Tutorial 9: Firms With No Market Power (cont.)
Choosing Output in the Long Run - The Role of Economic
Before we get started, review a
summary of the three steps taken by a firm as it analyzes
the profitability of its current output level. These three
steps are followed by any firm whose goal is to maximize
economic profit, whether that firm has no market power,
as is the case in this Tutorial, or considerable market
power, as is the case in Tutorial 10.
As we discovered in Tutorial 9b,
positive economic profit indicates that a firm's accounting
profit exceeds its opportunity cost. How do you suppose
other sellers with similar resources would respond to such
news? After all, if these firms have similar resources and
are not already producing this good, they are not earning
an economic profit like this firm. The existence of economic
profit lures them in to the market to produce, in this
case, an identical product.
Similarly, negative economic profit (i.e., an economic
loss) indicates that a firm's accounting profit falls short
of its opportunity cost. We saw that such losses will, sooner
or later (cæteris paribus), induce firms to
shut down. The existence of economic losses lures firms
out of the market for this product.
Economic profit thus plays a crucial role in free market
capitalism. Resource owners respond to the existence of
accounting profits in excess of opportunity cost by producing
more of those goods. They respond to the existence of economic
losses by producing less of those goods. No outside agency
is needed to order firms in to or out of the market. They
do so because it is in their self interest to produce more
or less of the good.
Let's explore the impact of firms entering or leaving this
perfectly competitive market.
Long-Run Competitive Equilibrium
Remember that when we built this model, we made the simplifying
assumption that the firms in this market all produced identical
products and faced identical costs -- essentially they are
clones. Figure 4 shows the model of a price-taking firm
and we will use the model of this firm as representing all
the firms in the market. As always, this firm chooses a
profit-maximizing level of output of about 27.5 units per
period, charging the market-set price of $150 per unit.
Note that this firm is earning zero economic profits. (Do
you know how the graph reveals this?)
Suppose market price falls to about $121 per unit. This
firm will reduce its profit-maximizing level of output to
about 21 units per period. Because of the drop in price,
even though it is maximizing economic profit, the firm faces
an economic loss in the short run as shown by the shaded
rectangle in Figure 5 marked P(Q)
This economic loss indicates that the firm's accounting
profit falls short of its opportunity cost. In the short
run it may minimize it losses by staying open and praying
for an increase in market price. But economic losses will,
sooner or later (cæteris paribus), induce firms
like this one to shut down. The existence of economic
losses lures firms out of the market for this product.
In the long run, with fewer sellers in the market, the market
supply curve shifts to the left (remember the N in SP-PENT).
This raises equilibrium price. As the price charged by the
firm rises, so does its profit-maximizing output and, because
ATC is falling here as q increases, economic losses diminish.
This process continues until no firm in the industry is
facing an economic loss. At that point price will have returned
to $125 per unit, and this firm's output will have returned
to about 27.5 units per period. Its economic profit will
once again be zero.
The same sort of story can be told, in reverse, if price
rises to about $175 per unit. (I'll leave the story telling
to you in the Questions listed below.)
Now it's time to
"do the thing".
Click on the following link
to download the Competitive
Product Market Workbook. Look
over Questions 1 - 4. Answer those
parts you are able with the information you
learned in this part of Tutorial 9. You will
answer the remaining parts of those questions
after reading the last part of this Tutorial.
Return here when you have finished.
downloading the Excel file?
Now that we have looked at how a single firm is affected
by changes in market price in the short run and in the long
run, let's review the market side of things.