Chapter 8

shutdown vs exit

By Shutdown I mean produce q=0. Notice that in the short-run at least firms still must pay their fixed cost and so they cannot exit.Exit means that a firm completely leaves the industry and goes on to bigger and better things.

profits are maximized when

MR(q) = MC

producer surplus equation (in the short run)

Producer surplus = PS = R − VC

profit in the short run

Profit = π = R − VC − FC

for a market demand is

always downward sloping

we maximize profit by

differentiating profit by q and setting the derivative equal to zero.

economic profit =0

firms do not enter or exit --> equilibrium

economic profit >0

firms enter -> profit falls

economic profit<0

firms exit -> profit rises

maximizing profit

max π (q ) = P*q - C(q) take derivative with respect to q and set to 0 and solve for P which of course is just P =MC P=MR=MC

the perfectly competitive firm

price taker, homogenous product, free entry and exit

profit

π (q )= R(q )-C (q )

relation between price ac and profit

π=P*Q - TC TC = AC*Q π= P*Q -AC*Q π= (P-AC)*Q profit is price minus average cost times quantity This tells us that Profits are positive when Price exceeds Average Cost.

relation between price ac and price

π=P*Q - TC TC = VC+FC TC = AVC*Q +FC π= P*Q -AVC*Q -FC π= (P-AVC)*Q -FC Profit is Price minus Average Variable Cost times Quantity minus Fixed Cost. This tells us that the firm should continue to produce as long as P>AVC in the Short-Run P>AVC means that Profits > -FC

price is determined by

MC = AC which occurs at the minimum of AC

profit maximization and the short run cost curve; produce

MC is decreasing and so producing more REDUCES cost! Never Produce on the downward sloping portion of MC.

in a long run equation P = ___

P=MC=AC

the long run supply curve is

flat

if demand decreases LR

-Price Falls causing Profits to Fall below Zero Economic Profit -Firms Exit -Industry Supply shifts left, causing Prices to Rise so that firms earn Zero Economic Profits

the elasticity of supply

% change in the quantity supplied from a 1% change in price. t his will always be positive (>0) % Change in Q / % Change in P = [100* ΔQ/Q ]/ [100* ΔP/P ] = P/Q *ΔQ /ΔP

if demand increases LR

-Price Rises causing Profits to Rise above Zero Economic Profits -Firms Enter -Industry Supply shifts right, causing Prices to Fall so that firms earn Zero Economic Profits

long run supply curve

- The Long-Run Supply Curve is Horizontal because we are assuming that costs are fixed. -IF Costs Rise as the demand for inputs rises then minAC will rise as market output increases and the LR-Supply Curve is upward sloping. -IF Costs Fall as the demand for inputs rises then minAC will fall as market output increases and the LR-Supply Curve is downward sloping.

long run competitive industry equilibrium

-In the Long-Run if firms are making negative economic profits, some of them will exit. -This reduces industry supply, which raises price and increases profits. -If firms were making positive economics profits, more firms would enter. -This increases industry supply, which lowers price and decreases profits -Thus the Long-Run equilibrium occurs where firms are making Zero economic profits. -No firms want to exit and No firms want to enter -Since firms are earning negative economic profits P2, q, Q is NOT a long run equilibrium -Firms will exit and the Industry supply curve will shiftleft leading to higher prices and profits. •If Industry supply shifts back to Industry Supply 1 Market quantity falls to Q1, price rises to P1.Individual firms increase production to q1 •Economic Profits are now positive •Firms Enter the Industry, Supply shifts right... -Long-Run Equilibrium occurs where firmsearn Zero economic profits •Price = min ATC at P3. Firms produce q3 •Zero economic profits •No reason for firms to enter or exit the industry.

profit maximization in the short run

A firm chooses output q*, so that profit, the difference AB between revenue R and cost C, is maximized. At that output, marginal revenue (the slope of the revenue curve) is equal to marginal cost (the slope of the cost curve). Δπ/Δq = ΔR/Δq − ΔC/Δq = 0 MR(q) = MC(q)

competitive industry

An Industry has a number (many) of firms. The Industry supply curve is the sum of the amount produced by each firm at each price. This is the sum of the individual firm's MC curves.

economic vs accounting profits

For Economists cost includes ALL foregone opportunities. So if you open a business ONE of your opportunity costs is the wage you would have made in the job you gave up to open the business.

shutdown in the short run

If Price is not at least as high as Average Variable Cost the firm's profits are less than their fixed costs and so they are better off paying their fixed cost and producing no output (shutting down). Firms cannot exit in the short run. Firms ONLY Produce when MC>AVC

for an individual firm demand is

If they raise their price a little bit their customers will buy from another supplier (the homogeneous product assumption). At the market price they can sell as much as they want.Lowering price reduces profit as we will show later.

if _____ firms will exit in the long run

P < AC firms will exit in the Long-Run

if _____ firms will shutdown in the short run

P < AVC firms will shutdown in the Short-Run

if _____ firms will enter in the long run

P > AC firms will enter in the Long-Run

producer surplus in the short run

Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production

producer surplus for a market

The producer surplus for a market is the area below the market price and above the market supply curve, between 0 and output Q*.

economic profit

Total Revenue-All Costs (opportunity costs)

accounting profits

Total Revenue-Cost an Accountant would consider

competitive firm's short run supply curve

Upward sloping part of MC above AVC. If Price is below the AVC firm shuts down and produces zero units. Supply curve is upward sloping as before.

simplified competitive industry

We are going to assume that all of the firms in the industry are identical: They have identical marginal cost curves.Thus one cost curve graph describes the profits for every firm in the industry. Price is determined by the intersection of Market Demand and Industry Supply.

profit maximation

We assume firms maximize profits. BUT, firms who do not behave `AS IF' they maximize profits are not likely to survive very long.

price taker

a firm that can sell any quantity it wants at the going market price (many buyers and sellers)

marginal cost

dC(q)/dq

marginal revenue

dR(q)/dq; Change in revenue resulting from a one-unit increase in output.

if the individual firm's demand was horizontal

indicates that the elasticity of demand for the good is perfectly elastic

producer surplus for a firm

measured by the area below the market price and above the marginal cost curve, between outputs 0 and q*, the profit-maximizing output. Alternatively, it is equal to rectangle because the sum of all marginal costs up to q* is equal to the variable costs of producing q*.

to maximize profits we need to know

price and total cost

in the long run competitive industry equilibrium

the market equilibrium corresponds to the point where ATC = MC (min ATC) firms earn zero economic profits

in the long run the equilibrium price is determined by

the minimum average cost

changes in demand

•Changes in Demand ONLY EFFECT the Number of Firms in the Long-Run! •The Long Run Equilibrium Price is equal to the Minimum of AC for EVERY Quantity. •Thus we say that the Long Run Supply Curve is Horizontal.

demand decreases

•Initially we are in a LR equilibrium at a price of P* and market quantity of Q*. •Each firm in the industry produces q* units and earns ZERO PROFITS. •The Decrease in Demand decreases Price and Quantity demand to P^ and Q^ •This decreases an individual firms output to q^ •Firms Make NEGATIVE ECONOMIC PROFIT •Firms Exit until Economic Profits Rise back to Zero: •This is where P=P* at min AC! •In the new Equilibrium firms produce the original quantity q* at the original price P* •BUT There are now Less Firms.

demand increases

•Initially we are in a LR equilibrium at a price of P* and market quantity of Q*. •Each firm in the industry produces q* units and earns zero profits. •The Increase in Demand increases Price and Quantity demand to P^ and Q^ •This increases an individual firms output to q^ •Firms Make Positive Economic Profits •Firms Enter until Economic Profits Fall back to Zero: •This is where P=P* at min AC! •In the new Equilibrium firms produce the original quantity q* at the original price P* •BUT There are now MORE Firms.

short run industry equilibrium

•P2, q and Q depict a Short-Run Equilibrium •Industry Demand=Industry Demand •Individual firms earn negative economic profits but P2>AVC and so none of the firms shut down in the ShortRun •Since each of the n firms in the industry are identical: q=Q/n •Each of the n firms produce q and so nq=Q

covering variable costs in the short run

∏=(P-AVC)Q-FC If Price is higher than Average Variable Cost the firm's profits are higher than their fixed costs and so they are better of continuing to produce in the Short-Run. Remember: Firms cannot exit in the Short-Run. In the Long-Run firms may choose to shutdown. Think about a restaurant: Often not busy at all but as long as they're making enough to pay staff, food costs and Electricity they should stay open.