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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 same reason.

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.

 

Constant-Cost Industry Top of page.

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).

 

Figure 6


Graph showing how a decrease in market demand  can, in the long run, lead to a decrease in market supply as firms drop out of the industry.

 

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 buying inputs.

 

Increasing-Cost Industry Top of page.

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.

 

Figure 7


Graph showing how a decrease in market demand  can, in the long run, lead to a decrease in market supply as firms drop out of the industry, and an increase in market supply as the price of variable inputs falls.

 

Long-Run Market Supply Top of page.

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.

 

Figure 8


Graph showing the long-run market supply curve for a constant-cost industry.

 

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.

 

Figure 9


Graph showing the long-run market supply curve for an increasing-cost industry.

 

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 increasing-cost scenarios.

Return here when you have finished.

Need help downloading the Excel file?

 

This is a good time to do, or review, GFE 21.

 

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 generalization however.

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.