1.4: Perfect Competition: Long Run

# 1.4: Perfect Competition: Long Run
## ECON 326 · Industrial Organization · Spring 2020
### Ryan Safner Assistant Professor of Economics <a href="mailto:safner@hood.edu"> safner@hood.edu</a> <a href="https://github.com/ryansafner/IOs20"> ryansafner/IOs20</a> <a href="https://IOs20.classes.ryansafner.com"> IOs20.classes.ryansafner.com</a>

---

# Firm's *Long Run* Supply Decisions

---

# Firm Decisions in the Long Run I

]

- `$AC(q)_{min}$` at a market price of $6

- At $6, the firm earns .hi["normal economic profits"]

- At any market price *below* $6.00, firm earns **losses**
 - Short Run: firm shuts down if `$p<AVC(q)$`

- At any market price *above* $6.00, firm earns .hi["supernormal profits"]

]

---

# Firm Supply Decisions in the Short Run vs. Long Run

.pull-left[
- .hi-purple[Short run]: firms that shut down `$(q^*=0)$` stuck in market, incur fixed costs `$\pi=-f$`
]

---

# Firm Supply Decisions in the Short Run vs. Long Run

.pull-left[
- .hi-purple[Short run]: firms that shut down `$(q^*=0)$` stuck in market, incur fixed costs `$\pi=-f$`

- .hi-purple[Long run]: firms earning losses `$(\pi < 0)$` can .hi[exit] the market and earn `$\pi=0$`
 - No more fixed costs, firms can sell/abandon `$f$` at `$q^*=0$`
]

.pull-right[
.center[
![](https://www.dropbox.com/s/ut01gm60urzbmtl/goingoutofbusiness.jpg?raw=1)
]
]

---

# Firm Supply Decisions in the Short Run vs. Long Run

.pull-left[
- .hi-purple[Short run]: firms that shut down `$(q^*=0)$` stuck in market, incur fixed costs `$\pi=-f$`

- .hi-purple[Long run]: firms earning losses `$(\pi < 0)$` can .hi[exit] the market and earn `$\pi=0$`
 - No more fixed costs, firms can sell/abandon `$f$` at `$q^*=0$`

- Entrepreneurs not *currently* in market can .hi[enter] and produce, if entry would earn them `$\pi>0$`
]

![:scale 75%](https://www.dropbox.com/s/20ghw4p6te0776x/entry.jpg?raw=1)
]
]

---

# Firm's Long Run Supply: Visualizing

<img src="1.4-slides_files/figure-html/unnamed-chunk-2-1.png" width="504" style="display: block; margin: auto;" />
]

- Profits are negative

- .hi-purple[Short run]: **shut down** production
  - Firm loses more `$\pi$` by producing than by not producing

- .hi-purple[Long run]: firms in industry **exit** the industry
  - *No* new firms will *enter* this industry
]

---

# Firm's Long Run Supply: Visualizing

<img src="1.4-slides_files/figure-html/unnamed-chunk-3-1.png" width="504" style="display: block; margin: auto;" />
]

- Profits are negative

- .hi-purple[Short run]: **continue** production
  - Firm loses *less* `$\pi$` by producing than by *not* producing

- .hi-purple[Long run]: firms in industry **exit** the industry
  - *No* new firms will *enter* this industry
]

---

# Firm's Long Run Supply: Visualizing

<img src="1.4-slides_files/figure-html/unnamed-chunk-4-1.png" width="504" style="display: block; margin: auto;" />
]

- Profits are positive

- .hi-purple[Short run]: **continue** production
  - Firm earn profits

- .hi-purple[Long run]: firms in industry **stay** in industry
  - **New** new firms will **enter** this industry
]

---

# Market Entry and Exit

---

# Exit, Entry, and Long Run Industry Equilibrium I

- Now we must combine optimizing *individual* firms with *market-wide* adjustment to equilibrium

- Since `$\pi = [p-AC(q)]q$`, in the **long run**, profit-seeking firms will:
]

---

# Exit, Entry, and Long Run Industry Equilibrium I

- Now we must combine optimizing *individual* firms with *market-wide* adjustment to equilibrium

- Since `$\pi = [p-AC(q)]q$`, in the **long run**, profit-seeking firms will:
  - **Enter** markets where `$p>AC(q)$`
]

---

# Exit, Entry, and Long Run Industry Equilibrium I

- Now we must combine optimizing *individual* firms with *market-wide* adjustment to equilibrium

- Since `$\pi = [p-AC(q)]q$`, in the **long run**, profit-seeking firms will:
 - **Enter** markets where `$p>AC(q)$`
 - **Exit** markets where `$p<AC(q)$`
]

![](https://www.dropbox.com/s/ut01gm60urzbmtl/goingoutofbusiness.jpg?raw=1)
]
]

---

# Exit, Entry, and Long Run Industry Equilibrium II

- .hi-purple[Long-run equilibrium]: entry and exit ceases when .hi-purple[`\$p=AC(q)\$`] for all firms, implying .hi-purple[normal economic profits] of .hi-purple[`\$\pi=0\$`]

]

.pull-right[
.center[
![:scale 100%](https://www.dropbox.com/s/g0cbarnhq81wl8e/breakeven.jpg?raw=1)
]
]

---

# Exit, Entry, and Long Run Industry Equilibrium II

- .hi-purple[Long-run equilibrium]: entry and exit ceases when .hi-purple[`\$p=AC(q)\$`] for all firms, implying .hi-purple[normal economic profits] of .hi-purple[`\$\pi=0\$`]

- .hi-purple[Zero Profits Theorem]: **long run economic profits for all firms in a _competitive_ industry are 0**

- Firms must earn an *accounting* profit to stay in business

]

]
]

---

# The Industry Supply Curve

- .hi[Industry supply curve]: sum of all individual firms' supply curves `$(MC(q)$` curve above `$AVC_{min})$`

- To keep it simple on the following slides:
  - assume no fixed costs, so `$AC(q)=AVC(q)$`
  - then industry supply curve is sum of individual `$MC(q)$` curves above `$AC(q)_{min}$`

---

# Industry Supply Curves (Identical Firms)

<img src="1.4-slides_files/figure-html/unnamed-chunk-5-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-6-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-7-1.png" width="504" style="display: block; margin: auto;" />

]

.smallest[
- .red[Industry supply curve] is the horizontal sum of all individual firm's supply curves
  - Which are each firm's marginal cost curve above its breakeven price
]

---

# Industry Supply Curves (Identical Firms)

<img src="1.4-slides_files/figure-html/unnamed-chunk-8-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-9-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-10-1.png" width="504" style="display: block; margin: auto;" />

]

.smallest[
- .blue[Industry demand curve] (where equal to supply) sets market price, demand for firms
]

---

# Industry Supply Curves (Identical Firms)

<img src="1.4-slides_files/figure-html/unnamed-chunk-11-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-12-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-13-1.png" width="504" style="display: block; margin: auto;" />

]

- **Short Run**: each firm is earning .hi-green[profits] `$p>AC(q)$`

- **Long run**: induces entry by firm 3, firm 4, `$\cdots$`, firm `$n$`
]
--
.smallest[
- .hi[Long run industry equilibrium]:
]
---

# Industry Supply Curves (Identical Firms)

<img src="1.4-slides_files/figure-html/unnamed-chunk-14-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-15-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-16-1.png" width="504" style="display: block; margin: auto;" />

]

- **Long run**: induces entry by firm 3, firm 4, `$\cdots$`, firm `$n$`

- .hi[Long run industry equilibrium]: `$p=AC(q)_{min}$`, `$\pi=0$` at `$p=$` $6; supply becomes more **elastic**
]
---

# Zero Profit Theorem & Economic Rents

---

# Back to Zero Profits

.pull-left[
- Recall, we've defined a .hi-purple[firm] as a completely .hi[replicable recipe] (.hi[production function]) of resources

- **Anyone** can enter market, buy required factors, and produce `$q^*$` at market price `$p$` and earn the market rate of `$\pi$`

- Let's *start* considering some realistic differences between firms
]

.pull-right[
.center[
![:scale 70%](https://www.dropbox.com/s/zu2c5ijzqvz5sbh/inputoutput.png?raw=1)
]
]

---

# Industry Supply Curves (*Different* Firms) I

.pull-left[
- Firms may have **different costs** due to differences in:
  - Managerial talent
  - Worker talent
  - Location
  - First-mover advantage
  - Technological secrets/IP
  - License/permit access
  - Political connections
  - Lobbying
]

---

# Industry Supply Curves (*Different* Firms) II

<img src="1.4-slides_files/figure-html/unnamed-chunk-17-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-18-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-19-1.png" width="504" style="display: block; margin: auto;" />

]

- .red[Industry supply curve] is the horizontal sum of all individual firm's supply curves
  - Which are each firm's marginal cost curve above its breakeven price

---

# Industry Supply Curves (*Different* Firms) II

<img src="1.4-slides_files/figure-html/unnamed-chunk-20-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-middle[
<img src="1.4-slides_files/figure-html/unnamed-chunk-21-1.png" width="504" style="display: block; margin: auto;" />
]

.tri-right[
<img src="1.4-slides_files/figure-html/unnamed-chunk-22-1.png" width="504" style="display: block; margin: auto;" />

]

.smallest[
- .blue[Industry demand curve] (where equal to supply) sets market price, demand for firms
]
--

.smallest[
- .hi[Long run industry equilibrium]: `$p=AC(q)_{min}$`, `$\pi=0$` for .hi-purple[marginal (highest cost) firm] (Firm 2)
]

---

# Economic Rents and Zero Economic Profits I

.pull-left[
.center[
![:scale 80%](https://www.dropbox.com/s/rbskabbd2pri9zk/rentvictory.jpg?raw=1)
]
]

.pull-right[
- With differences between firms, .hi-purple[**long-run equilibrium** `\$p=AC(q)_{min}\$` of the _marginal (highest-cost)_ firm]
  - If `$p>AC(q)$` for that firm, would induce *more* entry into industry!

]

---

# Economic Rents and Zero Economic Profits I

.pull-left[
.center[
![:scale 80%](https://www.dropbox.com/s/rbskabbd2pri9zk/rentvictory.jpg?raw=1)
]
]

.pull-right[
- .hi-purple["Inframarginal" (lower-cost)] firms earn .hi[economic rents]
  - returns higher than their opportunity cost (what is needed to bring them into *this* industry)

- Economic rents arise from **relative differences** between firms
  - actually using *different* inputs!

]

---

# Economic Rents and Zero Economic Profits III

.pull-left[
.center[
![:scale 80%](https://www.dropbox.com/s/rbskabbd2pri9zk/rentvictory.jpg?raw=1)
]
]

.pull-right[
- .hi-purple[Some factors are relatively scarce _in the economy_]
  - (talent, location, secrets, IP, licenses, being first, political favoritism)

- **Inframarginal** firms that use these scarce factors gain a cost-*advantage*

- It would seem these firms earn profits as other firms have higher costs...
  - ...But what will happen to the prices for the scarce factors?

]

---

# Economic Rents and Zero Economic Profits IV

.pull-left[
.center[
![:scale 80%](https://www.dropbox.com/s/znztfyevfm2nhrd/jobsiphone.jpg?raw=1)
]
]

- Rival firms willing to pay for rent-generating factor to gain advantage

- Competition over acquiring the scarce factors push up their prices

- .hi-purple[Rents are included in the opportunity cost (price) for inputs]
  - Must pay a factor enough to keep it *out of other uses*

]

---

# Economic Rents and Zero Economic Profits IV

.pull-left[
.center[
![:scale 80%](https://www.dropbox.com/s/znztfyevfm2nhrd/jobsiphone.jpg?raw=1)
]
]

- Economic rents `$\neq$` profits!
  - Rents actually *reduce* profits!

- Firm does not earn the rents, they raise firm's costs and squeeze out profits!

- .hi-purple[Scarce factor owners] (workers, landowners, inventors, etc) .hi-purple[earn the rents as higher income for their scarce services] (wages, rents, interest, royalties, etc).

]

---

# Recall: Accounting vs. Economic Point of View

- Recall **"economic" point of view**:

- Producing *your* product pulls scarce resources *out of other productive uses* in the economy

- **Profits attract resources** to be pulled out of other uses

- **Losses repel resources** to be pulled away to other uses

- **Zero profits** `$\implies$` resources should stay where they are
  - Optimal use of resources!

]

![](https://www.dropbox.com/s/mb9yaadujqe38fj/disappear.jpg?raw=1)
]
]

---

# Welfare Effects of Perfect Competition

---

# Market-Clearing Prices

- Supply and demand set the market-clearing price for all units exchanged (bought and sold)

]

]

---

# Consumer Surplus I

- .hi-blue[Demand function] measures how much you would *hypothetically* be willing to pay for various quantities
  - "reservation price"

- You often *actually* pay (the market-clearing price, `$p^*)$` a lot less than your reservation price

- The difference is .hi[consumer surplus]

`$$CS=WTP-p^*$$`

]

]

---

# Consumer Surplus II

`$$\begin{align*}
CS&=\frac{1}{2}bh\\
CS&=\frac{1}{2}(5-0)(\$10-\$5)\\
CS&=\$12.50\\
\end{align*}$$`

]

]

---

# Producer Surplus I

- .hi-red[Supply function] measures how much you would *hypothetically* be willing to accept to sell various quantities
  - "reservation price"

- You often *actually* receive (the market-clearing price, `$p^*)$` a lot more than your reservation price

- The difference is .hi[producer surplus]

`$$PS=p^*-WTA$$`

]

]

---

# Market Efficiency in Competitive Equilibrium I

- .hi[Allocative efficiency]: resources are allocated to highest-valued uses
  - Goods produced up to the point where `$MB=MC$` `$(p=MC)$`

- All potential gains from trade are fully exhausted
]

]

---

# Market Efficiency in Competitive Equilibrium II

- .hi-purple[Economic surplus] = .blue[Consumer surplus] + .red[Producer surplus]

- Maximized in competitive equilibrium

- Resources flow away from those who value them the lowest to those that value them the highest

- .hi-purple[The social value of resources is **maximized** by allocating them to their highest valued uses!]

]

]