University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

280

Pages:

25
Author:

unentafq3

5 The Firm and the Industry Under Perfect Competition Part 2 Shutdown and Break-Even Analysis ● Firms can't endure a loss forever. ● Sunk costs = costs that cannot be escaped in SR. ♦ E.g., restaurant owner has signed a one-year lease on a building. ● If firm shuts down → TR = 0 and TVC = 0, but TFC (or sunk costs) remain. Sometimes it is better to remain in operation until the sunk costs expire. Shutdown and Break-Even Analysis ● 2 rules that govern the shutdown decision: 1. If TR > TC → firm earns positive profits and should remain open in SR and LR. 2. Firm should operate in SR if TR > TVC, but should plan to close in LR if TR < TC. ● Proof: ♦ Loss if the firm stays open = TC - TR ♦ Loss if the firm shuts down = TFC = TC - TVC ● So stay open in SR if: TC - TR < TC - TVC or TR > TVC. TABLE 3. The Shutdown Decision ($1,000's) Firm A Firm B TR 100 100 TVC 80 130 Sunk Cost 60 60 TC 140 190 Loss if firm closes 60 60 Loss if the firm stays open 40 90 Shutdown and Break-Even Analysis ● In Table 3, both firms have the same TR and TFC, but differ in their TVC. ● Both firms should close in LR because TC > TR. ● Yet, firm A should remain open in SR because it earns $20,000 in TR above TVC, which can go toward TFC. ● Firm B should close now. By operating in SR, it adds $30,000 in TVC above TR, which can be avoided by closing. FIGURE 4. Shutdown Analysis MC Price P3 P2 B A P1 AC AVC P3 P2 P1 0 Quantity Supplied Shutdown and Break-Even Analysis ● This firm operates at a loss whether P is P1, P2, or P3. ● Lowest P to keep the firm open in SR is where P ≥ AVC. ● Stay open in SR if: TR > TVC P x Q > AVC x Q Since Q is equal, P > AVC. ● Firm will shut down immediately if P < AVC. Shutdown and Break-Even Analysis ● At P = P1 → shutdown; firm cannot cover TVC. ● At P = P3 → firm earns revenues above TVC so stay open in SR and produce at pt A where P3 = MC. But, firm will close in LR as TR < TC. ● At P = P2 → firm is indifferent between remaining open and closing since TR just covers TVC. If firm stays open it will produce at pt B where P2 = MC. P2 is lowest P which Q > 0 and it’s the min pt on AVC curve. The Competitive Firm’s Short-run Supply Curve ● SR S curve for competitive firm = portion of MC curve that lies above the min pt on AVC curve. ● Supply tells us how much output is produced at different prices. ● In SR: (1) If P > AVC → produce where P = MC. So for any P above pt B, MC tells us the Qs. (2) If P < AVC then Qs = 0. The Competitive Industry’s Shortrun Supply Curve ● SR for industry: too brief a period of time for new firms to enter or old firms to leave. Number of firms is fixed. ● LR for industry: long enough period of time for any firm that so chooses to enter or leave. Also, each firm can adjust its Q to fit LR costs. ● SR industry S curve is horizontal summation of the individual firm's S curves. ● SR industry S curve has (+) slope because individual firms have MC curves that slope upward. FIGURE 5. Derivation of the Industry Supply Curve e $8.00 c 6.00 Corn Industry s s Price per Bushel Price per Bushel Typical Corn Farmer S E $8.00 C 6.00 S 45 50 45 50 Quantity Supplied in Thousands of Bushels Quantity Supplied in Millions of Bushels (a) (b) The Competitive Industry’s Shortrun Supply Curve ● In Fig. 5, if 1,000 identical firms each supplied 45,000 when P = $6 → industry Qs is 45,000 x 1,000 = 45 million. Repeating this process for every P derives industry S curve. ● Entry of new firms shifts SR industry S curve out. ● Exit of old firms shifts SR industry S curve in. The Competitive Industry ● Industry S and market D determine equilibrium P and Q. ● Individual firms face horizontal D curves because they are so small. If 1 firm doubled its Q, market P is unchanged. But if every firm in industry doubled their Q, ↓P to induce consumers to purchase the add. Q. ● In Fig. 6, equilibrium → P = $8 and Q = 50 million. ● Recall: if P = $6 → shortage = 27. ↑P toward E as frustrated buyers bid up prices. FIGURE 6. Supply-Demand Equilibrium of a Competitive Industry Price per Bushel S D $10.00 E 8.00 C 6.00 A D S 0 45 50 Quantity of Corn in Millions of Bushels 72 Industry and Firm Equilibrium in the Long Run ● LR equilibrium may differ from SR equilibrium because: 1. number of firms may differ 2. firms can vary their plant size in LR ♦ Thus, firm and industry cost curves differ in LR. ● Firms enter or exit based on Π earned in industry. ♦ SR profits → new firms enter ♦ SR losses → existing firms exit ● If firms earn high profits in an industry then new firms enter, forcing ↓P as SR industry S curve shifts out. FIGURE 7. Entry of Firms into the Competitive Industry Industry Price per Bushel MC $8.00 6.00 e a AC D0 D1 b Price per Bushel Typical Firm (1,000 firms) S0 D E $8.00 A 6.00 S0 D S1 50 40 45 50 Quantity of Corn in Thousands of Bushels (a) (1,600 firms) S1 Quantity of Corn in Millions of Bushels (b) Typical firm earns profits at point e which encourages the entry of 600 new firms. This shifts industry S curve out and lowers P. 72 Entry of Firms into the Competitive Industry ● SR profits (point e in Fig. 7) encourages 600 firms to enter which shifts industry S out and pushes P down to $6 (new SR equilibrium point A). ● Existing firms react to ↓P by setting new P = MC and lowering their Q to 45,000. ● At P = $6 → 1,600 firms produce 45,000 each so industry Qs = 72M. ● Point A is another SR equilibrium as typical firm earns profits. Note: P > AC and per unit profits = a – b. FIGURE 8. LR Equilibrium of the Competitive Firm and Industry Industry MC AC $5.00 m D2 Price per Bushel Price per Bushel Typical Firm D (2,075 firms) S2 $5.00 M S2 83 40 Quantity of Corn in Thousands of Bushels (a) D Quantity of Corn in Millions of Bushels (b) Point m is a LR equilibrium where typical firm earns zero profits and produces where P = AC = MC. Entry of Firms into the Competitive Industry ● Entry continues until all profits are competed away. SR Industry S will shift out until P = min AC. ● LR equilibrium (point m in Fig. 8) is where typical firm earns zero profits and produces where P = AC = MC. ● There are no profits in LR. ♦ SR profits → firms enter and ↓P until all profits end. ♦ SR losses → firms leave and ↑P until all losses end. Zero Economic Profit ● Why do firms stay in the industry if profits are zero in LR? ● Recall: economist's definition of profit includes opportunity cost of any K or L supplied by firm's owners. 0 economic Π → (+) accounting Π ● E.g., if investors can earn 15% on their funds elsewhere → firm must earn 15% to cover opportunity cost of its K. If not, funds will not be given to the firm because investors will go elsewhere. Zero Economic Profit ● Zero economic profit indicates firms are earning the normal economy-wide rate of profit (in the accounting sense). ♦ An industry whose K earns a higher rate of return than K invested elsewhere attracts K into the industry. This shifts SR industry S curve out and ↓P until econ Π = 0. ♦ If K invested in an industry earns a lower return than K invested elsewhere, funds dry up in the industry. This shifts SR industry S curve in and ↑P until econ Π = 0. The LR Industry Supply Curve ● LR industry S curve reflects: 1. 2. ♦ Entry and exit of firms → shifts SR industry S curve toward its LR position. Each firm is freed of its sunk cost commitments → each firm is operating on its LR AC curve. LR industry S curve = Industry’s LR AC curve because LR Π = 0, so industry P = industry LR AC. ♦ ♦ If P > LRAC → firms enter, attracted by profits If P < LRAC → firms exit, due to losses FIGURE 9. SR Industry Supply and LR Industry Average Cost Price, Average Cost per Bushel S B $7.00 4.00 0 S A 70 Output in Millions of Bushels of Corn LRAC If LR P = $4 and current P = $7→ firms earn $3 in economic Π on each bushel they sell → entry of new firms → S shifts out to LRAC. Perfect Competition and Economic Efficiency ● Perfect competition leads to great efficiency in LR as firms must produce where P = min LR AC curve. Thus, output of competitive industries is produced at lowest possible cost to society. ● In Table 4, industry produces 12 million bushels by having 120 firms produce 100,000. ● Total industry cost = AC x industry output, so total industry cost is lowest by having each firm produce at lowest AC possible. TABLE 4. AC for the Firm and Total Cost for the Industry Firm's Q Firm's AC Number of firms Industry Output Industry Total Cost 60,000 $0.90 200 12,000,000 $10,800,000 100,000 0.70 120 12,000,000 8,400,000 120,000 0.80 100 12,000,000 9,600,000

The Firm and the Industry Under Perfect Competition, Part 2

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