1.7 Supply Flashcards
What questions required for profit maximisation?
Output decision - if firm produces, what output maximises profits
Shutdown decision - is it more profitable to produce q* or to shut down and produce no output
A firm will choose q such that profits are maximised
When are profits maximised
When marginal profit is 0, since it is not falling or rising - illustrated on page 21
Profit is a function of revenues and cost:
pi(q) = R(q) - C(q)
We can rewrite this as marginal profit condition:
d(pi)/dq = dR(q)/dq - dC(q)/dc = 0
Where those are marginal revenue and marginal cost^^
So at q*, MR(q) = MC(q)
When would a firm shutdown?
Only produces q* if it makes more profits at q* than at q=0 (shutdown)
If it shutdown it would make a loss equal to its fixed costs
Firms only shutdown if revenues < variable costs
What is perfect competition? What does this imply for MR?
Under perfect competition, both buyers and sellers are price takers. They cannot influence market prices and have to trade at current prices
If a firm charged higher price, sells nothing as consumers buy from competitors
Also makes no sense to sell at lower price as firms can sell as much as they want at market price
Price taking implies MR = p
r(q) = pxq
If p is constant, dR(q)/dq = p
What makes firms likely to be price takers?
-Large number of firms: decisions matter less
- Homogenous product - similar substitutes
- Full information - full knowledge of prices and quality for consumers
- Negligible transaction costs - waste little money/time finding each other so get best deal
- No barriers to entry/exit - large number of firms promoting price taking
Examples of perfect competition:
Stock markets, agriculture, commodities, construction, many service markets
(ALMOST PERFECT!!!!!!)
How do you calculate profits of a perfectly competitive market?
MR(q) = p so they expand until MC(q*) = p
Profits at q* are therefore
pi(q) = pq - C(q) = q(p - (cq)/q)
= q* (p - AC(q*))
What are the different types of proft?
If p = AC(Q*) firm earns normal profits
if p > AC(Q*) firm earns supernormal profits
if p < AC(Q*) firm earns subnormal profits
(Illustrated on page 21)
What profit level does a perfectly competitive firm produce at in the short run?
In the short run, a perfectly competitive firm produces where MC(q) = p but only if p => AVC(q)
What is the short run supply curve?
The relationship between price and quantity firm produces (=MC curve above the minimum AVC)
It is the horizontal sum of the supply curves of all individual firms
- In short run number of firms in a market, n, is fixed
- Assume identical firms - the more firms, the flatter the market supply curve at a given price - illustrated page 21
The short run equilibrium is where short run supply = demand
Note if there are n firms and q produced at equilibrium, since they are identical each firm produces q/n output
What is long run profit maximisation
In the long run firms either decide what output to maximise profit or if it is more profitable to produce q* or shutdown and produce no output
The key difference is that there are no fixed costs - makes shutdown decision easier, as they shut down if revenue is smaller than the cost at q*
Output decision is the same as before - expand until MC = price
What is/ how do you illustrate a long run firm supply curve?
How is it different from the short run?
It is the horizontal sum of individual firm supply curves (as in SR) - however in the long run firms can enter or exit the market so the number of firms is not fixed (illustrated page 22)
Long run marginal cost curve above minimum of long run average cost curve
The short run supply is based on the short run marginal costs
Supply in the short run = SRMC above SRAVC, not SRAC
Profits never lower in the long run
Why would firms enter/exit in the long run
Entry:
Market price > ATC => supernormal profits
Exit:
Market price < ATC => losses so exit
LR market supply shows the relationship between price and quantity supplied after allowing for entry and exit.
What are constant cost markets?
When input prices are constant as firms enter and exit
They assume free entry and identical firms
(illustrated page 22)
What happens if firms enter the constant cost markets?
Firms enter causing SR market supply to increase
- Market price falls
- Cost curves do not change because costs are constant
Process continues until market price = original MR/AR
What are the properties of LR supply
The relationship between market price and market quantity supplied after allowing for entry and exit
i.e. focus of LR equilibrium points traced out by changes in market demand
With identical firms/constant cost markets, the LR market supply if flat
- If firms differ the long run market supply curve can be upward
e.g. some farmers are lower cost producers than others
- May also be upward sloping if entry/exit affects input prices
How does a change in SR supply affect input prices?
-Constant cost market - rising supply doesnt affect price of inputs e.g. dentists
Increasing cost market - increase in supply increases input prices if industry is important source of input demand e.g. jet engines
Decreasing cost market - increase in supply lowers input prices due to scale effects e.g. computer industry and electronic components
What is an increasing cost market?
-Input prices increase as firms enter
LR market supply curve is upward sloping even with free entry and identical firms
Suppose LR equilibrium is at e1
If D increases, in SR firms will make supernormal profits
In LR the number of firms increases to n2, demand for inputs increase so input prices rise, costs shift up and new equilibrium at e2
Illustrated on page 22
What shifts demand, PED, supply and PES?
Demand:
PASIFIC
PED:
SPLAT
Supply:
PINTS WC
PES:
TRIBES
How is producer/consumer surplus illustrated in perfect competition?
Bottom of page 22
Welfare W = CS + PS
Distribution between CS and PS and among individual firms and consumers
What is producer surplus
Amount good sold for and minimumm amount necessary for selling to be willing to produce
The minimum amount is the avoidable production cost - measures the gains to a firm from participating in a market
What is deadweight loss?
If you produce more or less than the competitive output welfare is lower, creating “deadweight loss”
This arises because consumers willingness to pay is higher than the marginal cost of production.
If produce more cost of additional output > consumers willingness to pay
Perfect competition maximises welfare becasue at equilibrium, willigness to pay is equal to the marginal cost (p=MC)
How do taxes effect markets?
Taxes:
- Ad valorem percentage of the value of the good taxed e.g. VAT
- Specific/unit tax
Must distinguish between statutory and economic incidence of tax:
Statutory - who is responsible to pay the tax
Economic - what is the change in the distribution of income from the tax
On suppliers:
Incidence of tax very easy - just use supply/demand, supply falls due to tax and show effects on consumers surplus.
Remember tax is the rectangular area between producer and consumer, and deadweight loss is the triangle lost.
On buyers:
Consumers pay unit tax, demand falls and price falls.
Firms only get the lower price but consumers pay more. Effective prices received by firms and paid by consumers are same as before. Welfare effects also the same
What does the effect of tax depend on?
Incidence depends on price elasticity of supply and demand
If supply more elastic, consumer bears more of a tax burden
If demand more elastic, producers bear more of the tax burden
