Industrial Organization

1
Industrial Organization Perfect Competition
2
Perfectly Competitive Markets Structure
Assumptions

• Many buyers and sellers
• Homogeneous product or output
• Note these first two assumptions imply that the
  perfectly competitive firm is a price taker.
• P(x) P ? where ? is the demand for the
  individual firms output.
• Also note that if P(x) is just P, then mrP,
  too.
• Free entry and exit
• Full and symmetric information

3
Perfectly Competitive Markets

• Every demander is a price-taker (no buyer can
  influence the price).
• Every supplier is a price-taker (no seller can
  influence the price).
• The market price is known to all potential buyers
  and sellers and anyone who wishes to trade at
  that price can do so.

4
An Example

• Jonathans farm is perfectly competitive and uses
  the inputs shown to produce the quantities of
  apples indicated on the table.

5
Production Detail

• Here is some finer detail regarding the apple
  farm.

6
Factor Prices

• Jonathan is a factor price taker.
• Use these factor prices to build the cost tables.

7
Costs
8
Finer Cost Details
9
Graph of Jonathans Cost Curves

• The marginal cost of each ton of apples is shown
  as the red line.
• The average cost is shown as the blue line.
• Notice that the marginal cost average cost at
  average costs minimum.

10
Profit Maximization

• Profit (?) total revenue(tr) - total cost(tc).
• Profit depends on the firms output level (x).
• So ? (x) tr(x) - tc(x)
• Define
• marginal revenue (mr) ?tr/?x
• marginal cost (mc) ?tc/?x
• NOTE Since we have a perfectly competitive firm
  Pmr for all levels of production.

11
Profit Maximization

• General rules for profit maximization
• If x maximizes ? , then
• mr mc at x
• x is a profit max and not a profit min
• at x its worth operating
• Reminder since the firm is perfectly
  competitive, Pmr for all values of x.

12
Jonathans Profit and Loss

• Suppose the market price is 600/ton.
• The vertical difference between Jonathans total
  revenue and total cost curve is his profit.
• The profit maximum occurs at 240 tons/year.

13
Finding Profit Maximizing Points Using The
Marginal Cost Curve

• Jonathan will supply apples to the market in
  increasing quantities as the price rises.
• The points on the marginal cost curve correspond
  to profit maximizing quantities at two different
  market prices.
• The quantity supplied at a market price of
  600/ton is (about) 240 (black dot).
• Consider another market price, P1,200 and note
  that x increases.

Marginal Cost of Apples
1,600
mc
1,400
mr when P1,200
1,200
1,000
Price (/ton)
800
mr when P600
600
400
200
0
0
100
200
300
400
Apples (tons/year)
14
Finding the Value of Profit - Case A
mc
P
atc

• If market price is P, then the firm supplies x
  where mrmc.
• Total RevenueOACQ
• Total CostOBDQNote use the atc curve to get
  the value of total costs by multiplying atc by
  x
• Profit tr-tcBACD

P mr
A
C
B
D
O
x
Quantity
15
Finding the Value of Profit - Case B
P
mc
atc

• If market price is P, then the firm supplies x
  where mrmc.
• Total RevenueOBDQ
• Total CostOBDQ
• Profit tr-tc0
• Note economic profit 0

P mr
B
D
O
x
Quantity
16
Finding the Value of Profit - Case C

• If market price is P, then the firm supplies x
  where mrmc.
• Total RevenueOACQ
• Total CostOBDQProfit tr-tc -ABDCNote
  Profits are negative. They are loses.
• Should firm continue to operate? Good question.
  Now need to look at where the average variable
  cost curve is. Recall produce at a loss
  provided tr ? vc orp ? avc
• Since Pavc at x, firm should produce x.

P
mc
atc
avc
D
B
P mr
A
C
O
x
Quantity
17
The Firms Supply Curve

• An individual perfectly competitive firms supply
  curve (the srsfirm) is its marginal cost curve
  above its average variable cost curve.
• For a perfectly competitive firm, choosing the
  output at which market price equals marginal cost
  maximizes profits.
• Remember, its really mrmc at x, but since the
  firm is a price taker, Pmr all the time, so Pmc
  at x.

18
Jonathans Supply Curve

• At the market price indicated on the vertical
  axis, profit maximizing apple production is given
  by the marginal cost curve, which is Jonathans
  supply of apples curve.
• The supply curve is the the marginal cost curve
  above average variable cost because profit
  maximizing behavior means increasing production
  until marginal cost market price.

19
Total Costs and Economic Profits

• Total costs include fixed costs, variable costs
  (at market prices) and the opportunity cost of
  owned factors (such as the owners time, land,
  and equipment owned by the business).
• Economic profits are the difference between total
  revenue from sales and total costs, as defined
  above.

20
Back to Jonathans Farm...

• The apple market is competitive.
• Jonathan cannot control the price of apples.
• Consider, for the moment, a price of say 528/ton
  now
• To profit maximize Jonathan produces until P
  (mr) mc

21
Jonathans Economic Profit and Loss

• At the market price of 528, the profit
  maximizing apple production is the highlighted
  line.

22
Graph of Jonathans Revenue and Cost

• The vertical difference between Jonathans total
  revenue and total cost curves is his economic
  profits.
• The slope of the total cost line (marginal cost)
  is equal to the slope of the total revenue line
  (marginal revenue market price)

23
Graph of Jonathans Economic Profits

• The chart at the right shows that Jonathans
  economic profits are maximized at apple
  production where the market price is equal to the
  marginal cost (230 tons/year).
• Profits are maximized when marginal cost is as
  close as possible to market price, without
  exceeding it.
• The slope of economic profits zero at the
  profit maximum.

24
Accounting Profits

• Accounting profits are defined as total sales
  revenue (the same as total revenue in the
  economic profits definition) minus operating
  costs (costs of goods sold administrative and
  sales costs for those who know some accounting).
• Accounting Profits Sales Revenue - Accounting
  Costs

25
Did Jonathan Make Accounting Profits?

• The blue line in the table illustrates that
  Jonathan makes an accounting profit of 40,800
  when the apple price is 528/ton.

26
Economic Profits

• Economic profits are the difference between total
  revenue and total costs.
• Economic total costs include the opportunity
  costs of all inputs to the production processin
  particular, the opportunity costs of the owners
  time and physical capital (equipment and space).

27
Reconciling Economic and Accounting Profits

• The table to the right shows that Jonathans
  economic profits equal his accounting profits
  minus the opportunity cost of his time.
• Thus, when the price of apples is 528/ton and
  230 tons/year are sold, economic profits 27,600

28
Question 1

• At a market price of 440/ton for apples, what is
  the optimal annual production of apples?
• Use the data on your handout to answer this
  question.

29
Answer 1

• Marginal cost market price 440/ton at a
  production level of 210 tons/year.
• This is the profit maximizing level of output
  when the market price is 440/ton.

30
Question 2

• At a market price of 440/ton for apples, what
  are Jonathans accounting and economic profits?

31
Answer 2

• Total revenue 440 x 210 92,400.
• Total costs 124 x 100 (land) 8.00 x 7,320
  (labor) 12.00 x 1,100 (proprietors time)
  84,160 .
• Economic profits total revenue - total costs
  92,400 - 84,160 8,240.

32
Answer 2 (continued)

• Total revenue 440 x 210 92,400.
• Accounting costs 124 x 100 (land) 8.00 x
  7,320 (labor) 70,960.
• Accounting profits total revenue - accounting
  costs 92,400 - 70,960 21,440.
• Economic profits accounting profits -
  opportunity cost of owners time 21,440 -
  13,200 8,240.

33
Question 3

• At a market price of 400/ton for apples, what
  are Jonathans accounting and economic profits?

34
Answer 3

• Optimal production 200 tons/year.
• Total revenue 400 x 200 80,000.
• Economic profits total revenue - total costs
  80,000 - 80,000 0.
• Accounting profits total revenue - accounting
  costs 80,000 - 66,800 13,200.

35
Question 4

• Should Jonathan continue to operate the apple
  farm if the market price of apples is 400/ton?

36
Answer 4

• Jonathans economic profits are zero when the
  market price of apples is 400/ton (0.20/pound,
  about the current price wholesale price for first
  quality fresh apples).
• Jonathan just recovers the opportunity cost of
  his time (13,200), so he is indifferent between
  producing apples and taking a job at 12/hour.

37
Producers Surplus Revisited

• Producers surplus measures the gain to the firm
  from selling all units at the market price.
• Producers surplus is the supply-side equivalent
  of consumers surplus.
• Total producers surplus the area above the
  marginal cost curve and below the market price
  economic profits fixed costs.
• Incremental producers surplus the difference
  between the market price and the marginal cost of
  the given unit of production.

38
Jonathans Producers Surplus

• Jonathans total producers surplus, when the
  market price is 528, is the sum of his economic
  profits (27,600) and his fixed costs (25,600)
  53,200.

39
Producers Surplus and Economic Profits

• Producers surplus is not equal to economic
  profits.
• Producers surplus includes fixed costs.
• Economic profits producers surplus - fixed
  costs.
• Producers surplus economic profits fixed
  costs.

40
The Market Supply Curve

• The market supply curve is the sum of the
  quantities supplied by each seller at each market
  price.
• Market supply, thus reflects the marginal costs
  of each of the producers in the market.
• This is Short Run Market Supply (SRS)

41
Supply Curve for a New York Apple Farm

• The data used to construct Jonathans supply
  curve were representative of the typical New York
  State apple farm.
• The supply curve for a single apple farm is shown
  to the right.

• It is the same as the supply curve we have been
  using, based on the marginal cost curve of a
  single farm.

42
Market Supply Curve Horizontal Summation
Farm As Supply of Apples
Farm Bs Supply of Apples
1,600
1,600
1,400
1,400
1,200
1,200
1,000
1,000
Price (/ton)
Price (/ton)
800
800
600
600
400
400
200
200
0
0
0
100
200
300
400
0
100
200
300
400
Apples (tons/year)
Apples (tons/year)

• At a price of 1000/ton, add Farm As supply to
  Farm Bs supply to get market supply (about 560
  tons/year). Add over all farms.
• The market supply curve is the horizontal
  summation of the firms supply curves.

43
Short Run Equilibrium - Summary

• The firm is profit maximizing - no desire at
  current market price to change the quantity
  supplied.
• Firm is on its short run supply curve
• Market Demand Short run Market Supply
• No tendency for market price to change
• Note number of firms fixed, technology given
  and firms capital fixed.
• Get (P, X, x)
• Firms can have /0/- profit.

44
Profit Signal

• When profit in the short run is positive there
  are firms at the margin that want to enter the
  market and it is assumed that they can.
• When profit in the short run is negative there
  are firms at the margin that want to exit the
  market and it is assumed that they will.

45
Long Run Equilibrium

• All the short run equilibrium properties.
• But alsono firms wish to exit the market nor do
  firms want to enter.
• Get (P, X, x, N)
• Note For there to be neither entry or exit,
  need economic profit to be zero. This is a long
  run equilibrium requirement. Otherwise the
  number of firms in the market will still be in
  flux.

46
Long Run Equilibrium Position

• Profit max implies that mrlrmc at x.
• Zero profit implies Plratc at x.
• Since the firm is perfectly competitive, Pmr at
  all values of x.
• By substitution, Plratc at x and Plratc at x.
• Therefore lrmclratc at x.
• This implies that x is at the minimum of the
  typical firms lratc. x is at MES.
• P must be the price consistent with the minimum
  value on the lratc curve.
• N and X determined by position of market
  demand.

47
Long Run Equilibrium Picture
SRS w/N
lratc
A
a
P
P
mr
D
X
x
X
x
market
typical firm
48
Steps to Draw The Picture?

• Doesnt matter how you draw it, as long as you
  draw it correctly in the end.
• Draw-a-person test.

49
Whats not ok...
50
Increases in Demand

• When demand increases and is expected to remain
  at the increased level, the short run response is
  to move along the short run supply curve--higher
  price and greater quantity supplied.
• The long run response is to have entry in the
  market, movement along the long run supply
  curve--price returns to the minimum average total
  cost and quantity supplied increases.

51
Long Run Adjustment Picture
srmc
D new
SRS w/N
sratc
lratc
B
b
mr
P
P
A
a
P
P
mr
D
X
X
x
X
x
x
market
typical firm
52
Long Run Equilibrium Picture
srmc
D new
SRS w/N
sratc
lratc
SRS w/N
B
b
mr
P
P
A
C
a
P
P
mr
LRS
D
X
X
X
x
Q
x
x
market
typical firm
53
Long Run Supply in the Market

• Both points A and C in the previous picture are
  long run equilibrium points.
• Point B is a temporary short run equilibrium
  point.
• If you connect all points like A and C you get
  the market long run supply curve in a perfectly
  competitive market.

D new
SRS w/N
SRS w/N
B
P
A
C
P
LRS
D
X
X
X
X
54
Long Run Supply in the Market

• The long run supply curve in the market is
  horizontal at the long run equilibrium price P.
• P is sometimes called the normal price.
• P is the price consistent with the typical
  firms minimum long run average total cost.
• Note important assumption is that the position
  of the firms cost curve is unaffected by entry
  (or exit) of firms in the market.

D new
SRS w/N
SRS w/N
B
P
A
C
P
LRS
D
X
X
X
X
55
Example Long Run Supply in the System-fixer
Market

• The market demand for system installations is
  shown by the blue line in the graph.
• The market is very much larger than firms at the
  efficient scale, so we expect competitive
  conditions to prevail.
• The long run supply (in red) reflects the
  technological and competitive conditions in the
  market surviving firms must operate at the scale
  of firm B at a minimum average total cost of
  26/installation.
• Short run supply is shown in brown.

56
Question

• How many firms are there in the long run in the
  system-fixer market?

57
Answer

• Firms with the efficient scale do 8 installations
  per week at an average total cost of
  26/installation.
• At 26/installation the market demand is 8,000
  installations per week.
• Therefore, there are 1,000 firms in the market.

58
Increase in Demand in the System-fixer Market

• Demand increases in the market as indicated by
  the new (black) demand curve.
• The short run response is an increase in price
  with not much additional quantity supplied (point
  A), movement along the short run supply curve.
• The long run response is a return to the original
  price of 26/installation and an expansion of
  quantity supplied along the long run supply curve
  (point B).

59
Question

• What would be the long run result of a fall in
  demand for system installations when the quantity
  demanded at 26/installation is 4,000.

60
Answer

• Now, only 500 firms operating at the minimum
  efficient scale will survive.
• The industry will shrink by exit of some system
  fixer firms. Of the original 1,000 firms, only
  500 survive.

61
External Economies and Diseconomies of Scale

• If the industry exhibits no external economies or
  diseconomies of scale, then the industry long run
  supply curve is perfectly elastic (horizontal).
  The industry grows by replicating firms at the
  efficient scale. Entry and exit leaves the
  position of cost curves intact. This is called a
  constant cost industry.
• If the industry exhibits external diseconomies of
  scale, then the industry long run supply curve is
  upward sloping. The minimum average total cost
  of all firms in the industry rises as the size of
  the market grows. This is called an increasing
  cost industry.
• If the industry exhibits external economies of
  scale, then the industry long run supply curve is
  downward sloping. The minimum average total cost
  falls as the size of the industry grows. This is
  called a decreasing cost industry.

62
Constant Cost Industry

• When we draw the long run supply curve as a
  horizontal line, we are asserting that there are
  no external economies or diseconomies of scale.
• Lack of economies or diseconomies of scale means
  that growth of the industry doesnt foster
  technological improvements and doesnt change the
  prices of inputs.

63
External Diseconomies of Scale

• When an industry long run supply curve slopes
  upward, the industry exhibits external
  diseconomies of scale.
• This can occur because the prices of the inputs
  rise as the industry expands.
• This can also occur because the industry becomes
  congested and the minimum average total cost at
  the efficient scale rises.

64
Examples of Long Run Supply Curves that Slope Up

• As a competitive industry grows its demand for
  certain specialized factors increases
  (information systems specialists in the
  accounting service industry, fabrication
  equipment in the microprocessor industry).
• Increased demand for specialized factors means
  that the equilibrium price of these factors will
  increase (movement along a factor supply
  curve--increased quantity and increased price of
  the factor).
• So as the industry (not the firm) grows, the
  price of these specialized factors increases and
  the minimum average total cost rises.
• Thus, the long run supply curve slopes upward.

65
Long Run Competitive Equilibrium - Reviewed

• The firms in a perfectly competitive market are
  in long run equilibrium when
• Quantity supplied Quantity demanded at the
  current market price.
• Firms are profit maximizing so that marginal
  revenue ( Price) marginal cost for all firms
  in the market.
• Price minimum average total cost for all firms
  in the market, implying zero economic profit.
• No firm wants to enter the market.
• No firm currently in the market wants to exit.

66
Why are there zero economic profits in the long
run?

• Zero economic profits means that all factors used
  in production make exactly their opportunity
  cost.
• Purchased factors receive their market price,
  which is equal to their opportunity cost.
• Owned factors receive the same compensation that
  they would receive in their next best use, which
  is also equal to their opportunity cost.
• Thus, no firm wants to enter the market because
  it cannot make any more money than it is
  currently making.
• Similarly, no firm wants to leave the market
  because it cannot make any more money in any
  other business.

67
Performance

• Efficiency
• Allocative efficiency (look at market) The
  level of output traded is allocatively efficient
  if it maximizes net social surplus.
• Productive efficiency (look at the firm) The
  firms output level is productively efficient if
  it is at the minimum of the firms long run
  average total cost curve, that is, if it is at
  least as large as minimum efficient scale of
  production.
• Equity
• Is the outcome of the allocatoin process fair?
  Equitable? Just?

68
Long Run Competitive Equilibrium - Performance

• Efficiency
• The market equilibrium is allocatively efficient.
  That is, at X, net social surplus is maximized.
• Each firm is productively efficient. That is
  each firm operates at, at least, minimum
  efficient scale. Each firm operates at the
  minimum of its long run average total cost curve.
• Equity Is the outcome of the competitive
  process fair? Equitable? Just?
• Good questions that we do not answer here and
  now.

69
Allocative Efficiency - Proof

• If X is allocatively efficient, then net social
  surplus should be as high as it can feasibly be.
• Net Social Surplus TBsociety - TCsociety
• When net social surplus is as high as it can be,
  MBsociety MCsociety
• Question Is the outcome of the competitive
  process allocatively efficient?

70
Answer

• DemandSupply at X.
• Demand represents marginal benefit.
• Supply represents marginal cost.
• Somarginal benefit equals marginal cost at X.
• Sonet social surplus is maximized at X.
• There is no transaction among the buyers and
  sellers that improves the welfare of at least one
  person without reducing the welfare of at least
  one person.

71
Productive Efficiency - Proof

• Profit max implies that mrlrmc at x.
• Zero profit implies Plratc at x.
• Since the firm is perfectly competitive, Pmr at
  all values of x.
• By substitution, Plratc at x and Plratc at x.
• Therefore lrmclratc at x.
• This implies that x is at the minimum of the
  typical firms lratc. x is at MES.
• P must be the price consistent with the minimum
  value on the lratc curve.