Advanced Microeconomics Ivan Etzo University of Cagliari ietzo@unica.it Dottorato in Scienze Economiche e Aziendali, XXXIII ciclo Ivan Etzo (UNICA) Lecture 5: Supply 1 / 32
Overview 1 Market Environments 2 Pure Competition 3 The demand curve of a competitive firm 4 The firms Short-Run Supply Curve 5 The firm s Long-Run Supply Curve 6 Industry Supply 7 Long-Run Industry Equilibrium Ivan Etzo (UNICA) Lecture 5: Supply 2 / 32
Market Environments A firm faces two main decisions: 1 Choosing how much it should produce; 2 Choosing what price to set. The choice is not free. As we have seen, the firm faces the technological constraint (the feasible production possibilities) summarized by the production function. The technological constraint implies also some economic constraints summarized by the cost function. A further important constraint is the market constraint. In short, the market constraint says that the firm can only sell as much as people are willing to buy. Ivan Etzo (UNICA) Lecture 5: Supply 3 / 32
Market Environments The demand curve facing the firm describes the relationship between the price a firm sets and the quantity it sells. Remember that the demand curve facing the firm IS NOT the market demand curve, unless the firm is the only one in the market. If there are other firms in the market then the choices of the single firm is affected by the choices made by the other firms. The market environment describes how the firms respond to each other when they make their pricing and output decisions. Ivan Etzo (UNICA) Lecture 5: Supply 4 / 32
Market Environments Monopoly: Just one seller that determines the quantity supplied and the market-clearing price. Oligopoly: A few firms, the decisions of each influencing the payoffs of the others. Monopolistic Competition:Many firms each making a slightly different product. Each firm s output level is small relative to the total. Pure Competition: Many firms, all making the same product. Each firm s output level is small relative to the total. Ivan Etzo (UNICA) Lecture 5: Supply 5 / 32
Pure Competition The Pure Competition is a market environment where each firm assumes that the market price does not depend on its own level of output. In other words, the firm is left with the only decision of how much to produce because whatever amount will be sold at the (fixed) market price. Usually, is an industry composed of many small firms, where small means that their supply represents a negligible share of the market supply. Each firm is a price taker, the single firm cannot decide the price level. The product produced by each firm is the same (homogeneous product). Ivan Etzo (UNICA) Lecture 5: Supply 6 / 32
The demand curve of a competitive firm In pure competition the demand curve facing the firm is different from the market demand curve. The demand curve facing the firm measures the relationship between the market price and the output level of that particular firm. The market demand curve depends on consumers behavior. Ivan Etzo (UNICA) Lecture 5: Supply 7 / 32
The demand curve of a competitive firm The demand curve of the single firm Ivan Etzo (UNICA) Lecture 5: Supply 8 / 32
The demand curve of a competitive firm The demand curve of the single firm When p = p the quantity supplied by the single firm is y = 0. Ivan Etzo (UNICA) Lecture 5: Supply 9 / 32
The demand curve of a competitive firm The demand curve of the single firm When p = p the firm faces the all market. Ivan Etzo (UNICA) Lecture 5: Supply 10 / 32
The demand curve of a competitive firm The demand curve of the single firm Ivan Etzo (UNICA) Lecture 5: Supply 11 / 32
The demand curve of a competitive firm The demand curve of the single firm This is the demand curve facing a single firm in pure competition. Ivan Etzo (UNICA) Lecture 5: Supply 12 / 32
The firm supply curve The profit maximizing problem is the following: max py c(y) y where the price p is constant and c(y) is the cost function. The first-order and the second-order conditions are the following: FOC : p = c (y ) SOC : c (y ) 0 c (y ) 0 The FOC says that the price equals marginal cost and the SOC says that the marginal cost must be increasing. Thus, the supply function is given by the FOC: p = MC(y) Ivan Etzo (UNICA) Lecture 5: Supply 13 / 32
The firm supply curve The shutdown decision point The firm can always decide to produce zero units of output. In order to produce y > 0 it must be that: π(y > 0) π(y = 0) py c v (y) FC FC where FC are the profits when the firm produce zero units of output. Rearranging we get p c v (y) y That is, the price must be greater than the average variable costs. Therefore, the supply curve is only the segment of the MC curve lying above the AVC curve. Ivan Etzo (UNICA) Lecture 5: Supply 14 / 32
The firms Short-Run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 15 / 32
The inverse supply function The direct supply function is the output as a function of the price. On the opposite, the inverse supply function is the price as a function of the output level. According to the FOC of the profit maximizing problem the inverse supply function is the following: P = MC(y) So, every firm in the market must have the same marginal cost (if they are all maximizing profits). Ivan Etzo (UNICA) Lecture 5: Supply 16 / 32
The firm s Long-Run Supply Decision A competitive firm s long-run profit function is: π(y) = py c(y) The long-run cost c(y) of producing y units of output consists only of variable costs, since all inputs are variable in the long-run. That is, the long-run supply curve can be written as: p = MC l (y) = MC(y, k(y)) where k is the factor that is fixed in the short-run (e.g. plant size). Thus, in the long run the firm can adjust the fixed factor optimally to the output level. Remember that the short-run and the long-run marginal costs coincide at the level of output y, where the fixed factor choice associated with the short-run marginal cost is the optimal choice k. Ivan Etzo (UNICA) Lecture 5: Supply 17 / 32
The firm s Long-Run Supply Decision In the long-run equilibrium profits cannot be negative because the firm would go out of business: or, equivalently py c(y) 0 p c(v) y Thus, in the long-run price must be at least as large as average cost. The long-run supply curve is more elastic than the short-run supply curve. That is, the firm is more responsive to price because all factors can be adjusted. Ivan Etzo (UNICA) Lecture 5: Supply 18 / 32
The firm s Long-Run Supply Decision Ivan Etzo (UNICA) Lecture 5: Supply 19 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 20 / 32
Short-Run and Long-run Supply Curve where, ys is profit-maximizing in the short-run and y is profit-maximizing in the long-run. Ivan Etzo (UNICA) Lecture 5: Supply 21 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 22 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 23 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 24 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 25 / 32
Short-Run and Long-run Supply Curve Ivan Etzo (UNICA) Lecture 5: Supply 26 / 32
Industry Supply Since every firm in the industry is a price-taker, total quantity supplied at a given price is the sum of quantities supplied at that price by the individual firms. Therefore, the industry (o market) supply curve is S(p) = n s i (p) i=1 where, S(p) indicates the industry supply, s i (p) is the supply of the single firm and n is the number of firms. Ivan Etzo (UNICA) Lecture 5: Supply 27 / 32
Short-Run Industry Equilibrium In the short-run, neither entry nor exit can occur. Consequently, in a short-run equilibrium, some firms may earn positive economics profits, others may suffer economic losses, and still others may earn zero economic profit. Ivan Etzo (UNICA) Lecture 5: Supply 28 / 32
Short-Run Industry Equilibrium Ivan Etzo (UNICA) Lecture 5: Supply 29 / 32
Short-Run Industry Equilibrium Ivan Etzo (UNICA) Lecture 5: Supply 30 / 32
Short-Run Industry Equilibrium Ivan Etzo (UNICA) Lecture 5: Supply 31 / 32
Long-Run Industry Equilibrium free entry assumption: in pure competition there are no barriers to entry such as licenses, patents or legal restrictions on the number of firms. Therefore, in the long-run every firm now in the industry is free to exit and firms now outside the industry are free to enter. Positive economic profit induces entry. Entry increases industry supply, causing p e s to fall. How many firms will enter? The long-run number of firms in the industry is the largest number for which the market price is at least as large as min AC(y). In the long-run market equilibrium, the market price is determined solely by the long-run minimum average production cost. P e = min y>0 AC(y) Thus, in the long-run equilibrium the (economic) profit is zero. Ivan Etzo (UNICA) Lecture 5: Supply 32 / 32