Tutorial 9: Firms With No Market Power (cont.)
The Market's Long-Run Supply Curve
First of all, remember how the market demand curve is derived?
In Tutorial 6d we
learned that the market demand curve is the horizontal sum
of the individual consumer's demand curves. In the previous
part of this Tutorial we learned that each firm in a
perfectly competitive market faces an upward sloping supply
curve that is equal to most of its marginal cost curve.
The market's short run supply curve, then, is the
horizontal sum of all the individual firm's supply (MC)
curves. Because the law of diminishing returns guarantees
that the firm's marginal cost curve is upward sloping, the
market supply curve will also be upward sloping for the
That means that any change in the cost of variable inputs
hired by the firm will not only alter its supply
(MC) curve, but will also alter the short-run market
supply curve. (See the Excel Workbook Question 3 below for
practice with this.) In addition to the price of variable
inputs, subsidies and taxes, the price of other goods the
firm could produce, expectations about what will happen
to the price of the good the firm produces, and technology
-- because they all affect either the cost of production
for a firm or its opportunity cost -- also alter the firm's
supply (MC) curve and, hence, the market's supply curve.
The number of sellers in a market is a key non-price determinant
of market supply that, of course, does not affect
the firm's marginal costs. That variable plays a crucial
role, however, in moving the market back toward equilibrium
in the long run. Let's see how.
In the example in part e
(see Figure 4) the firm faced a drop in market price. Let's
suppose that drop in price was the result of a drop in market
demand. Equilibrium price fell from about $150 to about
$121. When the number of sellers dropped as firms exited
the market, the short run market supply curve shifted leftward
until equilibrium price increased back to its original level
of about $150. Figure 6 illustrates these shifts first in
market demand (from D to D1) then in market supply (from
S to S1).
In the long run, this drop in demand for the good has not
altered the price of the product, but has resulted in fewer
firms around to produce it, and it has resulted in less
of the product being available on the market -- equilibrium
market quantity, Q*, has dropped from about 20,000 to about
10,000 units per period.
Now this example made one rather important simplification;
as firm's left the market nothing happened to the price
of inputs. A clear understanding of how markets operate
should have led one to expect that the price of inputs would
fall. Fewer sellers of products means fewer buyers of resources,
dropping the demand for resources, and pushing input prices
lower. To keep our initial analysis simple, we assumed the
firm operated in a constant-cost industry. In a constant-cost
industry, input supply curves are assumed to be perfectly
elastic at the current price for inputs. As a result, input
prices are unaffected by changes in the number of firms
A more realistic scenario assumes the firm operates in
an increasing-cost industry. In an increasing-cost
industry, input supply curves are assumed to be upward sloping.
As a result, input prices are affected by changes in the
number of firms buying inputs. In this example, as firms
dropped out of the market the short run market supply curve
shifted leftward. But with fewer sellers of products there
are fewer buyers of resources, dropping the demand for resources,
and pushing input prices lower. Lower prices for variable
inputs will drop the firm's marginal cost curve, shifting
the short-run market supply curve to the right. This reduces
the overall drop in market supply caused by firms exiting
the market. Figure 7 shows the effect. The drop in market
demand is illustrated by the leftward shift from D to D1.
Market supply has dropped from S to S1, but it is a smaller
drop than in the case illustrated in Figure 4. As a result,
equilibrium price does not rise all the way back to $150,
but stops at about $135 per unit.
Long-Run Market Supply
The case of a constant-cost industry is illustrated again
in Figure 8. At the beginning of the story the firm was
in long-run equilibrium -- it was earning a zero economic
profit -- market price was about $150 per unit, and about
20,000 units per time period. The long-run adjustment to
a drop in market demand once again left the firm with zero
economic profit, and resulted in no change in equilibrium
price, but a decrease in equilibrium quantity to about 10,000
units per period. Connecting the two long-run market equilibria
shows that the long-run market supply (LRS) for this
constant-cost industry is perfectly elastic.
The case of an increasing-cost industry is
illustrated again in Figure 9. At the beginning of the story
the firm was in long-run equilibrium -- it was earning a
zero economic profit -- market price was about $150 per
unit, and about 20,000 units per time period. The long-run
adjustment to a drop in market demand once again left the
firm with zero economic profit, but resulted in a slightly
lower equilibrium price (to about $135 per unit), and a
decrease in equilibrium quantity to about 13,000 units per
period. Connecting the two long-run market equilibria shows
that the long-run market supply (LRS) for this increasing-cost
industry is more elastic than the short run supply curves,
but not as elastic as in the constant cost case.
Now it's time to
"do the thing".
Click on the following link
to download the Competitive
Product Market Workbook. Work
through Questions 1 - 4. This will
help you improve your understanding of how
competitive markets respond to changes in
market conditions in both the short run and
the long run, under constant-input-cost and
Return here when you have finished.
downloading the Excel file?
Many of the principles developed in this Tutorial can be
applied to model any type of firm whose objective is to
maximize economic profit. There are two exceptions to this
First, the perfectly competitive firm faces a price set
by the market in which it produces. In the long run that
price is equal to both MC and ATC, hence it earns
zero economic profit. Most firms, however, have at least
some ability to set price permanently above MC, if not ATC.
Another exception is the existence of the firm's supply
curve. The perfectly competitive firm faces an upward-sloping
supply curve equal to most of its marginal cost curve. That's
because it takes price as given and responds to it when
it sets the profit-maximizing level of output. Firms that
have the ability to set a price above the marginal cost
of production do not respond to price, but determine both
quanitity and price simultaneously.
In Tutorial 10 we will model this type of firm. One that
has the ability to set a price rather than take it as given.
Next: Tutorial 10- Firms with