demand (Starting in Long-Run Equilibrium) Short-Run Effects

q

mr1

P

Individual Firm

q1

atc1

mc1

mr2

q2

D2

P2

Q

Market

D1

S1

P1

P

Q2 Q1

Fall in Demand (Starting in Long-Run Equilibrium) Long-Run Effects

q

mc1

P

Individual Firm

q1,3

atc1

mr1,3mr2

q2

D2

Q2 Q1

S3

Q

Market

D1

S1

P1,3

P

P2

Q3

Fall in Marginal Cost (Starting in LR Equilibrium) Short-Run Effects

q

mr2

atc2

mc2

P

Individual Firm

mr1

mc1

q1

atc1

q2Q2

P2

Q1 Q

Market

D

S1

P1

P

S2

Fall in Marginal Cost (Starting in LR Equilibrium) Long-Run Effects

q

mr2

atc2

mc2

P

Individual Firm

mr1

mc1

q1,3

atc1

q2

mr3

Q2

P2

Q1 Q

Market

D

S1

P1

P

S2

P3

S3

Q3

Entry and Exit

• “Exit” can take the form of firms reducing their scale or of firms leaving the industry altogether.

• Likewise, “entry” can take the form of existing firms increasing their scale or of new firms coming into the industry.

The Invisible Hand

• In a market economy, profits provide signals that move resources across industries to where they are most valued.

• These movements occur without any centralized planning or direction.

• A corollary: In a well-functioning market economy, there are always some industries that are expanding and some that are contracting.

• This helps explain why barriers to entry usually make economists nervous.