Intermediate Microeconomic Theory

Market Supply 1

Market Supply

 Similar to demand, market supply will simply be the summation of all the individual firm supply curves: Q s (p) = q 1 s (p) + q 2 s (p) +…+ q n s (p) 2

Market Supply

 Given market supply curve, along with market demand curve, we can now define an equilibrium price.



Equilibrium price:

the price that equates supply and demand in a given market (p* such that Q d (p*) = Q s (p) ).

Q s (p) Q d (p) 3

Price and Costs in Equilibrium

 Note: all profit maximizing firms that are supplying output to a given market must be operating at p* = MC(q s (p*)).  So while each firm may have quite different cost functions, all must have the

same cost of producing their last unit of output

.

 Therefore,

in perfect competition

, the price consumers pay for a good equals the cost (including opportunity costs) each firm must incur to bring the

marginal good

to the market. 4

Economic Profits

 Key to understanding the role of competition however, will be changes in supply on the extensive margin, or the role of market entry by new firms.  When does it make sense to enter a given industry?

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Economic Profits

  Example: Should Lisa enter the carrot business?

 Lisa works at Moe’s bar for $18hr. (paid at the end of each month).  She also owns some land which she currently rents out to other farmers for $15/plot/month (paid upfront).   Any money she has she lends to Barney at in interest rate of 5%/month.

To grow carrots   She needs 2 plots of land for each bushel (q) of carrots she grows.

To grow carrots, she needs to put in labor according to q = 3L 0.5

 She also needs seeds, where seeds cost $8 per bushel and she needs other farming supplies (shovel, sun hat, etc.) which cost $200 (which she must pay for up front) .

Suppose the going price for carrots is $84/bushel.

 What would be Lisa’s monthly economic profits from this business?  What does this say about whether she should enter?

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Economic Profits

 What if price of a bushel carrots fell to $80/bushel?

 What if price of carrots remained $84/bushel, but the rental price for a plot of her land was actually $20?

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Economic Profits

 So, we should see entry into some industry if there are any positive

economic

profits to be made.

 By positive economic profits we mean there are excess returns to be had by optimally using factors of production in this industry relative to using them in the next best alternative way (i.e., using them to produce another good/renting them out or selling them to someone else). 8

Market Supply in the Long-run

 In general, how will things change over the longer-run?

 Think of the market demand/market supply graph. What is aggregate profit in graph?

 What if p = $84 there are a bunch more individuals like Lisa out there (specifically, the Lisa with the lower return on her land)? 9

Market Supply in the Long-run

 So how will Industry Supply curve change over the long-run? Why?

 So what is long-run shape?

 Where will it lie?

 So what happens to price in long run with entry?

 What does this mean about (economic) profits in a competitive market in the long-run?

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Profits in the Long-run

 So in short-run there are positive economic profits (or “rents”), but if there is “free-entry” the industry operates at zero (economic) profits in the long-run.

 However, it is still

rational

for suppliers to continue using resources to produce and supply goods to the market they are in (accounting profits are strictly positive)  Zero “economic” profits simply means that there are no excess returns to be had by allocating further resources and inputs into that market.

 In the end, this is what venture capital and entrepreneurism is all about---finding a market niches that allow for (possibly “short term”) excess returns (i.e. economic profits). 11

Costs and Benefits of Competition

 Our theory of the firm reveals the costs and benefits of competition.

 Benefits?

 Costs?

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Profits in the Long-run



How does selection from “Free: The Future of the Radical Price” relate to this discussion?

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Economic Rent

 So economic profits in the short-run are part of our theory (essentially come from innovation and cost saving choices)  But how do we explain firms in mature industries making seeming economic rents (i.e. Exxon Mobil, Haliburton)?

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Economic Rent

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Economic Rent

 Assumption of free-entry in the long-run fails because some factor is

fixed or limited

.

 There are a fixed number of functioning oil wells.

  Provision of services to military awarded by government contract only Any constraint that leads to limiting the number of suppliers (e.g., technological innovation).

 Why are such barriers to entry so valuable?

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Economic Rent

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Economic Rent

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Rent setting



The implicit “value” of the fixed factor is what we call “economic rent”.

 How would this “rent” be valued?

 Think of Lisa in the carrot business C(q) = 2q 2 + 40q + 210  At a price of $84/bushel, she would produce 11 bushels and earn economic profits of π = 11*84 – C(11) = $32.

 What would happen if there were no limits on entry?

 So, how much would she be willing to pay to a lobbyist to restrict entry into the carrot producing business?

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Rent Seeking

 So we can see why millions are spent each year lobbying by firms or individuals in an attempt to somehow constrain entry into an industry.    Positive economic profits can be made if free-entry is limited. So, it might make sense for firms to pay lots of money to lobby for entry barriers.

Often called “rent seeking”.

Examples:       Limits on medical school slots hair cutting licenses zoning restrictions Agricultural subsidies Military contracts NPR clip ..\ItalianGuilds_TheWorldPRI.mp3

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