Microeconomics and Policy Analysis PUAF 640

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Microeconomics and Policy Analysis PUAF 640

• Professor Randi Hjalmarsson
• Fall 2008
• Lecture 9

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Class Outline Chapters 10.1, 11.1

• Product Markets Perfect Competition
• Perfectly competitive model
• Price taking firm ? supply curves
• Short run equilibrium
• Sales tax and production tax (again)
• Long run equilibrium

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Price determination

• Lecture 1 market S/D curves taken as given
• Studied how consumers make choices given prices
• Derived individual and market demands.
• Looked at how firms make decisions given prices.
• But, how are prices determined?
• By the market
• By interactions between consumers and producers.
• Prices depend on the type of market (as well see
  in the next few lectures).

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Perfectly Competitive Market

• Characterized by the following assumptions
• Sellers are price-takers.
• In both prices of output and prices of inputs.
• Sellers do not behave strategically.
• Dont anticipate rivals decisions in deciding
  output level.
• Entry into the market is free.
• No special costs incurred and no restrictions on
  process of entry (opposite is blocked entry).
• Buyers are price takers.
• Can purchase as much as they want without
  affecting P.

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Market Structure to Meet These Assumptions

• How many buyers are there? How big are they?
• Many buyers, who are small.
• Satisfies assumption 4 (price taking buyers)
• How many suppliers? How big?
• Many suppliers (necessary for assumptions 1 and
  2 price takers and non-strategic), relatively
  small
• Why?
• With many firms, any single firm plays small role
  in the market. Doubling output of one firm has
  little effect on overall output and therefore
  price.
• Fewer the of firms, more likely they are to be
  strategic.
• U.S. long distance providers Sprint, ATT, MCI
  if one lowers price, others will react.

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Market Structure to Meet These Assumptions

• What about the degree of substitutability of
  different sellers products?
• Homogenous products buy from seller with lowest
  price, implies price taking sellers.
• Goods may seem homogenous, but there can still be
  differences nightclubs in NYC, gas stations
• Heterogeneous products seller can raise price
  without losing all customers, implies not price
  taking seller

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Market Structure to Meet These Assumptions

• Do buyers know everything?
• Yes, perfect information. If sellers increase
  prices but buyers dont know of available
  substitutes, then sellers keeps some customers.
• Conditions of entry no technological or legal
  barriers to entry exist.

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Examples of a perfectly competitive markets

• Agricultural markets tend to be closest to
  satisfying these characteristics.
• What about the following markets
• Pharmaceutical industry?
• No free entry must invest in RD or pay
  licensing fee for patented drugs.
• Clothes jeans?
• Product differentiation different designers.
• U.S. long distance phone service.
• Few firms yields strategic behavior.
• Big box stores like Walmart (see article)

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How are prices determined in market characterized
by perfect competition (PC)?

• Intersection of market demand and supply curves.
• We derived demand curves.
• Still need to derive individual firm and market
  supply curves.

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Supply decisions for price-taking firms (i.e. PC
firms)

• Review Profit maximizing firm follows 2 rules.
• Marginal output rule produce Q where MR MC.
• Shutdown rule If avg. revenue lt avg. cost at all
  Q, then the firm should shut down.

MC, AC
TC
MC
AC
Firms cost curves, but what does MR look like?
Q
Q
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MR, AR for a price taking firm
What does demand curve for a price taking firm
look like?
What is AR?
AR Total Revenue/QAR PQ/Q P So, AR D
Firm can sell as much as it wants at the market
price. TR PQ
What is MR?
P
Revenue for each unit sold P, so MR P. Or, MR
dTR/dQ P So, MR AR D
D
MRAR
Q
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How does price taking firm decide Q?

• But should the firm stay open? Shut if for all Q,
• ARltAC

• For profit maximization, set MR MC. So, for a
  price taker, Q occurs where
• MR P MC.

MC
AC
P
P
P0
P0
DMRAR
DMRAR
Q
Q
Q
So, at a price of P0, firm will stay or open or
close, and if it is open, it will produce Q.
This is one point on the supply curve!
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Short Run vs. Long Run Supply

• Will supply curve be the same in the short run
  and long run?
• In the SR, only one factor is variable.
• So, short-run decisions are based on SR average
  variable cost (SRAVC) (shut down decision)
• Since makes decision based on economic profits
  fixed costs are essentially sunk costs (cant be
  recovered) and exist if firm is open or shut.
• In the LR, all factors are variable.
• So, long-run decisions are based on LR cost
  curves.
• Firms supply curves will be different in SR and
  LR.

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Short-Run Supply
P Value at which MCAC
SSR
P ()
AVCSR
MCSR
Suppose firm can sell Q at PgtP
PMRAR
PgtP
Firm should produce at Q such that MR MC Firm
should stay open since ARgtAVC for some Q
P
For any PgtP, firm will produce Q along MC curve
Q
Q
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Short-Run Supply
What if PltP?
SSR
P ()
AVCSR
MCSR
ARltAC for all Q
PMRAR
Firm should shut down and produce 0.
PgtP
P
PMRAR
PltP
Q
Q
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Short-Run Supply
Firms SR supply curve MC curve for any PgtP
(i.e. there is economic profit) Supply 0 for
any PltP
ATCSR
SSR
P ()
AVCSR
MCSR
In SR, firm stays open even with accounting loss.
(ARltATC) Why?
P
Costs of fixed inputs are sunk. It would still
have to pay for the fixed factors even if it
werent operating. So, firm only takes variable
factors into consideration.
Q
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Short-Run Supply
ATCSR
Accounting loss PltPltP sinceP AR lt ATC
SSR
P ()
AVCSR
MCSR
For PgtP, there is positive accounting profit.
P
P
For PgtP, there is positive economic profit.
Q
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Long Run Supply Curves

• How would the firms supply curve change in the
  long run?
• Do similar analysis but use long run cost curves.
• Look at ATC since all factors are variable
  (ATCAVC)
• No fixed or sunk costs.
• Supply curve is the portion of the MC curve above
  the minimum of the average cost in the long run
  and the vertical axis otherwise.

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Long Run Supply Curves
SLR
P ()
ATCLR
MCLR
At PgtP, there is positive profit.
P
Q
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For a given P, where is profit?
P ()
ATCLR
MCLR
P AR MR
ATC(Q)
Profit TR - TC (P)(Q) (ATC)(Q)
Q
Q
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Long Run Supply vs. Short Run Supply
Long run supply is more elastic quantity
supplied changes more in response to small change
in P. Why?
P
SSR
SLR
Firm is more able to make changes to adjust in
the long run, since all factors are variable and
one can be substituted for another.
Q
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Aggregate Supply

• We have found SR supply curve for typical
  perfectly competitive firm.
• Horizontal sum to get market supply curve.

S1
P
S2
SM
For each P, what is total Q supplied in the
market?
P
Q
Q1
Q2
Q1Q2
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Equilibrium Price in Perfectly Competitive Market
P
In PC market, P is determined by intersection of
market supply and demand.
SMSR
P
DMSR
Q
Q
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Full Circle Review Causes of Shifts in S/D

• What could yield shifts in demand?
• Change in consumer income
• Changes in prices of substitutes and complements.
• Changes in tastes/preferences.
• What could yield shifts in supply?
• Changes in costs of variable inputs
• Technological change (though unlikely to affect
  short run much)
• Public policies can affect supply and demand!
• Sales tax, production tax, subsidies

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Excise Tax Review Sales vs. Production Tax

• Sales Tax tax of t/unit imposed on consumers
• Statutory incidence is on demand side.
• Tax causes demand curve to shift down by the
  amount of the tax
• For any consumer to buy what she did before, the
  market price must be lower by the amount of the
  tax.

• Production Tax tax of t/unit imposed on
  producers
• Statutory incidence is on supply side.
• Tax causes supply curve to shift up by the amount
  of the tax.
• To supply the same amount as before, the firm
  must receive more since it also has to pay the
  tax.

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Consumer Tax Graph
P
S
Consumer pays P1t in total
Equilibrium Q ?Price received by producer
?Price paid by consumer ?
P1t
P0
P1
D1
D0
P1 is price received by producer This is new
market price.
Q0
Q1
Q
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Production Tax Graph
Price paid by consumer to producer New market
price
S1
P
S0
P1
Equilibrium Q ?Price received by producer
?Price paid by consumer ?
P0
P1-t
D0
Price received by producer after paying the tax
Q0
Q1
Q
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Consumer and Production Tax Graphs
S1
P
P
S
S0
Market price
P1t
P1
P0
P0
P1
P1-t
D1
D0
D0
Market price
Q0
Q1
Q0
Q1
Q
Q
Consumer and producer taxes have identical
effects Equilibrium Q ? Price received by
producer ? Price paid by consumer ?
Only difference is statutory incidence and the
price observed in the market. Market price ? with
sales tax and ? with producer tax.
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• The effect of a tax does not depend on the
  statutory incidence. The effective price paid by
  consumers and received by sellers in the same
  regardless of whether it is a sales tax or a
  production tax.
• Key principle of tax theory, many applications.
• Debate over whether employers or employees should
  finance healthcare benefits.
• Competitive labor markets imply that it doesnt
  matter whether the money is collected through a
  tax on firms or employees.
• Either will have same effect on effective wages
  that firms pay and effective (after tax) wages
  that workers receive.
• Hinges on assumption of perfectly competitive
  labor markets!

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How does the long run equilibrium differ?

• Long run differs from the short run in 2 ways
• Firms can adjust all inputs to change output
• Firms can enter and exit the market.
• A long run equilibrium occurs when
• At the market prices for inputs and outputs, no
  firm has an incentive to change its input or
  output level (each firm is maximizing profits
  PMRMCLR)
• No firms want to enter/exit the industry.
• All firms in business have p0.
• Any firm that entered would lose money.

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In LR, can characterize industries in 3 ways

• Constant cost industry entry of new firms does
  not affect the costs of other firms in the
  industry.
• Long run supply is perfectly elastic.
• Increases in demand are met by additional firms
  entering the market.

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• Increasing cost industry entry of new firms
  drives up costs of all firms in the industry.
• This might occur if there is an increased demand
  for inputs, which yields a bidding up of prices.
• Could also be that only new firms face higher
  costs (but average costs across all firms are
  higher).
• Long-run supply curve slopes up, which reflects
  that expansion increases production costs.

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• Decreasing cost industry entry of new firms
  drives down costs faced by all firms.
• Entry could yield cheaper sources of power or
  transportation or result in a larger body of
  trained labor for the industry to use.
• Long run supply actually slopes down.
• Not typical!

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A closer look at the LR equilibrium in a constant
cost industry

• Assume that
• All firms are identical (have access to same
  technology and face the same prices).
• New firms (identical to the old ones) can
  enter/exit freely.

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LR in constant cost industry

• Lets consider the following scenario.
• Initially in short-run equilibrium and each firm
  is producing MCSRMCLRMRP0.
• No firm is making profits PAC. So, no firm
  would enter or exit.
• There is an increase in market demand.
• What happens?

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LR in constant cost industry
Typical Firm
Market
MCSR
S0SR
P
P
MCLR
ACLR
P1
P1
P0
P0
D1SR
D0SR
Q
Q
q0
Q0
q1
Q1
Initial equilibrium Typical firm produces q0 and
market output is Q0.
Increase in demand.
Price pushed up to P1. Typical firm increases
output to q1 and market to Q1.
Firms are now making a profit since P1gtAC.
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LR in constant cost industry
Typical Firm
Market
MCSR
S0SR
P
P
S1SR
MCLR
ACLR
P1
P1
SLR
P0
P0
D1SR
D0SR
Q
Q
q0
Q0
q1
Q1
If p gt0, more firms enter the market (costs of
firms dont change).
Entering firms shifts SSR until price is driven
back to P0 and there is no more incentive to
enter and typical firm again produces q0.
So, long run supply is perfectly elastic and is
determined by min. of LR average cost curve.