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PROFESSOR: All right.
So today we're going to continue
our discussion of the
perfectly competitive
market outcome.
And remember, once again, where
we're coming from here.
We're trying to figure
out how firms
decide how much to produce.
We talked about the firm's
production decision in costs.
Then we said how the firm
decides how much to produce is
going to get dictated
by the market.
We're going to talk about
different market structures.
We'll start with our benchmark
of perfect competition and
then move on to some more
interesting and realistic
cases next.
Now, I just want to finish up
where we were last time.
Remember last time we were
dealing with a firm that had a
cost function of the form
10 plus 0.5q squared.
And if you remember, the key
condition we derived last time
for profit maximization with a
perfectly competitive firm is
that price equals marginal cost.
If you differentiate
this with respect to q, you
get that that means that p
equals q is the profit
maximizing
condition for this firm.
It sets the price equal to
quantity it's going to sell.
That's the profit maximizing
condition with this particular
functional form of the
cost function.
Now, before we left last time,
I said, this was not enough.
There's one other thing you have
to consider which is the
firm's shutdown decision.
In the short run, a firm might
not shut down even if it's
losing money.
And the reason is because the
firm has already paid its
fixed costs.
It's already paid 10.
So even if it's losing money, it
might still not shut down.
So, for example, imagine that
the price, as I said last
time, imagine the price
fell from 6 to 3.
The price equals 3.
If the price equals 3, the firm
will choose to produce 3
units, because it will
still follow the
profit maximizing condition.
It will still choose to
produce three units.
If it produces 3 units,
its profits are its
revenues which is 9--
3 units at a price of 3--
minus its cost which is 14.5.
So that equals negative 5.5.
So its profits are negative.
So now I say, well, if profits
are negative, maybe I should
shut down and stop
doing business.
Well, what are its profits
if it shuts down?
Negative 10.
If it shuts down, its profits
are 0 minus 10
equals negative 10.
So it actually makes more money
by staying in business
than shutting down, because
it has these fixed costs.
So because it's going to pay the
10 anyway, as long as it's
going to lose less than
10, it might as
well stay in business.
More generally, what we say is
a firm will stay in business
in the short run as long
as its price covers
its variable costs.
So a firm will stay in business
so long as the price
is greater or equal to
its variable costs.
Then it will stay in business.
If we go further--
let me just derive it for a
second-- as long as they cover
its fixed costs, that means a
firm will stay in business as
long as its revenues
are greater than
its variable costs.
As long as its revenues are
greater than or equal to its
variable costs, it will
stay in business.
And that means that it will stay
in business at long as
its price is greater than or
equal-- this should be a
little q, sorry, this
is just a firm--
as long as its price is greater
than or equal to
variable costs over quantity, or
as long as price is greater
than or equal to average
variable cost.
As long as its price is greater
than or equal to its
average variable cost, it
will stay in business.
As long as its revenues cover
its variable costs, it will
say in business.
And that's saying the same as
long as its price is great
than or equal to average
variable cost, it
will stay in business.
Now, what are the average
variable costs for our firm?
Well, the variable costs
for our firm
are 0.5 times q squared.
The variable costs for our firm
are 0.5 times q squared.
We know that in equilibrium, if
it's profit maximizing, it
will produce where q equals p.
So we can replace the
q with the p.
The variable costs are 0.5 times
p squared, because we
know we'll produce
where q equals p.
So its average variable
costs are 0.5 times p.
Its average variable costs
are 0.5 times p.
Well, by definition,
p is always greater
than 0.5 times p.
So our firm will never go out of
business in the short run.
In the short run, our firm will
never go out of business,
because at the profit maximizing
price, at p equals
q, it will always be producing
a point where the price is
greater than its average
variable cost. So it will
never shut down.
So, more generally, when we
think about a short run supply
decision, a short run supply
decision for a
firm, there's two steps.
The first step is set price
equal to marginal cost to
figure out what the firm
is going to produce.
So step one is set price equal
to marginal cost. And that
will give you the firm's q*.
That will give you what the
firm is going to produce.
The second step is check that
price is greater than or equal
to average variable costs.
Because you may solve for an
optimal quantity that turns
out to be a money loser
for the firm.
So they'd rather shut down.
So it's a two-step process.
You've got to first solve for
the optimal quantity that the
firm is going to produce.
But then you've got to make sure
that the firm actually
makes money on that quantity,
or it won't produce at all.
And that's how we do the profit
maximization decision
in the short run for the firm.
You've got to produce at the
efficient point and make sure
the firm actually makes
some money.
All right, questions
about that?
Now, armed with these rules,
we can now, finally, derive
the supply curve.
Remember we derived the demand
curve a number of lectures ago
by getting the tangency at
different price ratios with
the indifference curves.
Well, to derive the firm's
supply function, what we now
need to do is say, OK, at
different prices, how much
will the firm produce?
Well, we can now get that
if we go to Figure 11-1.
We can now see the supply
curve for this firm.
What we see is that at a price
of 3, it will produce 3 units.
At a price of 4, it will produce
4 units, et cetera.
The supply curve is the
marginal cost curve.
So now we know where supply
curves come from.
Supply curves are marginal cost
curves above the point
where price equals average
variable cost. So the
definition of a firm's supply
curve is the marginal cost
curve above p is greater than
or equal to average variable
cost. That is the firm's
short run supply curve.
Now, in our case, p is always
greater than average variable
cost. So the second condition
is irrelevant.
The firm's supply curve is just
literally that marginal
cost curve.
With different functions, which
you may someday see in a
problem set or an exam,
that won't be true.
So, in that case, you'll
need to check
that shutdown condition.
But the supply curve is the
marginal cost curve above that
0 profit point.
And that's where supply
curves come from.
So where supply curves comes
from is the same kind of
maximization we did
with consumers.
But instead of their parents
giving them their income, the
market conditions firms face
are dictated by the
competitive nature
of the market.
And that's the firm's
supply curve.
Now, this is the firm's
supply curve.
Now, of course, what we talked
about in the first lecture was
not firm supply curves but
market supply curves.
So now let's take the next step
and say, well, where do
market supply curves
come from?
We now know where firm supply
curves come from.
The marginal cost stork
brings them.
Now, where do market supply
curves come from?
Well, to do that, we need to now
imagine that there's not
one firm in the market but
many firms in the market.
And we need to recognize that
the market demand may not be
perfectly elastic.
But, as we talked about last
time, the firm's own demand
will be close to perfectly
elastic.
Or, in this case, a perfect
competition will
be perfectly elastic.
So, basically, the way to get
market demand is to say, look,
we're going to take each firm.
It's going to take a market
price as given.
I'm sorry, we get
market supply.
I'm sorry.
Each firm is going to take
a market price as given.
Based on that market price, it's
going to decide how much
to produce.
We're going to add up
that production.
That will make a market
supply curve.
And that market supply curve
will then interact with market
demand to give you a price.
If that price is the same one
the firms were using, then the
whole thing is in equilibrium.
Let me explain that in less
steps just to make it clear.
Let's talk about the steps
involved in getting to short
run equilibrium in the market,
the steps involved in getting
to short run market
equilibrium.
The first step is each firm
chooses an amount of capital.
So the first step of the short
run is you're going to enter
this market.
And to enter this market, you're
going to have an amount
of capital you're
going to pick.
So each firm is going to have
some cost function which
involves picking some amount
of capital or fixed costs.
It's going to say, I want to
build a building this big.
Having built that building,
we're going to get the firm's
supply curve which
is p equals MC.
That's step one.
That's a step we've derived.
The second step is we're going
to add up the firm's supply
curves to get a market
supply curve.
We're going to add up the firm's
supply curve to get a
market supply curve.
So, for example, suppose
that there's five
firms in the market.
Suppose that there's five
firms in the market.
Those five firms are
going to produce.
Now to see that, let's
go to Figure 11-2.
This is the second step.
It's how we get to that short
run market supply curve.
Each firm has a marginal
cost curve.
Here we're using our same cost
function we've used.
That same cost function up
there where price equals
marginal cost, where p equals
q, is the supply curve.
So each firm has that
supply curve you see
in the first panel.
Then what you see is as you
add more firms, the second
panel gives you the market
supply curve.
So if there's only one firm in
the market, the market supply
curve would be S1.
Now, if there were two firms
in the market, the market
supply curve is S2.
That is, at a price of 2, you're
now producing 4 units
in the market.
If there's three firms,
the curve is S3, four
firms, S4, and so on.
As you add more firms, that
market supply curve shifts out
and becomes flatter.
Remember firms are
identical here.
We're adding identical firms.
That was an assumption of
perfect competition.
We're adding more and
more identical firms
producing the same good.
You can see that market supply
curve is shifting out and
becoming flatter.
That is the supply of goods is
becoming more elastic as there
are more firms. The more firms
in the market the more elastic
the supply.
And that comes to what we talked
about last time when I
derived residual demand.
It's sort of the flip
side of that.
Basically, the more firms you
have with a given supply curve
in the market, the more elastic
it's going to become.
Why is that?
Well, just think about it.
Think about what elasticity
of supply is.
It's saying, if I increase the
price by $1, how much more
production do I call forth?
Well, the more identical firms
I have, every time I increase
the price by $1, I call forth
production from all these
firms. So the more firms I have,
the more production I
call forth.
So for every increment in price,
the more firms in the
market, the more production
I call forth.
Therefore, the more elastic
is the supply.
So as there are more firms,
that market supply curve
becomes more and more elastic.
And that's the market
supply curve.
That's the second step.
The third step is we intersect
market supply with market
demand to get the equilibrium
price.
So, in other words, we say,
look, there's some market
supply, which we've derived.
Now let's imagine there's
some market demand.
And that will give us the
equilibrium price.
So, for example, in our case,
market supply is what?
Let's say, for example,
there's five
firms in the market.
Just to make an example, let's
say five firms have entered.
There's five firms
in the market.
Well, the total market supply
Q is 5 of the little q,
because there's five identical
firms in the market.
Five identical firms
are in the market.
Well, we know, from the marginal
cost condition,
that's the same as saying
Q equals 5 times p.
So our market supply curve,
which is actually S5 on Figure
11-2, is Q equals 5p.
You can see that.
Because when the price
is 2, Q equals 10.
When the price is
5, Q equals 25.
So you can see that S super 5
is the market supply curve.
Big Q equals 5p.
Let's just make this up.
So this is the quantity
supplied.
Let's say the demand function is
that the quantity demanded
is 30 minus p.
I just made this up.
I'm making all this up.
But this is just an example
demand curve.
We have a downward sloping
demand curve with a slope of
negative 1.
The quantity demanded
is 30 minus p.
So to get equilibrium,
we set these equal.
And we get that 30 minus p
equals 5p or p equals 5.
30 minus p equals 5p or
p equals 5, that's the
equilibrium price.
Given the market supply curve,
given the demand curve, I've
derived the equilibrium
price of 5.
Now, at a price of 5, what's
the quantity demanded?
At a price of 5, quantity
demanded equals 25.
So, at a price of 5, the market
wants 25 of these
things, whatever the heck
it's producing.
At a price of 5, the market
wants 25 of them.
That's the quantity demanded.
Then the final step in solving
for equilibrium is that each
firm then decides how
much to produce.
Well, what is each firm going
to decide to produce?
How much is each firm going
to decide to produce?
Somebody raise their
hand and tell me.
Yeah.
AUDIENCE: p.
PROFESSOR: p which is?
AUDIENCE: 5
PROFESSOR: 5.
So each firm is going
to produce 5.
How many firms are there?
AUDIENCE: 5.
PROFESSOR: How much
gets produced?
AUDIENCE: 25.
PROFESSOR: Which is exactly
what people want.
We're done.
That's the magic
of the market.
Through these four steps, we've
gotten equilibrium which
is defined as the quantity
supplied equals the quantity
demanded, just by following
these steps.
The firms didn't come at it
saying, hey, let's figure this
out beforehand.
Let's all get together and
coordinate and figure out how
much we're going to produce
at what price.
They didn't do that at all.
The firms just entered
the market.
They said, this is
my supply curve.
We added it up.
We interact it with demand.
We find an equilibrium price.
At that equilibrium price, the
quantity demanded equals the
quantity supplied.
We're done.
We've now finally gotten to
where we started this course.
We started this course with
a supply and demand graph.
I told you how to
derive demand.
You took a test on
that already.
Now I've just told you where
supply comes from.
Now we interact,
and we're done.
And this tells us now, given
this price, how much each firm
is going to produce.
So, basically, what do you
need to find equilibrium?
What do you need to find the
short run equilibrium?
To find the short run
equilibrium, you need a demand
function, a cost function, and a
number of firms. You have to
be given a number firms, because
there's no entry and
exit in the short
run, remember.
So, basically, the firms are
magically put on the earth in
the short run.
So if you're asked about the
short run equilibrium, you
have to be given the number
of firms. You
can't derive that yet.
That comes in the long run.
But given a number of firms,
given a cost function, and
given the demand function, you
can find the short run
equilibrium.
Questions about that?
Now, with that in place, now
let's get to where it gets
really interesting.
Let's talk now about
the long run.
Now what makes the long run
interesting is you no longer
have to be given the number of
firms. Now, in the long run,
we're going to actually
figure out how many
firms are in the market.
So at the end of the day, in the
long run, all we'll need
is two things, a demand function
and a cost function.
And then we'll be done.
Now, here's the key thing
for the long run.
The key point in the long run
is that in the long run, no
one can lose money.
So we don't have to
worry about the
shutdown condition anymore.
The shutdown condition
goes away.
In the long run, nothing
is fixed.
So in the long run, no
one loses money.
There's no reason to be in the
market if you're losing money
in the long run.
So, in long run, the first thing
is now we only have one
condition to worry about, which
is price equals marginal
cost. Price equals marginal
cost is what we
need to worry about.
And you're only going to be in
a situation, in the long run,
where you're only going
to be making either
0 or positive profits.
If you're making negative
profits, you'll be gone.
Now, the key difference in the
long run, is now we can't take
the number of firms as given.
Now we need to derive the number
of firms. And the way
we do that is by thinking
about entry and exit.
Now, what's going to determine
entry and exit?
Well, it's quite simple.
If in the market, as it stands
today with some number of
firms, there's profit to be
made, new firms will enter.
If in the market, as it stands
today with some number of
firms, there's losses being
made, some firms will leave.
Remember, no one stays in
making losses anymore.
And that continues until you
reach a situation where all
firms make zero profit.
And here's the key lesson.
In a perfectly competitive
long run equilibrium, all
firms make zero profit.
It's the fundamental lesson
about perfect competition.
Obviously, there's no
place that works
like this in the world.
This is an extreme.
But, nonetheless, you should
understand this extreme.
In a perfectly competitive
long run equilibrium, all
firms make zero profit.
Why?
Because if there's any profit
to be made, a new firm will
enter and take it away.
And if there's any unprofitable
industry, a firm
will exit until the profits
go back to zero.
So profits will always be zero
in the long run equilibrium.
Now, to understand how this
works, let's think about a
realistic example.
Let's think about the PC market
circa 1990 when all you
youngins were being born.
It's circa about 1990,
the PC market, cast
your mind way back.
It's a history lesson
for you guys.
In 1990, not that many
folks had PCs.
There was still a vibrant use
of mainframe computers.
And, basically, you had big
firms like IBM who were
producing these mainframe
computers, which is what I did
my computing on.
A lot of people did their
computing on it in 1990.
And there was starting to
be a market, however,
for personal computers.
The chip strength had gotten
large enough that it was
actually viable to have desktop
computing that was
powerful enough.
Firms like Dell were starting
out-- not starting out,
necessarily-- but were starting
to make money making
desktop computers, making PCs.
Let's actually think about how
that market might look.
So let's actually talk about,
in Figure 11-3, this is the
market for PCs circa 1990.
In 1990, if you were making
PCs, that was a great
business to be in.
Because people wanted them,
there weren't that many firms
making them, and you were
making a killing.
So if you were Dell in 1990,
that was a great place to be.
So let's say Dell in 1990 was
facing a demand curve D and
the supply curve SR1.
The supply curve was pretty
steep because there weren't
many firms making PCs.
So the market price was P1.
So on the right, you
have the market.
We should label this actually.
On the right, you
have the market.
On the left, you have Dell.
On the right, you
have the market.
In the market, in initial
equilibrium, there's a price
of P1 with big Q1 being sold.
So Q1 PCs are being sold
at a high price of P1.
It's the novel technology.
People want it, but not many
firms are doing it.
What happens with Dell?
Now let's go to the left-hand
side diagram.
Well, Dell is producing where
that price equals their
marginal cost. That price
equals their marginal
cost at little q1.
So Dell's producing little q1.
But its average costs at that
point are all the way down.
It's not really labeled.
But you can see it's where
that vertical line for Q1
intersects average total cost.
That's where their costs are.
So, in each unit, they're making
the height between
marginal cost and average
total cost at that Q1.
They're making that
vertical bar.
So they make that entire
rectangle of profit.
So Dell makes a big profit,
because not many firms are in
this business.
And yet demand for
PCs are high.
And that's where things
are circa 1990.
So what happens?
Well, Gateway arrives.
Does Gateway still exist?
Do people still buy Gateway?
Gateway is gone, right?
So, while Gateway was
big, they were
sort of a big upstart.
They had the boxes with cow
colors on them and stuff.
You guys didn't even
know Gateway?
Well, they were big.
They were the first cheap
knockoff computer makers that
competed with the big folks.
And they came and said
look, we can do this.
OK, we can produce.
This is a profitable business.
We can make PCs.
It's not that expensive.
It's largely a variable
cost business.
You just have to build
your plant first.
So they built their plant,
and then they come in.
Well, what happens when
a new firm comes in?
The market supply
curve flattens.
Because now, at any price,
you're producing more.
So the market supply curve
flattens to the point SR2.
In fact, maybe it's
not just Gateway.
Maybe you get a bunch of
entrants until you get the
market supply curve SR2.
Well, SR2 intersects demand
at a new higher market
quantity big Q2.
Well, that higher market
quantity going to the left,
there's now no longer
profits to be made.
Because at that market quantity,
Dell is going to
produce little q2.
Little q2 is exactly at the
minimum of the average total
cost curve.
It's where the marginal cost
curve intersects the average
total cost curve, the
minimum of that
average total cost curve.
So Dell no longer
makes profits.
Dell shrinks its production.
The price has fallen.
It doesn't lower its price.
Dell doesn't set the price.
Remember, this a price
taker in a
perfectly competitive market.
The price is given by that
diagram on the right.
Dell gets a price of P2.
It says look, at P2, I have
to produce along my
marginal cost curve.
I have no choice.
That's what's profit
maximizing.
I can't choose a point not on
that marginal cost curve.
That will not be profit
maximizing.
Well, where does that
price intersect that
marginal cost curve?
At little q2.
So I'm producing at little q2.
And at little q2, I
make no profit.
So the entry of Gateway and
other firms into the PC
business has removed the profit
from the PC business.
Now note what's interesting
here.
Market quantity has gone up.
Big Q2 is bigger than big Q1.
But Dell's quantity
has gone down.
Little q2 is smaller
than little q1.
That's because more firms are
in the market producing.
So as more firms come in, total
market quantity goes up.
But any given firm is going
to produce less.
And that will continue until
profits go to zero.
That is how firm entry
wipes out profits.
That is how firm entry wipes out
profits, by driving firms
to the point where price
equals average cost.
So, in the long run, firms
make zero profit because,
first of all, entry drives price
down to average cost.
Entry drives price down to
average cost. And when price
equals average cost,
profits are zero.
Profits are zero when price
equals average cost. Because
profits are pq minus C. So if
you divide by qp profits are p
minus average costs.
So if price equals average
cost, profits are zero.
So entry drives profits
to zero.
It drives price to equal average
cost. Since price
equals marginal cost, it's the
point where marginal cost
equals average cost. That's the
technological outcome in a
perfectly competitive long
run equilibrium.
You'll end up producing where
marginal cost equals average
cost. That's what will end up
happening naturally through
the forces of entry.
Likewise, you see this through
the force of exit.
Now let's go to Figure 11-4.
And now let's look at IBM.
I guess we're calling this the
broader computer market now.
It's not just a PC market.
It's the broader computer
market.
So IBM, they're producing
these mainframes.
This is the mainframe market.
This isn't the PC market.
This is the mainframe market.
In the mainframe market, now
people don't want mainframes
much anymore.
But there were a lot
of firms producing.
There was IBM and tons of other
firms producing these
mainframes.
Because that's what
everybody wanted.
So the original supply curve
was very flat at SR1.
So, initially, in the mainframe
market, we're in
equilibrium with quantity Q1--
big Q1-- and a price P1.
And what's happening there?
Where does that price intersect
marginal cost?
It intersects marginal cost for
IBM at little q1 which is
below average total cost.
So IBM is losing money.
In the initial short run
equilibrium, IBM is producing
at little q1, and it's
losing money.
Now, why is it still
in business?
Because it's the short run.
And as long as those losses are
less than its fixed cost,
it's staying in business.
So, in the short run,
you can lose money.
So IBM is losing money.
Because it's built
this big plant.
It's cranking out these
mainframes.
People don't want
them anymore.
The price has fallen so low
that they can still make
enough money than it costs to
produce the next mainframe.
Price is still greater than
marginal costs, but price is
below average costs.
I'm sorry.
Prices are greater than average
variable cost. But
it's lower the total average
cost. They're losing money.
So what happens?
They leave.
There was a company
called [? Deck ?]
that went out of business.
And what happened was that then
raised the supply curve.
It steepened the supply curve
in the mainframe market.
It steepened the supply curve,
because now you have fewer
firms producing mainframes.
That supply curve
gets steeper.
That raises the price.
And, indeed, exit will continue
until you raise the
price to the point where
marginal cost equals average
total cost.
And what you'll see is the
market will shrink from
big Q1 to big Q2.
The remaining market
participants will increase
from little q1 to little q2.
And profits go to 0 with price
going to the minimum average
cost. So through both entry
and exit, we get this
condition that's illustrated
in Figure 11-5.
In 11-5, we see that in the long
run, firms always supply
not on a single curve but
at a single point.
In the long run, with a
perfectly competitive market,
for a given firm, there is no
longer even meaningfully a
supply curve to a firm.
There's just literally
a supply point.
Every firm produces at exactly
the point where marginal costs
equal average costs.
So in some sense, once again,
for a given firm--
this is not the market-- but for
a given firm, there's not
even meaningfully a supply
curve anymore.
For a given firm, in the long
run, they literally choose one
production point which is
technologically given.
So this is interesting.
For a given firm, the market
doesn't matter.
For a given firm in a perfectly
competitive market,
we don't need to know anything
about demand.
All we need to know is the
firm's production function.
That's all we need to know.
We don't even need to know
anything about costs.
Well, we need to know
cost. We need to
know their cost function.
All we need to know is
their cost function.
And then all we need to do is
derive where marginal costs
equals average costs,
and we're done.
This is the power of the
perfectly competitive
equilibrium.
This is why economists
love it so much.
Because we don't need to
go through all this.
This is all short run stuff.
In the long run, it's easy.
You just say, give me a cost
function, I'll tell you what
the firm will produce.
And I'll tell you what
the price is.
The firm will produce where
marginal cost equals average
cost. And the price will be
where marginal cost equals
average costs.
I can tell you the p and the q
in equilibrium just if you
give me a cost function.
And that's the beauty of the
long run perfectly competitive
equilibrium.
That's why it's so attractive
to economists for modeling
purposes and other things.
It's incredibly easy
to work with.
Because all you need is a cost
function, and you're done.
The key lesson is what is true
at the point where marginal
costs equals average costs?
Well, look at our graph.
That is the point of
cost minimization.
Note that that is the very
minimum point of the long run
average cost curve.
So where marginal cost equals
average cost is the point of
cost minimization.
So we're saying further--
this is even more powerful--
we're saying that in the long
run of perfectly competitive
equilibrium firms will,
by definition,
minimize their costs.
They will produce as efficiently
as possible not
because God told them
to, but through the
power of the market.
Because what happens if you
start a firm and you aren't
cost minimizing?
What happens?
What happens is, in the short
run, you might make money even
if you aren't cost minimizing.
But, in long run, you'll get
driven out of business.
Because if there's someone
else who can produce more
cheaply than you, they'll be
able to charge a lower price
and drive you out of business.
Your price will end up above the
long run equilibrium price
if you're not cost minimizing.
So any firm that is not cost
minimizing will get driven out
of business.
And the equilibrium will be a
market where all firms are
producing at the cost
minimizing level.
And that's why we get the high
tech Figure 11-6, which is
that the long run market
supply curve
is perfectly elastic.
Now this comes all the way back
to what I talked about at
the beginning of the
last lecture.
Remember I said, what
determines perfect
competition?
Two things, the demand curve
to the firm was perfectly
elastic, and the supply
curve to the market
is perfectly elastic.
And we talked last time about
why the demand curve to the
firm is perfectly elastic.
Because with lots of firms, any
given firm has a perfectly
elastic demand.
Now we've just derived why the
market supply curve is
perfectly elastic.
It's perfectly elastic at the
cost minimizing point.
If the price ever rises above
that cost minimizing point,
what happens?
What happens if the price should
suddenly rise above it?
What happens?
Firms enter and drive
the price back down.
If the price ever drops below
that cost minimizing point,
firms exit, and the price
goes back up.
So through the power of firm
entry and exit, in the long
run, you end up with a
horizontal or perfectly
elastic supply curve.
And that's perfect
competition.
Questions about that?
Yeah?
AUDIENCE: You said that if it's
not profit maximizing,
then it cannot
[INAUDIBLE PHRASE].
But [INAUDIBLE PHRASE].
PROFESSOR: Yes, they are.
So that's a great point.
So what will happen is it's not
that a firm will charge a
lower price.
I shouldn't have said
it that way.
It's that another
firm will enter.
And, by definition, the price
will then fall, because the
supply curve will flatten, and
the price will then fall.
So if you're in there producing
inefficiently and I
say, hey, your firm sucks.
I can come in and produce much
more efficiently than you.
I'll hop in, that will flatten
the supply curve.
The price will fall.
At that price, if I'm
not cost minimizing,
I'll be losing money.
So I'll leave.
That's a good clarifying
question.
So if we have a market with a
bunch of guys in it, and one
of them is not cost minimizing,
well, that means
someone else can come in.
They'll, in the short run,
expand the market.
That will flatten the supply
curve, drive the price down.
At that lower price, the
non-cost maximizing firm says,
I'm losing money.
So I leave.
The price goes back up, and it
goes up and down and up and
down until it settles
at this point
where costs are minimized.
So perfect competition leads to
a perfectly elastic supply
and cost minimization.
So that is our extreme.
That is the theoretical
point of no return.
Of course, in reality,
we never get there.
In reality, there's no such
thing as a purely perfectly
competitive equilibrium.
Why not?
Well, in the long run, supply
is actually upward sloping.
In the long run, market supply
will be upward sloping.
And that's going to be for
at least three reasons.
So why is long run supply upward
sloping in reality?
Well, in reality, if would be
for at least three reasons.
The first reason is that entry
and exit are not free.
There could be barriers
to entry or exit.
Even in the long run, there
could be barriers
to entry and exit.
There could be features of the
market which make it hard to
leave or hard to join.
A classic example is something
that we introduced a couple
lectures ago, the notion of sunk
costs, costs which even
in the long run might
be fixed.
If they're large sunk costs, if
one firm's incurred them,
another firm is going to say,
look, it's not worth it
for me to get in.
If you have to build such a
massive plant to produce your
good, then it takes an
unbelievable amount of
capital, it's a huge investment,
and once you're
in, it's going to be really hard
to drive you out, because
you made that big investment,
other firms
might say, forget it.
Dell made this huge investment
in this huge plant.
They're never going to leave
having built that plant.
That's virtually a sunk cost.
So I'm not even going to
bother entering.
So Dell can exist making
some profit, maybe
not too much profit.
If they make too much profit,
then another firm
will build a plant.
Well, as long as they're not
making too much profit, they
can make some profit.
Because another firm says,
you know what, I
can't fight that battle.
I can't build a plant
that big.
Or there could be other
things like that.
That's sort of a natural
barrier to entry.
There are some artificial
barriers to entry we see.
For example, take med school.
The number of slots to be
doctors is limited by the
physician profession.
So even if docs make lots of
money, which they do--
especially specialists--
you can't just compete and
have new doctors enter.
Because the number of slots
are actually limited.
You have to be licensed by an
organization which is run by
the people making
all the money.
So if you're a doc, and
you're in, this is
a pretty good deal.
You say, hey, let's have
a system where new
docs can't be licensed.
They'll have to come
to me, and I can
charge whatever I want.
That's a barrier to entry.
We call that occupational
licensing.
We see that in lots
of professions.
Plumbing, taxi drivers,
we see it everywhere.
It's occupational licensing.
A second example, of
course, is patents.
And we'll talk about patents
more in a few lectures.
If I invented a new drug, and
it's patented, nobody can sell
that same chemical compound
for 17 years.
That's a barrier to entry.
There could be more informal
barriers to entry.
Let's say you're around Port
Authority setting up these
little shlocky stands, the
ones we said were perfect
competition.
You've got yours, and the guy
comes in next to you, you just
beat the crap out out of him.
That's an informal
barrier to entry.
You say, you come in, and you're
going to get beaten up.
The guy says, well look, if it's
a big profit, it's worth
getting beaten up.
Or I'll hire protection
if it's a big profit.
But it's not that big of a
profit, I'm not going to
bother getting beaten
up over it.
So I'll let you make
your profit.
I won't come in.
So barriers to entry exist
all over the place.
And they're a big reason why
we don't get a perfectly
elastic supply curve in most
markets because of things like
patents or thuggery.
So that's one example of
why you don't get it.
Another example of why you
might not get a perfectly
elastic supply curve is that
firms might differ.
In particular, we have assumed
critically, through the last
lecture and this lecture, that
firms are identical.
We have assumed that firms
are identical.
But, in fact, of course,
firms aren't.
And one firm's cost minimizing
production level might be
different than another
firm's cost
minimizing production level.
Not all firms will have
exactly the same cost
minimizing production level.
In particular, some firms may
have a lower minimum average
cost than others for a while.
So it may be that as long as
I'm producing less than x
units, I have a lower minimum
average cost than you do.
But once I produce more than x
units, my minimum average cost
rises to above yours.
Well, in that case, I might be
able to make money for a while
staying in.
But then once I produce too
much, I'm going to have to
raise the price.
So to see this, there's a great
example in Perloff which
you see in Figure 11-7, where
he talks about the
international long run market
supply curve for cotton.
And he says, look, in Pakistan,
you can produce
cotton incredibly cheaply.
This is a dated example, but in
Pakistan, you can produce
cotton incredibly cheaply.
You can produce it at
$0.71 per kilogram.
So if the world demand for
cotton is less than $2 billion
kilograms per year, or less than
$1.8 billion kilograms
per year, then Pakistan would
provide it all, and the price
would be $0.71.
But let's say the demand
is more than that.
Well, Pakistan just runs
out of cotton.
They can't do that.
Well, then you have to go to
the next cheapest country.
Well, the next cheapest
country is Argentina.
It costs a lot more to
produce cotton there.
And then comes Australia,
Brazil, Nicaragua, Turkey,
then finally the US.
And then Iran is the
most expensive.
So this is, effectively, an
upward sloping supply curve.
It's stepwise, but it's an
upward sloping supply in the
sense that as you want more
quantity, the price goes up.
So if the market wants $5
billion kilograms of cotton a
year, then that means that the
marginal producer is the US
even though they're much less
efficient than Pakistan.
Because Pakistan hit
a constraint.
You have to go to that next
less efficient producer.
So that's taking an upward
sloping supply curve.
Basically you're getting an
upward sloping supply curve,
because you have constraints
on how much any
given firm can produce.
Those constraints can make you
move onto less efficient firms
as you go on.
And so in a market, you'll end
up, in reality, with a
distribution of firms
ranging from most
efficient to least efficient.
The most efficient would produce
as much as it can at
that efficiency level.
But then some less efficient
ones will get in the game as
well just depending on
where demand is.
So you can see if you put in
demand curves at different
points in the supply curve,
you get different prices.
That's an upward sloping
supply curve.
That's a second reason.
And then a third reason--
these aren't a comprehensive
list, but types of reasons why
supply curves will slope
up in reality--
is that input prices might rise
as the market expands.
We've assumed fixed
input prices.
I gave you an r and w, and
I assume they were fixed.
But, in fact, that might
not be true.
It might be that, in reality,
as you want to produce more,
you need to buy more
of the input.
Well, if you need to buy more
of the input, and the input
has an upward sloping supply
curve, then you'll have to pay
more to get more
of that input.
So to see that, let's run
through an example.
Let's imagine that you want to
produce something in the long
run, and you need more
labor to produce it.
So as you produce more of
it, you need more labor.
So now let's go to
Figure 11-8.
You're initially, in your firm,
demanding L1 units of
labor at a the wage of W1.
And let's say that at that
point, at that wage, you're
cost minimizing.
That's the cost minimizing
point, and you've got this
flat supply curve.
You're at that point.
Now let's say you want
to produce more.
Well, to produce more, you've
got to go to the market and
hire more labor.
If the supply curve for labor is
upward sloping, if labor is
not a perfectly competitive
market and, therefore, is an
upward sloping supply,
they'll say, fine.
If you want more workers,
you've got to pay more.
You've got to pay W2.
You've got to pay more
for your workers.
Well, think about
what that does.
Now, go to Figure 11-9.
What that means is that as I
produce more units, I have to
pay more for the labor.
Now let's start on the left-hand
side figure.
That says that if I'm producing
little q1 as a firm,
my marginal cost is MC super
1, and my average
cost is AC super 1.
So I'm at P1.
Now if I want to produce more,
if I want to produce q2, my
average cost is going to be
higher, and my marginal cost
is going to be higher, because
I have to pay a
higher wage to workers.
So that's going to shift
me up to have to
charge a higher price.
Now, I'm still cost
minimizing.
Given the wage the market
gives me, I'm still cost
minimizing.
There's nothing non-cost
minimizing about this.
I'm still cost minimizing.
But to cost minimize, I
have to charge more.
Because the market's charging
me a higher price.
If you go back to solving our
initial production decision,
you'll see that because this is
a higher wage, that's going
to shift my cost function up.
A high wage is going to
make my costs higher.
That's going to make my cost
minimizing price be higher.
So I'm going to shift.
I'm going to need to charge
a higher price.
That, itself, will also
yield an upward
sloping supply curve.
So an upward sloping supply
curve comes from the fact that
as I produce more, I've
got to pay higher
prices for my inputs.
That means I've got to charge
higher prices for my outputs.
So these are three examples of
reasons why, in reality, we
don't see a perfectly flat
long run supply curve.
So once again, to review,
because this is the end of
this particular topic, to review
where we are, the way
it works is firms are given
a cost function.
Well, they choose
a technology.
That gives them a
cost function.
They enter the market.
In the short run, they're stuck
with that technology.
So they decide to produce where
price equals marginal
cost as long as they're not
losing more money than they've
paid in fixed costs.
In the long run, firms come in
and out until the point where
every firm is producing
efficiently.
As long as entry is free, as
long as there are not barriers
to entry, every firm is
producing efficiently.
Then every firm is producing
at a single point, which is
where marginal cost equals
average cost. That yields a
flat long run supply curve at
the technological minimum.
In reality, supply curves slope
up because there might
be barriers to entry which
leads to non-cost
minimization.
So this leads to non-cost
minimization.
And then there's two reasons,
even if you're cost
minimizing, you still could
have capacity constraints,
which is like our cotton
example, or you could have
upward sloping input supply.
So that's why, in reality, we
draw the upward sloping supply
curves that we started with at
the beginning of this course
even with a perfectly
competitive market.
So let's stop there.
That's a lot of stuff to digest.
We're going to come
back next time and talk about
why all this is crap, and
firms don't really cost minimize
or maximize profits
or any of that.
