Lecture 6

ECON1010
Introductory
Microeconomics

David Ricardo (1772-1823):

The Law of Diminishing Returns
On the Principles of
Political Economy and
Taxation;

Essay on the Influence of

a Low Price of Corn on the
Profits of Stock;

The Law of Supply Revisited

MC

ATC
AVC

The Law of Supply Revisited

Output rule: Firms choose the level of
production such that MC=P (PROFIT
MAXIMIZATION);
Short-run Shutdown rule: firms shutdown
operations if P<AVC;
Profitability and long-run analysis.

Questions

Profitability
MC

ATC

P =10
Profit = 250 150
= 100
ATC=6
Total Cost = 25 x 6 =
150
Q = 25

Individual Seller/ Market S and D

p

Individual

Market

MC

S
ATC

p*

D
q*

Q*

Long Run Perfect Competition

Short-run Competition:

Individual Seller vs- Market Supply; (Infinitely) Many

sellers (price takers)

Individual Buyer vs- Market Demand - (Infinitely)

Many buyers (price takers)

Homogeneous good

Long Run competition:

No barriers to entry/exit for firms

There may be fixed costs of production, but no barriers in terms of

information, technology/knowledge adoption, or costs associated
with entry or exit

The function of price in the longrun

Short-run Competition:

If price is at its equilibrium then we have market

clearing;

Price has a rationing function (distribute a scarce

good among potential claimants);

Long Run competition:

If price is at its equilibrium then there are no profits to

be made;

In this case the price has an allocative function (it

directs resources towards sectors with higher
profitability!)

Individual seller vs the Market

Example: 10 Sellers, each with supply q = 2p

Market supply:
Q = 10(2p) = 20p
Sum of individual supply curves.
Where does each individual supply curve come
from?

Individual seller: q = 2p
p

Market

P=10

q = 2p

S= 20p

P=4

P=4

q=8

Individual buyer vs the Market

Example: 20 buyers, each with demand q = 10 p

Market demand:
Q = 20(10 - p) = 200 20p
Sum of individual demand curves.
Where does each individual demand curve come
from?

Individual buyer: q = 10 - p
p

P=10

P=10

Market

q = 10-p

P=4

P=4

S
D
q=6

120

200

Short run equilibrium and profits

There are 3 possible cases:

1. P>ATC: positive profits;
2. P=ATC: zero profits;
3. P<ATC: negative profits;

Case 1: Profit is positive since P > ATC

Individual Firm

Market

MC

S
ATC

p*
ATC
D
q*

Q*

Case 2: Profit is zero since P = ATC

Individual Firm

Market

MC

S
ATC

p*=ATC

D
q*

Q*

Case 3: Profit is negative since P < ATC

Individual Firm

Market

MC

S
ATC

ATC
p*

D
q*

Q*

Questions

Long Run Perfect Competition

1. Firms can change all inputs (also fixed assets). All costs are
variable costs.
2. Free entry and exit of firms (at no cost).
3. All firms can copy technology freely (they all use the same
technology).
Implications:
All firms will use the same cost minimising technology,
and economic profits will be driven to zero.
A Long run competitive equilibrium (LRCE) is a competitive
Equilibrium where firms profit is zero (P = ATC).

Long Run Competitive

Equilibrium with U-Shaped ATC
The quantity supplied is chosen such that:
1. P=MC (Profit maximization, firms motivation);
2. P=ATC (Zero profit, long-run market outcome);
1 and 2 together imply that each seller chooses q such
that: MC=ATC;
In other words they produce the quantity which minimizes
ATC! This is optimal in aggregate (though firms would
like to make positive profits and seek for it explicitly)

Adam Smith invisible hand

The invisible hand is the
metaphor used to describe
the self-regulating behaviour
of competitive markets.
Even if individual seek for
surplus maximization
(profits) for their own good,
the outcome of the market
will benefit society.
This is true even if the
individuals have no
benevolent intentions (i.e.
their aim is to maximize
their individual suprlus, not
the surplus of society).

Describing a Long Run Competitive

Equilibrium:
p

Individual Seller

MC

Market
S

AC

p*

D
q*

Q*

How firms respond to profits

and losses?
For example, assume a demand shift due to population
growth.
What happens to the long run equilibrium and to the firm
profits?

Demand curve shifts out due to

Population Growth
p

One Seller

MC

Market
S

AC

p*
DN

D
q*

Q*

Short run effects

In the short run a shift of the demand curve (with

a fixed supply curve) will increase the short run
equilibrium price and quantity.
This will create positive profits for the firms!

Short run effects: P , q ,Q , profit

p

One Seller

MC

Market
S

AC
pN
p*
DN

D
q* q

Q*

QN

Long Run Effects

The positive profits are a strong
incentive for new firms to enter the
market (information, entry costs,
technology/knowledge).
This will shift the market supply curve
to the right (out) while the number of
supplier on the market increases.
Profit will fall back to zero.

Long Run Effects

p

One Seller

MC

Market
S
SN

AC

p*

D
q*

Q*

QN Q

DN

New long run competitive

equilibrium
Profits are zero;
Supply satisfy the new demand;
PRICE IS THE SAME! (ATC=P) WHY?
All changes are absorbed into a
quantity effect (rising consumption);
IMPLICATION: the long run supply curve
is perfectly elastic!

Long run supply curve is

perfectly elastic
p

Market

P=ATC

S
D
Q*

QN Q

DN

How firms respond to profits

and losses?
For example, assume a demand shift due to a reduction
in the price of a substitute.
What happens to the long run equilibrium and to the firms
profits?

Demand curve shifts to the left due to

cross-price elasticity
p

One Seller

MC

Market
S

AC

p*
D

q*

Q* Q

Demand curve shifts left due to

cross-price elasticity
p

One Seller

MC

Market
S

AC

p*

q*

D
Q*

Demand curve shifts to the left due to

cross-price elasticity
p

One Seller

MC

Market

S
S

AC

p*
D

q*

Q*

Long run supply curve is perfectly

elastic
p

Market

P=ATC

S
D
Q*

QN Q

DN

How firms respond to profits

and losses?
For example, assume that a new technology reduces the
average cost of production at the firm level.
What happens to the long run equilibrium and to the firms
profits?

Change in costs
p

One Seller

MC

Market
S

AC

p*
D

q*

Q* Q

Change in costs
p

One Seller

MC

Market
S

AC

p*
D

q*

Q* Q

Change in costs
p

One Seller

MC

Market
S

AC

p*
D

q*

Q*

Long run supply curve is perfectly elastic: the cost

saving benefit of technology improvement is passed to
the consumers!!!

Market

P*=ATC

P=ATC

D
Q*

QN

Long Run Summary

In the long run (with free entry), the supply curve for the
market is perfectly elastic.
Long run response to an increase in demand is to have
new entrants. However, each new entrant produces
the q where ATC = MC.
In the long run burden of tax falls on Buyers only
(perfectly elastic supply)
Cost reducing innovations are passed onto the
consumers as well.