# Micro Handout 13: Short and Long Run Applications

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1 Amherst College epartment of Economics Economics 111 ection 5 Fall 2015 Micro Handout 13: hort and Long Run Applications Euilibrium The euilibrium price and uantity are determined by the market demand and market supply curves. upply Curve The market supply curve is the horizontal sum of each individual firm s supply curve. Individual Firm s upply Curve: An individual firm s supply curve is its marginal cost curve, as long as the price exceeds average variable cost. * rofit Maximization: MR = Marginal Revenue (MR): Change in the firm s total revenue resulting from a one unit change in the uantity of output produced. Marginal Cost (): Change in the firm s total cost resulting in a one unit change in the uantity of output produced. When profits are maximized, marginal revenue euals marginal cost: MR > MR = MR < More production rofit is Less production increases profit maximized increases profit Marginal Revenue and erfect Competition: MR = In a perfectly competitive industry a firm s marginal revenue euals the price. A firm s marginal revenue curve is horizontal intersecting the vertical axis at the price. Marginal Cost Curve: Upward loping The marginal cost curve is upward sloping. Individual Firm s upply Curve: An individual firm s supply curve is its marginal cost curve with one caveat, as long as the price exceeds average variable cost. Rationale for the Caveat and the Long Run Behavior of an Individual Firm uestion: How does the owner of a firm decide to Continue to Operate or Go Out of Business Answer: Compare Owner s with Owner s if when operating he/she goes out of business the firm and works for someone else

2 2 hort Run and Long Run hort Run In the short run, a firm s actions are restricted by commitments which the firm made previously. For example, a firm may have entered into labor agreements, signed legal contracts, signed leases, etc. hort Run hutdown Rule rice () and Average Variable Cost (AVC) < AVC Firm goes out of business in the short run. Firm shuts down. Individual Firm s upply Curve: The individual firm s supply curve is its marginal cost curve until the price is very low and falls below average variable cost when the firm would shut down and produce nothing. Long Run However, commitments do not last forever. Labor agreements, contracts, and leases specify termination dates. The long run refers to the period of time after commitment expires. Long Run Exit Rule rice () and Average Total Cost (ATC) < ATC Firm goes out of business. Firm exits the industry. (Economic) rofit: ince economists include opportunity costs as part of total costs, profits compare the the owner earns when he/she operates the firm with the the owner would earn if he/she goes out of business and works for someone else Individual Firm s upply Curve hutdown: <AVC Curve

3 3 The Long Run and rofit Review: ince (the economist s) total cost includes opportunity costs, profit compares the Jeff would earn if he operates his firm if the if he would earn if he goes out of business. rofit = Total Revenue Total Costs Total Costs = Accounting Costs + Opportunity Costs = Total Revenues (Accounting Costs + Opportunity Costs) = Total Revenues Accounting Costs Opportunity Costs = (Total Revenues Accounting Costs) Opportunity Costs = monthly monthly Review: The sign of profit and hence the long run behavior depends on price () and average total cost (ATC). rofits = Total Revenues Total Costs = TR TC = ATC = ( ATC) TR = Factoring out : ATC = TC ATC = TC Review: rice, Average Total Cost, Exit, Entry, and Long Run Euilibrium Owner s Owner s rofit = when operating if he/she goes out of business = ( ATC) the firm and works for someone else < ATC = ATC > ATC rofit < 0 rofit = 0 rofit > 0 when < when = when > operating if he goes operating if he goes operating if he goes his firm out of business his firm out of business his firm out of business Jeff earns less by operating his firm than by working for someone else. Jeff earns the same by operating his firm or by working for someone else. Jeff is earns more by operating his firm than by working for someone else. Exit occurs Long run euilibrium Entry occurs

4 4 Review: Euilibrium rice, Minimum Average Total Cost, and the Long Run Euilibrium price less than minimum average total cost: < min ATC Max profit: = * ATC Firm s rofit 0 Firms will upply curve rice will * MR, Typical Firm ATC Euilibrium price greater than minimum average total cost: > min ATC Max profit: = * ATC Firm s rofit 0 Firms will upply curve rice will * MR, Typical Firm ATC Euilibrium price eual to minimum average total cost: = min ATC Max profit: = * ATC Firm s rofit 0 Is this a long run euilibrium? Explain. * MR, Typical Firm ATC

5 5 roject: Assess resident Clinton s Level laying Field Analysis of the izza Industry. On April 7, 1994, resident Clinton held a town meeting at the KCTV television studios in Kansas City, Missouri. He fielded a variety of uestions concerning his health care proposal. One uestion was posed by Herman Cain, president and chief executive officer of Godfather izza, Inc. Mr. Cain feared that Clinton s proposal would raise his costs, hurt his business, and force him to lay off workers. resident Clinton agreed that costs would rise, but argued that since the costs of all pizza firms would increase, Godfather would not suffer:..., so [for] you [the health proposal] would add about one and one-half percent to the total cost of doing business. Would that really cause you to lay a lot of people off if all your competitors had to do it too? Only if people stop eating out. If all your competitors had to do it, and your cost of doing business went up one and one-half percent, wouldn't that leave you in the same position you are in now? Why wouldn't they all be in the same position, and why wouldn't you all be able to raise the price of pizza two percent? I'm a satisfied customer. I'd keep buying from you. resident Clinton s Analysis: resident Clinton emphasizes that the costs of all pizza firms will be increased by his health proposal. Conseuently, he contends that the playing field will remain level and no individual firm would not be hurt. o you agree or disagree? izza Typical izza Firm * (millions) (hundreds) Before Implementation of the roposal: etting the tage On the graph above, illustrate the uantity of output that the typical pizza firm will produce. To do so, consider the following: What is the goal of each pizza firm? t. A profit maximizing firm produces the level of output at which =. In a metropolitan area, there are a large number of small, independent pizza firms; conseuently, the pizza market is : In a market, =. Illustrate the firm's profit maximizing level of output.

6 6 Before drawing the average total cost curve on the graph, consider the following: At the present time, the number of pizza firms is more or less constant; occasionally, a new firm will enter and occasionally, a firm will exit; but on the whole, the number of firms is constant. Is the industry is in long run euilibrium? When an industry is in long run euilibrium, the price,, euals. Explain. How is the average total cost curve shaped?. Now draw the average total cost curve on the above diagram After Implementation of the roposal: uppose that the Clinton proposal increases the pizza firms' costs by \$.10 per slice. Begin by considering the short run effect. What happens to the typical firm's average total cost curve?. What happens to the typical firm's marginal cost curve?. Where does the market supply curve "come from?". What happens to the market supply curve?. What happens to the euilibrium price?. What happens to the euilibrium uantity?. What happens to the firm's profit maximizing level of output?. How are the price and average total cost related?. Now, consider the long run. Will firms enter or exit?. Explain. On the above graph: What happens to the market supply curve?. Explain. What happens to the euilibrium price?. What happens to the euilibrium uantity?. Bottom Line: What grade would you give resident Clinton for his economic analysis?

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