Last chapter we looked at production costs. In next two chapters, we look at the interaction of prices, profits and production for two groups of firms:
PRICE TAKERS - Firms that must take/accept the market price, no control over setting price. Markets where:
1. Homogeneous, identical products: steel, oil, gold,
beef, milk, wheat, eggs, etc.
2. Many small firms whose output is small relative to
the market: e.g. wheat farms.
3. Sellers/producers can sell all output at the market
price, but cannot sell at a price above market price. No pricing
decision.
4. Horizontal demand curve.
5. No barriers to entering the market/industry.
Easy to get into the business.
PRICE SEARCHERS (next chapter) -
1. Downward sloping demand curve.
2. Products are not identical.
3. Firms may or may not be small relative to the market.
4. Firm faces a pricing decision, know that if it raises
(lowers) prices, it will sell less (more).
Examples: Nike, GM, Coke, Disney, Mars, etc.
Most firms are price searchers. Why study price-takers? Price taker markets are also known as "perfectly competitive markets" or markets with "pure or perfect competition."
Perfectly competitive markets: large numbers of small firms producing an identical, homogeneous product. "No brand names/no advertising" e.g. farms. No barriers to entry/exit.
Barriers to entry: obstacles to entering and competing in a market/industry.
See page 212. Market prices are determined by market
forces in the overall, world market for corn, soybeans, wheat, beef, etc.(Panel
a) The individual firm/farm then faces a horizontal demand curve
(panel b). If the price of wheat is $5/bu, the wheat farmer can sell
their entire crop at $5, but would find no buyers at $5.01. Farmer
is a "price taker" and his/her output decision cannot influence the market
price because their output is so small relative to the overall market.
OUTPUT IN THE SR
Firm's output decision is based on comparing Benefits (additional revenue, MR) vs. Costs of additional units of output (MC).
MR = d Total Revenue / d Output = d TR/ dQ
Due to the Law of Diminishing Marginal Returns, MC will eventually rise, so will ATC. In the SR, profit-maximizing Price Taker will expand output as long as MR > MC, and will stop when MR=MC. Beyond that level of output, MC > MR and firm would lose money on those units.
RULE: PRODUCE UNTIL MR = MC TO MAX PROFITS (MIN LOSSES).
See page 213. D = P = MR. If market price is $5/bu, that is the firm's Price, and also is the firm's MR, since each additional bu generates $5/bu in revenue. Firm would continue producing to Output level "q" to maximize profits.
TR($) = (P x q) = OPBq = Rectangle area for Total Revenue.
Remember that: ATC = TC / q, therefore TC = ATC x q. (Average total cost per unit ($) x the number of units (q)).
TC = C x q = OCAq = Rectangle area for Total Cost.
TR ($) - TC($) = Profits ($) = Rectangle area CPBA
Entrepreneur probably doesn't make decisions based on considering MR and MC curves, ATC curves, etc., but follows this process intuitively. To Max Profits, you want to sell output where the Price > Costs of Production, you don't want to sell units where the Cost > Price. Without formal understanding of economics, the entrepreneur follows economic principles - "organized common sense." Music example.
PROFIT MAX - EXAMPLE, see page 214.
At 1-10 units of output, and when Q > 20 profits are negative,
in both cases P < ATC. Between 11-19 units, profits are positive.
Profits are maximized when Q = 15, which is when MR = MC approx.
When Q > 15 MC > MC and profits fall. See graphs page 217.
LOSSES and GOING OUT OF BUSINESS
Firm should always produce where MR = MC, to either MAX profits or MIN loss. Profits/loss involve comparing ATC v P. What if firm is producing where MR = MC, but P < ATC, so that firm is losing money? See page 218. What to do?
1. Continue to operate in SR.
2. Shut down temporarily.
3. Shut down permanently (go out of business).
If the situation is permanent (P < ATC), firm should go out of business, since there is no possibility that the firm will ever make money. If the firm expects that eventually P > ATC, then they have to decide whether to operate in SR or shut down in SR. That decision is based on comparing P v AVC. Can the firm at least cover its average variable costs? If the firm can cover its variable costs (P > AVC or TR > VC), then it makes sense to operate in SR, since it can make some money to cover FC (fixed costs). If P < AVC (TR < VC), then the firm is better off shutting down in the SR, since it will lose more money by operating than by shutting down.
Example: restaurant near GM plant. Fixed costs are $1000/month (rent, etc.) or $250/week and variable costs are $500/week (labor, food, electricity, etc.). UAW goes on strike, business drops dramatically from $1000/wk down to???. Should the restaurant operate during the strike or shutdown? Depends on Revenue vs. VC of $500. If they can generate $600 in sales, then they should stay open, since $600 > $500, then make $100 contribution towards FC ($250/week), loss = - $150/week (TR = $600, TC = $500 VC + $250 FC).
But if the firm can only generate $400/week in sales, then it should shut down since $400 < $500, it can't even cover its variable costs. It will lose even more money by operating (-$350) than by not operating (-$250).
In fact, several restaurants, bars, sandwich shops near GM plants did shut down during the strike last summer (1998).
If they never expected TR > $3000 per month ($1000 FC
+ $2000 VC), then they should shut down permanently. They can avoid
FC by shutting down.
OUTPUT IN THE LONG RUN (LR)
In the LR, firm can make major changes (expansion or contraction) in output. New firms can enter, existing firms can exit.
Price taker market in LR equilibrium:
1. Qd = Qs = Market Price
2. Economic profits = 0. (P = ATC)
Why? Positive Economic Profits attract entry (P > ATC). Positive economic profits mean abnormally high risk-adjusted returns. Firms increase production, or new firms enter, Supply increases, P falls back to ATC.
Negative economic profits, P < ATC. Firms exit industry and/or contract production, Supply falls, Upward pressure on Price. P rises to ATC, normal profits are restored. See page 221.
"Rate-of-return Equalization Principle." Highly profitable industries attract entry, increased competition, normal returns in LR. Unprofitable industries, firms exit, normal profitability is restored in LR.
INCREASE IN DEMAND, see page 222.
Demand increases from D1 to D2 in market, from d1 to d2 for price-taking firm, market price rises from P1 to P2 in both markets. Firm make economic profits, since P2 > ATC. Profits attract entry and firm expands output to take advantage of high profits, Supply shifts from S1 to S2. Market price returns to P1. Short run profits are eliminated.
DECREASE IN DEMAND, see page 223.
Demand falls from D1 to D2 in market, from d1 to d2 for
firm, price falls from P1 to P2. Price is now < ATC, firms lose
money. Firms cut back on production, others go out of business.
Supply shifts back from S1 to S2, and Price goes back up to P1 from P2.
Short run losses are eliminated.
LR SUPPLY
Long-run Market Supply curve shows the minimum price at which firms will supply output, given enough time to adjust to market conditions. Shows the cost of production as the entire industry's output changes. Three possibilities:
1. Constant-cost industries. Input prices, resource prices, factor prices remain constant at output is expanded or contracted. LR Supply curve would be horizontal, perfectly elastic. In both cases on pages 222 and 223 the LR supply curve was perfectly elastic, indicating a constant-cost industry.
Example: industry where the resources used are very small relative to the entire supply/demand for these resources. Match industry - the demand for wood in the match industry is small relative to the entire market for wood, so that if the output of matches doubled, there would not be any upward pressure on prices for wood.
Probably not realistic for most industries/resources.
2. Increasing-cost industries. More realistic. As industry expands, the demand for inputs/resources/raw materials increases, which puts upward pressure on resource prices as prices for materials get bid up. Rising prices for resources means that the industry is one with increasing-costs. Upward sloping supply curve.
Example: Demand for new houses rises, due to population increases, low interest rates, rising income, changes in tax laws, etc. More homes are built, but resources for houses have to be bid away from other uses for wood, labor, supplies, etc. The cost of supplying housing will rise.
See page 226. D1 to D2 in market, d1 to d2 for firm, price goes from P1 to P2. P is initially > ATC, Supply increases from S1 to S2. New long-run equilibrium is established. Supply in LR is now upward sloping, reflecting increasing costs of production in the industry.
3. Decreasing cost industry. Industry where
input costs decline as output expands. Atypical. Could happen
if expanded production lowers component prices, e.g. electronic industry.
Supply curve would slope downward.
SUPPLY ELASTICITY and TIME
See page 227. Suppose market P rises from P1 to
P2. Firm will expand output from Q1 to Q2 initially. Over time,
firm will gradually adjust to higher price, by expanding output gradually
to Q3, Q4, Q5. Why not expand right away? Might be too costly,
"cost penalty" for immediate increases in output. Might take time
to find new sources of inputs/raw material, best sources of capital (credit
card vs. bank loan), new employees (vs overtime), etc. Supply curve
is more elastic over time, as firms can adjust to higher levels of output.
PROFITS and LOSSES
Profits and losses are signals to producers from consumers, about how well they are doing at pleasing consumers, creating value for consumers. Profits are rewards to successful producers for creating value, losses are penalties to firms that are unsuccessful at pleasing consumers. Profit/loss system is a very effective disciplining system, rewarding success, efficiency, value, service in the market and penalizing inefficiency, poor service, low value in the market. Successful firms are rewarded with profits, and they attract resources to expand. Unsuccessful firms face the discipline of the market, they are forced to operate more efficiently, serve customers more effectively, create more consumer value, or they will be forced out of business. Market system of Profits and Losses stimulates a continual reallocation of resources, away from unsuccessful, inefficient firms towards successful, efficient firms. Success = pleasing consumers. "Consumer sovereignty." " Incentives matter."
Example: Videotape rental market. Market
with low barriers to entry. In 1982, market was new, there
were
only 5000 stores in US, prices were $5/day. Profits were very high
in the videotape rental market, attracting entry, increasing supply to
25,000 stores in 1990. Prices came down to $1-2/night, due to intense
competition. Producers responded to the consumer preferences, profits
attracted resources to an expanding industry. Consumers were served
by the producers. Profits in the LR were restored to normal level.
Some firms have left the industry, it was so competitive.
PRICE TAKERS AND PROSPERITY
1. Price takers have no control over price, they have to take the market price. They can control costs, there is a strong incentive to reduce costs of production, operate more efficiently. Eggs - costs of production have been reduced by 80% over time.
2. Firms face the competitive pressure of the market -
forces them to be serve consumers, operate at maximum efficiency - or they
go out of business. Invisible hand - Adam Smith. See quote
page 230.