Chapter 10. The Firm and Industry in the Entrepreneurless Economy

March 23, 2003 Chapter 10 The Firm and Industry in the Entrepreneurless Economy The model of industry equilibrium in the entrepreneurless economy that we used in Chapter Nine can be used as a basis for simulating some aspects of the competition to supply household demands that occurs under the conditions of the market economy. The purpose of the next two chapters is to show how this is possible. There are two related models of competition: a long run model and a short run model. The two models are based on different assumptions about the alternatives faced by the firm. The difference concerns the possibility of producing what we shall call plant capital. Plant capital consists of resources that are necessary to get started in an industry. We might visualize it as the factory, machines, tools, and knowledge that are necessary to get started in an industry. The long run model assumes that plant capital can be produced and, therefore, that the prices of resources reach their normal level. This means that the pay for a resource that is used to produce plant capital equals the pay to the same resources if it is used to produce goods. The short run model assumes that new plant capital cannot be produced. As a result the pay to a resource may be higher in the production of plant capital than it is in the production of goods. Even though resource suppliers would maximize utility if they could shift their resource from producing goods into producing plant capital, they cannot do so. This distinction between long run and short run models is useful in at least two ways. First, it helps us recognize an economy-wide signaling function of prices. In using the two models, we break our idea of coordination in the entrepreneurless economy into two parts, or steps. In the first - the long run model - we conceive of a fully coordinated entrepreneurless economy. In the second - the short run model -- we conceive of a fully coordinated entrepreneurless economy with one exception. Resources that will bring more income to their owners if they are used to produce plant capital are being used to produce goods, capital, or vice versa. The higher prices prompt the owners of the resources to shift them. But there is not enough "time" for the shift to occur. The long run model assumes that the prompts can be followed. Producers of capital hire resources to increase the kinds of capital that in the short run have high prices and reduce the kinds of capital that in the short run have lower prices. In places where the new plant capital is produced, it competes with the old and causes a decrease in its prices. Where there is reduced new capital, the prices of the plant capital rise to a level that is consistent with full coordination. The second use of the models is to help us see that the prices and quantities of the various goods and resources in a fully coordinated economy depend on what assumption we make about household demands and technical knowledge. If we make one set of assumptions about demands and technology, full coordination in the entrepreneurless economy requires a particular set of prices and quantities. If we make a different set of assumptions, coordination requires a different set. Once we come to understand these two uses of the model of the entrepreneurless economy, we will be in a position to form a preliminary understanding of signaling and consumer sovereignty. Competition and consumer sovereignty are discussed at the end of Chapter Eleven. 1. THE TRADITIONAL MODEL OF THE FIRM AS A SURPLUS MAXIMIZER The purpose of this section is build a model of the firm as a surplus maximizer. Surplus to the firm refers to revenue minus costs. A model of the firm tells us how much revenue the firm can earn at each relevant

2 Knowledge and Entrepreneurship (10) output and price and how much cost it must pay. In other words, it tells us the total cost minus the total revenue under various circumstances that we assume the firm faces. As a surplus maximizer, the firm maximizes the difference between total revenue and total cost. Regarding revenue, we assume for the time being that the firm can sell whatever quantity it produces at the industry price and that its behavior has no effects on the industry price. Under these circumstances, once we determine the industry price, we can calculate the revenue the firm can earn at each possible output. Specifically, if the firm produces any output, q i, the total revenue would equal p x q i. For example if industry price is $5 per unit and the firm produces 20 units, its total revenue is $100. If it produces 40 units, its total revenue is $200. And so on. Cost is more complicated. How we characterize a firm s costs depends on whether we are interested in the short run or the long run. Accordingly, we begin this part by discussing short run costs. Then we discuss long run costs. Short Run Costs The short run is defined by the assumptions that non-plant resources can shift from one industry to another but that plant capital cannot be produced. Plant capital is fixed. Under these conditions, the costs faced by the firm take a specific form. This sub-section describes that form. Average Cost Average cost refers to the per unit costs of production. In this subsection, we want to describe how the short run average costs vary with the amount of output that the firm produces. Perhaps the best way to think about this relationship is to put yourself in the shoes of a would-be manager of a firm who is planning to enter a new business. You are uncertain exactly how much output you will eventually decide to produce. The exact amount depends on what consumers, resource suppliers, lenders, and other producers choose to do. But you do have an idea of the range of output within which your to-be-chosen output will fall. So you invest money to finance the building of the plant capital that is needed to help you produce an output within the range. In other words, you buy plant capital. The term plant is a metaphor that is intended to elicit an image of a manufacturing firm that builds or buys a factory and equips it with specialized machinery, which it plans to use for a substantial period of time. The decision to invest in a particular plant size instead of another corresponds to what we have called the decision to buy plant capital that you believe is most suited to producing a particular range of output. In the following, we shall use the term "plant" because it is simpler. We use the term "target output" to refer to the output in the middle of the range. The choice of a given plant size will enable you to produce a given range of output at the lowest possible cost. However, if you later decide to produce more than the amount that is in the range, your average costs will be higher than if you had chosen a slightly larger plant. Similarly, if you later decide to produce less than the amount in the range, your average costs will be higher than they would have been if you had chosen a slightly smaller plant. Under these conditions, your per unit, or average, cost curve would have a U-shape as shown in figure 10-1. In that figure, the average cost curve is labeled AC. We assume that q* is the target output. Note that the average cost is lowest at the target output. Marginal Cost As we have seen in previous chapters, marginal cost refers to the cost associated with hiring the resources needed to produce the marginal unit of the good. Consider your marginal cost as you increase your output from zero to one unit, from one to two units, and so on. We might conceive of it in the following way. To produce the first unit, you would need both the plant and additional resources. Thus the cost of producing the first unit would be comparatively high. The cost of producing the second unit would be quite a bit lower because you have already paid for the plant. You would only have to pay for the additional resources, since your plant had already been financed. Microeconomists have traditionally labeled the plant and equipment resources fixed resources and the additional resources variable resources. They have referred to the cost of the fixed resources as fixed costs and the costs of the variable resources as variable costs.

The Firm and the Industry (10) 3 Figure 10-1 AVERAGE AND MARGINAL COST Let us focus on the marginal variable costs as a firm increases its output. In other words, we consider the variable costs of the 2 nd unit, the 3 rd unit, the 4 th unit, and so on. To produce each additional unit of output, you would have to purchase additional variable resources. In the model, we assume that marginal cost rises as the firm produces more output. The marginal cost of producing the next unit is greater than the marginal cost of producing the previous unit. This is shown by the curve labeled MC. 1 Why does the marginal cost rise as a firm produces more output? We gave four possible reasons for this in Chapter Nine. A fifth reason is crowding. Crowding refers to the fact that the plant size is initially selected with a particular target output in mind. If the firm tries to produced a larger quantity, it will find the plant inadequate. The additional variable resources will have too few of the fixed resources to take full advantage of their potential productivity. Relationship Between Average and Marginal Cost Note that the MC curve passes through the AC curve at the minimum point of the AC curve. We can think of this in the following way. When the marginal cost is lower than the average cost, the cost of the next unit is lower than the per unit cost. Therefore the lower MC curve must be "pulling the AC curve down." But when marginal cost is higher than average cost, the cost of the next unit is higher than the per unit cost. Therefore, the higher MC curve must be "pulling the AC up." 1 It is important to keep in mind that we are looking here at costs from the standpoint of the individual firm at a particular time. As Adam Smith pointed out, we might expect that the specialization and division of labor that results from the expansion of markets would tend to reduce costs of producing particular goods over time.

4 Knowledge and Entrepreneurship (10) Long Run Costs The long run is defined by the assumption that resources can be used to produce all of the different types of capital. This means that there is enough time to produce plant capital. In the long run, the firm does not have to commit itself to a range of planned output (i.e., to a particular plant size). We ask: suppose that the firm wanted to produce a given output q i. What is the lowest possible cost it could achieve, given that it can use the plant size that is most suitable for producing that output. The idea of long run costs helps us to define two concepts that some microeconomists have regarded as useful: diseconomies of scale and economies of scale. We shall not use these concepts in future chapters. However, in order to provide a comprehensive treatment of the model, we present them here. Scale refers both to the size of the output and the size of the plant and equipment. A small output and plant size correspond to a small scale; a large output and plant size correspond to a large scale. Economies of scale refer to a range of output and plant sizes for which the long run average costs are falling. As the scale gets larger, the long run minimum average cost gets smaller. Diseconomies of scale refer to a range of output and plant size within which the long run minimum average costs are rising. As the scale gets larger, the long run minimum average costs get larger. Consider the long run average cost curve drawn in figure 10-2. It shows economies of scale. It contains five plant sizes, each corresponding to a different AC curve. The smaller the planned output, the smaller the plant that the firm should use. The lac curve, or long run average cost curve, which connects the minimum average costs of producing each output, is downsloping. This shows that if the firm produces a low output of q 1, it should use the plant size ac 1. Compared with the production of larger outputs and the use of other plant sizes, ac 1 is high. However, if the firm produces q 1, only it contains the lowest average cost that the firm can achieve, namely, mac 1. If it wants to produce a high output of q 5, it should use the plant size ac 5 in which case its average cost will be a low mac 5. This is an example of economies of scale. The larger the scale, the lower the average cost. Figure 10-2 ECONOMIES OF SCALE

The Firm and the Industry (10) 5 The same procedure is repeated for diseconomies of scale in figure 10-3. In that figure, if the firm produces a low output of q 1, it should use the plant size ac 1 in which case its average costs will be a low mac 1. However, if it produces a high output of q 5, it should use the plant size ac 5 in which case its average costs will be a high mac 5. The larger the scale, the higher the average cost. The long run average cost curve (lac) is upsloping. Figure 10-3 DISECONOMIES OF SCALE Demand Faced by the Perfectly Competitive Firm Figure 9-1 showed the market demand for a good by many consumers. If only one firm could produce and sell goods to satisfy this demand, the demand curve would show the revenue that the firm could achieve for each quantity it produced. However, a competitive industry contains many firms. To construct the demand curve faced by the firm in this case, microeconomists have built a special model called perfect competition. It assumes that each firm is so small that, no matter how much output it produces and sells, it can have no influence over the industry price. They refer to this assumption by saying that the firm is a price taker. Whereas the firm in a one-firm industry (a monopoly) is a price maker (that is, it can set the price), the firm in a perfectly competitive industry must accept the price that is set in the industry. Another way to say this is that the price in a perfectly competitive market is simultaneously determined by a large number of competing firms, although none of them independently has the power to set price by itself. The assumption that the perfectly competitive firm is a price taker means that no matter what output it produces and sells, it can receive the same price per unit. Consider figure 10-4. It contains both the cost curves that were described above and a demand line D. The horizontal demand line shows that if the market price is p*, the firm can sell all the output that it produces at that price.

6 Knowledge and Entrepreneurship (10) Surplus Maximization in the Short Run The surplus maximizing position of the perfectly competitive firm in short run equilibrium is represented in figure 10-4. The firm maximizes surplus by producing a quantity at which marginal revenue (= price) is equal to marginal cost. At all outputs past one unit and up to q*, the marginal revenue (or price in the case of perfect competition), exceeds the marginal cost. This means that at each of these outputs, the firm can gain more revenue than it pays in cost by producing a larger quantity. On the other hand, at all quantities beyond q*, the marginal cost exceeds marginal revenue. This means that if the firm happened to produce one of these large quantities, it could gain more in cost savings than it loses in revenue by producing a smaller quantity. For these two reasons, surplus maximization is achieved at the quantity q*. Figure 10-4 PERFECTLY COMPETITIVE FIRM MAKING A SURPLUS We can use the graph to find the surplus at q*. It is equal to the surplus per unit times the quantity q*. Surplus per unit, or average surplus, equals average revenue minus average cost. Since the price for the perfectly competitive firm is constant, average revenue equals price. To find the average surplus, we only have to subtract the average cost from the price at the quantity q*. In the diagram, this is equal to the distance dg. Surplus equals the shaded area cdgf, which equals average surplus (0p* - 0ac* = dg) times the quantity (q* = 0h). Figure 10-4 also shows the total revenue and total cost. We can find the total surplus by using these concepts. Total revenue equals price times quantity. If the firm produces q*, its total revenue is cdh0. Total cost is fgh0. Subtracting total cost from total revenue yields surplus. In the graph, surplus equals the shaded area cdgf, as shown before. Let us compare the choice of output q* with a different, larger output q'. If the firm chose the larger output. It could earn a higher total revenue equal to cej0. But its total costs would be higher still. They would be abj0, yielding a loss equal to abec. The firm could produce an output different from q* and still make a surplus. For example, if it chose an output slightly higher than q* or slightly lower, its total revenue would still exceed its total cost. But its surplus would be lower than it is at q*.

The Firm and the Industry (10) 7 Deficit Minimization Figure 10-5 is similar to figure 10-4. The only difference is that the demand faced by the firm is so low that the firm cannot earn a surplus. There is no quantity at which the average revenue is greater than the average cost. The problem faced by the firm in this case is to minimize its deficit. As in the case of surplus maximizing, it accomplishes this by producing the output at which marginal revenue (= price) is equal to marginal cost. This is the quantity q* in the diagram. The amount of the deficit is indicated by the shaded area abdc. It is the total cost (abe0) minus the total revenue (cde0). Figure 10-5 PERFECTLY COMPETITIVE FIRM INCURRING A DEFICIT A diagram like figure 10-5 is often used as a starting point to discuss the issue of whether a firm that is incurring a deficit should stay in business. The firm s total costs include the costs of building the plant that is most suitable for achieving its target output. So long as the total revenue is enough to cover the costs of its variable resources -- in other words, so long as total revenue exceeds total variable costs, it should stay in business. For in this event, it is earning more than it would earn if it shut down completely. If it shut down completely, it could avoid paying for the variable resources. But it could not avoid the initial outlay for its plant, which it has already made. If it can earn total revenue that is greater than the costs of these additional resources, it should continue operations and minimize its deficit. The Break-Even Firm We round out the discussion with a graph of the break even firm. Figure 10-6 shows a firm for which price equals average cost at the surplus-maximizing output q*. If the firm produces this output, it can break even. Its total revenue equals its total cost (abc0 = abc0). If it produces any other output, however, its total cost would exceed its total revenue. Inter-Industry Long Run Equilibrium Traditional microeconomists often represent the idea of inter-industry long run equilibrium by distinguishing between normal and economic surplus. They say that in long run equilibrium, there is no

8 Knowledge and Entrepreneurship (10) incentive for firms to shift money (and the resources that the money can buy) from one industry to another. The firms earn normal surplus, which is practically the same as they could earn if they shifted their money to another industry. But they do not earn economic surplus. Economic surplus refers to money surplus that is greater than what is needed to keep the producer's money in this industry instead of shifting it elsewhere. It is represented in figure 10-4 by the surplus area cdgf. When no firms are earning economic surplus (or incurring a deficit) in any industry, the economists say that the industry is in inter-industry long run equilibrium. Figure 10-6 PERFECTLY COMPETITIVE FIRM BREAKING EVEN An interesting aspect of this idea is that if economic surplus is being made in one industry, an economic deficit must be incurred in another industry. We can reason about this in the following way. If a firm could earn surplus by shifting resources from industry A to B, then the opportunity cost of using those resources in A must be greater than the revenue it is earning. It must be incurring a deficit in an opportunity cost sense. It follows from this discussion that we can use figure 10-6 to represent a firm under the condition of interindustry long run equilibrium. The firm could not earn a surplus by moving out of the industry and the outsiders could not earn a surplus by moving into the industry. The same figure would represent all firms in all industries, assuming that there is inter-industry long run equilibrium. 2. THE FIRM AND THE INDUSTRY In this part, we look at the relationship between the firm and the industry. We begin by considering conditions under which firms could gain by entering or leaving an industry. Then we describe the position of a firm in an industry that is in inter-industry long run-run equilibrium.

The Firm and the Industry (10) 9 Entering or Leaving an Industry As we noted, a firm that is incurs a deficit will still operate if it can cover its total variable costs. But this is only true for a short run situation. If it can build a larger or smaller plant (that is if we assume a long run situation) and if there is no quantity at which price exceeds average cost, the firm should leave the industry. If a firm leaves an industry, it reduces industry supply. To see why, we must consider the relationship between the firm s cost and industry supply. We begin by recalling that industry supply refers to the quantities of a given good that all producers, or firms, taken together would sell at each price. Before discussing this, let us consider a single firm s supply curve. It shows the quantities that a single firm would supply at each price. The Firm s Supply Curve Figure 10-7 shows that the firm s supply curve is the same as its marginal cost curve. Suppose that the price is p 1. Then the firm will want to supply the quantity at which price equals marginal cost, or q 1. If the price is p 2, it will want to supply q 2. And so on. The diagram shows four prices and four quantities. If we want to draw the firm s supply curve, we could simply trace out the marginal cost curve. Figure 10-7 THE PERFECTLY COMPETITIVE FIRM S SUPPLY CURVE There is one proviso. It is, as we have seen, that if we are considering the short run, it is possible that the firm would be incurring a deficit and that it would shut down, or go out of business. It would do this if its total revenue was insufficient to cover its variable costs. Thus, at any prices for which this is the case, the quantity supplied by the firm would be zero. For example, suppose that at p 2 in the figure, total revenue was just high enough to cover variable costs. Then the firm s supply curve would begin at that point. At any price below p 2, quantity supplied would be zero. We represent this fact by the dotted portion of the supply curve below p 2.

10 Knowledge and Entrepreneurship (10) The Firm and Industry Supply Curves The industry supply curve is simply the horizontal sum of the supply curves of the firm. A graphical method of deriving the industry supply curve for a two-firm industry is illustrated in figure 10-8. Graphs A and B show the supply curves of firms A and B. If we add the quantities that firm A would supply to the quantities that firm B would supply at three prices (p 1, p 2, and p 3 ), we can find three industry quantities corresponding to the three prices. Then if we connect the points, supply, we can derive the industry supply curve with a curve, we get the industry supply curve, S A+B. Figure 10-8 PERFECTLY COMPETITIVE FIRM AND INDUSTRY SUPPLY CURVES Effects on Industry Supply of Firms Leaving and Entering the Industry Suppose that there are many firms in an industry. Then the industry supply curve will be the sum of the supply curves of the many firms. If one of the firms leaves the industry, the industry supply curve will shift up and back to the left. Assuming that the demand for the good stays the same, industry price will rise. If new firms enter the industry the industry supply curve will shift down and out and to the right. Again assuming that demand stays the same, industry price will fall. This is shown in figure 10-9. The left panel shows the effects of firms leaving the industry. The supply curve shifts back from S 1 to S 2. Equilibrium quantity falls from q 1 to q 2 and equilibrium price rises from p 1 to p 2. The right panel shows the effects of firms entering an industry. The supply curve shift out from S 1 to S 2. Equilibrium quantity rises from q 1 to q 2, while industry price falls from p 1 to p 2. Effects on Firms of Exit and Entry We have seen that if firms are incurring deficits they leave an industry in the long run. This, in turn, shifts the industry supply curve to the left, causing the price of the good to rise. The result is that remaining firms incur a lower deficit than they incurred before.

The Firm and the Industry (10) 11 Figure 10-9 EFFECTS OF EXIT AND ENTRY ON PERFECTLY COMPETITIVE INDUSTRY SUPPLY Figure 10-10 EFFECTS OF EXIT AND ENTRY

12 Knowledge and Entrepreneurship (10) Just the opposite occurs when firms are making surplus. The surplus induces new firms enter the industry. The entry, in turn, shifts the industry supply curve to the right, causing the price of the good to fall. The firms already in the industry make lower surplus than they were making before. All of this is shown in figure 10-10. At industry price p 3, firms incur a deficit. As a result, some firms leave the industry and the industry supply curve shifts up and back, as shown in the left panel of figure 10-9. This raises the price. The exit of firms would continue until none of the firms that remain in the industry incur a deficit. Price would rise to p 2. On the other hand, at industry price p 1, firms make surplus. As a result, new firms enter the industry and the industry supply curve would shift down and out. This reduces the price. The entry of firms would continue until firms in the industry no longer earn a surplus. Price would fall to at least p 2. The exit of firms that incur a deficit and the entry of firms that make a surplus means that there is a tendency in the long run for surpluses and deficits to disappear. The Firm and Industry in Long Run Equilibrium Figure 10-11 can be used to represent the long run equilibrium position of a firm and an industry in interindustry long run equilibrium. The firm makes neither deficit nor surplus. And firms cannot gain by either leaving or entering. The long run equilibrium price is p, each firm produces a quantity q, and the total industry quantity is Q. Q = nq, where n is the number of firms. We shall use this model in Chapters Eleven and Twelve. Figure 10-11 PERFECTLY COMPETITIVE FIRM AND INDUSTRY IN LONG RUN EQUILIBRIUM

The Firm and the Industry (10) 13 Questions for Chapter 10 1. Define average cost, plant, target output, variable cost, fixed resource, fixed cost, economies of scale, diseconomies of scale. 2. In one sentence, tell the fundamental difference between the long run model of coordination in the entrepreneurless economy and the short run model. 3. Tell the economic rationale for assuming that the short run average cost curve of the traditional firm is U-shaped. 4. Why does the short run marginal cost of a firm rise as the firm produces more output. 5. Draw the short run marginal and average cost curves faced by the firm on the same graph. Make sure that you show that you know the relationship between the two curves. 6. Demonstrate graphically the concept of economies of scale. Make sure to explain how your graph demonstrates this. Note that to explain this you must be able to define economies of scale. 7. Demonstrate graphically the concept of diseconomies of scale. Make sure to explain how your graph demonstrates this. 8. Distinguish between a price maker and a price taker. 9. Explain why the demand curve faced by a perfectly competitive firm is horizontal. 10. Draw a graph representing the short run surplus-maximizing (or deficit-minimizing) position of a perfectly competitive firm that is: a. Making a surplus. b. incurring a deficit. c. Breaking even. For each case, explain in words how you know that the graph describes the situation. 11. Use the traditional model of the firm and industry as a basis for describing inter-industry long run equilibrium. 12. Distinguish between economic and normal surplus in the traditional model of the firm and industry. 13. In the traditional model of the firm in a perfectly competitive industry, the existence of a surplus (a deficit) provides an incentive for firms to enter (leave) an industry. How does this entry (leaving) affect the industry supply. Explain by drawing graphs. Also show how it affects industry price and quantity, assuming that other things remain the same. 14. In the traditional model of the firm in a perfectly competitive industry, when other firms leave (enter) an industry, there are effects on the firm's demand curve. Show this effect graphically and tell how they change the firm's choice of which output to produce. Assume in this example, that the firm's costs do not change. Gunning s Address J. Patrick Gunning Professor of Economics/ College of Business Feng Chia University 100 Wenhwa Rd, Taichung Taiwan, R.O.C. Please send feedback Email: gunning@fcu.edu.tw Go to Pat Gunning's Pages Mirror Site of Pat Gunning's Pages